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CREDIT RATING AGENCIES AND THE NEXT

FINANCIAL CRISIS

HEARING

BEFORE THE

COMMITTEE ON OVERSIGHT

AND GOVERNMENT REFORM

HOUSE OF REPRESENTATIVES

ONE HUNDRED ELEVENTH CONGRESS

FIRST SESSION

SEPTEMBER 30, 2009

Serial No. 111–45

Printed for the use of the Committee on Oversight and Government Reform

(

Available via the World Wide Web: http://www.gpoaccess.gov/congress/index.html

http://www.house.gov/reform

(II)

COMMITTEE ON OVERSIGHT AND GOVERNMENT REFORM

EDOLPHUS TOWNS, New York, Chairman

PAUL E. KANJORSKI, Pennsylvania

CAROLYN B. MALONEY, New York

ELIJAH E. CUMMINGS, Maryland

DENNIS J. KUCINICH, Ohio

JOHN F. TIERNEY, Massachusetts

WM. LACY CLAY, Missouri

DIANE E. WATSON, California

STEPHEN F. LYNCH, Massachusetts

JIM COOPER, Tennessee

GERALD E. CONNOLLY, Virginia

MIKE QUIGLEY, Illinois

MARCY KAPTUR, Ohio

ELEANOR HOLMES NORTON, District of

Columbia

PATRICK J. KENNEDY, Rhode Island

DANNY K. DAVIS, Illinois

CHRIS VAN HOLLEN, Maryland

HENRY CUELLAR, Texas

PAUL W. HODES, New Hampshire

CHRISTOPHER S. MURPHY, Connecticut

PETER WELCH, Vermont

BILL FOSTER, Illinois

JACKIE SPEIER, California

STEVE DRIEHAUS, Ohio

JUDY CHU, California

DARRELL E. ISSA, California

DAN BURTON, Indiana

JOHN L. MICA, Florida

MARK E. SOUDER, Indiana

JOHN J. DUNCAN, JR., Tennessee

MICHAEL R. TURNER, Ohio

LYNN A. WESTMORELAND, Georgia

PATRICK T. MCHENRY, North Carolina

BRIAN P. BILBRAY, California

JIM JORDAN, Ohio

JEFF FLAKE, Arizona

JEFF FORTENBERRY, Nebraska

JASON CHAFFETZ, Utah

AARON SCHOCK, Illinois

BLAINE LUETKEMEYER, Missouri

ANH ‘‘JOSEPH’’ CAO, Louisiana

RON STROMAN, Staff Director

MICHAEL MCCARTHY, Deputy Staff Director

CARLA HULTBERG, Chief Clerk

LARRY BRADY, Minority Staff Director

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C O N T E N T S

Page

Hearing held on September 30, 2009 ..................................................................... 1

Statement of:

D’Amato, Hon. Alfonse M., former chairman, Senate Committee on Banking; Floyd Abrams, partner, Cahill Gordon & Reindel, LLP; Eric

Baggesen, senior investment officer, California Public Employees Retirement System; and Lawrence J. White, professor, Leonard N. Stern

School of Business, New York University ................................................... 70

Abrams, Floyd ............................................................................................ 93

Baggesen, Eric ........................................................................................... 105

D’Amato, Hon. Alfonse M. ........................................................................ 70

White, Lawrence J. .................................................................................... 115

Kolchinsky, Ilya Eric, former managing director, Moody’s Investors Service; Scott McCleskey, former senior vice president for compliance,

Moody’s Corp.; and Richard Cantor, chief risk officer, Moody’s Corp.,

and chief credit officer, Moody’s Investors Service .................................... 13

Cantor, Richard ......................................................................................... 20

Kolchinsky, Ilya Eric ................................................................................. 13

McCleskey, Scott ....................................................................................... 18

Letters, statements, etc., submitted for the record by:

Abrams, Floyd, partner, Cahill Gordon & Reindel, LLP, prepared statement of ........................................................................................................... 95

Baggesen, Eric, senior investment officer, California Public Employees

Retirement System, prepared statement of ................................................ 107

Cantor, Richard, chief risk officer, Moody’s Corp., and chief credit officer,

Moody’s Investors Service, prepared statement of ..................................... 22

D’Amato, Hon. Alfonse M., former chairman, Senate Committee on Banking:

Financial Economics Roundtable statement ........................................... 72

Prepared statement of ............................................................................... 89

Issa, Hon. Darrell E., a Representative in Congress from the State of

California, prepared statement of ................................................................ 10

Kolchinsky, Ilya Eric, former managing director, Moody’s Investors Service, prepared statement of ............................................................................ 15

Towns, Chairman Edolphus, a Representative in Congress from the State

of New York, prepared statement of ........................................................... 3

White, Lawrence J., professor, Leonard N. Stern School of Business,

New York University, prepared statement of ............................................. 117

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CREDIT RATING AGENCIES AND THE NEXT

FINANCIAL CRISIS

WEDNESDAY, SEPTEMBER 30, 2009

HOUSE OF REPRESENTATIVES,

COMMITTEE ON OVERSIGHT AND GOVERNMENT REFORM,

Washington, DC.

The committee met, pursuant to notice, at 10:01 a.m. in room

2154, Rayburn House Office Building, Hon. Edolphus Towns (chairman of the committee) presiding.

Present: Representatives Towns, Issa, Chaffetz, Clay, Connolly,

Cuellar, Cummings, Foster, Jordan, Kanjorski, Kaptur, Kucinich,

Luetkemeyer, Lynch, McHenry, Mica, Murphy, Norton, Quigley,

Souder, Speier, Tierney, and Welch.

Staff present: John Arlington, chief counsel—investigations;

Brian Eiler and Neema Guliani, investigative counsels; Linda

Good, deputy chief clerk; Jean Gosa, clerk; Katherine Graham, investigator; Adam Hodge, deputy press secretary; Carla Hultberg,

chief clerk; Phyllis Love, Ryshelle McCadney, and Alex Wolf, professional staff members; Mike McCarthy, deputy staff director;

Ophelia Rivas, assistant clerk; Jenny Rosenberg, director of communications; Ron Stroman, staff director; Lawrence Brady, minority staff director; Rob Borden, minority general counsel; Jennifer

Safavian, minority chief counsel for oversight and investigations;

Frederick Hill, minority director of communications; Adam Fromm,

minority chief clerk and Member liaison; Kurt Bardella, minority

press secretary; Benjamin Cole, minority deputy press secretary;

Christopher Hixon, minority senior counsel; Brien Beattie, minority

professional staff member.

Chairman TOWNS. The committee will come to order.

Today, the committee continues its investigation of the credit rating agencies, companies at the heart of the last financial collapse,

companies that will be at the heart of the next financial collapse.

The average American has probably never heard of credit rating

agencies, but these companies play a powerful role in our economy

and they played a starring role in the collapse of the financial system last year.

The main mission of credit rating agencies is to tell investors

how risky bonds and other debt securities are. Pension plans,

banks, insurance companies, and other investors depend on these

ratings to help them decide where to invest their funds.

Unfortunately, for the past decade, the credit rating system has

not worked well at all. A year ago, this committee learned that ratings did not capture the true risk of many deals because the rating

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agencies were more concerned with their own bottom line than

anything else.

As one rating agency official said in an internal e-mail, ‘‘We rate

every deal. It could be structured by a group of cows and we would

rate it.’’ The result was a marketplace flooded with toxic debt, socalled structured securities, such as CDOs and other complicated

securitizations backed by risk mortgages and propped up by inflated ratings.

More and more money was funneled into bonds and other debts

that were destined to fail. Predatory lending flourished, which families got in over their heads buying houses they could not afford.

Investors were left holding bonds and other securities that were

dramatically over-valued. When the housing bubble finally burst,

we wound up in the deepest recession since the Great Depression.

A year after the collapse of Lehman Brothers and the massive government bailout of AIG, Bank of America and others, it looks like

not much has really changed.

Today, we will hear testimony from Eric Kolchinsky, until recently an insider at Moody’s, one of the largest credit rating agencies. We have obtained a memo written by Mr. Kolchinsky to his

superiors at Moody’s detailing very serious allegations about

Moody’s rating practices. If true, these allegations indicate troubling behavior in the credit rating industry. According to Mr.

Kolchinsky, they continue to use inaccurate and outdated models.

They continue to have conflicts of interest, and they continue to

rate novel securities with little historical data that no one really

understands.

He was not alone in having concerns about the new way Moody’s

operates. We will also have testimony from Mr. Scott McCleskey

who was senior vice president of compliance at Moody’s, until he

rocked the boat too hard. Mr. McCleskey’s job was to ensure compliance with SEC regulations and other requirements. In theory, he

was a senior executive with important responsibilities. In practice,

he got the old mushroom treatment: keep him in the dark and bury

him in fertilizer.

In short, it looks like not much has changed since the crash of

2008. We ignore this situation at our peril. In the next financial

crisis, will the credit rating agencies be part of the problem or part

of the solution?

Both the House and the Senate are drafting legislation to rein

in these types of abusive practices by credit rating agencies. Our

second panel of witnesses will provide suggestions on how to accomplish this.

One other note, I would particularly like to thank my good

friend, Senator Alfonse D’Amato, the former chairman of the Senate Banking Committee, for being here today as well; also Floyd

Adams, another well known and highly regarded New Yorker.

And let me conclude by saying I look forward to hearing from the

witnesses.

At this time, I yield to the gentleman from California, Congressman Issa, the ranking member of this committee.

[The prepared statement of Chairman Edolphus Towns follows:]

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Mr. ISSA. Thank you, Mr. Chairman, and thank you for holding

this hearing today.

I strongly suspect that the gentleman from Pennsylvania to my

left, Mr. Kanjorski, would rightfully so say, aren’t we coming

dreadfully close to overstepping the bounds of this committee and

going into the territory well held by the Financial Services Committee.

And I would agree with him up to a point. I would differ with

him in one sense. Although the oversight of this party of the financial community clearly belongs to the Financial Services Committee, as does the SEC, transparency in government and transparency for the people who live under that government clearly falls

within the jurisdiction of this committee.

So as we review the failures in the financial crisis, I would say

to my friend, the gentleman from New York, that in fact this committee must look beyond the failures of the private sector in this

case, look to the public sector which we have direct jurisdiction

over, and essentially we have the power today, which we didn’t

have back in the 1930’s when the New Deal came about and in the

Depression, post-collapse era, the Federal Government began

outsourcing the oversight and regulation and rating of credit instruments.

Today, we have technology like XBRL and other standards which

we, the Federal Government, can insist allow for full transparency,

not by the select few that we dribble and drabble out the ability

to rate for pay, but in fact we have the ability today to insist that

every instrument made available to the American people can be

transparent to the American people directly.

We have the ability that instead of standing in line at your

broker, you can go online and look at every element of that. That

allows, of course, not every private citizen to necessarily do his own

analysis. They don’t do that on every stock or mutual fund. But it

does allow literally thousands of educated people to scrutinize credit products and, on a continuous basis, evaluate the underlying risk

that happens.

In my own State of California, it is very clear, if you bought a

bond 2 years ago, it is not the same bond it was today. You

shouldn’t have to wait for a credit agency to tell you California is

in a financial meltdown in order to see a daily change. And you

shouldn’t have to do it if it is G.E. paper or anyone else’s.

So I would hope to work with the chairman in insisting on a real

change in reporting, one that eliminates these credit agencies as

monopolies, duopolies, triopolies or whatever a quadopoly is, and in

fact opens it up to all the people of America.

Additionally, as I said, this committee has broad jurisdiction, and

I would hope that as the chairman said this morning on CNBC, we

would use it. I cannot agree more with the chairman for what he

said today. He said, ‘‘People are now suffering.’’ But Mr. Chairman,

why are they suffering? When you said we are going to look at the

whole financial meltdown across the board, why is it we left

Freddie and Fannie out? Why is it Franklin Raines, who apparently committed perjury before this committee, has not been

brought back before this committee or referred for prosecution?

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Why is it that in fact Bank of America still holds vital documents

showing 28,000 loans, mixed in with them are hundreds or thousands of loans to government officials throughout the country, from

the top to the bottom, from Republican to Democrat to Independent, who were clearly given what amounts to a bribe of government

by a man who was brought before this committee because he made

too much money while Countrywide stock was dropping, but has

not been brought before this committee once we discovered that the

Friends of Angelo Program in fact was designed to influence Members of Congress, key staff, and people throughout the government.

That is not a small scandal. That is the crux of this scandal. If

the trillions of dollars that the American people are on the hook for

at Freddie and Fannie as GSEs are in fact because Countrywide

had a cozy relationship bought and paid for that allowed them to

unload not all, but much of these bad debts, and in fact allowed

for the promotion of subprime and other risky instruments, then in

fact, Mr. Chairman, that is the heart of the financial meltdown.

The financial meltdown is not about the failure of the SEC. It is

not even about Bernie Madoff and the billions that in fact he did

opaquely without proper supervision. That is important and we

need to deal with it, along with the Financial Services Committee.

But the very underpinnings of good government require that government officials when they take an oath to their city, their State

or our country, in fact operate without an agenda bought and paid

for by public or private money. It is clear that is not the case here.

It is clear that the distortions in the market go back years and they

go back to government officials, quasi-government officials and private sector, including obviously the Friends of Angelo Program.

So Mr. Chairman, I challenge you today either to issue a subpoena to Bank of America to get those records, or allow this committee to have an open vote so the people of America can understand that in fact this is an important issue. It is not a side issue.

It is at the crux of this very investigation.

And I might note that when we began looking at this problem,

when we had Angelo Mozilo in front of us, there were tapes, digital

copies of every single conversation between Members of Congress,

members of the administration, postal workers, Freddie and

Fannie, even Franklin Raines that were held so we could hear

them. Today, I am told they may have been destroyed. When I hear

they may have been destroyed, I realize we have been lax in our

duties. That chair was held by Mr. Waxman and we had a crook

in front of us that Mr. Waxman called a crook, said in fact that he

was hurting the American people. Now we know in fact he bought

and paid for what hurt the American people.

Mr. Chairman, I call on you today to issue that subpoena. It is

that important that I bring it up at this hearing, and I call for you,

if you cannot do it, to step aside and allow the committee to have

a vote.

And I yield back.

Chairman TOWNS. Let me just respond to the gentleman. I see

he is sort of worked up over that issue.

Mr. ISSA. Yes, Mr. Chairman, I am worked up because we need

to protect the American people. We won’t do it if we don’t investigate this corruption.

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Chairman TOWNS. Let me respond to you by saying, No. 1, the

Justice Department is looking at it.

Mr. ISSA. Mr. Chairman, that is what the chairman of this committee said previously as an excuse. It turns out they didn’t. It

turns out the Senate Ethics Committee has failed to act and said

in fact there was no ethical violation. We are beyond ethics here.

We are at a point where the American people at least should know

who they gave money to or benefit to, how they did it, and so on.

We have ignored that paper. I have never seen this committee

refuse to at least ask to see documents before deciding to ignore

them.

Chairman TOWNS. Before we go to our witness, let me just say

to you that I did not say the Senate Ethics Committee was looking

at it. I said the Justice Department. As you know, there is a difference.

Mr. ISSA. Mr. Chairman, if the Justice Department had subpoenaed the audiotapes, they would have them. They didn’t. It appears

as though Bank of America allowed them to become destroyed or

they were destroyed in the last days of Countrywide. But more important, those documents, as we have been told, have not, in fact,

been subpoenaed. The Justice Department does not have the boxes

of documents that Bank of America has gathered, but will not turn

over without a subpoena for reasons of privacy.

If you tell me today you are referring it, because you have

enough information, to the Justice Department for prosecution or

investigation, fine. But today, we don’t know what we don’t know.

What we do know is there is a level of intended corruption by

Countrywide that clearly had an effect on government decisions for

years, and we are ignoring it.

We cannot really understand the failure of government if we

don’t understand the failure of government officials led by, in fact,

an attempt to bribe them.

Chairman TOWNS. The gentleman’s time has expired.

Mr. ISSA. Thank you, Mr. Chairman.

[The prepared statement of Hon. Darrell E. Issa follows:]

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Chairman TOWNS. Let’s move forward.

We will now turn to our first panel of witnesses. It is committee

policy that all witnesses are sworn in, so please stand and raise

your right hands as I administer the oath.

[Witnesses sworn.]

Chairman TOWNS. You may be seated. Let the record reflect that

they answered in the affirmative.

Mr. Eric Kolchinsky is a former managing director at Moody’s

Corp. He has worked in structured finance for over 12 years, 8 of

which were at Moody’s. While at the rating agency, Mr. Kolchinsky

focused on rating collateral debt obligations [CDOs]. He has also

worked at Lehman Brothers, Merrill Lynch and MBIA in the CDO

groups.

We welcome you this morning.

We would also like to introduce Mr. Scott McCleskey. He was a

senior vice president for compliance at Moody’s Investors Service

from April 2006 until September 2008. In this role, he was responsible for the organization’s compliance with rules and regulations

established by the SEC and other regulators. Prior to joining

Moody’s, Mr. McCleskey spent approximately 15 years in the financial services industry in both compliance and regulatory positions

in the United States and in the European Union.

Mr. McCleskey is currently managing editor for a firm providing

news analysis and compliance solutions for the financial industry.

We welcome you as well.

Mr. Richard Cantor serves as the chief risk officer for Moody’s

Corp., and as the chief credit officer for Moody’s Investors Service.

In his role as chief credit officer, Mr. Cantor heads the Credit Policy Group and chairs the Credit Policy Committee, both of which

are responsible for the review and approval of rating methodologies.

Mr. Cantor’s Policy Group also works with the rating group at

Moody’s to promote consistent rating practices and improved rating

quality.

Let me welcome you as well.

At this time, I ask that each witness deliver their testimony

within 5 minutes. The yellow light means you have 1 minute remaining, and the red light means stop. Everywhere in America red

light means stop.

And then, of course, we will have time to raise questions with

you and seek the answers.

So we would like to start with you, Mr. Kolchinsky, and then

come right down the line.

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STATEMENTS OF ILYA ERIC KOLCHINSKY, FORMER MANAGING DIRECTOR, MOODY’S INVESTORS SERVICE; SCOTT

MCCLESKEY, FORMER SENIOR VICE PRESIDENT FOR COMPLIANCE, MOODY’S CORP.; AND RICHARD CANTOR, CHIEF

RISK OFFICER, MOODY’S CORP., AND CHIEF CREDIT OFFICER, MOODY’S INVESTORS SERVICE

STATEMENT OF ILYA ERIC KOLCHINSKY

Mr. KOLCHINSKY. Good morning. I want to thank Chairman

Towns, Ranking Member Issa and all the members of the committee for giving me an opportunity to speak this morning.

My name is Eric Kolchinsky and during the majority of 2007, I

was the managing director in charge of the business line which

rated subprime-backed CDOs for Moody’s Investors Service. More

recently, I was suspended by Moody’s as a result of a warning I

sent to the compliance group regarding what I believed to be a violation of securities laws within the rating agency.

I am grateful for the opportunity to speak in front of you on the

need of rating agency and financial markets reform. Despite the

circumstances of my separation, I still believe that Moody’s is a

good company and the vast majority of analysts there are smart,

capable, and want to do a good job of rating financial products.

Unfortunately, these ingredients are not sufficient to produce

quality ratings or to safeguard the financial system. While I do not

believe that the rating agencies were the main cause of the credit

crisis, there are other parties that were far more responsible, there

are still unresolved problems which will lead to poor ratings performance.

No. 1, conflicts of interest. The conflicts of interest which ail the

rating industry remain unmanaged. Senior management still favors revenue generation over ratings quality and is willing to dismiss or silence those employees who disagree with these unwritten

policies.

No. 2, Credit Policy Group lacks independence. The Credit Policy

Group is a team of analysts whose role is to ensure that the methodologies and procedures used in the ratings process are sound and

meet minimum credit standards. Unfortunately, the Credit Policy

Group at Moody’s remains weak and short-staffed. The group’s analysts get routinely bullied by business line managers and their decisions are overridden in the name of generating revenue.

Inadequate methodologies. Methodologies produced by Moody’s

for rating structure finance securities are inadequate and do not realistically reflect the underlying credits. Rating models are put together in a haphazard fashion and not validated if doing so would

jeopardize revenues.

Compliance Group lacks independence. The Compliance Group is

entrusted with enforcing laws and internal policies. The group is

understaffed and has little professional compliance experience. Instead of ensuring that the ratings process is free from conflict, this

group sits idly by while these transgressions occur.

In many ways, the incentives for rating agencies have become

worse since the credit crisis. There are more rating agencies and

they are all chasing significantly fewer transaction dollars. The

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new controls put in place by regulators are too weak to significantly alter this dynamic.

As an example of how little things have changed, ABS CDOs are

being rated once again. These are the same products which are responsible for hundreds of billions of dollars of losses at major financial institutions. They are significant contributors to the problems

at CitiBank, Merrill Lynch, and AIG. I firmly believe that ABS

CDOs cannot be rated with any certainty and especially not during

this volatile period in the capital markets.

The new methodologies used to rate ABS CDOs have not improved their poor credit performance. Many of the recent deals

have been downgraded or have had to resort to restructuring to

maintain their ratings. This toxic product needs to be consigned to

the dustbin of bad ideas, but unfortunately there are no incentives

for rating agencies to say no to a product no matter how poorly

thought through.

Investors like pension funds, insurance companies, and the Federal Reserve who are required to purchase securities with certain

ratings deserve better than this. They need ratings which reflect an

analyst’s best judgment and not the profit targets of the agency.

However, I believe there is a very simple and straightforward solution for the ills which haunt the ratings industry. It begins with

the admission that the function which their agencies perform is

quasi-regulatory. Fortunately, a model already exists which combines quasi-regulatory authority with private competition. It is the

accounting industry.

