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28–059 PDF 2006

S. HRG. 109–465

EXAMINING THE ROLE OF CREDIT RATING

AGENCIES IN THE CAPTIAL MARKETS

HEARING

BEFORE THE

COMMITTEE ON

BANKING, HOUSING, AND URBAN AFFAIRS

UNITED STATES SENATE

ONE HUNDRED NINTH CONGRESS

FIRST SESSION

ON

EXAMINATION OF THE ROLE OF CREDIT RATING AGENCIES IN CAPITAL

MARKETS

FEBRUARY 8, 2005

Printed for the use of the Committee on Banking, Housing, and Urban Affairs

(

Available at: http://www.access.gpo.gov/congress/senate/senate05sh.html

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS

RICHARD C. SHELBY, Alabama, Chairman

ROBERT F. BENNETT, Utah

WAYNE ALLARD, Colorado

MICHAEL B. ENZI, Wyoming

CHUCK HAGEL, Nebraska

RICK SANTORUM, Pennsylvania

JIM BUNNING, Kentucky

MIKE CRAPO, Idaho

JOHN E. SUNUNU, New Hampshire

ELIZABETH DOLE, North Carolina

MEL MARTINEZ, Florida

PAUL S. SARBANES, Maryland

CHRISTOPHER J. DODD, Connecticut

TIM JOHNSON, South Dakota

JACK REED, Rhode Island

CHARLES E. SCHUMER, New York

EVAN BAYH, Indiana

THOMAS R. CARPER, Delaware

DEBBIE STABENOW, Michigan

ROBERT MENENDEZ, New Jersey

KATHLEEN L. CASEY, Staff Director and Counsel

STEVEN B. HARRIS, Democratic Staff Director and Chief Counsel

DOUGLAS R. NAPPI, Chief Counsel

MARK OESTERLE, Counsel

BRYAN N. CORBETT, Counsel

DEAN V. SHAHINIAN, Democratic Counsel

JOSEPH R. KOLINSKI, Chief Clerk and Computer Systems Administrator

GEORGE E. WHITTLE, Editor

(II)

(III)

CONTENTS

TUESDAY, FEBRUARY 8, 2005

Page

Opening statement of Chairman Shelby ................................................................ 1

Opening statements, comments, or prepared statements of:

Senator Sarbanes .............................................................................................. 3

Senator Sununu ................................................................................................ 4

Senator Reed ..................................................................................................... 4

Senator Martinez .............................................................................................. 4

Senator Dodd .................................................................................................... 5

Senator Bunning ............................................................................................... 24

Prepared statement ................................................................................... 50

Senator Stabenow ............................................................................................. 27

Prepared statement ................................................................................... 50

Senator Hagel ................................................................................................... 30

Senator Corzine ................................................................................................ 32

Senator Schumer .............................................................................................. 36

WITNESSES

Kathleen A. Corbet, President, Standard & Poor’s ............................................... 5

Prepared statement .......................................................................................... 50

Sean J. Egan, Managing Director, Egan-Jones Ratings Company ...................... 6

Prepared statement .......................................................................................... 55

Response to a written question from Senator Shelby .................................... 82

Micha S. Green, President, Bond Market Association .......................................... 8

Prepared statement .......................................................................................... 57

Response to a written question from Senator Shelby .................................... 82

Yasuhiro Harada, Executive Vice President, Rating and Investment Information, Inc. ................................................................................................................ 10

Prepared statement .......................................................................................... 63

Response to a written question from Senator Shelby .................................... 83

Stephen W. Joynt, President and Chief Executive Officer, Fitch Ratings .......... 12

Prepared statement .......................................................................................... 66

James A. Kaitz, President and Chief Executive Officer, Association for Financial Professionals .................................................................................................. 13

Prepared statement .......................................................................................... 72

Response to a written question from Senator Shelby .................................... 84

Raymond W. McDaniel, Jr., President, Moody’s Investors Service ..................... 15

Prepared statement .......................................................................................... 75

ADDITIONAL MATERIAL SUPPLIED FOR THE RECORD

Letter to Senator Richard C. Shelby from Kathleen A. Corbet, President,

Standard & Poor’s dated March 28, 2005 .......................................................... 82

Letter to Senator Richard C. Shelby from Yasuhiro Harada, Executive Vice

President, Rating and Investment Information, Inc. dated March 1, 2005 .... 108

Letter to Senator Richard C. Shelby from Raymond W. McDaniel, Jr., President, Moody’s Investors Service dated February 22, 2005 ............................... 110

Letter to Senator Jim Bunning from Raymond W. McDaniel, Jr., President,

Moody’s Investors Service dated February 22, 2005 ......................................... 114

Letter to Senator Jim Bunning from Charles D. Brown, General Counsel,

Fitch Ratings dated March 8, 2005 .................................................................... 154

Letter to Senator Jon S. Corzine from Charles D. Brown, General Counsel,

Fitch Ratings dated March 8, 2005 .................................................................... 173

Page

IV

Statement of Kent Wideman, Executive Vice President, Dominion Bond Rating Service ............................................................................................................ 192

Article from The Washington Post, ‘‘Credit Raters’ Power Leads to Abuses,

Some Borrowers Say’’ by Alec Klein, Washington Post Staff Writer dated

November 24, 2004 submitted by Sean J. Egan, Managing Director, EganJones Ratings Company ...................................................................................... 196

(1)

EXAMINING THE ROLE OF CREDIT RATING

AGENCIES IN THE CAPITAL MARKETS

TUESDAY, FEBRUARY 8, 2005

U.S. SENATE, COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, Washington, DC.

The Committee met at 10 a.m., in room SD–538, Dirksen Senate

Office Building, Senator Richard C. Shelby (Chairman of the Committee) presiding.

OPENING STATEMENT OF CHAIRMAN RICHARD C. SHELBY

Chairman SHELBY. The hearing shall come to order.

Since their inception nearly a century ago, credit rating agencies

have come to occupy a prominent role as gatekeepers to the capital

markets. These entities wield extraordinary power in the marketplace, and their ratings affect an issuer’s access to capital, the

structure of transactions, and portfolio investment decisions. A

high rating effectively serves as a ‘‘seal of approval’’ that can save

an issuer millions of dollars in interest payments. Conversely, a

low rating or a ratings downgrade can trigger a sell-off of an

issuer’s stock and a drop in its bond prices, while making future

financing more expensive.

As new corporate and municipal issuers seek to access an increasingly global market and as issuers develop innovative and

complex financial products, there is every reason to expect that the

importance and influence of credit rating agencies will continue to

grow. Given investors’ reliance on these agencies, I believe that it

is important for this Committee to carefully examine the industry,

the ratings process, and the regulatory landscape.

In 1975, the SEC began using the designation of a ‘‘Nationally

Recognized Statistical Rating Organization,’’ or ‘‘NRSRO,’’ for the

purpose of determining the appropriate amount of capital that a

broker must hold to protect against trading losses. Although the

SEC initially created this designation for a narrow purpose in the

‘‘Net Capital Rule’’ that applies to broker-dealers, the designation

now serves as a universally accepted benchmark for investment

quality, and has been used in legislation, various regulations, and

financial contracts.

Some contend that the NRSRO designation has evolved into a

quasi-official stamp of market credibility that acts as a barrier to

entry. Although there are approximately 150 credit rating firms

worldwide, there are only four firms with the designation. Not surprisingly, revenues are concentrated in the firms with the designation. Moody’s, S&P, and Fitch represent 95 percent of the market

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share. Some assert that the SEC has effectively granted these companies a franchise and that meaningful competition is nearly impossible without the designation. There seems to be a ‘‘catch–22’’

because a firm cannot compete nationally without the NRSRO designation, but it cannot obtain the designation without a national

reputation in the first instance. Understanding the level of competition in this industry and the impact of the NRSRO designation

is an important element of this Committee’s inquiry.

We will also examine the SEC’s role in regulating the industry.

The SEC has never adopted a formal approval process or promulgated official recognition criteria for obtaining the NRSRO designation. Instead, the SEC makes determinations on a case-by-case

basis that leads many to question the transparency and fairness of

the entire approval process. Further, once the SEC grants the designation, it does not maintain any form of ongoing oversight. Some

believe that there is a misperception in the market that NRSRO’s

are regulated because they initially received the SEC’s stamp of approval. We will evaluate the SEC’s authority and regulatory actions

concerning the industry and consider whether additional oversight

is necessary. In the coming months, we will ask Chairman Donaldson to appear before this Committee to address these particular

issues.

Further, we will review the structure and operation of the rating

agencies. Some have raised concerns regarding the transparency of

the ratings process and the information that rating agencies make

available to issuers and the public at-large. Typically, rating agencies do not disclose their methodologies and analysis for determining a particular rating, identify the information they reviewed

in making a rating, or disclose the qualifications of the lead analyst. This lack of transparency leads some to question the reliability and credibility of ratings and whether the ratings process is

too subjective. Some contend that the marketplace needs to more

fully understand the reasoning behind a ratings decision and the

information on which it is based.

Finally, we will address the potential for conflicts in this industry. Too often, this Committee has held hearings on industry practices where corporate insiders exploit conflicts that ultimately hurt

investors. In the ratings industry, most agencies rely on payments

from the issuers that they rate. Some suggest that there may be

a strong incentive for ratings inflation. This situation is reminiscent of the analyst independence charges that were the focus of the

Global Settlement. A second potential conflict involves the sale of

consulting and advisory services by rating agencies to their ratings

clients. This practice is analogous to an auditor’s sale of consulting

services to an audit client: A conflict that was a focal point of the

Sarbanes-Oxley Act. The underlying concern is that these conflicts

could undermine the independent and objective status of rating

agencies and their ratings, leading investors to make important investment decisions based on compromised ratings.

To discuss these important issues with us this morning, we have

a panel of leading industry participants: Ms. Kathleen Corbet,

President, Standard & Poor’s; Mr. Sean Egan, Managing Director,

Egan-Jones Ratings Company; Mr. Micah Green, President, Bond

Market Association; Mr. Yasuhiro Harada, Executive Vice PresiVerDate 11-MAY-2000 17:55 Jul 12, 2006 Jkt 025856 PO 00000 Frm 00006 Fmt 6633 Sfmt 6633 28059.TXT SBANK4 PsN: SBANK4
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dent, Rating & Investment Information, Inc.; Mr. Stephen Joynt,

President and Chief Executive Officer, Fitch Ratings; Mr. James

Kaitz, President and Chief Executive Officer, Association for Finance Professionals; and Mr. Raymond McDaniel, Jr., President

and Chief Operating Officer, Moody’s Investors Services, Inc.

Each witness will have the opportunity here to make a short

opening statement. Given the number of witnesses this morning, I

would ask you to limit your statement to no more than 5 minutes,

and I look forward to your testimony.

Senator Sarbanes.