While accountants have not been free from scandal, the profession has not suffered the free-falling standards which have befallen

the ratings industry. The key limitation has been the existence of

a single set of standard methodologies which all accountants need

to abide by, for example, GAAP.

While CPAs are free to compete on price and service, they cannot

change much the definition of revenue or loss. A single set of

standards makes a lot of sense from a market and a regulatory

point of view. It is much easier for regulators to learn to pass judgment on a single set of policies, rather than understanding the minutiae in the particulars of multiple approaches. The same benefit

applies to investors. A single set of criteria which is debated and

promulgated in a public manner will greatly add to the cause of

transparencies.

I have witnessed too many instances of rating agencies talking

their way out of a poor decision by confusing the listener with esoteric details of their particular methodology.

If I were a doctor, I would diagnose the rating agency patient as

very curable. But treatment needs to be urgently applied to avoid

further damage. Rating agencies can once again be productive

members of the financial community, but they cannot do this by

themselves. They need a helping hand to get back on the right

track.

Thank you very much.

[The prepared statement of Mr. Kolchinsky follows:]

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Chairman TOWNS. Thank you very much.

Mr. McCleskey.

STATEMENT OF SCOTT MCCLESKEY

Mr. MCCLESKEY. Thank you, Mr. Chairman, Ranking Member

Issa, and members of the committee.

My name is Scott McCleskey and I served as senior vice president for compliance at Moody’s Investor Service [MIS], from April

2006 to early September 2008. In that capacity, I was the executive

formally designated as responsible for the organization’s compliance with relevant regulations and internal policies.

I have been asked to discuss my experiences with respect to the

independence and authority of the Compliance Department. I will

start by saying that in my time at Moody’s, I had the privilege to

work with a great many professionals of high ability and unquestioned integrity, and that in many cases and in many respects,

things worked well. However, my honest assessment is that the

compliance function came to lack independence and authority in

some important respects.

Before I go into detail, I think it is important to give a caveat

that it has been over a year since my departure from Moody’s, and

until I was contacted by the staff of this committee a few days ago,

I had not put a great deal of thought into these past events, so I

am at a slight disadvantage with respect to some of the specific

dates and details. And for clarity’s sake, I would point out that in

keeping with the scope of the SEC regulations, my remit did not

extend to the accuracy of the rating methodologies themselves.

Until the end of 2007, I reported to an executive vice president

who in turn reported to the CEO. This executive vice president had

responsibility for three departments: compliance, regulatory affairs,

which generally handles relations with regulators and legislators

on policy matters, and information technology. During this period,

I would characterize the environment as generally supportive of

compliance.

In late 2007, my reporting lines were changed. From that point

forward, I reported to Michael Kanef who was made responsible for

both my department and the Regulatory Affairs Department. Michael reported to the general counsel who reported to the CEO.

So as you can see, an extra layer of management was inserted

into my reporting chain, effectively moving the department one

level further away from the CEO. Nonetheless, I remained as the

formally designated compliance officer in all public SEC filings.

It soon became clear to me that my authority and independence

would be greatly diminished. In the interest of time, I will summarize my experience and concerns.

Over the following months, experienced compliance officers on

my staff were pushed out over my strenuous objections and structured finance analysts without a single day of compliance experience were foisted upon me. Although I did come to believe that one

of the new hires had promise, it does not balance the loss of 35

years of compliance experience from my staff.

The hiring of structured finance analysts also creates a clear conflict of interest issue since, like Michael Kanef, who came from

structured finance, they could find themselves passing judgment on

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their own former practices in deciding whether to discipline friends

or former colleagues and potentially their own future managers

should they return to their previous business units.

Second, I found myself more and more frequently excluded from

decisionmaking meetings concerning potential violations. I will

note that this did not occur on each and every occasion, but it did

so with increasing frequency and in particularly important matters.

This includes an examination conducted by the Securities and Exchange Commission which was handled by our Legal Department

and by outside counsel. I was flabbergasted that I, the designated

compliance officer, would be excluded from meetings with the SEC

during an examination and I was vocal in making this point.

A common answer whenever I would object to these exclusions

was that it was necessary in order to preserve attorney-client privilege, although it is my understanding that other non-legal department staff were included in these meetings. This focus on preserving confidentiality, I believe, also led to the sometimes explicit and

often implicit directive not to put anything in writing that could be

used against Moody’s in litigation or regulatory proceedings.

My time at Moody’s came to an abrupt end a little over a year

ago when I was dismissed without any specific reason, other than

senior management no longer has confidence in you. This came as

a bolt out of the blue. At no time had Michael or the general counsel given any indication of dissatisfaction with my performance.

Moreover, a few weeks before I was pushed out, I was given responsibility for addressing the issues raised by the SEC following

its examination, the one I had been excluded from, following which

Michael went on a previously scheduled and I think well-deserved

vacation. I hardly think that an organization which takes its regulatory responsibilities seriously would give such a critical project to

someone it had lost confidence in. I am left to speculate on the real

reason for my departure.

One hour after my departure, it was announced that I would be

replaced by an individual from the Structured Finance Department, who had no compliance experience and who, to my recollection, had been responsible previously for rating mortgage-backed

securities.

I do understand that he has been replaced now by somebody with

compliance background, and if that is the case, I hope that person

has the authority that I lacked in the organization.

The matter before you regards how credit rating agencies should

be regulated in the future, and I will make two brief observations

before closing.

First, my experience leads me to recommend strongly that the

regulations be amended to require that the designated compliance

officer report directly to the CEO or to the Board of Directors, and

that this person not have come from one of the business lines within that organization within the last 3 years. Second, with respect

to the notion of removing reference to NRSRO ratings from Federal

regulations, I would recommend caution. At present, NRSRO status

is the only hook by which regulators in the United States are able

to exercise oversight of credit rating agencies. If NRSRO status is

made irrelevant, I would urge you to ensure that other measures

20

are taken to continue this important oversight of these important

agencies.

Now, Moody’s will undoubtedly respond as they habitually do,

that I am a disgruntled ex-employee who has an axe to grind. To

this, I will simply respond that it has been a year since my departure and I did not actively seek the opportunity to testify today. By

putting my head above the parapet again, I am likely burning a lot

of bridges with former colleagues whose esteem I value. I am putting my family through stress that could be avoided very easily by

simply saying I don’t know anything.

Thank you for your time.

Chairman TOWNS. Thank you very much, Mr. McCleskey.

Mr. Cantor.

STATEMENT OF RICHARD CANTOR

Mr. CANTOR. Good morning, Chairman Towns, Congressman Issa

and members of the committee. I am Richard Cantor, the chief

credit officer for Moody’s Investors Service. I welcome the opportunity to contribute Moody’s views to this hearing.

I would like to begin with a brief overview of Moody’s rating

process. At the start of the ratings process, an analyst gathers relevant information from issuers and public sources. He or she then

conducts a credit analysis applying Moody’s methodologies which

are publicly disclosed and freely available on our Web site.

After forming an opinion an analyst brings his or her analysis to

a rating committee, which is a critical mechanism in promoting the

quality, consistency, and integrity of our ratings process. The committee discusses and then votes on the appropriate rating for the

security.

One of the core principles of this process is that different analysts can and will legitimately hold different views on the credit

risk, based on the same set of facts. And the committee process is

the vehicle for resolving these disagreements.

Once finalized, credit ratings are communicated to the general

public free of charge. We monitor these ratings on an ongoing basis

and we modify them if our view of the creditworthiness of the

issuer or the obligation changes.

The unprecedented credit crisis that began 2 years ago has provided important lessons for Moody’s, other credit rating agencies

and all market participants. In light of these lessons, Moody’s has

adopted an array of measures to enhance the quality and transparency of our credit ratings.

These steps include changes in the following five key areas:

strengthening the analytical quality of our ratings; enhancing consistency across rating groups; bolstering measures to manage conflicts of interest; improving transparency of ratings and the ratings

process; and increasing resources in key areas.

We believe we’ve made important progress, but more can be

done. Indeed, Moody’s supports a number of reform proposals currently under discussion that can help restore the credibility of credit rating agencies and return confidence to structured finance markets.

We also believe that other steps could be taken to increase disclosure in structured finance markets. Specifically, we believe that inVerDate 11-MAY-2000 13:42 Apr 30, 2010 Jkt 000000 PO 00000 Frm 00024 Fmt 6633 Sfmt 6633 U:\DOCS\55751.TXT KATIE PsN: KATIE
21

creasing information disclosure by issuers, sponsors, and underwriters of structured finance securities would yield three principal

benefits: one, reduce the risk of over-reliance on credit ratings; two,

improve the information available about structures and assets; and

three, broaden the range of opinions and analysis available to the

market.

Finally, let me turn to the allegations raised by Mr. Kolchinsky

in a letter sent to this committee. Mr. Kolchinsky has raised a series of evolving claims over the past year. And in July, Moody’s retained the outside law firm, Kramer Levin, to conduct an independent investigation of all of these issues. It is important to note that

Moody’s didn’t direct the investigation. Rather, the company gave

the independent law firm unfettered access to our personnel and

documents. I understand that the outside lawyers have interviewed

22 Moody’s employees and the only person who has refused to meet

with the investigators is Mr. Kolchinsky.

As the committee is aware, Moody’s, in anticipation of today’s

hearing, also asked the independent law firm to provide the committee staff with a briefing on the preliminary findings of that investigation. These findings have also been shared with our regulator. I understand that the committee has been informed that

these preliminary conclusions are consistent with Moody’s own internal review. Specifically, Mr. Kolchinsky’s claims of misconduct

are unsupported. Instead, Mr. Kolchinsky raises issues of longstanding and healthy debate within the company and the credit

rating industry. When debates have been resolved contrary to Mr.

Kolchinsky’s personal views, he has alleged that the process was

fraudulent, unreasonable or otherwise improper, when they were

not.

All of us at Moody’s are committed to meeting the highest standards of integrity, quality and transparency in our rating practices,

methodologies and analysis, and we will take all the appropriate

steps to uphold these standards.

I am happy to respond to any questions.

[The prepared statement of Mr. Cantor follows:]

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Chairman TOWNS. Thank you very much, Mr. Cantor.

Let me begin by raising questions, and each Member will have

5 minutes to do so.

Mr. Kolchinsky, I have here a memo you wrote to Michael Kanef,

the head of compliance at Moody’s. In the very first sentence, you

said, ‘‘Moody’s was engaged in illegal conduct.’’

What kind of illegal activities was Moody’s engaged in?

Mr. KOLCHINSKY. Sir, I believe that Moody’s violated securities

laws by issuing ratings on Nine Grade funding in January. They

knew that the ratings were incorrect. They had knowledge of it.

And yet they still went forward and issued the rating.

It is not, as Mr. Cantor states, a matter of policy. It is a matter

of law, whether you can or not knowing that the ratings are wrong

actually opine on a rating, and that is what I believe was the violation of the law.

Chairman TOWNS. Well, did you warn Moody’s of the problem?

Mr. KOLCHINSKY. Yes, sir, I did. In the past, Moody’s came very

close to doing something very similar, and that was September

2007. And at the time, I was able to prevent the occurrence of that

from happening. I had warned both the Compliance Group and the

Credit Policy Group about these issues, and about precisely this

type of an action leading to securities laws violation. And those

warnings were ignored.

Chairman TOWNS. Is it true that you also warned Moody’s that

the ratings procedure used by derivatives groups were inadequate?

Mr. KOLCHINSKY. Yes, sir, I did. I believe specifically this relates

to the new methodology for rating ABS CDOs, which was used in

the process of rating the deal in question here. I had told Mr. Cantor’s group and I had told the Compliance Group that the methodology was not realistic. It had many problems. It was not based

on real world scenarios or real world views of how the credit would

perform.

Chairman TOWNS. Is it true that you warned Moody’s that the

ABS CDO methodology used by the Derivatives Group produces

misleading ratings that will continue to destabilize the financial

markets, as well as cause losses for investors and shareholders?

Mr. KOLCHINSKY. Yes, sir. I did that.

Chairman TOWNS. Mr. Cantor, I understand that Moody’s hired

an outside counsel, as you indicated, from the law firm of Kramer

Levin to investigate Mr. Kolchinsky’s allegations. I want your commitment that Moody’s will provide to this committee within 1 week

copies of all documents that were provided to Kramer Levin regarding their investigation, along with a copy of the preliminary report

which they issued just yesterday.

Will you make that commitment right now?

Mr. CANTOR. Mr. Chairman, I will pass along your request to the

appropriate people at Moody’s and I am confident that they will be

able to comply.

Chairman TOWNS. I don’t quite understand you. In other words,

aren’t you appropriate? You are testifying here and you are under

oath?

Mr. CANTOR. Yes. I am the chief credit officer. I am responsible

for the methodologies that we produce and use in the ratings procVerDate 11-MAY-2000 13:42 Apr 30, 2010 Jkt 000000 PO 00000 Frm 00036 Fmt 6633 Sfmt 6633 U:\DOCS\55751.TXT KATIE PsN: KATIE
33

ess. And I will communicate your request to the appropriate people

at Moody’s and I am confident they will comply.

Chairman TOWNS. Well, who are the appropriate people?

Mr. CANTOR. I would expect the general counsel at Moody’s.

Chairman TOWNS. I am sorry?

Mr. CANTOR. The general counsel at Moody’s.

Chairman TOWNS. Right. OK. Thank you.

Mr. McCleskey, I have a letter you wrote to the SEC in March

2009. In it, you warned the SEC about Moody’s municipal securities ratings. Are these ratings just out of date and inaccurate? Is

it true that Moody’s did not warn investors these ratings were out

of date? Mr. McCleskey.

Mr. MCCLESKEY. Yes, sir. And the intention of that letter was to

alert the SEC so they could look into a situation that I was aware

of in which there are tens of thousands of municipal securities out

there that just due to the sheer number they are not getting the

same level of scrutiny, surveillance on the ratings that you would

expect from a normal bond or structured instrument.

There were concerns. I had expressed concerns about this because my feeling is that there will be municipal bonds out there

that haven’t been looked at that may have out of date bond ratings

that the public may not be aware that these are out of date.

It is one thing for the bond to be the city of New York or California, where everybody knows the economic state, but these include

very small school districts or very small municipalities where it

may not be as available to the public.

Now, I am not an economist, but the SEC has economists. And

that is the reason why I raised this issue and I urged them to include a review of this in their next routine examination. And I do

believe that is important. It has been, as I said, a year since I was

at Moody’s, maybe things have gotten better. I hope they have. But

at the time that I wrote this letter, I felt that it was something

that the SEC needed to be aware of.

Chairman TOWNS. Thank you very much. My time has expired.

I yield 5 minutes to the gentleman from California, Congressman

Issa.

Mr. ISSA. Thank you, Mr. Chairman.

And I would like to followup on the chairman’s statement, Mr.

Cantor, a question. To your knowledge since you supplied a great

deal of the information that went to the independent investigation,

is most of it information which you would consider not to be attorney-client privilege?

Mr. CANTOR. I am not——

Mr. ISSA. In other words, the information you provided was of a

statistical and numeric nature. It was emails pertinent to today’s

discovery. In other words, it was information that should not be

withheld based on a claim of attorney-client privilege. Would you

agree?

Mr. CANTOR. I have no expertise in this area.

Mr. ISSA. Well, then I will break it down a little bit so the chairman and I are consistent on this part. Was most of this information

internal emails and correspondence related to today’s hearing that

would either affirm or deny Mr. Kolchinsky’s claims?

34

Mr. CANTOR. I am sorry. I am not sure I understand the nature

of the question.

Mr. ISSA. It is real simple. Today, you weren’t able to answer and

you are referring to general counsel. My concern is you go back to

general counsel and they claim a broad attorney-client privilege,

and then we play that 20 questions game in a subsequent hearing,

where I guess we bring your general counsel in.

I want to understand today what it takes to investigate a claim

by a whistleblower. We are presuming, but I want an affirmation

at least to your knowledge, it doesn’t appear to be specific attorneys, you did not turn over, as far as you know, lots of things by

your attorneys to this independent group, which we would presume, if they are independent, they are not going to claim attorneyclient privilege just because you paid them.

Mr. CANTOR. The firm that conducted the investigation had unfettered access to all of our documentation.

Mr. ISSA. I am only asking if they had independence.

Mr. CANTOR. There was not specific materials that were turned

over.

Mr. ISSA. OK. So if I understand correctly today, the chairman

and I are going to close the hearing based on the hope that Moody’s

will turn over what the chairman has asked for, and if they don’t,

then we have to go back through the process of your claim that

they are independent, just as Moody’s is independent when they

issue credit ratings, and yet you paid them and therefore have an

ability to claim attorney-client privilege and may.

Mr. CANTOR. I expect there will be a full compliance with the request.

Mr. ISSA. Good. That is what we expect.

Mr. CANTOR. I am only pointing out that I am not an expert in

this area, and you are speaking to someone who——

Mr. ISSA. OK. The chairman and I will be patient on that issue,

but I wanted to clarify it because I am deeply concerned that the

word ‘‘independent’’ and ‘‘outside’’ generally means they were done

for our benefit and the people’s benefit, not just for the person paying them, which gets us back to Moody’s.

Do you believe that this very narrow, I guess three, now four

groups that are allowed to do what you do is reasonable or sustainable? In other words, is there any reason to have an ogopoly or oligopoly, to use a now-Russian word it seems, or could we have dozens of organizations allowed to try to do what you do, and then if

you do it better, you would rise. And if you didn’t, somebody else

who was more accurate would rise.

Is that a better way for this committee to look at the future? Or

should we continue with this narrow group that we trust, even

though they failed us?

Mr. CANTOR. Moody’s favors a vigorous competition in the credit

rating industry. There are currently perhaps 100 credit rating

agencies around the world. I don’t know how many there are in the

United States——

Mr. ISSA. Well, let’s just say that the big three have 90 percent,

and in electronics, the last 10 percent isn’t enough for anyone to

matter. So if three of you have 90 percent, you have a three-way

monopoly.

35

Mr. CANTOR. Well, there——

Mr. ISSA. Let me followup with another question.

This committee has promoted, I think vigorously, transparent reporting systems. XBRL is one of them. Obviously, well along the

way in a nonprofit. Would you believe that this committee should,

in fact, make that a public policy so that broadly this information

that is not available to the individual consumer or individual investors could become available?

Mr. CANTOR. Moody’s strongly supports enhanced disclosures in

securities markets, including the type that you have——

Mr. ISSA. OK. For my whistleblowers, and thank you for being

here today. I know it is tough and I know there are always the

other side whenever someone comes forward. But let me ask you

a question. Currently, Congress is considering giving more authority to the SEC to do what they didn’t do when you reported to the

SEC. Does that seem like it makes sense to you? If they didn’t act

when you reported, should we rely more heavily on government? Or

should we have, as I am suggesting, XBRL and other ways for people to second-guess reporting? Either one of you.

Mr. MCCLESKEY. Sir, if I could go first. I think that transparency

is generally a good idea, but I think a distinction needs to be made

between transparency and disclosure. In my mind, disclosure is

providing information. Transparency is providing it in a meaningful way. I would also draw a distinction in your example with respect to stocks and bonds. I agree with you that many people do

not research the stocks and bonds before they buy them. But I

would assert that is because they don’t wish to.

If you are putting our information about a structured finance

product, there may be people who wish to conduct an analysis, but

lack the expertise, the models, the methodologies to do so. So I

would make that distinction.

Should the SEC have more authority? To my knowledge, they

have not done their first routine cyclical examination of the firms

yet. I think that the reason for that is, frankly, this is an unregulated industry for the past century. They have needed time to get

up to speed. I would frankly have expected something to happen

by now, but I think that with respect to the aggressiveness of the

SEC with respect to the credit rating agencies, I would suspect that

part of that is simply because they are getting staff up to speed.

They are hiring staff. I wouldn’t write them off just yet.

Chairman TOWNS. The gentleman’s time has expired.

Go ahead, Mr. Kolchinsky.

Mr. KOLCHINSKY. I would agree with Mr. McCleskey. I think the

SEC has had a difficult role, especially since each agency has its

own methodology. I am very familiar with the methodology that I

was responsible for. It is very difficult to understand. It has a lot

of minutiae, lots of twists and turns.

I think what I propose as a public body along the lines of FASB,

where these decisions would be made in a public matter, which

would be overseen by the SEC as FASB is, but where these decisions are overseen in a public matter, the types of data that goes

out goes out to everybody, and decisions are made publicly with

public consent. And I think that would be the best way of opening

up this industry to transparency.

36

Mr. ISSA. Thank you, Mr. Chairman.

Chairman TOWNS. Thank you very much.

I now yield 5 minutes to the gentleman from Pennsylvania, Mr.

Kanjorski.

Mr. KANJORSKI. Thank you very much, Mr. Chairman.

Mr. Cantor, in your testimony, you sort of asserted with great

pride that the information is made available to the general public

free of charge. And there is nothing incorrect about that statement,

but do you mean to indicate that nobody pays for this information?

Mr. CANTOR. The information about our rating?

Mr. KANJORSKI. Yes.

Mr. CANTOR. That is correct that the distribution of ratings to investors is free of charge.

Mr. KANJORSKI. Yes, but are you going to tell us who pays for

it, or are you going to just indicate that it is free of charge?

Mr. CANTOR. Oh, who pays for the effort that——

Mr. KANJORSKI. You are an eleemosynary corporation, I assume?

You don’t charge? You do this for free?

Mr. CANTOR. No. We are paid by issuers of securities in the capital markets for the ratings we assign.

Mr. KANJORSKI. Ah, that is surprising.

Now, I am just going to pose a question to you and I hope you

can give me a reasonable response. If we went to our colleagues in

the House and the Senate and told them that we have discerned

a new way to reduce the budget of the United States by significant

proportions, and that is we could remove all the expenses for the

judiciary branch of government because we have come up with a

new formula that all lawyers who represent winning litigants have

agreed to pay the judges’ salaries.