STATEMENT OF SENATOR PAUL S. SARBANES

Senator SARBANES. Thank you very much, Mr. Chairman. I want

to commend you for holding this hearing. During the past two Congresses, this Committee has undertaken continuous review of the

securities markets and sought to respond to problems which have

occurred in those markets. Today, under your leadership, we resume this very important oversight function.

Credit rating agencies have played an important role in the capital markets for almost a century by providing analytic opinions to

investors on the ability and willingness of issuers to make timely

payments on debt instruments over the life of those instruments.

Issuers pay for the ratings in order to lower the cost of and increase their access to capital. Investors trust the agencies’ impartiality and quality, and rely on these ratings. The SEC created the

designation of Nationally Recognized Statistical Rating Organization, NRSRO, which it applies to only four agencies, and many institutional investors buy only debt rated by a NRSRO.

In recent years, concerns have been raised about the industry. In

late 2001, the major credit rating agencies maintained an investment grade rating on Enron debt after its major financial restatements and up until 4 days before Enron’s declared bankruptcy. As

a result, as Business Week reported, there was ‘‘a barrage of criticism that raters should have uncovered the problem sooner at

Enron, WorldCom, and other corporate disasters.’’

This subject was raised during hearings before this Committee,

as well as before the Senate Governmental Affairs Committee. Section 702 of the Sarbanes-Oxley Act, a section on which Senator

Bunning provided important leadership, directed the SEC to study

the role and function of credit rating agencies. The SEC issued a

report in compliance with that requirement and, in June 2003,

published a concept release on which they have received public

comments. I understand the SEC is continuing its analysis of the

issues. It has not yet proposed a course of action.

Questions have been raised about the Federal regulation of credit

rating agencies. James A. Kaitz, a witness today, who is President

and CEO of the Association for Financial Professionals, has said,

‘‘Here we have a huge issue that has a significant impact on the

U.S. economy and the global economy, and nobody seems to be paying attention.’’

Well, Mr. Chairman, you are paying attention and this Committee is paying attention. Today’s hearing gives us an opportunity

to hear testimony from the industry on issues that have been

raised both in the concept release of the SEC and in the press, inVerDate 11-MAY-2000 17:55 Jul 12, 2006 Jkt 025856 PO 00000 Frm 00007 Fmt 6633 Sfmt 6633 28059.TXT SBANK4 PsN: SBANK4
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cluding: The extent of the SEC’s authority to regulate, examine, or

imposed requirements on Nationally Recognized Statistical Rating

Organizations; whether the NRSRO recognition process should be

more transparent; conflicts of interest that arise because rating

agencies are paid by and sell consulting services to the issuers they

rate; the influence of issuers on the ratings they receive; alleged

anticompetitive processes; corporate governance and the potential

for conflicts of interest when the director of a rating agency also

sits on the board of an issuer that is rated; and analyst compensation. And obviously there are many others as well.

Mr. Chairman, I look forward to hearing the testimony of the

witnesses this morning. You have assembled a very good panel,

and I look forward to hearing testimony from the SEC and Chairman Donaldson on a future occasion.

Thank you.

Chairman SHELBY. Thank you.

Senator Sununu.

STATEMENT OF SENATOR JOHN E. SUNUNU

Senator SUNUNU. Thank you, Mr. Chairman. I am anxious to

hear the testimony of the panel. I do not know a great deal about

this industry, but anytime you have an industry where two firms

comprise 80-percent market share, I think it is safe to say that

there probably has not been enormous motivation or incentive for

dramatic changes. And I think a lot of the issues raised by the

Chairman and Ranking Member attest to that. So this will be not

only an opportunity for further education of our Members, but also

to understand how and why certain decisions are made at the rating agencies regarding not just firms that are out there competing

in the private equity and bond markets, but also some of the recent

decisions to speak out on legislation that is before this Committee.

So, I anxiously await the testimony. Thank you.

Chairman SHELBY. Senator Reed.

STATEMENT OF SENATOR JACK REED

Senator REED. Mr. Chairman, thank you for holding these hearings, and I am, like my colleague from New Hampshire, eager to

listen to the witnesses. And you have assembled a very good group

of witnesses today.

Thank you, Mr. Chairman.

Chairman SHELBY. Senator Martinez.

COMMEMTS OF SENATOR MEL MARTINEZ

Senator MARTINEZ. Thank you very much. I appreciate your holding the hearing and look forward to the witnesses’ testimony. I

have had a little experience in the rating world with municipal

credit, but I look forward to learning more and hearing the witnesses.

Thank you.

Chairman SHELBY. Senator Dodd.

STATEMENT OF SENATOR CHRISTOPHER J. DODD

Senator DODD. Thank you, Mr. Chairman, and let me commend

you and Senator Sarbanes. This is a tremendously important hearVerDate 11-MAY-2000 17:55 Jul 12, 2006 Jkt 025856 PO 00000 Frm 00008 Fmt 6633 Sfmt 6633 28059.TXT SBANK4 PsN: SBANK4
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ing, and you just cannot overstate the importance that these credit

agencies have on capital markets. And the Good Housekeeping Seal

of Approval that the SEC gives, whether intended or not, has huge

implications. So this is very important, and I am very grateful to

you for holding it.

Let me associate myself with your remarks and the remarks of

Senator Sarbanes as well. Thank you.

Chairman SHELBY. Ms. Corbet, we will start with you, if you will

sum up your testimony. All of your written testimony will be made

part of the record in its entirety, if you will just sum up your top

points.

STATEMENT OF KATHLEEN A. CORBET

PRESIDENT, STANDARD & POOR’S

Ms. CORBET. Thank you. Mr. Chairman, Members of the Committee, good morning. I am Kathleen Corbet, President of Standard

& Poor’s, and I welcome the opportunity to appear at this hearing

to discuss the important role of credit rating agencies, such as S&P

Ratings Services, in the capital markets. This morning I will briefly

focus my remarks on three topics: First, our ongoing initiatives to

safeguard the independence, integrity, and transparency of our ratings process; second, our management of potential conflicts of interest; and, third, our support for greater transparency in the SEC’s

NRSRO designation process and for the reduction of regulatory

barriers to entry in the credit rating industry.

As background, a credit rating is our opinion of the creditworthiness of an issuer or of a specific issue. Unlike equity analysis, a

credit rating is not a recommendation to buy, hold, or sell a particular security. Credit ratings have provided benchmarks for

issuers and investors around the world, facilitating efficient capital

raising and the growth of new markets. S&P also publishes credit

research on new markets and new asset classes; and it is through

this process that there is more information, a wider array of tools

for understanding credit, and far greater transparency in the marketplace today.

At S&P, independence, transparency, and quality have been the

cornerstones of our business for nearly a century, and they have

driven our longstanding track record of analytical excellence and

effectiveness in alerting the market to both deterioration and improvements in credit quality.

The unprecedented corporate misconduct that has been revealed

in recent years has resulted in constructive responses by market

participants, including S&P. Many of these cases have involved

issuer fraud. In Enron, for example, key personnel have expressly

admitted their role in deliberately misleading S&P and other rating agencies.

While we believe that the credit rating system works effectively,

we have, consistent with our tradition of self-evaluation, reviewed

our ratings process from top to bottom in order to ensure that ratings are responsive to evolving market needs. We have also taken

a number of actions as part of this effort, including updating our

policies and procedures and aggregating them in a newly published

Code of Practices and Procedures, which is publicly available on

our website. Among the other measures described in my written

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testimony, we have added specialized forensic accounting expertise

and expanded the scope of our published commentary.

We have had a longstanding commitment to ensuring that any

potential conflicts of interest do not compromise our analytical

independence. Our code contains a significant number of policies,

procedures, and structural safeguards.

For decades, issuers have generally paid for our rating opinions,

and these opinions have been published for the benefit of all investors and the public without cost.

Numerous market participants, including the great majority of

witnesses before the SEC and IOSCO, as well as economists at the

Federal Reserve Board, have reached the same conclusion: There

is no evidence that the issuer-paid model undermines the objectivity of these ratings.

Indeed, the value of our ratings lies in their objectivity and independence; without these essential attributes, our rating opinions

would cease to be credible.

As the Committee is aware, the SEC developed the NRSRO designation in 1975, and S&P Ratings Services is one of four credit

rating agencies designated by the Commission. As you also know,

the Commission is currently in the process of reviewing this system

and considering possible changes. We support greater transparency

in the designation criteria and the reduction of regulatory barriers

to entry into the credit rating industry.

The Commission is also considering whether and to what extent

it should engage in enhanced regulatory oversight if the designation system is retained. And as we have expressed to the Commission, we believe that it is imperative to avoid overly intrusive Government supervision of credit rating agencies, particularly supervision that may suggest a substantive role for Government in the

ratings process itself.

Let me conclude by saying that independence and objectivity are

critical to the effectiveness of the credit rating agencies in serving

the marketplace and the investing public, and great care should be

taken to ensure that the principles and the structures that have so

greatly benefited the market are not compromised.

Thank you for the opportunity to participate in this hearing. I

look forward to your questions, comments, and the ensuing discussion.

Chairman SHELBY. Mr. Egan.

STATEMENT OF SEAN J. EGAN

MANAGING DIRECTOR, EGAN-JONES RATINGS COMPANY

Mr. EGAN. Thank you. Chairman Shelby, Members of the Committee, good morning. I am Sean Egan, Managing Director of EganJones Ratings Company, a credit rating firm. By way of background, I am co-founder of Egan-Jones, which was established to

provide timely, accurate credit ratings to institutional investors.

Our firm differs significantly from other rating agencies in that we

have distinguished ourselves by providing timely, accurate ratings

and we are not paid by issuers of debt, which we view as a significant conflict of interest. Instead, we are paid by approximately 400

firms consisting mainly of institutional investors and broker-dealVerDate 11-MAY-2000 17:55 Jul 12, 2006 Jkt 025856 PO 00000 Frm 00010 Fmt 6633 Sfmt 6633 28059.TXT SBANK4 PsN: SBANK4
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ers. We are based in Philadelphia, Pennsylvania, although we have

employees throughout the world.

The rating industry is in crisis. At a time when the capital markets have become increasingly reliant on credit ratings, the rating

industry is suffering from a state that is hard to characterize as

anything other than dysfunctional. The problems are:

One, severe consolidation. The Department of Justice personnel

referred to the industry as a ‘‘partner monopoly’’ since S&P and

Moody’s control over 90 percent of the revenues and do not compete

against each other for the two ratings which are normally required.

This is important. They do not compete against each other.

Chairman SHELBY. Explain.

Mr. EGAN. What I mean by that is that if S&P is brought into

a transaction, Moody’s is soon to follow, so they both get paid for

the issuance of bonds. That is a key difference. Everyone refers to

this as an oligopoly. It is not an oligopoly if you just look at 90 percent of the revenues. It is a partner monopoly.