Would you sort of conclude that is a good, fair, and proper way

to carry on the judicial system of the United States?

Mr. CANTOR. I must admit the hypothetical is a little confusing

to me, but I imagine you are proposing something that you feel is

a very bad idea. I must admit I got a bit lost.

Mr. KANJORSKI. I am proposing what occurs in the rating agencies. You get paid by the issuers, don’t you?

Mr. CANTOR. We do.

Mr. KANJORSKI. Well, you didn’t want to indicate that. You were

bragging about that the public gets it free of charge. That can or

cannot be true. If it is an incorrect or prejudicial rating, it is not

free of charge. The price we would pay for that was exactly what

happened a year ago. The markets would have bad securities. Some

people call them toxic securities, and it could in fact cause a crash

to occur, which in fact happened.

And I am not saying that we can trace it directly to the rating

agency, but that is a possibility. That wouldn’t make it free of

charge. That would make it extremely expensive.

Do you agree?

Mr. CANTOR. Moody’s has been operating under the issuer-pay

model that we were just talking about for 40 years. And we have

a long track record under this business model that we stand behind

and it is the basis of our performing.

Mr. KANJORSKI. One of your colleagues in testifying said they

wanted to operate like the accounting businesses, that they don’t

37

have any problem. Maybe you are of a short memory. Do you recall

Enron?

Mr. KOLCHINSKY. Yes, sir.

Mr. KANJORSKI. What was the problem that we found in Enron?

Mr. KOLCHINSKY. Sir, I believe it was fraud.

Mr. KANJORSKI. No. We found that Enron was being paid exorbitant fees for consulting services and those fees had a tendency to

affect their professional opinions as accountants, this exact conflict

of interest that exists in this rating agency problem today.

Now, I appreciate if you are whistleblowers that you came

through, but I listened to both of your testimony, and I didn’t hear

anything terribly shocking. If this is the best testimony that we

have, I am surprised that Moody’s went out and hired the lawyer

that they did to attack you.

You haven’t given a course of conduct in my opinion of fraud.

You haven’t given a course of conduct of real gross neglect or negligence. You have said there are some instances like the supervisor

was not allowed in the room to meet when the SEC came by. Eh?

Maybe good, maybe bad. We should rap their knuckles, but there

is nothing criminal about that, or really extreme about that.

And in your instance, what do you find after all these years of

issuing these opinions, you said they did things that violated the

law. What did they do?

Mr. KOLCHINSKY. Sir, I believe they violated rule 10b(5) of

the——

Chairman TOWNS. Speak into the mic.

Mr. KOLCHINSKY. My apologies. I believe they violated rule

10b(5).

Mr. KANJORSKI. And what is rule 10b(5)?

Mr. KOLCHINSKY. The rule 10b(5) is fraud, securities fraud in securities markets.

Mr. KANJORSKI. And how did they do that?

Mr. KOLCHINSKY. Sir, if I might, I can quote from a memo that

was produced on behalf of Moody’s by another prominent New York

law firm, written to the SEC, and they state, ‘‘A rating agency

would be liable,’’ this is with respect to 10b(5), ‘‘if it knowingly published a report that falsely misrepresented its own evaluation of securities.’’ And that is exactly what they did.

Mr. KANJORSKI. And how did they do that?

Mr. KOLCHINSKY. Sir, they knew that the underlying ratings,

this was essentially CLO squared. In December, they had just decided to change the methodology on the underlying CLOs. And they

knew, in fact, that all those ratings were now wrong. In fact, they

ran internal tests that showed that rated securities that were rated

below AAA would be moved three to six notches.

That knowledge should have been, must have been incorporated

in any new rating. Once that was decided, once the step was taken,

it should have been decided, if you are going to base your other ratings on those ratings.

Mr. KANJORSKI. OK. Now, was that directly reported to the appropriate officials at the SEC? Or how was that handled on your

part?

Mr. KOLCHINSKY. How was my complaint handled?

38

Mr. KANJORSKI. What did you do? You found out that they were

using false information that they knew was false, so knowingly

they did this.

Mr. KOLCHINSKY. Yes, sir. I was not a part of this. I reported it

to the Compliance Group as I was supposed to. Once I was——

Mr. KANJORSKI. What do you mean, you were not part of this?

Mr. KOLCHINSKY. I was not in the rating agency.

Mr. KANJORSKI. Well, how did you find this information?

Mr. KOLCHINSKY. From speaking to colleagues and off of——

Mr. KANJORSKI. So this is hearsay?

Mr. KOLCHINSKY. Yes, sir, but it is backed by documented evidence which is available.

Mr. KANJORSKI. Did those colleagues that told you this then report that to appropriate officials, either in the Justice Department

or the SEC?

Mr. KOLCHINSKY. I don’t know, sir.

Mr. KANJORSKI. Didn’t you figure out it may be important to determine that?

Mr. KOLCHINSKY. Sir, I am just a single person. I was trying to

do the right thing. As soon as I knew anything, I reported to my

Compliance Group. After my suspension, I reported it, tried to report to SEC, and I also spoke to the committee here. But I believe

I tried to make sure that these matters were brought up to the attention of the appropriate parties.

Mr. KANJORSKI. If I could just ask one question of all three panelists?

Chairman TOWNS. I ask unanimous consent to give the gentleman another additional minute.

Mr. KANJORSKI. You have heard the example of how rating agencies are paid by the issuer, which poses potentially great conflicts

of interest. Do the three of you have opinions whether we should

examine this and change this practice? Or do you think it is working perfectly well and has no effect on what the rating agencies are

doing in the marketplace?

Mr. KOLCHINSKY. Sir, I think the conflict of interest at the rating

agencies is much more pedestrian. It is more a short-term profits

versus long-term credit quality. There is nothing special issue pays

or investor pays. It is a short-term profit-focused conflict of interest.

In many cases, in my world, in ABS CDOs, one of the reasons

you are seeing all the banks like Merrill Lynch, UBS, and

Citigroup have problems is because they retained the vast bulk of

the debt that they issued, so it was effectively an investor-paid

model. They couldn’t get outside investors to buy the stuff so they

retained the deals on the balance sheet.

So it is very difficult to actually implement a good investor-pay

model that would not have the same conflict of interest if the investor has the same incentives as the banker does.

In the case of ABS CDOs, in many cases, the investor and the

banker were the same party and they just brought it on the balance sheet because they wanted to show revenue.

So theoretically, I agree with you.

Mr. KANJORSKI. Do I understand your testimony to say it doesn’t

make a difference who pays? It has no effect on the end result?

39

Mr. KOLCHINSKY. No, of course it does. Of course it does. My testimony is that in practical terms, it is very difficult to find the ideal

investor. Not every investor is a Warren Buffett.

Mr. KANJORSKI. Whoa, whoa, whoa. I didn’t ask you the question

about whether investors should pay. That is our big problem, who

should pay or who can pay, and why we got to this peculiar system

that we have. That is what we are examining into.

Mr. KOLCHINSKY. Yes, sir.

Mr. KANJORSKI. I don’t want you to conclude we think that is the

better system.

I want to ask you, do you see the gross potential conflict of interest when the person issuing the security pays the person who rates

that security?

Mr. KOLCHINSKY. Yes, sir.

Mr. KANJORSKI. OK.

Mr. MCCLESKEY. Sir, I think I would agree with Mr. Kolchinsky.

I do see the gross conflict. The problem then becomes what do you

replace it with? And I don’t have an opinion. I am not smart

enough to know the answer to that question.

Mr. KANJORSKI. Neither are we. That is why we are working on

it.

Mr. MCCLESKEY. If I could, I think I should also respond to your

other point about whether it is important that I was or was not in

a particular meeting. The compliance officer position is embedded

into law with respect to credit rating agencies, as it is in many

other sectors of the financial industry, and for good reason. These

are the people that are supposed to be independent and supposed

to keep their eyes open for any potential violations. If that position

is not properly resourced, does not have enough authority, then

that puts the firm, that puts the industry at risk.

And so this is not just what you would have in normal office politics. This was something that, in my view, weakened the oversight

of the credit rating agencies.

Mr. KANJORSKI. All right.

Mr. Cantor.

Mr. CANTOR. We believe that any rating agency system in which

a party that obtains the rating and is interested in the outcome of

the ratings process is also paying for the rating. Whether it be an

investor-pays model, a government-pays model, or an issue-pay

model, it presents a potential conflict of interest which must be

carefully managed.

There are a variety of rating agencies using different models

today and we carefully manage our potential conflicts of interest to

the highest possible standards. We have been engaged in this particular business model for 40 years and produced a strong track

record.

We actually have historical experience of operating under an investor-pay model for the previous 60 years, which we can reflect

back upon and compare our performance and we have to how we

performed under that business model compared to the model we

adopted around 1970. And the historical data indicates that our

performance has been stronger since that time, both in terms of the

way we have been able to rank order the probability of loss across

different credits, and in terms of the losses that would have been

40

experienced by investors who bought all the securities that we

rated investment-grade in the two different periods.

Chairman TOWNS. The gentleman’s time has expired.

Mr. KANJORSKI. Thank you, Mr. Chairman.

Chairman TOWNS. I now yield to the gentleman from North

Carolina, Mr. McHenry.

Mr. MCHENRY. Thank you, Mr. Chairman.

Thank you all for testifying today. This is certainly important in

light of the financial crisis we have faced over the last year. I am

on the Financial Services Committee with my colleague, Mr. Kanjorski. We have gone into the, you know, causes of this crisis and

I think there is a wide agreement that the credit rating agencies

were complicit in this crisis for a number of reasons, some of which

were errors and omissions; others outright fraud by those that are

disclosing information to the NRSROs.

So Mr. Kolchinsky, you believe that corruption played a major

role in this crisis. Is that true?

Mr. KOLCHINSKY. Sir, I wouldn’t call it corruption. I would just

say very poor incentives were the major part of——

Mr. MCHENRY. OK. Do you believe that a weak analysis of these

new complex financial products was a part of it as well?

Mr. KOLCHINSKY. I think so, as well. More could have been done

and should have been done in 20/20 hindsight that could have analyzed these products. The main part of it is a lot of people just

should have said no to some of these products. And that is 20/20

hindsight, but I think that is the major part, to have just said, we

can’t analyze this with any degree of confidence and we should just

walk away from it. But that was just not possible.

Mr. MCHENRY. I think there is probably agreement on the panel

that reforms need to be instituted. I mean, I think that is fair.

Even Mr. Cantor gives a small nod.

But of particular interest to me as a policymaker on the Financial Services Committee is whether or not giving the SEC the authority to outline the minimum information that issuers should

provide the NRSROs. Is that a worthy policy that we should put

forward, empowering the SEC to specify what information needs to

be given to credit rating agencies? Mr. Kolchinsky.

Mr. KOLCHINSKY. Yes, sir. I think it is important for anybody to

set, it could be a private-public, self-regulating organization, to set

minimum standards that are applicable across the board for data

that can be provided. And there should be some government body

that passes judgment on that, whether that is sufficient.

Mr. MCHENRY. OK.

Mr. McCleskey.

We will finish with you, Mr. Cantor. I am asking Mr. McCleskey

first, then we can finish with you, Mr. Cantor.

Mr. MCCLESKEY. Yes, sir. I would first have to say that this is

more within the remit of my colleagues. But I would say this from

my own experience with regulations here and in Europe that I am

generally in favor of this, but you have to be careful that if you set

minimum standards, there is sometimes a tendency that people

will only do the minimum.

And I am also familiar enough with the complexity of the market

that there will be different types of information that will be approVerDate 11-MAY-2000 13:42 Apr 30, 2010 Jkt 000000 PO 00000 Frm 00044 Fmt 6633 Sfmt 6633 U:\DOCS\55751.TXT KATIE PsN: KATIE
41

priate for different types of securities. And as the universe of rated

securities expands, that will be difficult.

So there will challenges. But having said that, I am in favor of

it.

Mr. MCHENRY. Mr. Cantor.

Mr. CANTOR. I would be opposed of the idea to create minimum

standards for disclosure to rating agencies. I think minimum

standards for disclosure should be to the general public. I don’t

think we want to privilege rating agencies with special access to information based on government decisionmaking; that there is a

wealth of analysis that is done on fixed-income securities by rating

agencies, by investors at large, asset management companies, and

in the financial press and by academics, and I think it would be

a very bad idea to have specific rules for what should be shared

with credit rating agencies.

Mr. MCHENRY. I think what I am saying is, what is the, you

know, what is ratable, what information should the issuer provide

to rating agencies in order to provide a rate. I think you are answering a different question because——

Mr. CANTOR. Well, I am sorry. Maybe I was just particularly

struck by the notion of what should be shared with rating agencies.

I do believe there should be minimum standards for information

disclosure generally, including to rating agencies, and it should be

expanded for structured finance securities from where it is today.

Mr. MCHENRY. OK. It seems like you are answering a different

question originally. Yes, I am saying basically what is holding you

accountable, what is holding your client accountable to provide accurate, full, and complete disclosure? Because otherwise, then the

credit rating agencies are simply incompetent and didn’t see a financial crisis coming, if you are saying, you know, you got complete

information. Is that fair?

Mr. CANTOR. You are correct. The standards for what is required

for an issuer to disclose publicly is very different in structured finance than it is in corporate securities.

Mr. MCHENRY. Obviously.

Mr. CANTOR. And the potential liability of the issuer of such securities for false disclosures is different, and the completeness of

those disclosures. The requirements regarding completeness is very

different.

Mr. MCHENRY. So then you are in favor of the SEC providing

those minimums by which the issuer should provide the NRSROs?

Mr. CANTOR. The NRSROs and the general investing public.

Mr. MCHENRY. Thank you.

Chairman TOWNS. Thank you very much.

I now yield 5 minutes to the gentleman from Ohio, Congressman

Kucinich.

Mr. KUCINICH. Thank you, Mr. Chairman. I want to thank you

for holding the hearing.

Through the housing crisis and larger financial crisis, the credit

rating agencies seemed to have otherwise escaped any real scrutiny. I have been troubled by the increasing popularity of instruments called ‘‘re-remics.’’ What this stands for is resecuritization of

real estate mortgage investment conduits, and the shorthand is

called ‘‘re-remics.’’ And it basically amounts to repackaging original

42

investment instruments that no investor will touch into more complex investment vehicles.

Mr. Kolchinsky, are you familiar with these re-remics?

Mr. KOLCHINSKY. Yes, sir, I am.

Mr. KUCINICH. Mr. Cantor.

Mr. CANTOR. Yes.

Mr. KUCINICH. I wrote a letter, Mr. Chairman, to the chairman

of the SEC, Mary Schapiro, and I have spoken to her about this

issue. And here is what I have learned. The total resecuritization

market right now is approximately $664 billion. Of that total, only

$60 million is considered registered transactions. That means that

the SEC has looked at only $60 million. The vast majority of the

transactions are exempt from registration with the SEC.

But, Mr. Chairman, do you know who does look at these

resecuritized ties to real estate mortgage investment conduits, the

re-remics? Credit rating agencies.

So here we have a group of companies who played a substantial

role in bringing our economy to the brink of collapse and we have

to ask if they are doing it again. Financial institution takes some

toxic assets that no one wants, crams them together into a more

complex instrument, and presto, according to rating agencies, you

can have an investment-grade product. The practice of

securitization gained popularity as a way to provide liquidity to the

mortgage market and hedge against risk.

Apparently, the financial services industry has learned nothing

from our housing crisis because the rationale behind

resecuritization is to provide liquidity to the mortgage market and

hedge against risk, and the credit rating agencies, paid by the

issuers, are all too happy to oblige.

Now, Mr. Kolchinsky, seeing as that the re-remics are more complex, more opaque than the collateralized debt obligations, the

CDOs that came before them, what is to stop these resecuritization

of real estate mortgage investment conduits from bringing the entire system to the brink once again? What does the SEC have to

do to protect against a new disaster in the securities market? Do

you agree?

Mr. KOLCHINSKY. I agree that these re-remics or ‘‘repacks’’ as

they are called are potentially dangerous. Some have a purpose.

That purpose may be a gaming of capital requirements, accounting

requirements or what have you.

Mr. KUCINICH. Gaming?

Mr. KOLCHINSKY. Yes, sir. Recently, I actually saw a repack that

was proposed that had absolutely, to my view, no discernible economic value. Substantial costs would be incurred, but to my knowledge there would be no value added. So to me, that is a sign that

somebody is playing a game with some regulation somewhere.

Mr. KUCINICH. So you would agree, there is a danger here?

Mr. KOLCHINSKY. Yes, sir. Yes, sir.

Mr. KUCINICH. And then what about the role of credit rating

agencies? If someone tries to get assessed what the value of a

resecuritized real estate mortgage investment conduit is, they go to

a rating agency. Right?

Mr. KOLCHINSKY. That is correct.

43

Mr. KUCINICH. And is it in the interest of the rating agency to

try to find a way to give a rating so that they can get these things

out in the market?

Mr. KOLCHINSKY. That is correct.

Mr. KUCINICH. And Mr. Kolchinsky, that is even if you have just

a bundle of toxic assets where the value of it might be washed

away, essentially.

Mr. KOLCHINSKY. Yes, yes. These can be very problematic. Some

re-remics that were done last year went from AAA to C or CA.

Mr. KUCINICH. And Mr. Kolchinsky and Mr. Chairman, in light

of that, and we may want to do another hearing on this point,

Standard & Poor’s has already downgraded these re-remics that

they rated less than 5 months ago, due ‘‘to the significant deterioration in the performance of the loans backing the underlying certificate.’’

So the bottom line, Mr. Chairman, these are homes, and these

are families, and communities, our constituents. You have to watch

these credit ratings agencies. They could be setting us up for the

same thing all over again, and I am glad you are holding this hearing, Mr. Chairman. I hope we can get into this deeper.

I yield back.

Chairman TOWNS. Thank you very much. I thank the gentleman

from Ohio for his words.

From the State of Missouri, Mr. Luetkemeyer.

Mr. LUETKEMEYER. Thank you, Mr. Chairman. I appreciate the

opportunity to discuss this issue today.

Before I get started, I would like to echo the comments and sentiments of the ranking member with regards to the subpoenaed documents, to be able to further investigate and hold accountable

those entities that he was discussing a while ago, and I would hope

that you would certainly respond to his request.

With regards to the gentlemen before us, as a former bank regulator, I can assure you that when we looked at the investment portfolio of the financial institutions, your ratings are extremely important in our analysis of their financial structure and the liabilities

that they have on the books, and assets they have on the books.

And so for us to have this hearing today with regards to the viability of your ratings is extremely disconcerting to me from the

standpoint of what has happened and how important they are not

only to the banks, but other investment firms and the general public as a whole.

I guess my question to Mr. Kolchinsky is initially, and Mr.

McCleskey as well, is why do you believe that this happened? What

is the incentive for the ratings agencies to not do their job correctly

or to stray from the practice of doing the job they should be doing?

Mr. KOLCHINSKY. Sir, in my view, it is slightly the opposite.

There is no incentive for them not to. There is no incentive, and

to me, that is the benchmark for the whole industry. There is no

incentive to say no to a transaction.

Mr. LEUTKEMEYER. Then why did they do it?

Mr. KOLCHINSKY. For revenue. Rating agencies are large institutions with large fixed costs. And people getting a transaction in the

door. It is very difficult to say no to that transaction, especially if

that means you can take the revenue. You say no to it, you can

44

take it to another rating agency. There are no 11 rating agencies.

You can take it to another one, somebody who will say yes, and

that is a problem.

Mr. LEUTKEMEYER. So what you are saying is Congressman Kanjorski’s comment to the question of the agency’s being paid by the

very people who they are rating these securities for is an inherent

problem, and that is probably the reason for some of the problems

we have here. That is what you are saying?

Mr. KOLCHINSKY. That is right, sir. But the problem is that the

person can also select which rating agency they go to.

Mr. LEUTKEMEYER. OK.

Mr. KOLCHINSKY. And they are free to go to one or another until

they find one that will help them out. And again, these are——

Mr. LEUTKEMEYER. So there is really, I guess the question, it

begs the question, how rampant do you believe the inadequacies

are, or their willingness to look the other way, or their willingness

to do an inadequate job in lieu of or for further profitable gain is

there? I mean, is that the general method of operating, or are there

some inherent, or they are normally trying to do a good job, or they

just see a big client, we have to skew it so we can make a few

bucks here.

Mr. KOLCHINSKY. Sir, I don’t believe it is direct. I believe what

happens is that you have a client, you have a business, and people

talk themselves into being able to think that they can understand

a deal, can understand the structure and are comfortable with it.

I do not believe in most cases that any of this is a direct willingness to do something wrong. In most cases, it is getting comfortable

with something that may be outside of the envelope and there are

usually small little steps all the way down. It is a slippery slope.

Mr. LEUTKEMEYER. OK.

Mr. McCleskey.

Mr. MCCLESKEY. Sir, it would be speculation on my part to guess

why organizations are following particular paths, but I will make

three points. First, I would just observe that, especially earlier on

in my time at Moody’s, I will simply say that the senior management of the Structured Finance Group was very proud of the

amount of revenues they brought in, quite vocally. And that is all

I will say on that matter.

Also, I would say with respect to incentives, organizations don’t

make decisions. People do. And I think we need to take a look at

the incentives that fall on the individuals. And Mr. Cantor will

point out, and rightly so, that ratings are arrived at by committees,

but committees are led. Committees are made up of individuals.

And I think that you would actually have to look not just at, for

instance, the compensation practices, but you should also take a

look at things like the performance evaluations. What are the criteria on which key people are being evaluated? Yes, sir.

Mr. LEUTKEMEYER. OK.

Very quickly, my time is running out and I have one more quick

question for you.