Number two, severe conflicts of interest. Issuers’ payment for

ratings create conflicts of interest that are similar to those experienced by the equity research analysts.

Number three, freedom of speech defense. There is no downside

to bad rating calls by the two dominant firms. Basically there is

no place else for the issuers to go.

Manifestations of the flawed structure are:

Failure to warn investors about credit problems such as Enron,

the California utilities, WorldCom, Global Crossing, AT&T Canada,

and Parmalat. Enron was rated investment grade by the NRSRO’s

4 days before bankruptcy. The California utilities were rated A

minus 2 weeks before defaulting. And WorldCom was rated investment grade 3 months before filing for bankruptcy. Parmalat was

rated investment grade 45 days before filing for bankruptcy.

Chairman SHELBY. What was Parmalat rated before bankruptcy?

Mr. EGAN. I think it was rated BBB minus, and I can confirm

that later.

Chairman SHELBY. Who issued that rating?

Mr. EGAN. S&P. Moody’s was not involved in it.

Losses from the Enron and WorldCom failures alone were in excess of $100 billion—some people have estimated it at $200 billion—thousands of jobs, and the evaporation of pensions for thousands. It is likely that some of these failures could have been

avoided had the problems been identified and addressed sooner.

This is basically the ‘‘nail in time saves nine’’ concept. Enron was

left with only Dynergy as an acquirer by the time the alarm was

sounded.

Another problem in the industry is under-rating credits. Firms

such as Nextel, American Tower, and Tyssenkrupp were assigned

credit ratings which were too low, thereby significantly increasing

their cost of capital and restricting growth.

Another problem with the industry is insider trading. CitiGroup

and probably other institutions were given advance information

about the Enron downgrade. Additionally, S&P and Moody’s request advance information about transactions and other major

events which creates opportunities for insider trading. S&P analyst

Rick Marano and his associates traded on confidential information

8

relating to the acquisition of ReliaStar and American General, two

insurance companies.

Another problem is investor fraud. The NRSRO firms pulled

their ratings on an Allied Signal entity so Allied could repurchase

the debt more cheaply. This is outrageous.

Another problem is issuers coercion, forcing issuers to pay rating

fees. There is a Washington Post article elaborating on Hanover

Re’s experience.

Two other problems are punishment ratings—we have that in

the municipal area—and expansion of the monopoly. S&P and

Moody’s are getting into corporate debt ratings, governance ratings,

and also consulting.

You will hear today that the rating agencies were misled by

Enron and the others. They have defenses for why they did not

take action.

The first defense is basically ‘‘they did not tell us’’ that is, it was

an issuer misdeed.

The second one is the Jack Grubman defense, that they have little incentive for not taking action since they are a relatively little

portion of the overall revenue base.

The next one is the Arthur Andersen defense: Our reputation is

key. We do not buy that.

The next defense is the committee approach. We refer to that as

the Lemming defense.

There are a few others, too.

What we recommend in this industry is to recognize some rating

firms that have succeeded in providing timely, accurate ratings.

Number two, wean the rating firms from issuer compensation. It

is fine that S&P and Moody’s get paid for their analysis, but the

SEC should not give them their seal of approval if they have a conflict of interest.

Also, adopt the Code of Standard Practices for Participants in the

Credit Rating Process issued by the ACT, AFP, and AFTE—you

will hear that later today on this.

Also, prohibit rating firms from obtaining insider information.

The last thing is sever the ties between rating firm personnel

and issuers and dealers. Moody’s Chairman was sitting on—this is

outrageous—WorldCom’s board basically 6 months before the bankruptcy.

I have some additional comments, and you can refer to the written material. Thank you for your time.

Chairman SHELBY. Mr. Green.

STATEMENT OF MICAH S. GREEN

PRESIDENT, BOND MARKET ASSOCIATION

Mr. GREEN. Thank you, Chairman Shelby and Members of the

Committee, for the opportunity to testify today on credit rating

agencies.

My name is Micah Green. I am President of the Bond Market Association. As you know, the Association represents securities firms

and banks that underwrite, distribute, and trade debt securities in

the United States and internationally—a global market that is estimated at about $44 trillion today. Our efforts include outreach to

retail investors as well, among other things through our family of

9

* Held in Committee files.

websites. Last week, in fact, we launched a new version of our

Investinginbonds.com website which offers a wide range of investor

education information, and for the first time ever real-time bond

price information—which, frankly, this Committee deserves a great

deal of credit for—that is free to any user on the site. And an important element included in that investor education material is the

credit rating attached to the bond.

The past 15 years have seen dramatic growth in the number of

issuers and the range and complexity of fixed-income securities.

The importance of credit ratings to investors and other securities

market participants has increased proportionally. Rating agencies

are critical to the efficient functioning of the fixed-income markets.

What credit rating agencies do is offer an opinion, known in the

market as a rating, the credit risk of a bond. The credit rating

process employs both quantitative and subjective judgment. Factors

such as a security’s yield, maturity, call features, and covenants

specific to a bond can be objectively determined from the issuer’s

mandated disclosure. Independent analysis of an issuer’s credit

quality, however, involves individual judgments of professional

credit analysts. It is a valuable complement to an investor’s own

credit analysis precisely because it is independent.

As Chairman Shelby correctly pointed out earlier, credit ratings

also guide the market’s pricing decisions. Bonds with lower ratings

are viewed as riskier than higher-rated bonds by investors who demand a yield premium as compensation. Conversely, higher-rated

bonds will offer a relatively lower yield as a reflection of their

stronger credit standing.

In order for credit ratings to have credibility as a pricing guide,

rating agencies must be viewed by the market as independent. Recently, regulators in the United States and in Europe have stepped

up their focus on rating agencies and question the need to make

changes in the current approach to regulatory oversight. In 2003,

the SEC issued a concept release intended to draw a response on

several rating agency-related issues.

Last year, the International Organization of Securities regulators, commonly known as IOSCO, drafted a comprehensive Code

of Conduct for rating agencies. Currently, the European Commission has requested public comment on whether to develop rating

agency regulation.

The Association’s response to these initiatives in both the United

States and in Europe is fundamentally the same. We have attached

our comment letters on the subject as part of our written testimony.* While those are detailed in the written testimony, I will

briefly summarize those positions.

We believe that the criteria adopted by regulators for approving

designated rating agencies should be flexible enough to allow increased competition, while ensuring that designated rating agencies have the expertise to produce accurate ratings. In the United

States, we favor eliminating the current requirement that a rating

agency be widely recognized rather than accepted in a defined sector of the market, either by product or by geographic specialization.

10

We believe credit rating agencies should have policies and procedures to ensure the independence of the credit rating process. In

fact, the IOSCO Code of Ethics details a number of different measures that can be taken by the rating agencies to deal with many

of those inherent conflicts. Again, it is about managing those conflicts. A good example of how this can be done can be seen by the

Bond Market Association’s own comprehensive guiding principles

on research in the fixed-income marketplace. In the aftermath of

the settlement in the equity marketplace, our members believed

that they needed to come up with a very tough, very comprehensive

way of managing those conflicts, and our guiding principles provided that.

We believe that credit rating agencies should publish their rating

methodologies for various types of securities so that both issuers

and users will understand the agencies’ requirements and standards, and so that different rating analysts in the same agency will

produce consistent ratings.

We do not believe that regulation of the credit rating process is

necessary or desirable, since Government regulation would tend to

result in less diversity of opinion and would be less responsive to

the changing marketplace and new product developments.

We believe issuers should be given an opportunity to correct factual misstatements in rating agency reports, but not to appeal rating designations outside the rating agency. This should not be a

lobbied rating agency. It should not be a subjective influence from

the outside. It should be an objective independent rating.

We believe rating agencies should publish information on the historical accuracy of their rating assessments.

In conclusion, as the capital markets develop and mature globally, the need for a measured approach by regulators toward the

conduct of rating agencies grows in importance. The Association

does support those actions by regulators that we believe will help

enhance competition among rating agencies. We do not support

steps that would limit the independence of rating agencies to determine their opinions of the creditworthiness of issuers. This would

make the fixed-income markets less efficient, ultimately harming

investors, issuers, dealers, and regulators.

Again, thank you for the opportunity to testify. I look forward to

answering any questions that you have.

Chairman SHELBY. Mr. Harada.

STATEMENT OF YASUHIRO HARADA

EXECUTIVE VICE PRESIDENT,

RATING AND INVESTMENT INFORMATION, INC.

Mr. HARADA. Thank you, Chairman Shelby, Ranking Member

Sarbanes, and Members of the Senate Banking Committee, for your

kind invitation to present testimony at today’s hearing. My name

is Yasuhiro Harada. I am the Executive Vice President of Rating

and Investment Information, Inc., a Japanese rating company.

We are very pleased to offer our thoughts on this topic as well

as some more specific information about the challenges faced by

our company as we have sought to clear the hurdles necessary to

become a new competitor in the U.S. market. Even though our

company is the most recognized credit rating agency in Japan and

11

the broader Asian markets, obtaining designation in the United

States as a national recognized statistical rating organization has

been an exercise in delay and disappointment.

R&I is a respected independent source of financial information

for the overwhelming majority of United States broker-dealers and

financial institutions that conduct operations in Japan. Market

participants particularly appreciate that R&I calculates and publishes a default ratio based on a 27-year record which indicates the

probability that an issuer that has been given a publicly released

rating will fall into default within that given period of time. Our

company’s ratings are regularly announced and published by the

leading financial electronic and print media in Japan, and in the

United States as well.

In order to compete effectively in the U.S. market, a designation

by the SEC as a NRSRO is a critical factor. From a procedural

standpoint, the problem is that the NRSRO application process has

little regulatory structure and no established timetables for agency

decisionmaking. The substantive problem for us is the entry barrier

presented by the SEC requirement that a new NRSRO be ‘‘nationally recognized’’ by the predominant users of such ratings in the

United States before it can gain such a designation to enter the

U.S. market. As Chairman Shelby indicated, this is a circular test.

It was precisely this circular standard which the Antitrust Division

of the U.S. Department of Justice singled out in 1998 as likely to

preclude new competitors in this credit rating market. Moreover,

concern about the lack of new competitors in this market led the

Justice Department to recommend to the SEC in 1998 that NRSRO

designation be specifically awarded to some foreign rating agencies.

For over a decade, our company, R&I, and its predecessors have

engaged in an effort to receive NRSRO designation. In 2002, R&I

submitted an amended request for NRSRO designation that was

limited in scope in that R&I sshould be recognized as an NRSRO

solely with respect to yen-denominated securities. Such recognition

on a limited basis is considered appropriate if a rating agency can

demonstrate that it possesses unique expertise in rating particular

securities, or securities of a particular currency denomination.