Because it seems to be a prevalent problem with all the rating

agencies, is there collusion between the agencies? Have you seen

that? Or are you aware of that? Or would you speculate on that?

45

Mr. MCCLESKEY. I am not aware of any, and I would actually say

that there were a lot of efforts to make sure that there wasn’t even

the appearance of collusion.

Mr. LEUTKEMEYER. OK.

Mr. ISSA. Would the gentleman yield?

Mr. LEUTKEMEYER. Yes.

Mr. KOLCHINSKY. I agree with that.

Mr. LEUTKEMEYER. Yes. Thank you.

Thank you, Mr. Chairman.

Mr. ISSA. Yes, the model you have is the same model that basically PriceWaterhouseCoopers, Ernst & Young uses. You pay to get

an audit. Why is it yours appears to have failed where audits by

comparison, particularly after Sarbanes-Oxley, have been considered to do better?

Mr. KOLCHINSKY. Sir, I believe it is the existence of a minimum

standard. The problem is rating agencies today are judges and juries and executioners of their own methodologies. And it is very

easy for them to go down a slippery slope and to change methodologies and adjust it in order to get a client.

If you can imagine, for example, if an accountant could go to a

potential client and say, you know, your current auditor thinks

that this is a loss, but we think it is a gain. According to our methodology, it is a gain. If you hire us, bring us in, pass money, we

will do your books and we will make sure that is a gain. You would

see standards fall precipitously across the industry.

Accountants can’t really do that. And moreover, because there is

a minimum standard, if they do deviate from that, it is a clear case

of fraud or liability. That is one of the reasons I think you do see

some fraud cases, but it is very clear when fraud has occurred, and

you can take action in those cases.

Chairman TOWNS. The gentleman’s time has expired.

I now yield 5 minutes to the gentleman from Illinois, Mr.

Quigley.

Mr. QUIGLEY. Thank you, Mr. Chairman.

Mr. Cantor, you began by talking about some of the improvements you thought your firm had made in the last year. I guess

you would specifically talk about changes in methodology, your expertise would be methodology. Can you specify from where we were

at a year ago how your firm has changed or methodologies that

they no longer use that someone might have questioned at that

time?

Mr. CANTOR. Well, I will point out two examples.

Mr. QUIGLEY. I am sorry. Could everybody move their microphone closer because, especially over here, it is just very hard to

hear.

Mr. CANTOR. I will point to two examples of changes in methodology that reflect some of the lessons learned from the crisis. One of

the big surprises in the crisis was that real estate markets, mortgage credit quality declined extremely rapidly across the entire Nation within a very short period of time, and the ability to refinance

a loan, which had been generally widely available, would suddenly

disappear in nearly a blink of an eye.

This was a change in the environment for mortgage credit that

was beyond the range of our expectations. We consider a lot of sceVerDate 11-MAY-2000 13:42 Apr 30, 2010 Jkt 000000 PO 00000 Frm 00049 Fmt 6633 Sfmt 6633 U:\DOCS\55751.TXT KATIE PsN: KATIE
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narios, some of them positive for the outlook for mortgage credit

quality; many of them negative. And we have a whole distribution

of scenarios that we are contemplating when we evaluate the risk

of a mortgage-backed security.

But the particular experience of the last few years was outside

that range. We were not alone in being mistaken about this. Most

observers of the market, I would say nearly all observers of the

market, were completely surprised by what happened.

But having said been so surprised in this particular instance, we

recognize now that in all our methodologies, we must allow for a

greater possibility that outcomes well beyond our normal range of

expectations could be realized in a short period of time. So that is

one area of change.

The other area of change would be in our expectations of what

issuers of mortgage-backed securities would be providing to us

when we rate a mortgage-backed security. While it has been standard always for issuers of mortgage-backed securities or their underwriters to provide representations and warranties that the loans

underlying the mortgage-backed security met certain minimum criteria or were described accurately in their offering documents, the

ability to enforce those representations and warranties was not as

strong as it turned out was needed to make them effective.

We are now requiring much stronger representations and warranties, so if a loan defaults underlying a mortgage-backed security, and it is then discovered that loan was misrepresented in

terms of its initial credit characteristics, such as whether income

verification had been undertaken by the originator, that loan would

have to be bought back by the underwriter and the issuer and investors would not lose any money as a result.

Mr. QUIGLEY. There were new plans. There were new creative

ways of pooling mortgages together that were presented to the rating agencies. And it was described as financial alchemy that somehow a bunch of lower-rated mortgages bundled together and then

some sort of wand match waved over them and the package as a

whole was given a higher rating.

You know, are products like that given much greater scrutiny?

Or is that process not allowed at all in your firm?

Mr. CANTOR. Products that have a subprime collateral or lowrated collateral are given greater scrutiny than they had in the

past because it has been revealed that the performance of those

loans, while we always recognized the performance of those loans

were going to be worse than higher quality loans, we hadn’t anticipated the suddenness with which we could have a radical change

from the historical experience associated with those loans and a simultaneous defaulting across all of them at once.

Mr. QUIGLEY. All right. I am running out of time.

Mr. McCleskey, if there is time, as it relates to municipal bonds.

Your concern is primarily the fact that the process isn’t reviewed

often enough? Or are there processes similar to the ones that have

been described last year and the succeeding year, are there still,

are there questionable practices as well as to how municipal bonds

are reviewed at the same time?

Mr. MCCLESKEY. My concern was with respect to the frequency

of the review.

47

Mr. QUIGLEY. You didn’t review and find anything that was similar to the alchemy that has been talked about previously?

Mr. MCCLESKEY. No, sir. The municipal bonds tend to be a bit

more straightforward than these complex products.

Mr. QUIGLEY. Very good. Thank you.

Chairman TOWNS. The gentleman’s time has expired.

Congressman Chaffetz from Utah.

Mr. CHAFFETZ. Thank you, Mr. Chairman.

And thank you all for being here.

Mr. Chairman, let me just note at the beginning that I too would

echo the sentiments of our ranking member and the need to dive

deep into the Friends of Angelo and Countrywide program. I would

hope and encourage at the very least, Mr. Chairman, is that something that we could potentially vote on in this committee in terms

of being with the offer, or go after those subpoenas?

Chairman TOWNS. As indicated early on, the Justice Department,

I understand, is seriously looking at it and we do not want to interfere with what the Justice Department is doing. But I understand

your concern, and I respect the fact that you——

Mr. CHAFFETZ. Thank you, Mr. Chairman. This committee has

done an admirable job in a bipartisan way to dive into issues of

great importance. It is just my way of saying, as one Member on

the minority side of the aisle here, that this would be important

and certainly encourage that.

Let me get right to Mr. Cantor. Over the last 24 months, as you

look at this, did Moody’s succeed or fail over the last 24 months?

Mr. CANTOR. In the years leading up to the crisis——

Mr. CHAFFETZ. No, I am just looking at the last 2 years here. Do

you think you have succeeded or failed?

Mr. CANTOR. Well, the ratings that were put in place in 2006 and

2007 on mortgage-backed securities did not perform as we expected.

Mr. CHAFFETZ. Is that a——

Mr. CANTOR. They performed worse than we expected, much

worse.

Mr. CHAFFETZ. You are a rating agency. How would you rate

yourself?

Mr. CANTOR. We were deeply disappointed in the performance of

those——

Mr. CHAFFETZ. But how would you rate yourself? I mean, what

kind of——

Mr. CANTOR. We would not give a high grade to this performance

in this sector. We were deeply disappointed.

Mr. CHAFFETZ. You said earlier in your testimony, I was listening here, in response to one of the questions. It was about competition, saying that you would encourage and want competition. What

are you suggesting, then, that we do with the nationally recognized

statistical rating organization, the kind of oligopoly that you have?

Are you suggesting we break that up? Or are you suggesting that

we allow more people to compete and more institutions to compete?

When you say you are in favor of competition, what does that really mean?

Mr. CANTOR. We welcome additional competition. If the SEC

wishes to approve additional NRSROs, we would favor that.

48

Mr. CHAFFETZ. Do you think you have too much of a grip and a

stranglehold on that process, in being able to—and this oligopoly

that exists between the different agencies?

Mr. CANTOR. I don’t think we have any influence on that process.

We don’t have any influence on the SEC’s process.

Mr. CHAFFETZ. But, I mean, you say on the one hand you want

more competition. On the other hand, and you say that you give

yourself a, you know, not a very high grade. Is that compatible

with the current model that we have with the NRSROs?

Mr. CANTOR. Right. Well, I think we had a lot of company in failing to anticipate the depth of the mortgage crisis. So I expect when

investors look at our ratings and think about their utility, they are

reflecting on the long historical track record that we have, the performance of our ratings in the corporate sector, in the municipal

sector, and other sectors during this crisis. And it is not limited to

the performance of mortgage-backed and mortgage-related securities.

Mr. CHAFFETZ. You said that you are increasing the scrutiny that

is going on within the marketplace. I think I heard you say that

correctly. How many employees do you have now versus, say, 2 or

3 years ago? Do you have more employees or less employees?

Mr. CANTOR. We have a few more employees.

Mr. CHAFFETZ. Like a few more—help me with the numbers

here.

Mr. CANTOR. I am really not that familiar with the head count

numbers. I know we have had some expansion in our overall staffing during a period in time when the volume of activity has gone

significantly down. So during a period of actually reduction in the

business, we have actually added employees.

Mr. CHAFFETZ. For the people that you are responsible for, give

me a sense of how many people that is. Do you have more?

Mr. CANTOR. In my area, the size of the Credit Policy Group has

doubled from roughly 25 to over 50. We are a key part of our initiatives to improve the ratings quality, so it has been a particular

focus. And I am regularly asked by my boss, do I have the resources I need, and if I need more, I have been able to get it in

all cases.

Mr. CHAFFETZ. Thank you. Let me keep going. My time is so

short.

Did you see CNBC’s House of Cards?

Mr. CANTOR. No, I did not.

Mr. CHAFFETZ. You have not watched that program?

Mr. CANTOR. I did not.

Mr. CHAFFETZ. I would be interested to hear your reaction if you

have seen that.

Let me go specifically to the two gentlemen that are to your

right.

Did Moody’s retaliate against Mr. Kolchinsky in September 2007

after he raised his concerns that the company implement its

planned downgrade policy for the subprime CDOs, the

collateralized debt obligations? Did you or did you not retaliate

against him?

Mr. CANTOR. [inaudible] me?

Mr. CHAFFETZ. Yes.

49

Mr. CANTOR. Mr. Kolchinsky’s allegations have been investigated

and have been found to have no merit.

Mr. CHAFFETZ. So why was he transferred and his salary cut

after he raised these concerns?

Mr. CANTOR. I am not familiar with the personnel decisions that

were made, and I am certainly not familiar with Mr. Kolchinsky’s

salary.

Mr. CHAFFETZ. You don’t have any first-hand knowledge of why

he was transferred?

Mr. CANTOR. I know there was a reduction in staff in his area

within Moody’s. It was an area that——

Mr. CHAFFETZ. And he just happened to be the guy that——

Mr. CANTOR. This was—he was the manager in charge of rating

the mortgage-backed, mortgage-related securities from 2005 to

2007, I believe, and that area was the area of the poorest performance of our ratings, and it was an area that wasn’t going to see

hardly any activity going forward.

Mr. CHAFFETZ. So is that the extent of your first-hand knowledge? And may I ask you please if there is additional first-hand

knowledge that you have as to why he was transferred and why

this happened, that you provide it to this committee.

Mr. CANTOR. That is the extent of my knowledge, totally.

Mr. CHAFFETZ. Did Moody’s eventually adopt Mr. Kolchinsky’s

recommended policy after his transfer?

Mr. CANTOR. I know there was a policy recommendation made

before, I am not sure when it was. Before or after his transfer, he

made one policy recommendation that was communicated I think

to Compliance, maybe to others. It was carefully considered and it

was adopted, yes.

Mr. CHAFFETZ. So it was.

Mr. CANTOR. Yes.

Mr. CHAFFETZ. So he did give some good advice. Interesting. OK.

Mr. Kolchinsky, did the SEC ever respond to you when you contacted them about our allegations of misconduct at Moody’s?

Mr. KOLCHINSKY. They did. They contacted me last week.

Mr. CHAFFETZ. Just last week? So after this hearing was announced, you got contacted.

Mr. KOLCHINSKY. Yes.

Mr. CHAFFETZ. That is amazing. I am just absolutely amazed.

In your opinion, does the SEC’s failure to respond to your allegation shed any light on the agency’s ability to police the credit rating

agencies, as some in the administration has advocated?

One of the concerns, Mr. Chairman, that we have, and now my

time is up, is that here we have an agency that is failing to police

and dive into instances of alleged abuse, when you have whistleblowers like these gentlemen here who have stepped up and done

what is essentially the right thing, and trying to shed light, and

yet they only respond the week before this committee actually calls

them to testify.

So I know my time is expired, but I thank the chairman.

Chairman TOWNS. Thank you very much. The gentleman’s time

has expired.

I now call on Mr. Foster of Illinois.

50

Mr. FOSTER. Thank you, Mr. Chairman, for holding this important hearing.

One of the major problems that we are wrestling with here are

the conflicts of interest inherent in the issuer-pays business model

for the rating agencies. And I agree with Mr. Kolchinsky that the

best analog of this is how we handle conflicts in the oversight of

the accounting industry. And I believe that the best model for

going forward may be modeled on the Public Company Accounting

Oversight Board [PCAOB].

An oversight board like the PCAOB would be constituted largely

or dominantly by users of credit ratings and would have teeth. Specifically, it would have the powers to set standards, to mandate disclosures. It could conduct spot checks and investigations. It could

impose civil fines. It could ban firms and individuals from the credit rating industry.

I believe that the PCAOB has been necessary and sufficient to

restore credibility to the accounting industry in the post-Enron era.

And so my question is: What, if any, might be the downside of instituting a similar oversight board for the credit rating industry?

I guess I will start with Mr. Kolchinsky.

Mr. KOLCHINSKY. Sir, the only downside I can see from that

would be the argument of homogeneity of the ratings. In practical

terms, that is not much of a downside because with ratings shopping and the bankers in charge of selecting which ratings agency

to go to, they were effectively, there were very few differences between ratings.

So theoretically, that would be a downside, but in practical purposes, that was already the practice.

Mr. FOSTER. So your reservations are that it might not be a complete solution, but that there would be no——

Mr. KOLCHINSKY. It would not be a complete solution.

Mr. FOSTER. Right.

Mr. KOLCHINSKY. There is no perfect solution to this problem,

but I think this is something that allows competition between ratings firms. It allows some minimum standards for the protection of

taxpayers and investors. And it allows things to be done in a public

transparent matter, instead of being done in backrooms or committee rooms at the rating agencies.

Mr. FOSTER. All right. So in general, you would endorse that way

forward?

Mr. KOLCHINSKY. Very strongly. Yes, sir.

Mr. FOSTER. Mr. McCleskey.

Mr. MCCLESKEY. Sir, the model that you describe also sounds

analogous to FINRA, which was NASD when I worked there. I

worked there for 5 years as an investigator, and I have to say that

I am supportive of that model for the reasons that you have already mentioned.

I think that you are able to draw on more experience. You are

able to pay people more than on government scale when you have

essentially a self-regulatory organization.

Now, I would point out that in essence the SEC backstops

FINRA, that there are some shared jurisdiction. And I think that

is a good model as well. The SEC also provides oversight of the

self-regulatory organizations, and I think that should be a legitiVerDate 11-MAY-2000 13:42 Apr 30, 2010 Jkt 000000 PO 00000 Frm 00054 Fmt 6633 Sfmt 6633 U:\DOCS\55751.TXT KATIE PsN: KATIE
51

mate role of such an organization. So I would agree it is not a complete solution, but I would say that it would be helpful.

What is the downside? I would say, you know, it has to be funded, but you know, some things, you know, my view, having been

in this business for quite some time, is sometimes regulation does

cost money. It is a cost of doing business.

Mr. FOSTER. Pure industry self-regulation did not stop the Enron

scandals and so on. And that would be the advantage of making

it somewhat less than pure industry self-regulation.

Mr. Cantor.

Mr. CANTOR. In the list of powers that you would ascribe to this

new entity, it seemed to me that most of those powers already reside with the SEC, and I would leave it for others to decide where

those, you know, what type of organization is best able to implement those powers. But I would support and continue to support

the type of powers that you describe, with the exception of a proposal I thought I heard you say to establish essentially standards

for methodologies, which would basically introduce a government

agency or a government-type agency into the opinion-setting process and effectively stifle diversity of opinion and would lead to essentially, eventually lead to government-based ratings, not privately determined opinions.

Mr. FOSTER. I understand. That is an issue that I am personally

conflicted on. You know, there is the usual debate about discouraging innovation versus setting standards. And I think there is certainly merit that at least part of what gets reported is based on

standards that can be compared side by side for all rating agencies.

Anyway, thank you and I yield back.

Chairman TOWNS. Thank you very much.

I now yield 5 minutes to the gentleman from Indiana, Mr.

Souder.

Mr. SOUDER. I thank the chairman, and I want to join with the

other Republicans. I know you are fair. You try to work these

things out, to have a Friends of Angelo hearing. I understand the

Justice Department is looking at it. They look at a lot of things

that we do, but it appears if we don’t do a hearing on that very

public subject that we are afraid to touch it because it might have

involved Members of Congress. And I would encourage the chairman to continue to look at and I would appreciate if he would do

so.

Chairman TOWNS. I appreciate the gentleman’s concern.

Mr. SOUDER. I have a couple of general comments I want to

make, and then a couple of very direct questions that I fear I am

not going to be able to get an answer to.

One is that I don’t view this as a failure of capitalism. Part of

the problem here is, as Mr. Issa said, is when you have three companies that have 90 percent of the market, how does an oligopoly

work versus a true competition? And that is really what we are

kind of probing in these hearings, because the function of this committee is to look at the past. We are an oversight committee. Other

legislative committees look at the future.

So Mr. Cantor, when you say we have made changes, that isn’t

really enough right now. We have to dig in and find out what happened to see whether those changes are adequate. We had this disVerDate 11-MAY-2000 13:42 Apr 30, 2010 Jkt 000000 PO 00000 Frm 00055 Fmt 6633 Sfmt 6633 U:\DOCS\55751.TXT KATIE PsN: KATIE
52

cussion with Mark McGwire who didn’t want to be here to walk

about the past, but we had to understand steroids before we could

talk about what we were going to do in the future.

And that the whole fundamental premise of capitalism requires

accurate information. We believe capitalism can regulate itself if in

fact ratings are accurate, information is there, and can do that. But

in the failure to do that, which clearly there were whoppers of errors here, we had five billionaires on the panel here.

When I asked Mr. Paulson, who made the most that year, $3.7

billion, how did you make the money, how did you make that

much, because it seemed to me a lot of the evidence of the housing

bubble was there, he said, ‘‘I bet against all the people who were

going the other direction.’’

That is how they made $1 billion that year because they could

figure out that the market was about to collapse, and why couldn’t

the rating agencies figure that out, which are more for the average

person is likely to buy based on the rating agencies. And that suggests that very sophisticated analysts could get different information or had either access to information or understood information

differently than the basic bond rating agencies.

Now, Mr. Issa raised another fundamental question, and Mr.

Cantor, you gave two things that have been frustrating to this committee. One is we never seem to have the right person there to answer the questions. And the second part is that in the legal question, it was said by Mr. McCleskey, I think, in his testimony, says

there may be civil lawsuits here. And part of the problem in getting

all the information is that if you have pending lawsuits, just like

in the case of Friends of Angelo, the No. 1 thing that people in my

District want to know, is if there was corruption or if there was collusion or withholding information, did people go to jail? That is the

No. 1 thing. They don’t want our committee to trample on that.

But the chairman may have to call some people in to let the

American people see that there is a refusal to answer the questions

because, in fact, there is an investigation, because my fundamental

question is, in Mr. McCleskey’s charge, for example, that it was 15

to 20 years that some of these agencies hadn’t been reviewed for

public securities of cities and towns and so on. Is that true? And

have you submitted emails to suggest that you had a debate about

that?

Mr. CANTOR. You want to know what are, describe our surveillance practices for U.S., local and regional governments?

Mr. SOUDER. In other words, have you submitted evidence to this

committee that suggests that he was factually incorrect?

Mr. CANTOR. I haven’t seen the particulars of what Mr.

McCleskey has been asserting, so I don’t know whether it is correct

or not correct.

Mr. SOUDER. Mr. McCleskey, you made the allegation here today

in your testimony. Have you ever seen any evidence that suggests

you were incorrect in your allegation that they hadn’t reviewed

these securities in many years?

Mr. MCCLESKEY. No, sir. I think that by the time I left, there

were some discussions about how to improve it, but that as I recall

there were still a lot of problems out there. And the simple fact of

53

the matter is that you have tens of thousands of these things out

there.

In my view, the only way that these can be reviewed at all is

through algorithms that will pop up alerts, the same way that we

do in a lot of other compliance and regulatory matters.

Mr. SOUDER. Let me ask you a broader question here, because

both of you have made allegations. You were whistleblowers. You

have a track record of that. The company is responding that you

were inaccurate; that for one reason or another your department

wasn’t performing well. That is why you were terminated. It wasn’t

anything to do with being whistleblowers.

Well, the only way to check that is because they claim that there

was internal debate, and you claim there wasn’t internal debate.

One of the only ways this committee can verify whether there was

an internal debate is to get documents from the company that

prove that there was an internal debate. And to my knowledge, we

don’t have those documents.

And the question is, is the reason we don’t have those documents

is because this is about a lawsuit that if, in fact, we found that

there were no such documents, that the company would be vulnerable to lawsuits because it would show that there wasn’t any internal debate.

Do you believe such documents exist anywhere in the system? Or

have any knowledge that once it matches up, that they had a debate and your argument was rejected, as opposed to the fact there

wasn’t a debate, and that is why you were filing your complaints?

Mr. MCCLESKEY. Well, I think, as I said before, the problem is:

Was anything documented? So there may be, whether there is a debate or not, the question of whether people could provide you documents may be a different issue, whether documents were actually

created.

Mr. SOUDER. Mr. Chairman, this is a very critical point because

if they can, because the basic establishment question here is that

the whistleblowers’ charges were just their opinion, and that in fact

there was a robust debate and their opinion was rejected, and they

just made a bad decision about what was happening in the market.

Whereas the counter-argument that would say the government

does it is basically saying that there was corruption involved. And

if there is a civil lawsuit threat here, we may not get those documents. But if there is proof that they actually had an internal debate and they just made a bad decision, that would affect what we

would propose legislatively.

I yield back.

Chairman TOWNS. Good point, and that is why we would ask Mr.

Cantor to make certain that we get the documents. I mean, I think

this is so important. There was a meltdown and we are really trying to get to the bottom of it, and we need your help in the process.

When we look at the fact that Lehman Brothers was rated AAA.

AIG was AAA. And then all of a sudden, look what happened? So

it is important that, you know, we know. And I am hoping that you

will cooperate, you know, or maybe you feel there is no problem.

Do you feel there is a problem?

Mr. CANTOR. Problem with what?

54

Chairman TOWNS. You don’t think there is a meltdown? I mean,

you have heard of that, haven’t you?

Mr. CANTOR. The financial crisis has been severe.

Chairman TOWNS. Yes. And you don’t see that you had a role in

it in terms of the rating agencies?

Mr. CANTOR. During the buildup to this financial crisis, there

was a whole chain of events and participants in the market of

which we were one that made poor decisions and did not perform

as expected. I think we were not alone, and I don’t think we were

the biggest and most important player in this, but we did misjudge

the extent of the coming meltdown in mortgage-related securities.

Chairman TOWNS. So that is the reason why we need the documents.

Congresswoman Speier from California.

Ms. SPEIER. Thank you, Mr. Chairman.

Mr. Cantor, I have probably sat in on 200 or 300 hours of hearings in the last year on the financial services industry, and I come

to one simple conclusion. The financial service industry has basically created this structure so that heads they win, and tails the

American people lose.

And it all comes down to something so very basic. Let’s start with Lehman’s. You rated them as AAA. $2 billion was lost in Lehman’s AAA securities by cities and counties throughout this country, money that they were setting aside because they were about

to do constructions on schools and firehouses and the like. And it

was just up in air. Poof.

The American people really want to have some level of accountability. And I want to ask you if you took action or Moody’s took

action against anyone who had rated Lehman’s as AAA. Was there

any disciplinary action taken against anyone?

Mr. CANTOR. Lehman was rated A and was rated through a rating committee process. There were no actions taken against anyone

involved in that process, that everything that was done was according to our codes of conduct, and there was no basis for doing——

Ms. SPEIER. If nothing was done to anyone who rated Lehman’s

as an A when it was bankrupt, then something is wrong with your

methodology.

Now, isn’t it true that a couple of years ago your industry, and

Moody’s was part of it, came to Congress and said, we want to be

regulated, but we want you also to pass a law that provides that

no private right of action can be brought against us as rating agencies.

Mr. CANTOR. I don’t recall any such thing. We currently are subject to securities law, and we are subject and can be sued, and have

been sued.

Ms. SPEIER. But no individual private rights of action?

Mr. CANTOR. Again, I am not an expert in legal matters. My understanding is there are private rights of action.

Ms. SPEIER. All right. Let me ask you about this. In Mr.

Kolchinsky’s internal memo to Moody’s executives, he said that the

assigned ratings in the Sahara Finance EUR, Limited were clearly

wrong. In fact, Mr. Kolchinsky then urged Moody’s to stop a related

transaction from adding billions of more toxic assets to investment

balance sheets.

55

I guess the first question should be to Mr. Kolchinsky. Did

Moody’s take any action?

Mr. KOLCHINSKY. Ma’am, I do not believe the second transaction

was rated, as far as I know.

Ms. SPEIER. Was not rated?

Mr. KOLCHINSKY. Was not rated. So the second transaction that

I warned about——

Ms. SPEIER. And the first was rated, and it was rated at what?

Mr. KOLCHINSKY. I do not recall at this point. It was an investment-grade rating, but I don’t recall off the top of my head.

Ms. SPEIER. Mr. Cantor, do you recall?

Mr. CANTOR. I believe this transaction was rated and was rated

AA three.

Ms. SPEIER. AA three. And then what happened to this particular transaction?

Mr. CANTOR. It is currently rated AA three.

Ms. SPEIER. It still is rated as——

Mr. CANTOR. Its rating hasn’t changed.

Ms. SPEIER. I am sorry?

Mr. CANTOR. Its rating has not changed.

Ms. SPEIER. Its rating has not changed. And the subsequent

transaction was not rated. And why was it not rated?

Mr. CANTOR. I am not familiar with the specifics of that, so I

can’t address it.

Ms. SPEIER. All right. Let me ask you this. One of the big problems that some of us see is that there is a huge conflict of interest,

that issuers come to you and ask you to give them consulting services so that when they package their particular issuance, it will be

rated highly. So much like the accounting industry where we put

firewalls up, many of us suggest that you should have firewalls between your consulting services and your rating services.

It also appears that your compliance staff reports to your general

counsel, and the general counsel’s responsibility is to prevent liability for Moody’s. But the compliance officers are there to make sure

that Moody’s is complying with all the SEC regulation. So it would

suggest that you have on the one hand compliance officers who are

supposedly making sure that you are following SEC guidelines, reporting to an individual as general counsel who wants to make

sure that you have no liability, so there will be a conflict, just very

significant. Has that particular structure——

Mr. CANTOR. I believe on the contrary. The general counsel’s role

is to avoid liability exposure for the company and there is no better

way to avoid liability than to have your employees comply with

your regulations and code of conduct.

Ms. SPEIER. Well, Mr. Chairman, my time has expired, but I

can’t understand how you could take qualified people in your compliance section, dump them, and bring people who don’t have any

expertise in compliance and place them in that role under the general counsel unless you were really trying to avoid having people

who were going to ask questions about how you were doing business.

I yield back.

Chairman TOWNS. Thank you very much.

56

I now yield to the gentleman from Virginia, Congressman

Connolly.

Mr. CONNOLLY. I thank the chairman, and I thank him for this

thoughtful hearing.

Well, let me pick up on the last exchange between the gentlelady

from California and yourself, Mr. Cantor. You said the best way to

avoid liability is to make sure you comply. Is there some reason,

our staff were briefed this morning about the Kramer Levin review,

which I guess you were referring to when you said that the allegations put forward by Mr. Kolchinsky were investigated and found

to be baseless. Although it is my understanding that, a), that review is not complete; and that b), the entirety of this review will

be oral. It will not be put in writing. Is there a reason for that?

Mr. CANTOR. We discussed earlier the communications around

and documentation around that investigation. I will communicate

the wishes of this committee to our legal counsel and I expect they

will be able to comply with any request that comes from the committee.

Mr. CONNOLLY. Well, that is really not my question. Is there a

reason why, I mean, this strikes me as quite unusual that a review

of charges of fraud by your outside counsel would, in fact, not be

in writing. And apparently, Kramer Levin indicated it is not going

to be put in writing.

Mr. CANTOR. I am not familiar with whether there will be a written report or not.

Mr. CONNOLLY. Are you familiar with the fact that it is or is not

the practice of Moody’s to give such instructions to outside counsel?

Mr. CANTOR. I am not familiar with the instructions that we

have given in these cases. My role as the chief credit officer is to

review the methodologies and the quality of the ratings.

Mr. CONNOLLY. Do you remember any outside counsel ever investigating anything at Moody’s in the past? Anything strike you in

terms of a review and whether it was put in writing or not?

Mr. CANTOR. I have not been part of a process of a previous external review.

Mr. CONNOLLY. Well, all right. Sticking to the same sort of seeming penchant for secrecy, Mr. McCleskey, in your letter to the SEC,

you said that John Goggins, the general counsel at Moody’s, told

employees not to put any compliance or rating problem in emails

or any other written form. Why would he give such instructions, do

you think?

Mr. MCCLESKEY. Well, sir, the first thing I would say is I didn’t

have that directly from John Goggins because I had very few conversations with John Goggins at all. Everything came through Michael Kanef. And although Mr. Goggins, the general counsel, was

my second-level supervisor, and although he spent considerable

time with the other person at my level, in the almost year that I

was underneath him, he did not set foot in my office a single time.

Mr. CONNOLLY. Well, irrespective of whether it was Mr. Goggins

or not, was it in fact your understanding generally, company-wide,

don’t put anything in writing?

Mr. MCCLESKEY. That was definitely communicated.

Mr. CONNOLLY. And why do you think that was generally communicated?

57

Mr. MCCLESKEY. Well, my speculation, sir, would be really going

back to the point that was raised earlier. You have two different

comparatives, if you will, between compliance and legal departments that are concerned about liability. In compliance, you need

to document when you see a problem. You need to document what

you did about it, because if it is not documented, it didn’t happen

in the eyes of the regulators.

Mr. CONNOLLY. Yes.

Mr. MCCLESKEY. So if we would see something, we would want

to document it. From a liability point of view, at least theoretically,

you don’t want to have documents lying around.

Mr. CONNOLLY. Let me ask you, Mr. McCleskey, at any points

did superiors at Moody’s tell you not to talk to SEC investigators

during the SEC sweep investigation?

Mr. MCCLESKEY. Nobody ever directed me not to talk to the SEC.

Mr. CONNOLLY. So we do have secrecy, well, or at least a desire

to avoid putting things in writing, whether it be outside reports

about fraud allegations or whether it be anything that could be

traceable by the SEC, apparently built into the culture. Would that

be a fair characterization, in your opinion?

Mr. MCCLESKEY. Yes, sir.

Mr. CONNOLLY. Mr. Cantor.

Mr. CANTOR. I am sorry. What was the question? That we have

a secrecy culture?

Mr. CONNOLLY. I guess I am asking you to comment as to whether there is this culture of the avoidance of having anything traceable in writing, even to the extent, as I asked you earlier, about

an outside counsel report on an allegation of fraud, from Mr.

Kolchinsky which, by the way, earlier you assured us was baseless

based on a report that is not completed and not in writing, and

then you told us, well, I am not familiar with past history or why

it might not be in writing. You were confident enough to cite it as

exonerating, but not confident to talk about the details of whether

it is in writing or not.

Mr. CANTOR. Moody’s conducted its own internal review and

reached that conclusion. The preliminary findings of the outside

law firm confirms those findings.

Mr. CONNOLLY. Was the Moody’s internal review in writing? Is

that something you can share with the committee?

Mr. CANTOR. I have not reviewed anything. There may be a document. I don’t know.

Mr. CONNOLLY. Well, if you haven’t reviewed it, sir, how can you

speak with such confidence before this committee under oath that

internal review can be trusted?

Mr. CANTOR. Because I spoke with our head of compliance and

regulatory affairs, and he discussed it with me.

Mr. CONNOLLY. I see.

My time is up, Mr. Chairman.

Ms. NORTON [presiding]. Next, the gentleman from Florida, Mr.

Mica.

Mr. MICA. Thank you.

Just a couple of quick questions, I guess to Mr. Kolchinsky. You

made a series of allegations about Moody’s misconduct. I believe

you are the one who made those allegations in a letter to the SEC.

58

What was the basis of your allegations? I mean, you saw things

that were going on and then you thought it was your responsibility

to report to SEC what you saw going wrong. So what did you see

wrong at what point, and when did you notify the SEC?

Mr. KOLCHINSKY. Sir, my first report was to the Compliance

Group about——

Mr. MICA. I am sorry?

Mr. KOLCHINSKY. My first report was to the Compliance Group.

I put it into——

Mr. MICA. In writing?

Mr. KOLCHINSKY. In writing. It was a 14-page memorandum.

Mr. MICA. And did they respond to you?

Mr. KOLCHINSKY. As far as I know, they hired Kramer Levin and

also suspended me.

Mr. MICA. They what?

Mr. KOLCHINSKY. They suspended me.

Mr. MICA. The company suspended you.

Mr. KOLCHINSKY. Yes, sir.

Mr. MICA. For whistleblowing?

Mr. KOLCHINSKY. That is my belief, yes.

Mr. MICA. OK. But you never got a written response from SEC

to this date?

Mr. KOLCHINSKY. Sir, after I was suspended, I reached out to the

SEC to make them aware of these violations. I spoke to them last

week, and we are planning on meeting so I can discuss further

with them.

Mr. MICA. OK. But again, first you found that you thought it was

incumbent on you to report what you saw as improper activities.

And you talked to Compliance and you also wrote to Compliance

both?

Mr. KOLCHINSKY. I wrote to Compliance.

Mr. MICA. I am sorry?

Mr. KOLCHINSKY. I wrote to Compliance.

Mr. MICA. You wrote. OK. And you never had gotten a response?

Mr. KOLCHINSKY. I, as we discussed previous, everything was

mostly done by phone call. So I received a phone call.

Mr. MICA. They called you in response to your letter?

Mr. KOLCHINSKY. They called me and they said they are bringing

in Kramer Levin and somebody from Kramer Levin will be in contact with me. All communications from them were verbal.

Mr. MICA. So how did Moody’s find out about what took place?

Mr. KOLCHINSKY. I handed Michael Kanef the memo that I

wrote.

Mr. MICA. OK.

Mr. McCleskey, you also reported wrongdoing. Did you report

that to the SEC?

Mr. MCCLESKEY. Sir, I sent a letter after my departure to the

SEC. It is probably going too far.

Mr. MICA. I am sorry. For some reason, I couldn’t hear you. You

sent a letter?

Mr. MCCLESKEY. I am sorry. I sent a letter to the SEC after my

departure.

Mr. MICA. After your departure?

59

Mr. MCCLESKEY. Yes, sir. And I don’t think I would characterize

it as necessarily whistleblowing with respect to wrongdoing. I

wanted to flag an issue to them to make sure that they were aware

of it when they were preparing to conduct their examinations.

Mr. MICA. Was your departure voluntary?

Mr. MCCLESKEY. No, sir.

Mr. MICA. So they terminated you. Did they cite the cause for

which you were terminated?

Mr. MCCLESKEY. No, sir. All they did was they said that senior

management had lost confidence in me.

Mr. MICA. Had you had any contact with SEC or any other individuals in reporting activities before the letter that you sent after

you departed and were dismissed?

Mr. MCCLESKEY. I did not have any contact with the SEC prior

to my departure.

Mr. MICA. Or anyone else who you reported whatever activities

you thought should have attention of a regulatory body?

Mr. MCCLESKEY. No, sir. I don’t think my departure was directly

related to any whistleblowing.

Mr. MICA. OK. And did you get a response to your comments

that you made for attention to SEC after you were terminated and

departed?

Mr. MCCLESKEY. They sent me an email confirming receipt and

said they were considering what to do about it.

Mr. MICA. OK.

Mr. Cantor, why should the Federal Government continue to

grant Moody’s and other big credit rating agencies a protected oligopoly by requiring financial institutions to rely only on your ratings?

Mr. CANTOR. Moody’s favors the reduction and elimination of the

use of ratings in regulation, so we do not favor it.

Mr. MICA. So you feel that others could be involved in the process?

Mr. CANTOR. Yes.

Mr. MICA. Do you think Congress should regulate that process?

Mr. CANTOR. There is currently a draft bill that has been prepared in Congress to remove the use of ratings in many government legislation and regulations.

Mr. MICA. How do you think that should be structured? You

don’t have to comment on the bill that is before us, but what would

be a fair way to have, say, some competitiveness in credit rating,

but also keep a high standard of rating?

Mr. CANTOR. Right. Well, I think in addition to reducing the regulatory reliance on ratings, the field of competition in the market

could be improved by enhancing the financial disclosures required

by issuers of structured finance securities.

At present, given the limited disclosure requirements in that

market, only rating agencies that have been asked to rate those securities have the full access to all the information that might be

needed to evaluate the risks of those securities. And we recommend

that the SEC require more extensive financial disclosure, much as

is required of corporations in America when they issue debt into

the capital markets.

60

And that way, multiple rating agencies, not just the ratings

agencies asked to rate the debt, and multiple analysts from different types of firms, can do their own analysis and choose to publish that analysis if they wish to monetize their conclusions or just

provide for some other reason that information to the broader marketplace.

Ms. NORTON. The gentleman’s time has expired.

I will take 5 minutes.

I am curious before I ask a question about the Compliance Group

that fascinates me, this internal watchdog. Given the blanket dependence, I would say of the Nation. It is hard to think of an institution, or for that matter, individuals that weren’t dependent upon

these credit agencies. Given the source of their revenue, has the

fall, the collapse of the economy, had an effect on the revenue of

Moody’s, or for that matter, if you know of any of the other rating

agencies?

Mr. Cantor.

Mr. CANTOR. Moody’s has had significant decline in revenue over

the last 2 years, yes.

Ms. NORTON. Why is that? Is it because people aren’t, those who

fund them, which of course those whom they regulate, as it were,

or who we depend upon them, is it because they go less often to

the rating agencies? Why has the revenue fallen?

Mr. CANTOR. We have had fewer requests for ratings.

Ms. NORTON. Sorry?

Mr. CANTOR. We have had fewer requests for ratings.

Ms. NORTON. So people are out there on their own? There is nobody watching. If you can say they were watching, there is nobody

watching now. People, does that, any of the three of you think that

shows a lack of confidence in the agencies now, that revenue has

fallen and folks don’t regard a rating as particularly, or at least absolutely indispensable any longer?

Mr. Kolchinsky.

Mr. KOLCHINSKY. I think certainly the confidence in the rating

agencies has fallen. The drop in revenue is primarily due to drop

in revenue from structured products, and I think——

Ms. NORTON. Due to what? I am sorry.

Mr. KOLCHINSKY. The drop in revenue in structured products.

Those are the products, like mortgage-backed securities.

Ms. NORTON. Yes. Fewer of those products, derivatives, etc., to

talk about or to grade.

Ms. KOLCHINSKY. Yes, ma’am. And I think a lot of that has to

do with the fact that at the time of the boom, one structured product would buy another structured product. So ABS CDO would buy

subprime, and SIV would buy a part of the ABS CDO.

When that chain broke, that whole market disappeared. So there

weren’t a lot of what is called in the industry ‘‘real money investors’’ that were actually buying these products. These were all

moved on bank balance sheets or somewhere else into another

structured product.

Ms. NORTON. I am fascinated by this internal watchdog. Internal

watchdogs normally do not yield a lot of confidence, and one reason

it is hard to set one that can yield confidence. We have tried here

in this Congress. You know, how do you get enough without too

61

much if you are, in essence, trying to do internal regulation of your

own conduct.

Mr. Kolchinsky, you have indicated or cast doubt upon the independence of Moody’s’ compliance Group.

Mr. KOLCHINSKY. Yes, ma’am.

Ms. NORTON. Why do you believe the Compliance Group is not

independent, in whatever the word independent can mean within

those internal watchdog circumstances?

Mr. KOLCHINSKY. Ma’am, there are several reasons. First of all,

I believe——

Ms. NORTON. Speak a little louder into the microphone.

Mr. KOLCHINSKY. Sorry. I believe there are several reasons for

that. I believe, first, a truly independent Compliance Group would

report up to the independent members of the Board of Directors.

They would not have a reporting line from the general counsel to

the CEO on the business generation.

Second of all, I——

Ms. NORTON. So are they reporting in the same way they were

reporting?

Mr. KOLCHINSKY. I believe so. They are still reporting through

the general counsel up to the CEO. And there is no scrutiny of that

from the Board of Directors, or the independent members——

Ms. NORTON. So the same people who were reviewing their work

are still reviewing their work, with whatever lessons the collapse

may have taught them?

Mr. KOLCHINSKY. Yes.

Ms. NORTON. Do you believe that with the same, is it the same

chain of command, essentially?

Mr. KOLCHINSKY. It is the same chain of command as I believe

when Scott, Mr. McCleskey, was at the rating agency. Yes.

Ms. NORTON. So no change in the chain. And I understand the

conundrum here. How do you change, there are only so many people you can report to. What would be the resistance, since this is

a watchdog? Because it doesn’t involve matters of ethical matters,

matters of the law. You could always ask the general counsel to advise you.

Mr. McCleskey, Mr. Cantor, what would be the resistance to reporting to the Board of Trustees who have a fiduciary obligation

and therefore, it seems to me, are the only really appropriate overseers within the organization?

Mr. CANTOR. The individual that is responsible for both compliance and regulatory affairs, so the person in charge of compliance,

has an additional duty as well to also liaise with our regulators.

That person has met regularly with our Board of Directors, I believe quarterly, and meets with our independent Board of Directors.

Ms. NORTON. My time, too, is limited. I want to know why, as

I say, I would expect him to meet. I expect the Board to consult

with him. What reason could a rating agency offer for not having

the report unfiltered of a violation go first to the Board of Directors? Then they could ask general counsel. They could ask outside

counsel. They could ask the government.

Why, in light of what it seems to me was the unkindest cut of

all, the cut that came from the agencies on whom everybody deVerDate 11-MAY-2000 13:42 Apr 30, 2010 Jkt 000000 PO 00000 Frm 00065 Fmt 6633 Sfmt 6633 U:\DOCS\55751.TXT KATIE PsN: KATIE
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pended, why isn’t the way to restore confidence at least to place responsibility for notification of violations of ethical standards and

the law, first to the Board of Trustees or to the Board, whatever

it is called, so that it can decide whom to consult?

What is the resistance and how would anybody justify reporting

in the very same way that the chain of command occurred before,

and that everyone agrees was an ingredient to the collapse of the

economy?