R&I is well-qualified to contribute to the flow of information and

expert analysis so valuable to U.S. investors and issuers. Therefore,

the lack of progress on our company’s application harms both R&I

and investors. If allowed to enter the market, U.S. investors, especially institution investors such as life insurance companies, would

benefit from having an additional source of proven credit analyses

and U.S. issuers benefit from having more providers of rating services in the Samurai bond market.

Without the NRSRO designation, we operate at a competitive

disadvantage every day under the current regulatory scheme. Until

such time as a new regulatory scheme is implemented with respect

to credit rating agencies, we respectfully suggest the SEC should

be focusing on approving qualified NRSRO’s. We encourage the

Committee to advise the SEC not to neglect pending NRSRO applications nor require such applicants to await further rulemaking

prior to approval.

Thank you for the opportunity to present these views.

Chairman SHELBY. Mr. Joynt.

12

STATEMENT OF STEPHEN W. JOYNT

PRESIDENT AND CHIEF EXECUTIVE OFFICER, FITCH RATINGS

Mr. JOYNT. Thank you, Mr. Chairman and Members of the Committee. I am pleased to be here this morning. I would like to share

some brief comments on competition, regulatory recognition and

oversight, and conflicts of interest.

After an ownership change and capital injection in 1989, Fitch

worked continuously to build its reputation for a credit research,

modeling, and analysis in the corporate finance, public finance, and

securitization markets in the United States. By 1997, we were wellrespected and prominently recognized for our contributions, especially in the rapidly expanding mortgage- and asset-backed markets. Subsequently, in 1997 and also in 2000, we merged with the

fourth, fifth, and sixth largest NRSRO’s to create the product

breadth and geographic coverage demanded by today’s global investors. At Fitch, we firmly believe in the power of competition. Fitch’s

emergence as a global full-service rating agency capable of competing with Moody’s and Standard & Poor’s across all products and

market segments has created meaningful competition in the ratings market. Fitch’s expanding business profile has enhanced innovation, forced transparency in the rating process, improved service

to investors, and created price competition.

Regarding regulation, Fitch has been actively participating in a

dialogue with many United States and international organizations,

such as the SEC, the United Kingdom’s FSA, the Committee of European Securities Regulators, and the aforementioned IOSCO committee, about the role and function of the rating agencies in the

global capital markets. In September 2002, IOSCO, with the important involvement of the SEC, published its Statement of Principles,

and in 2004 also published its Code of Conduct Fundamentals for

Credit Rating Agencies.

Fitch supports the four high-level principles outlined by IOSCO

and presented in the code. These four principles include transparency, symmetry of information to all market participants, independence, and freedom from conflict of interest. We believe that

our present operating policies and practices exemplify the principles of the IOSCO code, and we expect to embody them clearly

in a Fitch Code of Conduct.

Regarding the U.S. recognition structure, we believe there is

value in the NRSRO system that assures recognized organizations

possess the competence to develop accurate and reliable ratings.

Many investment practices and guidelines interwoven in the fabric

of the capital markets reference this system. However, this recognition is only the beginning as one’s market reputation and usefulness to investors must be built over time. In fact, after 15 years

of effort, only this year has Fitch Ratings been recognized by several global bond indexes.

Given the importance of credit ratings in the financial markets,

Fitch concurs that there is a strong need for credit rating agencies

to maintain high standards, and we do. Fitch culture emphasizes

the importance of integrity and independence as critical foundations of our most important asset—our reputation. Fitch goes to

great efforts to assure that our receipt of fees from issuers does not

affect or impair the objectivity of our ratings. Our analyst comVerDate 11-MAY-2000 17:55 Jul 12, 2006 Jkt 025856 PO 00000 Frm 00016 Fmt 6633 Sfmt 6633 28059.TXT SBANK4 PsN: SBANK4
13

pensation philosophy reflects quality of effort and individual accomplishment in research and ratings. Individual company fees, revenue production, and individual department profitability do not factor into analyst compensation, and analysts may not own securities

in companies they rate.

We are aware of the potential for conflict that is inherent in our

business model, and we do our utmost to maintain our objectivity

and preserve our reputation in world markets. For each of these

themes, we are, of course, open to all ideas that help us improve

the quality of our product and the business practices and profile of

our company.

Thank you.

Chairman SHELBY. Mr. Kaitz.

STATEMENT OF JAMES A. KAITZ

PRESIDENT AND CHIEF EXECUTIVE OFFICER,

ASSOCIATION FOR FINANCIAL PROFESSIONALS

Mr. KAITZ. Good morning. I am Jim Kaitz, President and CEO

of the Association for Financial Professionals. AFP represents more

than 14,000 finance and treasury professionals representing more

than 5,000 organizations. Our members are responsible for issuing

short- and long-term debt and managing corporate cash and pension assets for their organizations.

AFP believes that the credit rating agencies and investor confidence in the ratings they issue are vital to the efficient operation

of global capital markets. Yet as evidenced by AFP’s research, confidence in rating agencies and their ratings has diminished over

the past few years.

Why is reforming the credit rating system so important? Along

with the SEC and other regulators that have incorporated the

NRSRO designation into their rules, institutional and individual

investors have long relied on credit ratings when purchasing individual corporate and municipal bonds. Further, nearly every mutual fund manager that individuals and institutional investors

have entrusted with over $8 trillion relies to some degree on the

ratings of nationally recognized agencies. Rating actions on corporate debt also have an indirect but sizeable impact on the stock

prices of rated companies.

Debt issuers rely on the credit rating agencies to issue ratings

that accurately reflect the company’s creditworthiness. These ratings determine the conditions under which a company can raise

capital to maintain and grow their business.

Finally, while credit rating agencies have long played a significant role in the operation of capital markets, the Administration’s

recent single-employer pension reform proposal would tie pension

funding and Pension Benefit Guaranty Corporation premiums to a

plan sponsor’s financial condition as determined by existing credit

ratings. In some cases, plan sponsors would be prohibited from increasing benefits or making lump sum payments based on their

credit rating and funded status. Such a proposal would further codify the NRSRO designation and increase the already significant

market power of the rating agencies.

More than 10 years after it first began examining the role and

regulation of credit rating agencies and despite the increased reliVerDate 11-MAY-2000 17:55 Jul 12, 2006 Jkt 025856 PO 00000 Frm 00017 Fmt 6633 Sfmt 6633 28059.TXT SBANK4 PsN: SBANK4
14

ance on credit ratings, the Securities and Exchange Commission

has not taken any meaningful action to address the concerns of

issuers and investors. These concerns include questions about the

credibility and reliability of credit ratings and conflicts of interest

and potential abusive practices in the ratings process. Chairman

Shelby and Members of the Committee, these issues are far too important for the SEC to remain silent while investors and regulators

worldwide wait for it to take action.

Now I would like to briefly outline some of our concerns.

When the SEC recognized the first Nationally Recognized Statistical Rating Organization in 1975 without outlining the criteria by

which others could be recognized, it, in effect, created an artificial

barrier to entry to the credit ratings market. This barrier has led

to a concentration of market power with the recognized rating

agencies and a lack of competition and innovation in the credit

market. Only the SEC can remove the artificial barrier to competition it has created. Therefore, we strongly recommend that the

SEC maintain the NRSRO designation and clearly articulate the

process by which qualified credit rating agencies can attain the

NRSRO designation.

The SEC must also take an active role in the ongoing oversight

of the rating agencies to ensure that they continue to merit

NRSRO status.

The Commission further empowered the rating agencies when it

exempted them from Regulation Fair Disclosure. Through this exemption, the rating agencies have access to nonpublic information

about the companies they rate. The Commission has done nothing

to ensure that those who are granted this powerful exemption do

not use the nonpublic information inappropriately. The SEC must

require that NRSRO’s have policies in place to protect this valuable

and privileged information. This must be part of the SEC’s ongoing

oversight of the rating agencies.

As highlighted in some recent media reports, rating agencies continue to promulgate unsolicited ratings which are issued without

the benefit of access to company management or nonpublic information about the issuer. The resulting ratings are often not an accurate reflection of an organization’s financial condition. Credit ratings are critical to an organization’s ability to issue debt, and

issuers often feel compelled to participate in the rating process and

pay for the rating that was never solicited. The potential for abuse

of these unsolicited ratings by the rating agencies must be addressed by the SEC.

Finally, an NRSRO is also in a position to compel companies to

purchase ancillary services. These ancillary services include ratings

evaluations and corporate governance reviews. Further, the revenue derived from these services has the potential to taint the objectivity of the ratings. You need look no further than the equity

research and audit professions to understand why these potential

abusive practices and conflicts of interest must be addressed by the

SEC.

Chairman Shelby and Members of the Committee, we strongly

recommend that you hold the SEC accountable on the issues that

have been raised here today. With credit ratings being so important to investors in this country, Congress should also not allow

15

the SEC to cede oversight of the agencies to an organization outside the United States that has no binding authority, including

oversight authority, of the rating companies.

Finally, it has been 10 years since the SEC has considered regulating credit rating agencies, and as reported in today’s Washington

Post, we find it incredible that they have now concluded they do

not have oversight authority over the rating agencies.

In conclusion, Mr. Chairman, AFP commends you and the Committee for pursuing this issue.

Chairman SHELBY. Mr. McDaniel.

STATEMENT OF RAYMOND W. McDANIEL, JR.

PRESIDENT, MOODY’S INVESTORS SERVICE

Mr. MCDANIEL. Good morning, and thank you, Mr. Chairman,

Senator Sarbanes, and all the Members of the Committee for inviting Moody’s to participate in today’s hearing.

Moody’s offers forward-looking credit rating opinions and credit

research about entities active in the debt capital markets globally.

As the oldest and one of the most established credit rating agencies, we have more than 1,000 analysts in 18 countries worldwide.

Moody’s distributes our opinions broadly and free of charge to investors in the form of credit ratings. We also public credit research

about the debt obligations and issuers we rate. We sell this research to about 3,000 institutional investors.

Our opinions are communicated to the market through a symbol

system originated almost 100 years ago. The system ranks relative

credit risk on a scale with 9 broad letter categories from Aaa to C.

Most of the letter categories are further refined with numbers, 1

through 3. Overall our ratings have consistently done a good job in

predicting the relative credit risk of debt securities and debt

issuers. Ratings are not pass/fail assessments of an entity’s future

performance or performance guarantees, investment recommendations, or statements of fact; rather, Moody’s ratings intend to predict the relative probability that debt obligations will be repaid on

a full and timely basis with the probability declining at each lower

level in the rating scale. The attributes of ratings as offered by

major rating agencies include their predictive content, public availability, and free distribution. The combination of these attributes

has encouraged use by diverse groups, including issuers, intermediaries, parties to financial contracts, institutional investors,

and regulators.