Mr. MCCLESKEY. If I could respond to that question, because I

was the person who was involved in this chain of command. The

first distinction I would make is that the person who Mr. Cantor

described is not the head of Compliance. The head of Compliance,

as designated on public filings to the SEC, reports to Mr. Kanef.

Mr. Kanef reports to the general counsel.

Now, when I first got to Moody’s, we had a different reporting

chain and the idea was that once a year I would report to the

Board, and in the first year, I did. After the chain of command

changed, I did not have access to the board.

Ms. NORTON. Should you have?

Mr. MCCLESKEY. Yes. And to answer your question, what is the

motivation for it, I can only speculate, but in my view, having been

there and in that situation, it is a matter of controlling risk, that

you have somebody there who doesn’t come from the litigation

background or has this different agenda, the compliance officer. I

simply don’t believe that it was viewed prudent to have the actual

head of Compliance have that kind of access.

Ms. NORTON. Prudent? I am just looking for a reason, you know.

Mr. MCCLESKEY. It is my speculation, but it is speculation based

on my experience.

Ms. NORTON. Yes. Finally, if one is looking at how to regulate

this matter and one is trying to keep the government from getting

into the weeds, would you suggest that a report directly to the

Board might be one place to begin?

Mr. MCCLESKEY. I would, yes.

Ms. NORTON. The requirement of a report to the Board might be

one place to begin?

Mr. MCCLESKEY. I would.

Ms. NORTON. Yes.

Mr. KOLCHINSKY. Yes, ma’am.

Ms. NORTON. What about you, Mr. Cantor?

Mr. CANTOR. A report from Compliance directly to the Board of

Directors would be something we would consider. I don’t see a difficulty with it.

Ms. NORTON. So what was good enough before is good enough

now. Thank you, Mr. Cantor.

Mr. Lynch of Massachusetts.

Mr. LYNCH. Thank you, Madam Chair.

I want to thank the witnesses for helping us with our work.

It appears that, at least as this reform proposal moves forward,

we are still going to have over the counter derivatives traded.

These structured products are going to be traded outside of exchanges. And it appears, at least the way this is developing, we are

still going to have an issuer-pays model after all this reform is

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done. So we are still going to have the conflict of interest that we

have been dealing with in the past.

It seems to me that if we are not going to eliminate the conflict

of interest in the issuer-pays model, then we have to somehow balance that. And at least the only way I can imagine doing that is

to introduce some type of liability on the part of rating agencies

that stamp AAA on these structured products. Because the vast

majority of the market, they don’t understand deeply the mechanisms of these structured products, but they do understand AAA.

They do. And that is what allowed a lot of these projects to go viral

and cause problems in the first place.

It seems to me that there has to be some type of underlying liability for the rating agency if they slap AAA on something that

doesn’t deserve it. And right now, the way we have this system, it

is tantamount to immunity for the rating agencies, even though

they recklessly put AAA on a product that turned into junk 30 days

later or 60 days later or 90 days later.

Mr. Kolchinsky and Mr. McCleskey and Mr. Cantor, is this a viable option of introducing some liability that might act as a constraint on these rating agencies from giving ratings to these products in return for cash? Because the rating agencies are also going

to get extra money, they are going to get a bigger payday for rating

these complex structured products, then they do the standard products.

So how would you suggest that we eliminate this conflict of interest and there is liability, one of those options?

Mr. Kolchinsky.

Mr. KOLCHINSKY. Sir, I believe that extra liability should come

hand in hand with specific defined standards. And that does two

things. On the one hand, it helps investigators and regulators to

see when a fraud or misconduct has occurred, because they can

compare it to a defined set of standards. Today, most of these

standards come from the rating agency itself, so the rating agency

becomes the judge, jury and executioner of its own standards.

Second of all, having a defined set of standards would cut down

on frivolous lawsuits by an investor, for example, who just made

a bad decision. So if you have a set of standards for some minimum

sets of things that a rating agency must do, that is a good benchmark to see when liability or fraud has actually occurred or other

types of negligence. At the same time, it prevents frivolous lawsuits

from investors who just made a bad decision.

Mr. LYNCH. Yes. I do agree that it shouldn’t be a hair-trigger test

for liability, otherwise you would have everybody who didn’t think

the instrument performed the way they wanted it to would have

a cause of action. We don’t want that.

Mr. McCleskey.

Mr. MCCLESKEY. Well, sir, I would be against any kind of blanket immunity of the type that you are describing. I think that, you

know, with respect to the first amendment protection for rating

agencies, I am not a lawyer, but come on, that is not what the first

amendment was for.

Having said that, I would agree that if you are going to introduce

more liability, you do need to do it in a measured way with some

sort of controls, because we did have difficulties about a decade ago

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with a lot of frivolous securities lawsuits where, as you say, every

time the stock ticked up or down and somebody lost money, off to

court we were. So I do see that as a potential danger.

But having said that, I am not a lawyer, but my personal view

is that there ought to be some measure of liability.

Mr. LYNCH. Thank you.

Mr. Cantor.

Mr. CANTOR. As we discussed today, Moody’s is already subject

to liability. We can be sued for fraud and for violation of securities

laws. We have a number of lawsuits publicly announced and outstanding. So we already are subject to significant liability.

What I think is most important is that there be accountability,

and I think there is a fair measure of accountability, certainly in

the private market, in the private use of ratings we are accountable. Our reputation is being constantly reevaluated, and our reputation is being evaluated now.

It has always been the focus of Moody’s management and its analysts on producing the highest quality ratings and strengthening

our reputation to the maximum degree. And the current and recent

experience, if anything, has reinforced that concern and the primacy of that concern in our rating practices.

Mr. LYNCH. Thank you. My time has expired.

Madam Chair, I yield back.

Ms. NORTON. The gentlewoman from Ohio, Ms. Kaptur.

Ms. KAPTUR. Thank you very, very much for appearing this

morning.

May I ask each of you gentlemen to state for the record your professional qualifications? In other words, what your background is?

Are you attorneys? Are you mathematicians?

We can begin with the first gentleman here.

Mr. KOLCHINSKY. I have an undergraduate degree in aerospace

engineering. I have a law degree and a master’s of science in statistics. I have worked in structured finance my entire career.

Ms. KAPTUR. Thank you very much.

Mr. CANTOR. I have a Ph.D. in economics. I taught economics for

a number of years at universities, and I worked for 10 years in the

Federal Reserve system, and have been at Moody’s for 12 years.

Ms. KAPTUR. Mr. Cantor, thank you.

And what about Mr. McCleskey?

Mr. MCCLESKEY. I have a master’s degree in financial regulation

and compliance management. I also have a master’s degree in

international relations from Cambridge, where my dissertation concerned financial regulation. I have been in the markets in the

United States and Europe for approximately 15 years. I participated in the drafting of regulations and I have several published

articles and books on the subject.

Ms. KAPTUR. All right. Are any of you gentlemen familiar with

the term in the law control fraud?

[Pause.]

Ms. KAPTUR. You are not? Well, if you are not familiar with it,

then if you have been a part of it, you wouldn’t know it, I guess,

if you don’t even know the term.

Mr. MCCLESKEY. Can you repeat the term again?

Ms. KAPTUR. Control fraud.

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Mr. MCCLESKEY. I am not familiar with it, no.

Ms. KAPTUR. Control fraud is systemic fraud in which many, it

goes beyond a single person, but the person participates in a system that is essentially fraudulent, and as a participant in that system causes a great deal of harm and participates in illegal activity.

Let me ask you, as the housing bubble burst and foreclosures increased, mortgage-backed securities issued by mortgage brokers

began to crumble, despite the AAA ratings that Moody’s and others

had placed on these issuances.

As you look back on this, with all of your education and experience, how could you participate in rating particularly the senior

tranches that had AAA ratings that collapsed? How is this possible? Would you please explain that? We can start, each one of

you.

What happened, Mr. Kolchinsky?

Mr. KOLCHINSKY. I think the main part of the problem were was

poor incentives everywhere across the board.

Ms. KAPTUR. Poor incentives?

Mr. KOLCHINSKY. Poor incentives.

Ms. KAPTUR. Define that.

Mr. KOLCHINSKY. You had mortgage brokers who were

incentivized to get as many mortgages as possible, without any concern for the credit quality. They would be paid upon closing of the

mortgage.

Ms. KAPTUR. Yes, but the rating you gave them, you gave them

very favorable ratings, AAA ratings. So the paper was brought to

you. I am asking you, though, in terms of how could you have been

a participant and your company a participant in a system that collapsed? Don’t blame those that brought it to you. Once you got it,

what did you do?

Mr. KOLCHINSKY. I think we over-relied on quantitative models.

Ms. KAPTUR. On quantitative models. I wanted to ask you for

Moody’s, how many people actually worked for Moody’s prior to the

collapse of the market?

Mr. KOLCHINSKY. I don’t have that information off-hand.

Ms. KAPTUR. What would you guess? Anybody?

Mr. KOLCHINSKY. My guess is about 3,000; 3,000 to 4,000.

Mr. CANTOR. Yes, 2,000, maybe in the rating——

Ms. KAPTUR. 2,000, did you say?

Mr. CANTOR. In the rating agency itself, 2,000.

Ms. KAPTUR. Could you speak into the mic?

Mr. CANTOR. 2,000, I believe, maybe more.

Ms. KAPTUR. About 2,000 people. OK. How many of those people,

then, would you, of the 2,000, Mr. Kolchinsky, your job was Managing Director. You were the head of it all?

Mr. KOLCHINSKY. No, ma’am. I was one of four managing directors, one of the four managing directors within the CDO group.

And we had about 100 people total within that group.

Ms. KAPTUR. About 100 people. Were these the people that were

the mathematical brains that ascertained risk?

Mr. KOLCHINSKY. Some were mathematicians. We had a lot of

Ph.D.s. We had a lot of lawyers. People came from across the

board. But that was part of the group which decided methodologies,

built the models, and ran the models.

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Ms. KAPTUR. All right. So in other words, the made big mistakes.

Mr. KOLCHINSKY. Yes, ma’am.

Ms. KAPTUR. All right. And so it wasn’t just that the mortgage

brokers brought this paper to you, but there was a system set up.

And explain to me internally, inside your company, what happened

in that risk division that was so faulty? What happened and why

did it happen?

Mr. KOLCHINSKY. I think the system that existed in place allowed bankers and other participants to game the models that were

set up. The models are actually very public, and what participants

could do, could look at the models and change——

Ms. KAPTUR. When you say model, are you talking mathematical

model?

Mr. KOLCHINSKY. Yes, mathematical models, as put into an actual spread sheet or a piece of software or even a methodology. In

my group in the ABS CDO Group and CDOs in general, those models were actually publicly available. Some were free to download

from the Web site. But that allowed bankers and other participants

to game those models.

Ms. KAPTUR. But who approved those models?

Chairman TOWNS [presiding]. The gentlewoman’s time has expired. I ask unanimous consent to give her an additional 1 minute.

Ms. KAPTUR. I thank the gentleman.

Who approved those models? Who invented the models and who

approved them?

Mr. KOLCHINSKY. It was different groups and people who were

tasked with that. Most of them internally, based on data that was

provided to Moody’s.

Ms. KAPTUR. Did you approve them?

Mr. KOLCHINSKY. I did not approve any specific one model.

Ms. KAPTUR. Who approved them? Somebody above your pay

grade?

Mr. KOLCHINSKY. In some cases it was above my pay rate because I wasn’t in the position yet.

Ms. KAPTUR. Can you get me a list of who approved them?

Mr. KOLCHINSKY. Ma’am, I wouldn’t know. It was done by the

committee, and usually——

Ms. KAPTUR. Which committee?

Mr. KOLCHINSKY. By a committee set up for a particular methodology. So there is a——

Ms. KAPTUR. Under your watch?

Mr. KOLCHINSKY. No, not under, not under my specific——

Ms. KAPTUR. Above you?

Mr. KOLCHINSKY. It would be in some cases above me, some

cases below me, but it all, there was no standard process of model

review and approval during the credit crisis.

Ms. KAPTUR. Let me just, in closing, Mr. Chairman, I wanted to

ask Mr. McCleskey. You were the chief compliance officer?

Mr. MCCLESKEY. Yes, I was.

Ms. KAPTUR. OK. The SEC did an examination of Moody’s in

what was it, 2006, 2007, something back then?

Mr. MCCLESKEY. I believe 2007.

Ms. KAPTUR. How long did you meet with them as chief compliance officer?

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Mr. MCCLESKEY. How long did I meet with them?

Ms. KAPTUR. Yes.

Mr. MCCLESKEY. I did not meet with them.

Ms. KAPTUR. They did not——

Mr. MCCLESKEY. They did not meet with me.

Ms. KAPTUR. You were the chief compliance officer and the SEC

did not meet with you?

Mr. MCCLESKEY. That is correct. They met with our Legal Department and outside counsel, and I did object.

Ms. KAPTUR. That is a shocking statement.

Mr. MCCLESKEY. I did object to that.

Ms. KAPTUR. Thank you, Mr. Chairman.

Chairman TOWNS. Thank you very much.

I now yield 5 minutes to the gentleman from Maryland, Mr.

Cummings.

Mr. CUMMINGS. Thank you very much, Mr. Chairman.

Mr. Chairman, I wasn’t going to ask any questions, but listening

to Ms. Kaptur’s questions, I was just curious, and could not help

what I heard when she was asking about this fraud, and she went

on to ask questions concerning why all of this happened. And I

think you said something about insufficient incentives. Did somebody say that? Mr. Kolchinsky.

Mr. KOLCHINSKY. Yes, sir, I believe.

Mr. CUMMINGS. And can you help me with that, explain that to

me? With all my constituents losing their houses, losing their savings, losing everything they have, we hear about people on Wall

Street getting these phenomenal bonuses. And I mean, when I

heard those words, I almost fell out of my chair. I was trying to

eat my lunch, and I had to come and ask you a question about that.

Can you help me with that? Were they making, do we have some

making a little bit of money on Wall Street? Is that it?

Mr. KOLCHINSKY. No. Obviously, people on Wall Street——

Mr. CUMMINGS. Make a lot of money.

Mr. KOLCHINSKY. Yes, sir.

Mr. CUMMINGS. While messing over the American people, big

time.

Now, tell me, just explain to me because my constituents want

to know, when you say a lot of this happened because of insufficient incentives——

Mr. KOLCHINSKY. Poor incentives, yes.

Mr. CUMMINGS. What does that mean?

Mr. KOLCHINSKY. Because for the most part, most people in the

securitization chain were not paid based on the long-term performance of the product they originated. So a mortgage broker was paid

at the closing of the mortgage, not depending on how the mortgage

did. The mortgage originator, like a Countrywide or a New Century, was paid when they sold the mortgages to an aggregator

bank, like a Lehman Brothers or a Merrill Lynch. They were paid

right there and then, not depending on how the mortgage performed. The bank then structured those mortgages. The bankers

were paid on the closing of the deal, not on depending on how the

security performed. That security went through an ABS CDO.

Mr. CUMMINGS. So in other words, it was like selling a piece of

zero, I started to use another word, and calling it something more

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valuable than what it is, pass it on like a hot potato. At some point,

somebody is going to have to pay, and the American people paid

by being thrown out of their houses and losing their savings and

what have you. Is that right?

And so, is that right?

Mr. KOLCHINSKY. Yes.

Mr. CUMMINGS. Yes. And then they were also put in a position

where, what you are saying is that they were being paid for quantity and not quality. Is that right?

Mr. KOLCHINSKY. That is correct.

Mr. CUMMINGS. And, I mean, if you were, say, Secretary

Geithner, what advice would you give to the President of the

United States? Because I can tell you there are a lot of people in

my District who are mad, and they are wondering whether or not

we are doing the things that we need to do to straighten out this

mess, but not only to straighten it out, but to make sure it does

not happen again.

And I want you to look into, just look straight ahead, there is

probably a camera facing you right now, as if you are talking to

the President of the United States, and say, Mr. President, this is

what I would do; this is how you correct this mess; this is how you

make is so that we don’t have to go through this again; this is so

that Mr. Cummings will not be coming before you telling him about

all of the things that his constituents have suffered through, and

continue to suffer through, and how they have been robbed of their

savings, robbed of their futures, robbed of their houses.

Tell him. Tell the President. He’s watching.

Mr. KOLCHINSKY. Well, sir, I would recommend that alignment

of incentives across the board would probably be by far the best solution. And that is actually return to the old roots of Wall Street

where there used to be a term called ‘‘eat what you kill,’’ and that

meant somebody only takes home whatever they actually produce,

and whatever money that they bring in.

And my recommendation would be that people who work in complex products and structured products retain a vertical slice of

whatever they produce. And hopefully that would align their incentives that their eventual pay and whatever they take home is based

on whatever they produce.

So the mortgage broker will get paid based on the mortgage. If

that mortgage didn’t pay on the first payment, then they wouldn’t

originate. They would know that is a bad investment, and the same

down the line. Countrywide, New Century, Lehman, Merrill Lynch

and all those bankers, they would not put the taxpayers at risk,

because they were putting their own livelihood at risk.

Mr. CUMMINGS. Did you have something, Mr. McCleskey?

Mr. MCCLESKEY. No, sir.

Mr. CUMMINGS. OK.

Thank you very much, Mr. Chairman.

Chairman TOWNS. Thank you. Thank you.

I yield a minute to the gentleman from Indiana.

Mr. SOUDER. Reinforcing the gentlelady from Ohio and the gentleman from Maryland’s point, sales people to some degree sell, and

yes, it would be nice if they had long term. The check was supposed

to be you. You are the rating agency. You knew, obviously, that

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they had a motive to sell, that there was no back check. The back

check is supposed to be the rating agencies. You are supposed to

say what they sold wasn’t real.

And instead, we had the hedge fund people figuring out and telling us that they figured out it wasn’t real. They made money betting against your ratings. And that is what we are trying to figure

out how to address here because in the market, yes, some people

are sellers. Other people are supposed to long term, but if the rating agencies are cahoots with the sellers, there is no public backstop.

And now everybody is turning to government because the private

sector didn’t perform the function. And her questioning was along

the lines of where were you all. Now, we are going to have some

testimony from an attorney, Mr. Abrams, who says that you didn’t

perform an investigative function. You took basically the word of

the management and you basically said a similar thing that they

were reporting to you. And the American people think you are an

investigative agency. They think you are doing an independent investigation, not just taking a pass-on from the companies.

And so you weren’t the check to the sales part. And that is part

of our frustration.

I yield back.

Chairman TOWNS. They were saying that if you pay us, then we

will rate it. I mean, all you have to do is just pay us. I mean, that

is basically what happened here.

So let me thank all of you for your testimony, and say to you,

Mr. Cantor, we would appreciate if you would help us get the documents. You know, we would like that very, very much, because, as

we look at the overall meltdown, that our interest and concern is

to try to make certain that it does not happen again. And in order

to do that, you could be very, very helpful in that process. Thank

you very, very much for coming.

Thank you, Mr. Kolchinsky.

Thank you, Mr. McCleskey.

Thank you, Mr. Cantor.

Thank you very, very much.

Now, we move to the second panel.

I would like to welcome our second panel. As with the first panel,

it is committee policy that all witnesses are sworn in. So if you

would please stand and raise your right hands while I administer

the oath.

[Witnesses sworn.]

Chairman TOWNS. You may be seated. Let the record reflect that

all witnesses answered in the affirmative.

Let me begin by introducing our witnesses.

Senator Alfonse D’Amato served as a New York Senator for 18

years. During his Senate career, Alfonse D’Amato served as the

chairman of the Senate Banking Committee and was also a member of the Senate Appropriations Committee and the Senate Finance Committee. Since leaving Congress, Senator D’Amato has

founded a public policy firm called Park Strategies.

Good to see you, and I am happy to know there is life after you

leave this place.

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Mr. Floyd Abrams is a nationally recognized first amendment

lawyer. Over his long career, Mr. Abrams has represented a wide

variety of clients, including the Brooklyn Museum of Art, the New

York Times, Time Magazine, Senator Mitch McConnell, AIG, and

most recently, Standard & Poor’s. Welcome.

Mr. Eric Baggesen is a senior investment officer of Global Equity

for the California Public Employees Retirement System. He is responsible for implementation and management of investment strategy and policy for the pension fund, $132 billion portfolio in publicly traded equity investments worldwide under his current leadership. The Global Equity Unit also oversees CalPERS corporate governance, hedge fund, domestic long and short cash management,

and manager development programs, and the ongoing restructuring

of the asset class that began last year.

Welcome.

Dr. Lawrence White is a professor of economics and the deputy

chair of the Economics Department at New York University, Stern

School of Business. Dr. White has also served as a board member

for the Federal Home Loan Board and as the director of the Economic Policy Office in the Antitrust Division at the Department of

Justice. Before joining the Stern School, Dr. White was a member

of the President’s Council of Economic Advisers during the Carter

administration.

Welcome.

At this time, I ask that each witness deliver their statement

within 5 minutes, and of course, you know the procedure. The yellow light comes on, which means you have a minute remaining.

And after that, then it becomes the red light, and that means stop.

I have been having some problems with the members of the committee recognizing red today because it is such an interesting topic

and, of course, they are trying to get to the bottom of it because

so many people have been hurt as a result of what has gone on

with this meltdown.

So we will start with you, Senator D’Amato. Good to see you.

STATEMENTS OF HON. ALFONSE M. D’AMATO, FORMER CHAIRMAN, SENATE COMMITTEE ON BANKING; FLOYD ABRAMS,

PARTNER, CAHILL GORDON & REINDEL, LLP; ERIC

BAGGESEN, SENIOR INVESTMENT OFFICER, CALIFORNIA

PUBLIC EMPLOYEES RETIREMENT SYSTEM; AND LAWRENCE

J. WHITE, PROFESSOR, LEONARD N. STERN SCHOOL OF

BUSINESS, NEW YORK UNIVERSITY

STATEMENT OF HON. ALFONSE M. D’AMATO

Mr. D’AMATO. Thank you, Mr. Chairman.

First of all, Mr. Chairman, let me congratulate you for holding

this hearing. It is important, because I feel very strongly that the

failure of the system, and the credit rating agencies in particular,

contributed substantially to the economic chaos that hit this country, small homeowners, business owners, and right across.

Mr. Chairman, credit rating agencies began their lives providing

an important and very legitimate investment tool that allowed investors to evaluate securities. Once the system change to one

71

where issuers paid for the agencies to rate their securities, the

stage was really set for trouble.

There have been a number of Members today who have raised

that issue. And if you want to cut through it all, that is the problem with the system. Issuers are paying the rating agency, and the

rating agencies are looking the other way.

Why? You had two young men testify today, and I dare say they

lost their jobs and were fired unfairly because they dared to sound

an alarm. And the higher-ups didn’t like it. And the fellow who testified for Moody’s today, that was a debacle. He didn’t know anything. He just knew that they try to do good ratings.

You have one person who was the chief compliance officer. They

finally adopted things that he had recommended. In the interim,

they said, well, you didn’t get along and they dumped him out.

By the way, he wasn’t the traditional whistleblower. He came in

here only after the committee invited him. And I dare say Mr.

Kolchinsky, his colleague, somewhat naively thought that if he

brought certain matters to the attention of the people that he

should have that they would have responded, and they did. They

threw him out. And the SEC did not investigate until 1 week ago

after you held these hearings. Shame on the SEC. Shame on them.

It is like putting a lamb guarding the tiger’s den. That is what has

been going on. And at long last, they finally came out with a list

of recommendations, at long last. I think that this committee and

the Financial Services Committee should examine them, because

they are meritorious. But one that is most important and should

be acted upon, and they have the ability, and Congress has the

ability to do so, is the SEC’s proposed prohibition against letting

a rating agency act as both a rater and a paid adviser for securities

issuers. This dual capacity is one that unavoidably creates conflicts

of interest. And don’t buy this firewall nonsense. It doesn’t work.

And the American people have a right to be protected.

Mr. Chairman, I have spent some time discussing this matter

with the prestigious Financial Economics Roundtable, and they

have a number of methodologies that they suggest. I am going to

ask that their testimony that we have submitted, that their statement be placed in the record as if read in its entirety.

Chairman TOWNS. Without objection, so ordered.

[The information referred to follows:]

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Mr. D’AMATO. Mr. Chairman, let me go on to say that reference

was made to the debacle that took place at Enron and that took

place in corporate America, and things were done to deal with that.

That doesn’t mean we have a perfect system today, but you did

have an analogy that was striking in terms of conflicts, and it undermines the credibility of organizations that people are dependent

upon.

Our accounting industry was subverted for a while when you had

accountants, the big three, the big four, who were not only auditing, but being paid as advisers. We stopped that. You can’t be an

adviser today to a public company and be an auditor. And that is

as it should be because inherently there is a conflict to both being

an adviser and an auditor.

And Mr. Chairman and members of the committee, that inherent

conflict of interest exists today. And all this business about, let me

tell you. Every one of the big three rating agencies tell you they

want competition. First of all, there is no competition really. They

enjoy 90 percent of it. They have the stamp of approval from the

SEC. The way to really provide competition and get the most modern methodologies involved today, and there is a way to do that,

is to see to it that there is a ban on issuers being paid, or paying

rating agencies.

It is rather simplistic, but that is where we should start, and

that is the nub of the problem.

Thank you, Mr. Chairman.

[The prepared statement of Hon. Alfonse M. D’Amato follows:]

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Chairman TOWNS. Thank you very much for your testimony, Senator D’Amato.

Mr. Abrams.

STATEMENT OF FLOYD ABRAMS

Mr. ABRAMS. Good morning. Thank you very much for inviting

me, Mr. Chairman and Mr. Ranking Member.

I would like to say, first, it is good to have Senator D’Amato back

in town. We all miss him. I come from New York, so I can say that

freely.

I am appearing on my own behalf today because I was asked by

the committee to come, which is to say I was not designated by my

client to come. But I do want you to know that I represent Standard & Poor’s and have, and represented them for over 20 years,

and I have represented the McGraw-Hill Co., their parent, for over

20 years.

Chairman TOWNS. But I am impressed that you represent the

Brooklyn Library.

Mr. ABRAMS. So I am here to talk, at least in the first instance,

about the issue of liability and the questions and issues raised in

part by the new discussion draft released by Representative Kanjorski, because I thought that I could add something from the fact

that I represent Standard & Poor’s in now over 30 litigations commenced around the country after and as a result of the economic

collapse that has occurred.

Those litigations are of lots of different sorts, under lots of different statutes, Federal, State and common law theories. The proposal before Congress now, at least in the discussion draft, is to

amend the 1934 Securities Act, which is a fraud statute. And I

come here to urge you to try to see that three principles are adhered to, if you should amendment that act.

The first is that we should adhere to the core principle of the act

that currently exists, the 1934 Act, which is liability for knowing

or reckless misconduct, as distinct from allegedly negligent misconduct, not what is argued by someone to be unreasonable, but by

doing something in bad faith, intentionally, on purpose.

Mr. Kolchinsky, who sat in Senator D’Amato’s seat a few minutes ago, had the legal test right when he articulated to you what

he thought the test was. If a rating agency or anyone else issues

a rating or does something in the securities field where they are

saying something they don’t believe in, that they either know or

think is false, if they do that, they can be held liable. And my view

is that you ought to continue to adhere to that standard, whatever

else you do.

The second thing I think you should do is to treat every defendant equally. Rating agencies should be singled out so that they

wind up in a situation where if a rating agency, an accounting

firm, and a securities analyst are in the same case, you have different legal standards apply to the three of them. They should be

the same legal standards, whatever they are.

And the third is that whatever you do, you ought to do something which is as pro-competitive as possible. And what I mean by

that is that there are proposals now in the discussion draft, for example, which I consider extraordinarily anti-competitive. There is

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a proposal, for example, which would say in so many words that

rating agencies have to share all the information they gather with

all the other NRSROs that exist, to investigate everything that

comes in from all those other rating agencies, to review them, and

to be liable if another rating agency does something which is

against the law. This is what the draft statute calls joint liability.

I think that is not a good idea. I don’t think it is fair. I don’t

think it is deserved. I also know it is uninsurable. And I ask, who

is going to go into this business? Who are the new NRSROs going

to be if you enact legislation of that sort?

So I conclude, then, with the notion that with those principles

outstanding, you can change the statute if you think it is necessary

to do so. I can assure you on personal knowledge there is lots of

litigation against rating agencies in the multi-billions of dollars

going on right now.

Thank you.

[The prepared statement of Mr. Abrams follows:]

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Chairman TOWNS. Thank you very, very much for your testimony, Mr. Abrams.

Mr. Baggesen.

STATEMENT OF ERIC BAGGESEN

Mr. BAGGESEN. Yes, good afternoon, Mr. Chairman. Thank you

very much for inviting me here, and all the rest of the committee

members, for hearing CalPERS’ voice and perspective on this issue.

My name is Eric Baggesen. I am the Senior Investment Officer

for Global Equity, which also incorporates our corporate governance activities at CalPERS. We see the rating agency issue as one

of governance. That is the reason that I am here. This is not simply

about fixed income instruments.

CalPERS is the largest State pension fund in the United States. We manage approximately $200 billion currently for 1.6 billion

members—excuse me, million members, not billion, not yet.

[Laughter.]

We definitely rely on the quality and the integrity of market information, and credit ratings are an important portion of that information set. There is a public interest in ensuring that the information disseminated to investors is reliable, that the providers of

the information are free from conflicts, and that there is accountability, transparency and proper oversight of the delivery and the

development of that information set.

There are three components of information that we find critical

to making investment decisions and positioning our investment

portfolio. The first of those is financial information, constituting financial statements. Those financial statements are attested to by

auditors.

The next is governance-type information, where companies give

us information about the activities of the organization in their

prospectuses and the activities they have planned for the organization.

And a third component of information is credit-worthiness.

The first two of these, financial statements and governance information, are held to high standards of accountability and are highly

regulated. The third, credit ratings, fall into a never-never land.

They are not in the same category of integrity as the first two.

If any of these components of information are weak and unreliable, that weakened the entire financial system. There are a number of entities that have attempted to quantify the impact of credit

losses in the recent market dislocations that have happened over

the last 2 years, and these figures currently run into the trillions

of dollars.

The credit rating agencies certainly had a role in that activity.

Part of the market dislocation that we experienced potentially can

be laid at the feet of rapidly shifting perspectives as to the creditworthiness of various entities that existed in the marketplace.

When you go from a highly rated entity to an entity that is virtually bankrupt overnight, that creates a huge amount of risk in

the system, and that rolled through every aspect of the financial

marketplace.

CalPERS uses credit ratings in a number of different ways. The

most prevalent area where we have credit ratings are in our policy

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documents that guide how we structure our investment portfolios.

Credit ratings are an integral part of that activity. They reflect the

degree of risk-taking and return expectations that we have relative

to a number of segments of our investment portfolio.

Another area where these things impact CalPERS is the aspect

that credit ratings are embedded in many of the market indices. As

we engage in asset allocation activities, we look at market indices

to tell us what is the risk and return profile of different investment

categories. Credit ratings are an integral part of that, particularly

in the fixed-income arena.

In the third area, credit ratings are used to control the risk-taking of outside investment managers, so we will oftentimes specify

certain types of securities indicated by credit ratings as being applicable to outside managers.

Certainly, our fixed income portfolios make use of credit ratings,

as well as their own research and activities. The credit rating agencies have a position where they have access to sets of information

that we do not have in our own research activities at CalPERS.

And to the extent in our global equity portfolio, we have approximately 10,000 different securities contained within that portfolio

globally. Many of those issuers are dependent on the attachment

of a credit rating to allow them to access the capital markets as

they execute their capital-raising activities.

And the very last area that I see us using credit ratings is in the

area of performance attribution. It helps us understand and disentangle whether investment managers are making money for

CalPERS based on taking credit risk, whether they are taking duration risk, all of the different attributes that can be used in that.

So there are a number of places that these things intersect with

CalPERS’ activities.

The organization has a number of proposals or concepts that they

think will help you as you move forward with attempting to address these issues. We do believe that the compensation model is

a problem. We certainly support the SEC’s actions. We support a

stronger SEC. We think that organization is charged with investor

protection. We see no other comparable organization.

The agency should have high level compliance staff. They also

need to have accountability and responsibility for the actions and

the results that stem from their activities in the marketplace.

And at that, I will stop and invite your questions.

[The prepared statement of Mr. Baggesen follows:]

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Chairman TOWNS. Thank you very much for your testimony.

Professor White.

STATEMENT OF LAWRENCE J. WHITE

Mr. WHITE. Chairman Towns, Ranking Member Issa, and members of the committee, my name is Lawrence J. White. I am a professor of economics at the NYU Stern School of Business, and a

member of the Financial Markets Working Group at the Mercatus

Center at George Mason University.

During 1986 to 1989, I served as a board member on the Federal

Home Loan Bank Board. I represent solely myself at this hearing.

Thank you for the opportunity to testify today on this important

topic.

The three large U.S.-based credit rating agencies, Moody’s,

Standard & Poor’s, and Fitch, and their excessively optimistic ratings of subprime residential mortgage-backed securities in the middle years of this decade played a central role in the financial debacle of the past 2 years.

Given this context and history, it is understandable that there

would be strong political sentiment as expressed in the recent proposals by the Obama administration, as well as other proposed legislation, and recent rulemaking by the SEC for more extensive regulation of the credit ratings agencies in hope of forestalling future

such debacles.

The advocates of such regulation want figuratively to grab the

rating agencies by the lapels, to shake them, and shout: Do a better job. This urge for greater regulation is understandable and well

intentioned, but it is misguided and potentially quite harmful. The

heightened regulation of the rating agencies is likely to discourage

entry, rigidify a specified set of structures and procedures, and discourage innovation in new ways of gathering and assessing information, new technologies, new methodologies, new models, including new business models, and may well not achieve the goal of inducing better ratings from the agencies.

Ironically, it will also likely create a protective barrier around

the incumbent rating agencies and is thus likely to make them

even more central to and important for the bond markets.

There is a better route. That route starts with the recognition

that the centrality of the three major rating agencies for the bond

information process has been mandated by more than 70 years of

prudential financial regulation of banks and other financial institutions.

In essence, regulatory reliance on ratings, for example, the prohibition on banks being able to hold speculative bonds as determined

by the rating agencies ratings, has imbued these third party judgments about the credit-worthiness of bonds with the force of law.

This problem was compounded when the SEC created the category

of nationally recognized statistical rating organizations, NRSROs,

in 1975 and subsequently became a barrier to entry into the rating

business. As of year end 2000, there were only three NRSROs:

Moody’s, Standard & Poor’s, and Fitch.

It should therefore come as no surprise that when this literal

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rious. This recognition of the longstanding role of financial regulation enforcing the centrality of major rating agencies then leads to

an alternative prescription: eliminate regulatory reliance on ratings; eliminate it; eliminate the ratings force of law and bring market forces to bear.

Since the bond markets are primarily institutional markets, and

not the retail security markets where retail customers are likely to

need more help, market forces can be expected to work. And the

detailed regulation that has been proposed would be unnecessary.

Indeed, if regulatory reliance on ratings were eliminated, the entire

NRSRO structure could be dismantled and the NRSRO category

could be eliminated. This could well make the incumbent rating

agencies less important for the future.

The regulatory requirements that prudentially regulated financial institutions must maintain safe bond portfolios should remain

in force. But the burden should be placed directly on the regulated

institutions to demonstrate and justify to their regulators that

their bond portfolios are safe and appropriate, either by doing the

research themselves or by relying on third party advisers.

Since financial institutions could then call upon a wider array of

sources of advice on the safety of their bond portfolios, the bond information market would be opened to innovation and entry in ways

that have not been possible since the 1930’s.

Thank you again for the opportunity to testify today. I would be

happy to answer questions from the committee.

[The prepared statement of Mr. White follows:]

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Chairman TOWNS. Thank you very much.

Let me thank all of you for your testimony. You know, we talked

earlier with Mr. Cantor. He didn’t feel that they have played a role

in this meltdown, but I want you to know that our role here today

is to try to find ways and methods to fix what is going on.

I want to start with you, Senator D’Amato, and of course, Mr.

Baggesen, and probably all of you, as to what can we do to prevent

credit rating agencies from contributing to the next financial collapse. What can we do?

Mr. D’AMATO. Mr. Chairman, Professor White did touch on a

number of things, and they can get a little bit esoteric. But the fact

is that once we stamped NRSRO on those three agencies, and I

think there is one other now, Moody’s, Fitch, Standard & Poor’s

and one other. We gave them a headlock. We kept out competition,

innovation that the market forces are very capable of providing.

So I think there is a lot to what we can do. And I will come back,

to beat the dead horse, how do you keep honest people honest? You

have the fence or the wall or the prohibition. You do it one way

or the other. I think the fence and the wall are half-hearted attempts, and you are always going to find, I mean, here you saw

this fellow McCleskey, who was in charge of compliance, and they

moved him right out. You know, you are still going to have those

kinds of things.

If you want to keep honest people honest, an issuer should not

be paying or, put it the other way around, the rating agencies

should not be paid by an issuer for a particular issue. The two are

incompatible. You saw that situation in the accounting problems.

It is the same here.

And I think that is one of the important elements, and I think

the SEC finally has it right in their proposed recommendation.

That should be adopted, and we should open the system up to competition. Professor White touched on some methodologies that can

and should be employed.

Chairman TOWNS. Right. You know, I get your point because

even in research with doctors and with the patients, they finally

had to come up with patients that were involved in the research

to have their own doctors, because the person that was involved in

research, the only thing he was doing or she was doing was looking

at their research, and not at the patient, how the patient was

doing. So I get your point very well there, Senator.

Any other comments here?

Mr Abrams, yes?

Mr. ABRAMS. My reaction is two-fold. First, one of the problems

here is that there has been too much reliance on rating agencies,

as if they were the only source of information, which they have

never been, as if that was the place to go. CalPERS, by way of example, is suing my client, so I am very interested in CalPERS and

I am glad to sit next to the gentleman here who I may depose

someday.

Chairman TOWNS. Well, we arranged this. [Laughter.]

Mr. ABRAMS. And for over $1 billion, by the way. And let me read

you one line from CalPERS complaint in that case. It says: ‘‘Other

than the rating agencies’ evaluation and subsequent credit rating

of an SIV, a special investment vehicle, an investor had no access

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to any information on which to base a judgment of an SIV’s creditworthiness.’’ My reaction is that if that is the case, and I don’t

want to argue our case, if that were the case, they shouldn’t be investing in the sort of entities where they know nothing other than

its rating. And I think in general there has been an over-reliance

on ratings only.

One of the things I know that my client has been trying to do

since the bad events of the last few years is to try to get out the

story a little bit better about what ratings are and what they are

not; that they are essentially an assessment of credit-worthiness in

the future, the likelihood of repayment down the road, not of market value, not of volatility, not of liquidity, not of a lot of things

which will ultimately and even short term affect pricing.

But it is not easy to get that story out, and I think one of the

things that has to be done is for a much better public understanding of just what ratings are and what they are not.

Chairman TOWNS. So are you saying that the SEC should play

a greater role in this process? I mean, I am not sure I understand.

Mr. ABRAMS. I think there are things the SEC can do. Indeed,

I think the SEC can play a role in helping to restore credibility,

if you will, of this whole process, particularly if we are moving in

the direction of more competition. We have 10 NRSROs now. As

Senator D’Amato said, not so long ago we had three, four, give.

Now we have 10 since and because of the act passed by Congress

in 1966, the Credit Rating Reform Act, which took effect in 2000,

rather, 2006 which took effect in 2007.

If we are going to open this up and have more and more and

more NRSROs or perhaps, as Professor White says, not have

NRSROs anymore, we will still need a significant level of oversight

by the SEC, and some of their proposals in that respect are in the

direction, I think, of helping the industry to be better viewed because, again with all these entities in now and more and more to

come, you are taking entities which may not always be of the highest level in terms of experience and making them NRSROs.

The SEC used to say, you can’t be an NRSRO because you

haven’t had experience. And the argument against that was, how

can we get experience? And we need the designation, etc.

All right, we went in the direction, then, of saying we will give

the stamp, so to speak, of NRSRO to, I don’t want to say almost

any, but any financially secure entity, even if they don’t have a lot

of past experience. There is a societal risk in that. I think it was

a good decision, but there is a risk-reward in it. And one of the consequences of doing that is that I think you need a higher level of

SEC involvement so long, at least, as you have the NRSRO designation in the first place.

Chairman TOWNS. I yield to the gentleman from California. My

time is expired.

Mr. ISSA. Thank you, Mr. Chairman.

Mr. Abrams, under Sarbanes-Oxley, we looked at the auditing

world and the big 10, 9, 8, 7, 6, 5, 4 accounting firms. And we

found that in fact they were playing two sides of the game. They

were doing the annual audited financial, and then they were selling a bunch of products. And the two basically could not have firewalls. They simply couldn’t get past the fact that partners all beneVerDate 11-MAY-2000 13:42 Apr 30, 2010 Jkt 000000 PO 00000 Frm 00138 Fmt 6633 Sfmt 6633 U:\DOCS\55751.TXT KATIE PsN: KATIE
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fited effectively from that. And if there wasn’t money in one side,

and there was money in the other side, the partners wanted to

share, or they didn’t want to be on the other side. So Congress

made a decision that we could no longer have that.

In the case of rating agencies, do you believe that we should consider narrowing what 1 or 3, 5, 10, whatever amount of rating

agencies can do, versus other services so as to make it as close to

the equivalent of your annual audit, rather than a more broad set

of opinions and products being sold? Do you think that would help?

Mr. ABRAMS. Two thoughts. One is I think the notion of saying

that rating agencies shouldn’t do consulting, say———

Mr. ISSA. That is exactly what I am saying.

Mr. ABRAMS. I understand—it is an appropriate one. My understanding is my client doesn’t do consulting. But without, you know,

getting into definitional issues, the notion of separating consulting

as such from ratings I think is a wise one.

But that said, I think you really do have to take care about how

far you go in terms of limiting———

Mr. ISSA. Let’s take it for a moment in the direction that Professor White would take it. If I look at stocks, rather than bonds or

other debt instruments, if I look at stocks, if Goldman Sachs wants

to take me public, they take me public and everybody understands

that they are making a market. They are making a lot of money.

They have a lot of fees. They are making their portfolio for me look

as good as possible. Basically, they are finding ways in a legal way

to kite the stock’s value to the highest possible level for the public

offering, and then they set it at a little less than that so it pops

on day one. We all understand that.

However, if five other institutions begin tracking my stock, they

are tracking it much more independently, and that is the difference

between who takes me public and who, in fact, is giving their clients’ advice.

Is that model, and I will go to Professor White I think, part of

where the direction we need to go? We need to recognize that those

who look at the papers and present an opinion are very different

than those who provide an opinion on an ongoing basis for the

value of something.

And I would like to go to Professor White, perhaps, to see when

you look at the obsolescence of the existing model, should we end

it in favor of something with more transparency and a number of

rating organizations for the protection of CalPERS and others? Or

should we try to mend the existing system?

Mr. WHITE. Congressman, the existing model that I would abandon is the regulatory reliance on ratings. That is the crucial thing.

That is where everything else follows. Once we get rid of that, and

you know, the SEC has taken some initial steps. We need bank

regulators to do the same, pensions fund regulators, insurance regulators. The Congress can legislate in this direction.