For these users, ratings must meet demands for accuracy, stability, and timeliness. Accuracy is measured by the predictive content of the ratings, the ability of the rating system to properly rank

order the relative riskiness of credit from low to high. Moody’s publishes on our website a quarterly report card of the accuracy of our

ratings reaching back 20 years. Moody’s rating stability is an important attribute because ratings volatility has consequences for,

among other things, the composition of investment portfolios and

capital adequacy calculations. As a result, rating reversals, a rating

downgraded followed shortly by an upgrade, or vice versa, may add

unnecessary volatility and costs. It is, therefore, important for

Moody’s to manage its ratings so that ratings are changed only

16

after judicious deliberation and in response to changes in fundamental creditworthiness, not transitory events.

In order to balance the market’s demand for accuracy and stability with its demand for timeliness, Moody’s uses additional public signals called watchlists and outlooks through which we communicate our opinion on possible trends in future creditworthiness.

Rating outlooks and the watchlists permit rating agencies to signal

developing trends and preliminary views without disrupting markets. In an effort to learn from our mistakes and to keep pace with

complex credit markets, we continue to augment our analytical

process. Some of the initiatives we have instituted include formation of analytical specialist teams in areas such as accounting and

financial disclosure; mandatory professional development programs; introduction of new credit monitoring tools; the expansion

of our centralized credit policy function; and the appointment of

chief credit officers.

Most of Moody’s revenue comes from fees paid by debt issuers.

Issuers request and pay for ratings from us because of the broad

marketability of their bonds that ratings facilitate. Issuers pay

these fees rather than investors because we broadly distribute our

ratings to all investors simultaneously free of charge. The issuerpayment business model has potential conflicts of interest, as does

a subscription-based business that some firms use as an alternative. The critical question is not which model is used, but whether potential conflicts of interest are prudently and effectively managed and disclosed. In Moody’s case, we have a range of policies

and procedures in place to achieve this goal, including that rating

decisions must be taken by a committee and not by an individual

analyst; that analyst compensation must not related in any way to

the fees received from the issuers they evaluate; and that analysts

may not own securities in the issuers they rate.

Finally, Mr. Chairman, turning to the regulatory environment,

over the past 3 years much attention has been focused on the global financial services industry, including rating agencies. To the extent that here in the United States the NRSRO designation is seen

to limit competition, Moody’s supports its discontinuation. Moody’s

has consistently supported competition in the industry and eliminating barriers to entry caused by, for example, vague or difficult

to achieve recognition standards. A healthy industry structure is

one in which the role of natural economic forces is conspicuous and

where competition is based on performance quality to promote the

objectives of market efficiency and investor protection.

The obligation to assure that the U.S. financial market remains

among the fairest and most transparent in the world is one that

all market participants should share. I look forward to answering

any questions the Committee may have. Thank you.

Chairman SHELBY. Thank you.

Ms. Corbet, Mr. Joynt, and Mr. McDaniel, I will pose this first

question to the three of you. About 2 years ago, this Committee

held a hearing on the Global Settlement and examined potential

conflicts of interest with research analysts. Essentially, analysts

were being paid to tout a banking client’s stock. Some contend that

a similar conflict of interest exists in the credit ratings industry.

17

How do you respond to concerns that this conflict compromises the

independent and objective analysis of the rating agencies?

We will start with you, Ms. Corbet.

Ms. CORBET. Thank you, Mr. Chairman——

Chairman SHELBY. How do you defend that, in other words?

Ms. CORBET. Sure. The conflicts of interest are indeed ones that

we must be vigilant in terms of managing, and similar to the provisions in our Code of Policies and Procedures, which are similar to

those raised by Mr. McDaniel, we also would add that analysts are

not engaged in any commercial or business matters with respect to

ratings. In addition to strict procedures prohibiting trading and securities ownership in the companies that they rate, we also prohibit any board representation by analysts.

Chairman SHELBY. Mr. Joynt.

Mr. JOYNT. As I mentioned, I think the culture of our company

is probably the first line of defense, instructing all our employees

and our analysts and building over time on the importance of integrity and independence.

As was mentioned earlier, but I think it is a positive, the ratings

are done by a committee and not by individuals, so it is harder for

individuals to sway the rating by themselves, although I would concede that a primary analyst and a secondary analyst that lead

those committees would have more knowledge and information and

I suppose could try to have undue influence, and also compensation

of analysts, which is probably the most direct issue. From the beginning of our development we have focused all compensation away

from any kind of revenue production activity on the part of the analyst. I think those are all important ingredients.

Chairman SHELBY. What about serving on boards that you rate?

Mr. JOYNT. None of our analysts or executives nor do I serve on

any boards.

Chairman SHELBY. Mr. McDaniel.

Mr. MCDANIEL. In addition to the actions that were listed by Ms.

Corbet and Mr. Joynt, Moody’s has published a set of core principles which guide our behavior. The core principles include the

independence of the analyst from the issuer, that there is not permitted to be any link to the analyst compensation from either the

ratings or the fees received from the issuers that they are responsible for reviewing.

Chairman SHELBY. What about perception? You say link, but

what about perception?

Mr. MCDANIEL. We have publicly disclosed that the analyst compensation is unrelated to the issuers that they rate. That is how

we try to manage the perception issue, sir.

In addition, commercial considerations with respect to issuers

are prohibited from being discussed or considered in rating committees. We have a codification of all of our methodologies which are

available publicly, and there is a requirement that those methodologies be followed by the rating committees. We have a rating

compliance unit. We publish our quarterly ratings performance,

which is available in verifiable formats. And we avoid concentration of fees from issuers so that no one issuer is material to

Moody’s commercial interests.

18

Chairman SHELBY. A second question to all three of you. Collectively, Moody’s, S&P, and Fitch account for about 95 percent of the

market share in the ratings business. Some people contend that by

designating these firms as NRSRO’s, the SEC has granted them a

franchise that deters new competitors.

How does this market concentration that has developed—discuss

whether it is good thing for investors, and how would you propose

to increase competition, if you would? We will start with you, Mr.

McDaniel, and go back.

Mr. MCDANIEL. As I mentioned——

Chairman SHELBY. Ninety-five percent is a lot of concentration.

Mr. MCDANIEL. As I mentioned in my opening, Senator, this is

an important issue. We recognize that. I believe that there are natural economic forces that are important in guiding the structure of

this industry. However, the issue is very distractive if it is not

dealt with, and I believe that one of two solutions should be pursued: Either the elimination of the national recognition designation

as currently used, or the opening of the industry to more nationally

recognized agencies.

Chairman SHELBY. Okay. Mr. Egan, do you have any comment

here?

Mr. EGAN. I do not think it is a natural monopoly or oligopoly.

I think it is far from it. The case of the equity research analysts,

you had some 20-odd analysts following AT&T as Jack Grubman,

who had the most bullish opinion, and the equity research firms

were fined $1.4 billion for their poor behavior.

I think that what has happened is that there are some natural

ways that the two major firms are able to maintain and extend

their monopoly. It is very interesting that the poor investment

banker that would try to recommend any other rating firm to rate

securities would find it very difficult to go in front of S&P and

Moody’s the next time they come around. As I said before, there is

no problem with these firms getting paid by the issuers. It is just

that the SEC should not be in the business of encouraging a basic

conflict of interest.

Chairman SHELBY. Mr. Kaitz.

Mr. KAITZ. Senator, one of the recommendations I heard from

Mr. McDaniel was to eliminate the NRSRO designation. I would

suggest if you do that, you have eliminated an artificial barrier to

competition, and you have erected a permanent barrier to competition. As we have all discussed, the ratings are embedded in banking law, insurance, mutual funds, and potentially into the pension

area. So that would create a permanent barrier to competition from

any other organizations.

Chairman SHELBY. Three with a stamp of approval, and no one

else, right?

Mr. KAITZ. Yes, sir.

Chairman SHELBY. Senator Sarbanes.

Senator SARBANES. Thank you, Mr. Chairman.

I just want to underscore that last point that was being made.

Since 1931, the Federal Reserve Board, the Comptroller of the Currency, and Federal and State laws have regulated the debt held by

banks and other financial institutions using credit ratings assigned

to the debt. Pension funds, banks, and money market funds are

19

barred from buying debt issues that carry ratings below a certain

level. So the ratings have in a sense kind of a life-and-death impact. I think it is pretty clear.

Let me ask the people at the table just a very general question.

Does everyone think that there is a problem here that needs to be

addressed? Or do some at the table think there is really not a problem and the situation is pretty good, and whatever there is, we are

fixing it up okay? How many think that there is a problem that

really needs to be dealt with?

Mr. EGAN. I think there is a huge problem.

Mr. GREEN. Senator Sarbanes, I think there is a problem of competition, and I think expanding the scope of designated rating

agencies would be a very good thing for the marketplace. The one

thing we have not talked about and that I think was implied by

Mr. Harada, the marketplace has become inherently global now.

There has been growth of the capital markets in Asia, tremendous

growth most recently with the development of a comprehensive European economy. That really does raise the opportunity for new entrants into the marketplace, and the SEC really should review the

designation process to be more open.

But make no mistake about it. Opening up——

Senator SARBANES. How do I get some assurance that the process, even if more people are participating in it, is going to be objective? Gretchen Morgenson had an article in The New York Times

on Sunday entitled: ‘‘Wanted, credit ratings, objective ones, please.’’

How do I get some assurance—and now the credit—as I understand it, the credit rating agencies are now beginning to do consulting for the companies with respect to whom they issue ratings.

Is that correct? Mr. McDaniel, are you doing consulting?

Mr. MCDANIEL. No. Moody’s does not engage in consulting. There

is one activity which we believe is part of the core rating process

called a rating assessment service, where we answer hypothetical

questions that companies have for a fee. That is the only activity

we engage in that might be considered consulting. It is less than

1 percent of our business and will remain so.

Senator SARBANES. Mr. Joynt.

Mr. JOYNT. We also would only have a few cases of rating assessments, but no broad consulting practice.

Senator SARBANES. Do you have a narrow consulting practice?

Mr. JOYNT. Pardon me?

Senator SARBANES. Do you have a narrow consulting practice?

[Laughter.]

Mr. JOYNT. No. However, I might add that our parent company

has recently acquired a company called Algorithmics, which is an

enterprise risk management, and they are a financial software

company and often would consult with people on the installation of

the financial software.

Senator SARBANES. Ms. Corbet.

Ms. CORBET. Senator, within our rating services practice, we

have no consulting or advisory business. Indeed, we similarly have

a ratings evaluation service that we provide to issuers at their request.

20

Senator SARBANES. Well, am I to draw from that is that these

concerns some are raising that there is consulting going on are

without any foundation or basis, Mr. Egan?

Mr. EGAN. No. It is an extension of the monopoly. Fannie Mae

had a corporate governance rating from S&P of 9 on a scale of 1

to 10 up until just a week ago. Basically they said Fannie Mae was

fantastic, and we all found out that it was not. What were the

problems? They had the same Chairman and CEO. They had accounting problems, CFO problems, evaluation of securities, regulatory problems, on and on and on. And it is a 9 on a scale of 1

to 10, 10 being the best.

Basically these firms are using their SEC-sanctioned monopoly in

one area, and extending it to the other areas, and there is no check

on them.

By the way, the conflicts cannot be managed. They simply cannot

be managed. If I am selling a company and I am representing Company A and instead I am getting paid by Company B, which is buying Company A, I cannot say, well, I am going to set up barriers

or Chinese walls and somehow manage that. That does not work.

If I am hiring a litigator and I find out that the litigator is paid

by the other side, you have a basic conflict there.

The Philadelphia Eagles just lost the Super Bowl. If my son

found out that Philadelphia coach Andy Reid was paid by the New

England Patriots, he would hit the roof. You know, it does not

work.

Senator SARBANES. That is a very understandable example.

[Laughter.]

Mr. EGAN. Thank you.

Senator SARBANES. I do not understand why you would get any

consulting fees. The reason I am concerned about this, over a period of 25 years consulting services have replaced audits as the

principle source of accounting firms’ revenues. Now, the legislation

we passed, as you know, precluded certain consulting services altogether, set up a rigorous process for any others that they might

want to engage the auditor for. There is one other thing, just a little thing that does not amount to much. You said you limit it to

1 percent.

In 1977, core auditing and accounting fees accounted for 70 percent of revenues of the auditing firms while management advisory

services accounted for just 12 percent. By 1998, a little more than

20 years later, the pattern had been reversed. Just 34 percent of

revenues came from auditing and accounting services and over 50

percent from management advisory services.

I do not understand why you should do any consulting services

if you are doing the rating. I mean, we have other issues here to

discuss. Who pays you to do the ratings? How do you do it? I see

I have used up my time. I want to take just this one narrow area.

Why should you get any fees from consulting services?

Ms. CORBET. Senator, if I may, the ratings evaluation service

that we provide to issuers at their request is truly an extension of

the ratings process. It helps a company evaluate certain financial

decisions that they may take with respect to potential acquisitions,

with respect to financial policy in terms of dividend or share buyback policies. And so, someone described it as a what-if scenario in

21

terms of what the issuers may undertake, and we provide that

evaluation for them in this particular service. It is truly an extension of the ratings process.

Senator SARBANES. Mr. Harada.

Mr. HARADA. Thank you very much. R&I does not carry out any

consulting business which is closely linked to the rating activities.

We strictly refrain from those kind of activities to keep the independence of the rating performance.

Senator SARBANES. Mr. Joynt.

Mr. JOYNT. The alternative to receiving fees on this kind of consulting assignment for rating assessments would be to charge all

issuers more, spread across the advice, because essentially we have

free-flow information back and forth from the analytical committees to the issuers. They come in and present their financial information. We describe our process, our standards, their expectations.

And so there is a regular dialogue. So the identification of specific

dialogue and assigning a consulting fee to that could be replaced

by just higher fees.

Senator SARBANES. It would get you out of this potential conflict,

would it not?

Mr. JOYNT. I do not think it would because the dialogue would

continue anyway. I think part of what we want to do is have a

transparent dialogue with everyone in the market, including all

issuers, investors, and so describing our rating process I think is

important.

Senator SARBANES. Mr. Kaitz.

Mr. KAITZ. Senator, all of these are commendable, except there

is no competition. Where else are these companies going to go other

than Moody’s, S&P, and Fitch? So in a perfect world, maybe consulting would be fine, but this is hardly a perfect world when it

comes to the competitive nature of this business.

Senator SARBANES. Thank you, Mr. Chairman.

Chairman SHELBY. Senator Sununu.

Senator SUNUNU. I am amazed to see an industry with threefirm concentration of 95 percent where there is a regulatory status

conferred by the Government that bars all entrants, actually coming before the Committee and saying, you know, if we are not allowed to engage in any line of business we want, we are going to

raise prices. But I have another line of questioning I want to engage in, and maybe that will just be food for thought for further

questions for the rest of the Committee Members.

Ms. Corbet, less than a year ago, one of your analysts, Michael

DeStefano, suggested that the GSE legislation we were considering

before this Committee would cause S&P to reconsider the AAA rating it had for GSE unsecured debt. I read this account to mean

that if we included receivership provision in that bill, then you

would basically downgrade the credit rating of the GSE’s. What

was the process that S&P used to arrive at that conclusion?

Ms. CORBET. First of all, Senator, if I may, let me start by saying

that Standard & Poor’s does not advocate positions on any legislation. And indeed in that particular case that you reference, consistent with our published commentary on the GSE’s, which dates

back to the early 1980’s, we have always stated that any change

in the relationship between the GSE’s and the Government would

22

necessarily be an important factor in our ongoing ratings assessment.

Indeed, back in March, I believe, a statement was made by our

senior analyst that our analysis of any legislation would be to examine each individual proposal as well as the legislation as a

whole. We have never said that any specific factor within proposed

legislation would result in an automatic downgrade.

Senator SUNUNU. What data was the analyst using to make the

statement he made?

Ms. CORBET. He was using and referencing our published commentary on our position on the GSE’s. We have published commentary during the course of 2004, in January, in May, and most

recently in December 2004. And that commentary has been consistent.

Senator SUNUNU. Is it still S&P’s position then the legislation

being considered would result in a weakening of the credit rating?

Ms. CORBET. In May 2004, our ratings committee concluded that

we no longer had the highest degree of confidence of Government

support and determined that our ratings on GSE’s would reflect

both the financial strength of the GSE’s and the degree of confidence in Government support. And based on this combined criteria, not simply the Government support criteria, we affirmed the

GSE ratings at AAA.

Senator SUNUNU. You say that it is not your intention or your

policy to have analysts comment on or lobby for or against specific

pieces of legislation. But do not you think weighing in with a perspective on how this affects the credit of a particular company is

a de facto position on legislation?

Ms. CORBET. As I said, we do not advocate positions on any legislation. What we did do is reaffirm our position that we have taken

on the GSE’s for many years, and we did comment on that in

March.

Senator SUNUNU. Mr. McDaniel, you talked about volatility and

your concerns about volatility in issuing credit ratings, that if they

moved back and forth, that would have undesirable consequences,

and I certainly would not disagree with that.

Do you think that is worse than the alternative, which is to lag

behind, as was obviously the case in Enron and MCI, and shift position or in this case downgrade credit too slowly and as a result

not give markets a clear indication of what might be happening at

a company?

Mr. MCDANIEL. The situations such as Enron are clearly situations that Moody’s was unhappy with. We do not benefit, we do not

have our reputation enhanced by having investment grade companies of the size of an Enron default. That obviously was a matter

of serious concern for us.

We do believe that timeliness is extremely important to the rating process. As I said in my opening statement, we try to balance

the need for stability with the need for timeliness by using additional signals in the marketplace, the signals being watchlists and

outlooks, which are more forward-looking in terms of potential

credit trends. And we think that those are important elements of

the management of the rating system to provide responses to both

demands for stability and for timeliness.

23

Senator SUNUNU. Thank you.

Thank you, Mr. Chairman.

Chairman SHELBY. Senator Reed.

Senator REED. Thank you, Mr. Chairman.

Ms. Corbet, I think Senator Sununu touched on this question,

which is comments made by S&P analysts about the possible legislation affecting the Government Sponsored Enterprises. In fact, I

think a quote from a report by Mr. DeStefano and Ms. Wagner

would be, ‘‘The slightest evidence that Congress would in any way

agree to lessen its authority or cede it to others would in itself necessitate a rethinking of how much confidence bondholders should

have that their interests would be taken into consideration in the

case of a failed GSE.’’ And I think your response was you do not

comment on legislation, but can you comment on that quote?

Ms. CORBET. Sure, happy to. Thank you, Senator.

Indeed, again, as that quote indicated, and as other published

criteria about our ratings opinion on the GSE’s indicted we take

into consideration all and each factor in any legislation, whether

proposed or actual legislation, to determine whether or not it would

result in any change in our ratings opinion.

Indeed, we furthermore stated—and this is most recently—in our

publication in December 2004 that, whatever the course of any legislative change in the relationship between the GSE’s and the Government, whatever change it may take, our analysts consider the

credit implications and will be responsive to the intent of Congress.

Senator REED. Thank you. I think we all recognize why this is

an important issue since we are actually contemplating changes,

which you apparently will take into consideration.

Mr. Joynt, Fitch Ratings, do you have a position with respect to

this issue of potential changes with respect to issues like receivership and others?

Mr. JOYNT. We would. Actually, we follow the same credits. We

have ratings on the GSE’s, their mortgage securities as well as

their unsecured obligations and preferred stock. We would have offered our opinion around that same time also, focused on the credit

impact of whatever the change might be.

Senator REED. Again, this may be from popular reporting, but

the impression that I received was that you would not necessarily

make changes based upon statutory changes. Is that fair?

Mr. JOYNT. I think that was the conclusion that we presented,

yes, that at that time we did not see the impact. We see the potential, and it is, of course, a complicated set of legislation and influences.

Senator REED. And, Ms. Corbet, is that a fair summary of where

you are today, that you would not necessarily make changes but

you would look very carefully at what we did?

Ms. CORBET. That is correct, Senator.

Senator REED. And just for the sake of completeness, Mr.

McDaniel, Moody’s position on this issue of statutory changes affecting GSE’s?

Mr. MCDANIEL. We do not believe that the proposed legislation

would have an effect on our credit rating opinion of the GSE’s.

Senator REED. Thank you very much.

24

Mr. Green, again, because we are very near to considering legislation—in fact, I think we are having a hearing later this week—

what would be the impact from an economic standpoint across the

economy as a whole if, in fact, there was a downgrade of the GSE’s

based upon statutory changes or based upon their performance in

the marketplace, or a combination?

Mr. GREEN. Senator Reed, as you have heard, there is not necessarily agreement that there would be a downgrade. But obviously

with the amount of securities outstanding by the GSE’s directly

and through their mortgage portfolio as well, any question as to

their creditworthiness would have a significant impact on the marketplace. And I would add it is a marketplace that is vastly global

in nature with investors of differing degrees of knowledge and understanding, so they would look to the credit rating as a very key

element of information with which to make an investment decision.

To the extent that any business practice, legislative or regulatory

activity would affect their credit rating, because of the amount of

debt outstanding, it would have a market effect.

Senator REED. Thank you very much.

Does anyone else want to generally comment on this line of questioning? Mr. Egan.

Mr. EGAN. From our perspective, neither Fannie Mae nor

Freddie Mac are AAA-rated credits. They are far from a AAA. If

you speak to anybody in the Government, they will not give you

the confidence that there is the full faith and credit of the U.S.

Government behind them, number one. Number two, they have 2

percent and possibly even less than 2 percent equity to assets, and

the typical A or A plus-rated bank has 8 percent.