Once that is done, remember this is an institutional market and

bond managers at pension funds, at banks, at insurance companies,

at money market mutual funds should be and can be expected to

exercise judgment about who is a trusted source of information,

look at the business model of an adviser and say, you know, I am

not so good with that.

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Mr. ISSA. I have one person with $200 billion at stake here. Mr.

Baggesen, in your case, if we moved to a model where obviously

somebody is going to put the wrapper together initially, but instead

of relying either on that rating organization or, Lord help us, on

AIG to wrap it in the AAA rating, which often was the problem,

wouldn’t you be better served if, in fact, that model were in place,

because you are a sophisticated buyer, but you don’t have enough

to do a full analysis, perhaps, in the old model without relying too

heavily on the rating agency?

Mr. BAGGESEN. Yes. There are a number of areas where the current model breaks down. These things have been addressed, for example, in the auditing profession. You are well aware of that. That

is one possible alternative, is to move down that kind of a structure.

Certainly, another structure is to remove the regulatory reliance.

That is another alternative. There is no, in the equity world that

I am most familiar with, there is no requirement, for example, that

I look at Goldman Sachs stock rating before I purchase a security.

That is, you know, or to put it into a particular type of a portfolio.

That does not exist in the equity world in that area.

Mr. ISSA. And you invest in the equity world on an informed

basis?

Mr. BAGGESEN. Absolutely, absolutely. The credit rating agencies, currently we are almost required, again by my naive judgment, in respect to Mr. Abrams wanting to oppose me potentially

later.

Mr. ISSA. We will try it later, not here.

Mr. BAGGESEN. We are almost required to look a those ratings

simply because the credit rating agencies are allowed access to inside information that we do not have access to. So if we did not

consider that information, we would certainly potentially be ignoring another pool of information, and that in itself could cause problems.

So there are a number of different structures to this. If you take

away the accessibility of inside information to credit rating agencies and make them the equivalent of any other security analyst

or whatever you care to out there, that certainly changes the degree of reliance that we would be able to place or would be willing

to place on that pool of activity. That is definitely a way to mitigate

against the power and the leverage that these organizations have.

Mr. ISSA. My time is expired. I just want to sort of bring to a

focus your statement.

So if you had all the same information that the credit agencies

had as a sophisticated investor, a large sophisticated investor, you

wouldn’t even be having this potential day in court if you had all

the same information. At the heart of it, you had to rely on something you didn’t know that he did know.

Mr. BAGGESEN. Conceptually, sir, but recognize there are hundreds of thousands of credit instruments out there. So the scale of

this industry makes it almost impossible for any enterprise, even

one the size of CalPERS, to go in and dissect every possible issue,

issuer and so on and so forth. So there are some resource limitations to that even in the presence of place like CalPERS.

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Mr. ISSA. Sure. We understand that, you know, we rely on Google

when we put in a word, and we don’t necessarily get it all. But in

this case, you believe you were denied access to the same information and therefore you relied on it, both regulatory-wise and because they were given information you were not.

Mr. BAGGESEN. Yes, sir.

Mr. ISSA. Thank you.

Chairman TOWNS. Right. Thank you very much. The gentleman’s

time is expired.

I now call on the gentleman from Maryland, Mr. Elijah

Cummings.

Mr. CUMMINGS. Thank you very much.

I want to put all this into some kind of context, Mr. Baggesen.

I think the point for all of us to remember is that CalPERS and

other public pension systems is that they manage the retirement

security for a lot of our constituents. I mean, you are from California, I assume, but for teachers, bus drivers, policemen, other public

servants, and those pensions are funded with public tax dollars and

losses, however they may occur, cost taxpayers money. Is that

right?

Mr. BAGGESEN. Yes. That would ultimately be correct, sir, but

recognize that our pension beneficiaries, we do not see as being in

any risk in this issue. But certainly, if we lose money or make less

in return on our portfolios, the contribution rates that roll back to

taxpayers could have to increase, certainly.

Mr. CUMMINGS. Yes, that is the point I was trying to make.

And I know for a fact, having been a former, in the red book and

a bond counsel before I came to Congress, that I remember when

I first started doing bond work and they talked about Moody’s and

Fitch, and what they said, you know, the rating of a bond agency

you can rely on because it is like God talking. That is exactly what

they told me. And now I realize that, you know, maybe they were

over-rating the bond agencies.

And that brings me to the point of, you know, you didn’t have

much of a choice as to whether or not to use the credit rating agencies. Is that right, Mr. Baggesen? What else were you going to do?

Mr. BAGGESEN. Well, that is exactly right. Their activities are enshrined in market practice and regulation throughout the marketplace. Throughout the marketplace, sir, their activities are rife

throughout it.

Mr. CUMMINGS. Right.

Mr. BAGGESEN. Whether it is regulatory requirement, historic

practice, whatever you care to———

Mr. CUMMINGS. And so your own investment policies determine

the portfolio’s risk and the bond ratings. Is that correct?

Mr. BAGGESEN. Yes, sir. Enshrined again in our policies, there

are references to the amount of risk that we are willing to take

within certain segments of our investment portfolio. That risk is

often expressed in the terms of a rating. Those ratings have been

held out historically as the yardstick by which to judge credit-worthiness.

Mr. CUMMINGS. And you didn’t say this, but the fact is that in

talking to a member of my staff who used to be involved in looking

at how Baltimore invests its pension money, he told me that they

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would often look at CalPERS to see what kind of things that you

all were doing.

I know you didn’t say this, but because you all were seen to be

so good at it, and of course you are dealing with, what did you say,

200 million people? And they figured that if you all were doing

something, they might want to at least take a look at it, because

you all, whether you admit it or not, became sort of a gold standard. And your gold standard, I guess, was based largely on information that you were getting from these rating agencies. Is that a

fair statement?

Mr. BAGGESEN. The information from the rating agencies is absolutely incorporated in everything CalPERS does. The degree of reliance is something, I guess, that we will explore probably in a courtroom.

Mr. CUMMINGS. Had you decided at some point that you could no

longer trust the bond ratings being issued? What were your options, if any?

Mr. BAGGESEN. The option is to try to do the research yourself,

and that becomes extremely, obviously, labor-intensive, resource-intensive and very expensive.

Mr. CUMMINGS. And almost impossible, is that right?

Mr. BAGGESEN. Well, the scale of the marketplace is so large that

we certainly don’t have a staff. We have 40 people in our fixed income area.

Mr. CUMMINGS. Now, could you have disregarded those ratings

without risking suits for breach of fiduciary duties? In other words,

you are looking at a rating and you don’t rely on it. I mean, what

happens then?

Mr. BAGGESEN. Well, for example, I will go back to the example

of the benchmarks that we use in order to execute our asset allocation work to determine where we deploy capital in the portfolio.

Credit ratings are enshrined in a portion of that benchmark exercise. The fixed income indices all are rated by are these investment-grade debts, are these junk bonds, all different kinds of implied ratings attached to that.

Those benchmarks have an effect on how you deploy your capital

as you match your capital deployment to the liability stream that

we are trying to meet the needs of with the pension fund. So certainly the activity in the presence of those ratings and their use in

the marketplace have impacts on how we allocate capital. That is

inescapable.

Mr. CUMMINGS. If I might just ask one quick followup, and that

is that as a result of all of this, all of this information, how has

that affected, if at all, your business? I mean, from what you have

learned about what the rating agencies may have failed to do?

Mr. BAGGESEN. Well, again, from the perspective of what I do on

behalf of CalPERS, this looks like a very familiar governance problem. This is the same problem that was dealt with back in the days

of Sarbanes-Oxley with auditors and all the rest of that. I mean,

so this is a very similar governance issue, and it is providing, obviously, a huge array of work for us in trying to figure out how to

accommodate and how to compensate for that.

So even now, our fixed income portfolios, for example, if we are

not able to farm capital out to external managers where those exVerDate 11-MAY-2000 13:42 Apr 30, 2010 Jkt 000000 PO 00000 Frm 00142 Fmt 6633 Sfmt 6633 U:\DOCS\55751.TXT KATIE PsN: KATIE
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ternal managers are being controlled by being constrained to investing in certain rated securities or certain tiers of securities, if

we cannot rely on those managers to be able to really understand

the risks attached to those securities, that causes us to have to

bring capital back internally to manage, which we may or may not

have the resources to do.

So there is a whole raft of effects on our business model that are

stemming from this activity.

Mr. CUMMINGS. Thank you, Mr. Chairman.

Chairman TOWNS. Thank you very much.

You know, we promised to have the Senator out by 1:30, so Senator, we recognize———

Mr. D’AMATO. Mr. Chairman, the clock is ticking and I have a

plane to catch.

Chairman TOWNS. Yes.

Mr. D’AMATO. I commend you again for the hearing.

Chairman TOWNS. Thank you, thank you very, very much.

Mr. D’AMATO. Thank you, Mr. Chairman.

Chairman TOWNS. Pleasure. All right.

We now yield 5 minutes to the gentlewoman from Ohio.

Oh, I am sorry. I didn’t realize you were here.

The gentleman from Indiana. They change up on me here. Mr.

Souder? I am sorry.

Mr. SOUDER. No. I understood. I switched seats.

There is a big temptation to go off on a higher level challenge

about how bubbles work, because in fact, like we talked about

Enron, the dot.com bubble, back to tulips in Holland, like mark to

market. You know, you go too much and then you contract too

much, and it is the challenge of how to keep an even flow.

But one of the fundamental questions that comes every time we

go through one of these in world history is: Who is actually doing

the investigating?

And one of the bankers from my area who is on the Federal Reserve sat down with me early on as we were going through TARP

and TALF and so on, and said one of the challenges here was that

basically the housing market went up by 400 percent. The growth

was going up 25 percent. So how did people miss the bubble? And

that one of the challenges any of you—in other words, how did

Moody’s, how did the investment firms, how did the banks? Because once you sit back and go, well, there is going to be a housing

bubble whenever you have, just like in the dot.coms or a run-up in

energy, historical, looking back on it, you can see it, but sometimes

you want to say on this one, it was pretty evident.

Now, I want to probe a little bit with Mr. Abrams’ testimony, because we had lots of good testimony here. But most people thought

that bond ratings were investigating, but the implications of your

talking about what is a reasonable verification, reasonable investigation in your written testimony, and what in fact bond entities,

the rating agencies do, that underneath this, if you are mandated,

if the firms are, and I realize you are not officially representing

them today, but these firms are to look at the underlying capital.

In other words, does this firm have enough capital?

Wouldn’t that require investigation into whether some basic assumptions like did the housing market grow 400 percent, where

140

the economy was only going 25 percent; in securitization, that the

different tranches, the more far out you went in the tranches, the

more risk you were taking. And doesn’t that require investigation

to do a capital requirement?

Mr. ABRAMS. Well, my understanding is this, that Standard &

Poor’s, at least, has conducted a loan-by-loan investigation through

its computerized analytic efforts, which I don’t begin to understand

personally, but it is loan by loan. But it does presuppose that when

they receive information from the entities that supply it to them,

the information itself is accurate. Then they deal with the information.

Mr. SOUDER. May I interrupt for a second?

Mr. ABRAMS. Yes, please.

Mr. SOUDER. In your written testimony, you said that, for example, if required assuming in forecasting, because Standard & Poor’s

isn’t a forecasting organization, that the management forecasts

were reasonable. But isn’t that assuming that the entity that you

are about to rate is, in fact, giving you a forecast that is accurate,

rather than going and looking back at the housing market to determine whether the forecast was accurate, because otherwise, the

capital assumption is wrong?

Mr. ABRAMS. Now look, Standard & Poor’s has economists. Their

job is to do the best job they can in forecasting internally in a way

that helps them how the housing market and other markets are

going to do. They gather information, lots and lots of information,

which bears on it. They come to assumptions based on history

which goes back to the Great Depression. And they did that, and

they did it with respect to the housing market, and the presupposed that the housing market was going to go down. I mean,

it isn’t so, that they thought that it was going to keep going up.

They thought it would go down, and they worked with models

based on historic experience to try to tell them how much it could

rationally, predictably be said to go down, and that wasn’t enough.

It went down much more and much more quickly.

I am sorry.

Mr. SOUDER. AIG, I mean, it was a house of cards that it appears

that nobody really investigated.

And if I could go to Mr Baggesen for a second. When you say

that you can’t afford enough investigators, I mean, I think your investors assume you are doing it. What you are really saying is that

it would cost you more money and reduce the return to your investors if you hired a bunch more investigators. Isn’t that correct? If

you hired 80 investigators, it would lower your rate of return.

And part of the problem here is everybody wants a high rate of

return, so everybody starts chasing, hoping that they can get this

high rate of return. Nobody really wants to check because if you

only offer 4 percent and somebody else is offering 12 percent, then

your holders will complain. And that is how it spread to the whole

economy because everybody started going into speculative stocks

because if you didn’t buy housing tranches and securitization, if

you didn’t buy pharmaceuticals and you didn’t buy energy, you

couldn’t get higher than a 4-percent to 6 percent because 4 percent

to 6 percent was what the economy was growing.

141

So anything you were getting up here was pretty speculative, yet

nobody really wanted to dig in, and everybody goes, well, we didn’t

do the kind of core investigation. We were just relying on the statistics. And based on past models, we thought it might go down a

little, but not this much. Yes, but nobody got in and looked at the

core. And that is what is hard to understand. The consumer didn’t,

the agencies that were placing the consumers’ dollars, the different

companies. Insurance companies started speculating more than

they would have in order to be able to compete to get money into

insurance policies.

And it is like somewhere in here, we have to have somebody

looking at the core, not just circulating information, or we will repeat it.

Chairman TOWNS. The gentleman’s time has expired.

I now yield 5 minutes for the gentlewoman from Ohio, Ms. Kaptur.

Ms. KAPTUR. I thank the chairman for the time and inviting this

excellent group of panelists this morning, and this afternoon.

[Laughter.]

Mr. Abrams, I wanted to ask for the record, in what community

is your law firm located?

Mr. ABRAM. I am sorry. In what?

Ms. KAPTUR. In what community is your law firm?

Mr. ABRAM. Oh, I am sorry. New York City.

Ms. KAPTUR. You are in New York City.

Mr. ABRAM. Yes.

Ms. KAPTUR. I noticed as a Midwesterner the coastal nature of

most of our witnesses. And therefore, from the heartland, I have

to send this message. The first is that going back to the 1980’s, the

abuse that occurred in the savings and loan system was followed

by an even greater set of abuses we are experiencing today, because what Congress did back then, and I served back then, sent

the wrong message. It sent the message that if you abuse the financial system, the taxpayers would bail you out, and it has been

done again to a much greater degree.

If I look at the current situation today and how it affects my region, just so the folks from the coast know this, Ohio has now lost

an additional money center bank. PNC, whose Vice President, Mr.

Demchak, invented the derivative when he worked for J.P. Morgan

up there in New York moves to Pittsburgh. And one of the results

of this debacle has been we have made the big banks bigger and

places like Ohio, now, we only have three money center banks left.

National City was bought by PNC.

We look at which banks are failing, 126 of them, I guess, have

been resolved at this point at the FDIC. And we see the big banks

getting bigger. I think three rating services isn’t enough. That is

an oligopoly, the way I look at it. All right? Out from the heartland. Maybe folks from the coasts look at it a different way.

I am just putting this on the record. The result of this system

of housing rescue has been that now the Federal Government is the

dump basket for all the mistakes of the private sector. The large

banks have essentially taken profits and socialized losses. Just look

at FHA. If we look at our Federal mortgage instrumentalities, we

used to hold one of 50 mortgages. Guess what? We now hold one

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of four, because all the toxic assets have been dumped on the public.

And what worries me most is that what is going to happen again,

because of the power of these institutions, is that we are going to

open the floodgates more. I don’t know how much more damage

they can do than they have done already.

But here is what I want, and this is going to be my question to

you, as you see the financial reform proceeding, whatever that reform is over in some of these committees, here is what I want. Tell

me how close we are going to get from what you have seen is occurring over in the Financial Services Committee to it?

I want a safe and sound banking system again. I want more than

financial services. I want a banking system again. I want a healthy

housing market. I want the re-empowerment of communities capital accumulation versus the movement of that capital to just a few

money center institutions.

How close am I going to get to the re-empowerment of community capital accumulation? And how close am I going to come to the

restoration of prudent lending and responsible savings, based on

what you have heard is occurring here, you heard the President’s

speech, you talk to your colleagues up there in New York?

I asked Mr. Bernanke, and I will end with this statement: ‘‘Mr

Bernanke, you know, we are under the Cleveland Fed, and the

Cleveland Fed sort of has something to say about what the New

York Fed does, but not really. Would you be for the democratization of the Fed, where every single region has an equal vote?’’

You know what his answer was? Absolutely not.

So my question to you is, based on what you have heard, how

close are we coming under these reform proposals to a safe and

sound banking system, a healthier housing market, the empowerment of community capital accumulation versus money center bank

capital accumulation, and prudent lending and savings in this

country again? Who is brave enough to take that on?

Mr. ABRAMS. I will go first because I can be very brief on this

because it is so far from my area of expertise. But speaking for myself, I think a number of the proposals will move us significantly

in the direction that you want, including a number that the President has proposed. But to get where you want to wind up is going

to take a lot of doing.

Ms. KAPTUR. Yes, it is.

Mr. BAGGESEN. That is a very difficult question. From the capital

market perspective, we think that many of the reforms that have

been proposed are certainly encouraging, things like proxy access.

There is a whole raft of governance things that have been proposed

under the, I would say, the new SEC, which seems to be reinvigorated at its job as a protector of investor interests.

So we are very encouraged by those actions. It has yet to translate into real differences in the behavior of the marketplace. You

have laid out a number of attributes here that it is not clear to me

how much of this can be commanded by a regulatory system. In

many cases, what you are asking for———

Ms. KAPTUR. Excuse me. May I just interject there, it isn’t just

the regulatory system which is the track we are on. It is the architecture of the entire system.

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Mr. BAGGESEN. Excellent point. But you cannot, I don’t think

that you can turn the clock back. For example, if capital formation

and people are moving, for example, from Ohio to California, you

are not going to turn back the influence that migrates, let’s say, to

California, in other words, from Ohio. So that, you know, people in

the dynamics of how they live and where they choose to live and

what they choose to do are going to have a large impact on the relative influence of the different regions of the United States.

Ms. KAPTUR. I hear what you are saying, but, I mean, we want

to have strong community lending. We want rigor and prudent

lending to be possible again, and it won’t be unless everyone has

a piece of the action. And you just can’t sell risk up the chain that

then ends up being dumped on the Federal Government.

And my concern is we are going to be off into consumer agencies,

a little tinkering here with regulatory, and we are missing the big

picture. I can remember the day, and my time has expired, and

Professor, I would love for you to answer my questions to the

record, by the way, when they came down to the Banking Committee and they took the name off the door. It used to be Banking,

Housing and Urban Affairs. That is when we had a real, that is

what was left of a real banking system, what was left of a sound

housing market, and what was left of a real commitment to our

urban areas across this country.

What we have ended up with is financial services. The name

says it all. We have to go back on top. We are down here in the

middle. We have to go back to the architecture. And my greatest

fear is we are not going to get there and we will end up with even

bigger crisis because the architecture will be wrong, and just dealing with regulation won’t be enough.

Thank you very much, Mr. Chairman.

Chairman TOWNS. Right. Thank you very much.

In closing, you know, I am still having problems with this conflict

of interest. A few rating agencies are paid to help structure securities. They then get paid to rate the same securities. I am telling

you, that to me sounds like a conflict of interest. So I am still having that problem.

You know, Winston Churchill—did the ranking member have

anything else that he would like to add?

Mr. ISSA. Mr. Chairman, I just want to thank you for this hearing. I think, in closing, it certainly has shed light on the fact that

we are not going to mend this system without significant change.

And I commend you for doing comprehensive and I hope more comprehensive review of all the causes of the financial meltdown.

I yield back.

Chairman TOWNS. Right. Thank you very much.

And let me close by saying Winston Churchill once described Soviet Russia as a riddle wrapped in a mystery inside an enigma.

After listening to today’s testimony, I think he could just as easily

have said that about the way credit rating agencies operate.

Today, we had testimony from two former senior employees at

Moody’s who described a culture of secrecy, a place where putting

things in writing was frowned upon. Can you imagine working at

a place where the very act of writing a memo or sending an email

is suspect?

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This culture of secrecy extended to companies outside Moody’s as

well. Moody’s tells us they retained an outside law firm, Kramer

Levin, to investigate Mr. Kolchinsky’s allegations of illegal conduct

at Moody’s. But this morning, we learned that this outside firm

was given oral instructions, only oral instructions.

Moody’s says there is no written statement or work and no contract specifying the work to be done. In addition, this outside firm

is not expected to produce any written report of its findings and

has no schedule of completion.

On top of that, Kramer Levin says this is their normal behavior.

They never produce written reports. Instead, they give their clients

oral briefings. In other words, the Moody’s business model could be

summed up as: leave no fingerprints; don’t ask, don’t tell.

This might be all right if the credit rating agencies hadn’t played

a starring role in the collapse of the financial system. For that reason, this cannot continue. It is very clear to me at this point that

effective legislation is needed, along with effective oversight, to

bring about the confidence that is needed to be able to turn things

around.

The testimony we have heard today is just the opening chapter

of what promises to be a sordid story. We intend to pursue this further.

Finally, I want to thank all of our witnesses, and I want to thank

the two witnesses, Mr. Kolchinsky and Mr. McCleskey, who had

the courage to come forward to testify about what they saw at

Moody’s.

I am aware that testifying before Congress is never, never easy,

and we want you to know that we appreciate their participation

and also we appreciate the participation of all the witnesses.

On that note, without anything further to do, the committee

stands adjourned.

[Whereupon, at 1:43 p.m. the committee was adjourned.]

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