So we have told our clients and will continue to tell our clients

that these are not AAA-rated credits, we do not care what our competitors say. Some people claim the Government will step in. Yes,

they might step in, but that will be for the new capital. It is not

for the existing capital. It would be like the airlines.

We think right now you have an untenable situation with Fannie

Mae and Freddie Mac. Something has to be done and done quickly.

Really probably the best model is the Sallie Maes. Sallie Mae is

doing very well. It does not have any support, either implied or not

implied, from the U.S. Government, and that is the right way to

look at it. But get there quickly. You know, the lesson learned from

Enron and WorldCom and all these other failures is you have to

address the problem quickly. You do not wait until everybody panics. We have had our rating, maintained it for 2 years. You know,

people are adjusting, our clients and others are adjusting to it. But

do not keep up this falsehood that they are AAA-rated because they

are not. And if they continue to grow, it creates a bigger problem

in another 2 years. So address it as quickly as you possibly can.

Senator REED. Thank you, Mr. Chairman.

Chairman SHELBY. Senator Bunning.

STATEMENT OF SENATOR JIM BUNNING

Senator BUNNING. I just want to ask a general question since I

have had some experience in this business since 1961. Is there anyone at the table currently rating credit that has a relationship with

25

the corporation they are rating and/or any kind of fiduciary responsibility other than independent credit rating?

Mr. EGAN. At Egan-Jones, we do not sit on any board, serve on

any committees. It is public knowledge that in the case of Moody’s,

Clifford Alexander, the ex-chairman——

Senator BUNNING. I will let Moody’s speak for itself.

Mr. EGAN. Okay.

Ms. CORBET. As my earlier testimony indicated, we prohibit analysts from sitting on any corporate boards.

Senator BUNNING. For how long has that been happening?

Ms. CORBET. It has been as long as I know, but we have codified

that in our policies and procedures that are publicly available.

Senator BUNNING. Is that just recently, or has that been in the

past 30 years?

Ms. CORBET. I can only speak for the period of time that I have

been involved at S&P, and I know that since that time, and even

before that, it has been our policy.

Senator BUNNING. How long has that been?

Ms. CORBET. I joined Standard & Poor’s in April of last year.

Senator BUNNING. How about officers of your company?

Ms. CORBET. In terms of myself, I do not participate in the ratings process, but I do sit on the board of a university.

Senator BUNNING. No, no, no. How about officers of your company that are involved with other companies?

Ms. CORBET. There are no officers of the company that are involved in the ratings process who sit on any issuer or any public

board that issues debt.

Senator BUNNING. You are missing the point. Do you have any

officers of Standard & Poor’s that sit on any other boards of any

other companies? Not that are involved in the rating system.

Ms. CORBET. We do not have any officers at Standard & Poor’s,

that I am aware of, that sit on any public boards.

Senator BUNNING. At McGraw-Hill?

Ms. CORBET. At McGraw-Hill, we are part of McGraw-Hill.

Standard & Poor’s is a division of McGraw-Hill, and there are

members of that board of directors——

Senator BUNNING. Joint.

Ms. CORBET. Excuse me?

Senator BUNNING. They are joint board of directors.

Ms. CORBET. They are not joint board of directors. They are directors of McGraw-Hill Companies.

Senator BUNNING. And Standard & Poor’s?

Ms. CORBET. Standard & Poor’s is a division of the McGraw-Hill

Companies.

Senator BUNNING. Well, okay. It is publicly held.

Does anyone else have anything to say about this?

Mr. MCDANIEL. For Moody’s, employees at Moody’s do not sit on

the boards of any rated companies. We do have members of the

Moody’s——

Senator BUNNING. Now. And how long has that been?

Mr. MCDANIEL. I believe that is an accurate statement through

our history.

Senator BUNNING. Through your history.

Mr. MCDANIEL. I would have to go back and confirm that.

26

Senator BUNNING. Mr. Joynt.

Mr. JOYNT. Since I have been involved with Fitch, 1989, none of

the analytical people, whatever level, have been involved on any

public boards. I am not sure it was a written requirement, but it

has certainly been our practice and continues to be our practice.

Senator BUNNING. In the Enron case, are the two on the ends the

Enron rating people of the debt?

Ms. CORBET. We did rate Enron.

Mr. MCDANIEL. Moody’s rated Enron, yes.

Senator BUNNING. Moody’s and S&P.

Mr. JOYNT. Fitch did as well.

Senator BUNNING. Fitch did as well.

Mr. EGAN. And Egan-Jones.

Senator BUNNING. And Egan-Jones. What was the first time that

you notified the public that there was a problem?

Mr. EGAN. We had it listed as part of our——

Senator BUNNING. No, the three people that are rating them——

Senator HAGEL. He rated them, too.

Senator BUNNING. Oh, I apologize. Go right ahead.

Mr. EGAN. It is in our written testimony.

Senator BUNNING. I have three meetings today, so the written

testimony did not get read.

Mr. EGAN. By the way, as far as that last question, you should

ask it very carefully and you are not. These people are deferring

it. You want to ask: Are there any directors, officers, or anybody

affiliated with the rating firm, do they serve on any other corporations?

Senator BUNNING. That is exactly the question I asked.

Mr. EGAN. Well, it was not answered that way.

Senator BUNNING. You mean I was deceived in the answer?

Mr. EGAN. You may want a written request because you did not

get the answer that——

Senator BUNNING. Well, that was my question.

Mr. EGAN. Okay. It was not answered accurately. They misunderstood the question.

Senator BUNNING. Well, speak up, Mr. Egan, if you know others

that are then.

Mr. EGAN. Well, it is public knowledge that the chairman—and

they make the distinction between credit officers versus chairmen.

The Chairman of Moody’s, Clifford Alexander, sat on the board of

WorldCom. And he sat on the predecessor board, MCI. Now it is

back to the MCI name, but it was MCI, then WorldCom, because

WorldCom acquired MCI. And Clifford Alexander was on the board

for about 8 years, resigned probably about 9 or 12 months before

it went bankrupt. He was an insider’s insider. He was one of the

three people on the nominating committee. And so they answered

the question there is no rating officer or credit officer. That is true.

But, you have to ask a broader question.

The second point is that the prior President of Moody’s current

chairman, served on the board of the NASD. The NASD overlooks

all the broker-dealers. That is a cozy relationship. Also, the chairman sat on Wyeth, and I think there is another corporation. It is

part of the writeup in The Washington Post as of November of last

year. But that question was not answered. I do not know if

27

McGraw-Hill directors or chairmen sit on any other boards, but

that would not be unusual. But that question was not answered.

Senator BUNNING. I will get my second round in then. Thank

you, Mr. Chairman.

Chairman SHELBY. Senator Stabenow.

STATEMENT OF SENATOR DEBBIE STABENOW

Senator STABENOW. Thank you, Mr. Chairman, and thank you to

each of you for being here. It is a very important topic.

I would like to go back to the catch–22 that was talked about

earlier today. There would appear to be a significant hurdle to

many firms who are seeking the NRSRO status, and I would like

to talk more about that. The fact that a firm cannot be nationally

recognized until they have had wide acceptance in the market but

cannot get wide acceptance in the market until they are nationally

recognized places incredible hurdles in the path of qualified firms.

Of course, since the SEC issues the NRSRO designation, it has

taken on a quasi-governmental stamp of approval in this process.

So my question would be: How do you feel, could you speak about

the SEC issuing guidance in terms of the designation process?

What would the standards look like to achieve status? What would

the provisions look like from your perspective that would address

this obvious catch-22? I would be happy to have each of you answer

that. Yes, we will start here.

Mr. MCDANIEL. From Moody’s perspective, I think there are

probably several solutions to the question that you pose. We certainly support greater transparency in the recognition process. We

support competition in the industry. And we think that transparency in the standards necessary to become an NRSRO will invite more competition, and that will contribute to, in our opinion,

a healthy industry structure.

Senator STABENOW. Get a little more specific for me, if you

would. What does that look like?

Mr. MCDANIEL. The SEC has in the past identified criteria that

it felt were relevant to national recognition, and I think that those

criteria, if they were used formally, would certainly add to the

transparency of the process. But one of the things that gets away

from the chicken and egg or catch-22 problem that you have identified is whether or not, in fact, national recognition is necessary or

whether there are other more limited forms of recognition or a

lower hurdle for recognition, in fact, that would open the industry

to competition. And there is some precedent for this historically

where smaller agencies were nationally recognized for their particular industry expertise.

Mr. KAITZ. Senator, I again would reiterate that if you eliminate

that NRSRO designation without any SEC involvement, you erect

a permanent barrier to competition. AFP has laid out with our

counterparts in Britain and in France a code of standard practice

in the credit rating process that addresses the regulatory issues we

believe the SEC needs to address. But I think just for a quick answer, we need to have credible and reliable ratings, and that really

needs to be the criteria by which they start to look at rating agencies.

28

Again, we have laid this all out in our standard code of practice,

and we think it is critically important that the SEC do this.

Senator STABENOW. Thank you.

Mr. JOYNT. Senator, as I mentioned in my opening remarks,

Fitch is a combination of four rating agencies that merged together,

and in fact, as of 8 years ago, the SEC had designated other rating

agencies. There were more. There were six different rating agencies. And some of the companies that we merged with were designated for individual disciplines. For example, IBCA, International

Bank Credit Analysts, was recognized for their expertise in bank

analysis, and Thompson Bank Watch, another firm that we acquired, was recognized for its expertise in bank analysis as well.

So it has only been recently—the combination of those mergers

was to deal with an economic reality about the requirement for investors to have a rating agency that had a global presence and

could offer credit opinions on corporations and structured

financings globally, not just in the United States. So that is an economic reason for the mergers. But it seems like there would be a

pattern and an availability for the SEC to approve based on their

past precedents to open up the approval process, and I do not think

anything is necessarily stopping them from doing that at this point.

Mr. HARADA. May I?

Senator STABENOW. Yes, please.

Mr. HARADA. R&I as a foreign rating agency, as you suggest before, the requirement of national recognition is very hard to overcome to us. But, nevertheless, we did some efforts, that is, we have

already received 10 letters of support from the very established,

leading financial institutions in the United States. So, I think to

some extent such effort to be recognized by the national financial

institutions might be necessary, but I do strongly ask the SEC,

first, to set the clear requirements as far as possible and to the foreign rating agencies, I think that such a barrier or such a standard

or such a requirement should be lowered, taking into consideration

the avoidance of such a catch–22 problem.

Thank you.

Mr. GREEN. Senator, the hurdle is too high, but it does not mean

the hurdle should be low. The fact is you can broaden the number

of participant designated rating agencies and not necessarily—and

not at all—lower the quality of the rating because there are lots

of rating agencies that have particular specialties, particular markets that they have expertise in, that the currently ‘‘widely accepted,’’ as you correctly stated, just sets too high of a burden.

If you step back from the ‘‘widely accepted’’ but still maintain the

quality, because it is all about credibility, I think you could have

many more participants in the marketplace, and that is particularly important now as these markets have become global, and the

four designees right now all come from North America. And as the

markets grow in Europe and Asia, it is not necessarily the most

healthy situation. So, I think they can do a better job.

Senator STABENOW. Yes, thank you.

Mr. EGAN. We have no problem with the SEC’s national recognition. In fact, there is a firm that was recognized in the past year,

year and a half, DBRS. It is a Canadian firm. There are independent surveys done. We have about three times recognition of

29

that firm as of about 2 years ago, and it has grown since then. So

we do not have a problem with that issue.

We have had an application in, now I guess it will be 7 years—

I guess we are on the fast track—8 years this August with the

SEC, and the hang-up appears to be the SEC looking at our staffing and saying it is not large enough.

Now, keep in mind we are early and right with Enron,

WorldCom, Global Crossing, and Genuity. We have to take issue

with the process that the SEC is using for evaluating it. It is hard

not to conclude that the ultimate objective might be maintaining

the status quo, which is fantastic for the existing firms.

Senator STABENOW. So from your perspective there is not a

catch-22. Is that what you are saying?

Mr. EGAN. No, it is not. But even if we were recognized—and

hopefully we eventually will be recognized. I think the market is

really being mis-served by not recognizing firms like ours, others

that are early and right with these ratings, that is not going to

solve the problem. The problem is the fundamental conflicts of interest.

There were seven firms, seven NRSRO firms 10 years ago or so.

You still have the problems of the fundamental conflict of interest.

What happens is that there is a separation between the interests

of the country, in terms of enabling these companies to grow, encouraging jobs, reducing costs of capital, and a few bad apples, the

Bernie Ebbers of the world who had $400 million positioned with

WorldCom. He wanted to do everything possible to keep that company afloat. And the rating firms that were paid millions of dollars,

too, would give him the benefit of the doubt. That is the problem.

And by the time it comes to light, you have no alternatives.

Enron might have been able to be saved, it really could have, if

the problems came to light a year or 2 years earlier. You know, we

rated it and we downgraded the company. But by the time S&P,

Moody’s, and Fitch cut it from investment grade to noninvestment

grade, they had 4 days before filing for bankruptcy. Basically the

bankruptcy attorneys were already in there drafting the papers.

There had just one firm that they could deal with, and that is

Dynergy. If that deal went away, there is nobody else. That is a

real problem.

It is like a child. If you have a child that has a speech impediment, you are better off taking that child to the speech therapist

and getting them on the right track so they are not criticized in

school. Or if you have a child that has a music talent. Give them

the extra instruction, do it early. And it is not being done right

now. And it is because of the SEC’s approach to this industry

which has had the effect of severe limits on competition.

Ms. CORBET. Senator, to your original question, we also support—and I think what you have heard collectively across all the

participants and more broadly throughout the market—increased

competition, and we believe we can get there through more transparency in the designation criteria and the process. And indeed,

with rating agencies that either focus on specific areas or geographic areas, we think the opportunity for them to compete is potentially very good.

Senator STABENOW. Thank you, Mr. Chairman.

30

Chairman SHELBY. Senator Hagel.

STATEMENT OF SENATOR CHUCK HAGEL

Senator HAGEL. Mr. Chairman, thank you.

I wanted to go back to a point that Senator Sununu raised on

GSE’s, and then we will move on to a couple of other areas. But

one of the specific points that I wanted to cover is this—and I

think, Ms. Corbet, you were the only one of the three rating agencies that responded to Senator Sununu’s question. But in the past

few months, all three of the major rating agencies placed Fannie

Mae’s subordinated debt and preferred stock on watches or outlooks, for possible downgrades. But yet all three rating agencies

continued to reaffirm Fannie’s AAA rating, AAA ratings with longterm debt with a stable outlook.

Why is that? Is that because of the implied Government backing?

Or why would that be the case if you would put them on a watch

or an outlook but continue to list them as AAA credits? And you

mentioned to some extent, Ms. Corbet, why Standard & Poor’s

would do this. But in light of the specific rating you have given

them, explain, if the three of you would, why that would be the

case. Would you do that with some other company? For example,

Fannie Mae has a situation, which we all now know, of $9 billion

of income restatement. I do not know if you consider that serious.

I do.

Ms. CORBET. Indeed.

Senator HAGEL. But yet you still have them as a AAA rating.

Now, there may be justifiable reasons for that, but would you explain to this poor Senator?

Ms. CORBET. Sure.

Senator HAGEL. Thank you.

Ms. CORBET. Thank you, Senator. Indeed, after reviewing the situation involving the senior unsecured debt of the GSE’s, indeed, we

combined now both the financial strengths of the GSE’s with the

degree of confidence that we had in the Government support. Indeed, after going through our evaluation and the ratings process,

the rating committee concluded that while it no longer had the

highest degree, which it had earlier, it did have some degree of confidence that a combination of both the financial strength of the

GSE’s—and I would point out we do not—on a financial strength

basis, we do not have them as AAA. We have them as AA minus,

combined with the Government support or degree of confidence in

the Government support, resulted in an affirmation of the ratings

at AAA, and we hold that view today.

Senator HAGEL. So it just essentially meets the threshold, as you

said, some degree of confidence.

Ms. CORBET. Correct.

Senator HAGEL. So that merits AA minus.

Ms. CORBET. On financial strength alone, we have published our

opinion that the GSE’s, Fannie Mae and Freddie Mac, would be AA

minus for their senior unsecured debt.

Senator HAGEL. Thank you. Mr. McDaniel.

Mr. MCDANIEL. It is very important to our thinking to consider

the status of the GSE’s and their relationship to the Government,

their strategic position and role in housing finance policy, and

31

those are critical supports to why we have a AAA rating on Fannie

Mae and Freddie Mac and why that is a stable outlook from our

perspective.

Senator HAGEL. A $9 billion income restatement does not trouble

you that much?

Mr. MCDANIEL. Not for the GSE’s given, as I said, their Government-sponsored status and their strategic position in the housing

market. That is correct.

Senator HAGEL. Thank you.

Mr. Joynt.

Mr. JOYNT. Maybe I could just possibly read this short paragraph

from one of the public releases we made, which I think addresses

the issue:

Importantly, the subordinated debt and preferred stock of Fannie and Freddie, respectively, are primarily based on their stand-alone financial profiles and prudent

management of risks. Their AAA senior debt ratings reflect the benefits they receive

from their GSE status, principally with access to capital markets and favorable pricing. Their GSE status is an extension of the role that Government has played in

all areas of social interest, a role that Fitch believes will not be changed by the legislative and regulatory proposals under consideration.

Senator HAGEL. All right. Thank you.

I would like to ask each of you very quickly the issue of transparency. Starting with you, Mr. McDaniel, in answer to Senator

Stabenow’s question about, I think you said, supporting greater

transparency in the process. How are you doing that? Isn’t it a reality that lack of transparency cuts to the credibility and the reliability of ratings organizations? What have you done, what are you

doing? And why don’t, for example, your agencies develop public—

any methodology or how you get to where you are with these rating

agencies? Can you start there and give us some brief answers? I

know there are no brief answers, but if you could in the interest

of time—and I would like to hear from all of you because I think

the transparency issue is pretty critical here. And you said you

think it is important for the process, but what are you doing?

Mr. MCDANIEL. We certainly agree that lack of transparency undermines credibility and reliance on rating agencies. Among the

things that we are doing, we publish and make available on our

website all of our rating methodologies. We have rating methodologies for all industries and sectors that Moody’s rates. We have

added to our research specific commentary that says what will

move the ratings up and what will move the ratings down.

When we are considering changing methodologies, we are now

publishing on a request for comment basis from the market our

thinking about the reasons for the change and seeking the best information we can from the best thinkers in the marketplace about

what would most inform a change in methodology before we are

implementing that.

I think those are probably three of the most important things we

are undertaking. As I mentioned earlier, we have been, since 2003,

publishing on a quarterly basis our ratings performance so that can

be judged for accuracy and stability.

Senator HAGEL. Thank you. Mr. Kaitz.

Mr. KAITZ. To the extent that Mr. McDaniel has laid out that

they are looking at publishing methodologies, we commend that.

That is something, I think, that we feel very important, especially

32

those of us that are—we represent the issuers of debt, but we also

feel this is something that the other rating agencies need to do as

well as part of the process.

Senator HAGEL. Mr. Joynt.

Mr. JOYNT. I think that was a quote from a reporter, and actually I think that may not be representative of the market view. I

think the market view is that rating agencies have been very

transparent over time. We also have published our criteria on all

areas of ratings consistently for 15 years. I am surprised by that

comment. On individual company credits, individual

securitizations, we put our information also on the Web, freely

available, so I think we are actually quite transparent.

Senator HAGEL. Thank you. Mr. Harada.

Mr. HARADA. Yes, Senator, R&I also discloses almost all the criteria and the methodology at the website so that everybody can

check and can read our methodology, and if such methodology

might be changed, very soon we disclose such change, and we also

disclose all of the outcomes of our rating performance. We disclose

every material with which every outsider can check our rating performance.

Senator HAGEL. Thank you. Mr. Green.

Mr. GREEN. Senator, the Bond Market Association completely

supports transparency of the methodology and consistent application of that methodology, as well as communicating as quickly as

possible any changes in the methodology, keeping in mind, though,

that we also need to make sure that there is enough flexibility for

rating agencies to adapt to differing markets and new products as

quickly as possible, too. But transparency is very, very important

to the marketplace.

Senator HAGEL. Thank you. Mr. Egan.

Mr. EGAN. We provide issuers with the supporting materials for

our ratings. Typically, we get a lot of grief from those issuers where

we are different, significantly lower than the other rating firms.

That is normally not the case. In fact, we have been more bullish

than the other rating firms for the past 21⁄2 years or so. But they

will take issue with the ratings we assign. We give them what our

projections are and explain why we assume these different things.

They offer to provide us with inside information. We say we do not

want that, in contrast to the other rating firms. We want it to be

released to the market, and then they can give it to us. So we provide all the support that they need on how we base our ratings decisions.

Senator HAGEL. Thank you. Ms. Corbet.

Ms. CORBET. Transparency is critical. We publish our ratings

methodology, our criteria, our default and transition studies, and

we also publish any changes in methodology.

Senator HAGEL. Thank you, Mr. Chairman.

Chairman SHELBY. Senator Corzine.

STATEMENT OF SENATOR JON S. CORZINE

Senator CORZINE. Thank you, Mr. Chairman. I have a statement

for the record which I would like to submit. That statement deals

with opaque or transparent issues, barriers to entry, lack of oversight on the SEC, which I will follow on in a question, and also poVerDate 11-MAY-2000 17:55 Jul 12, 2006 Jkt 025856 PO 00000 Frm 00036 Fmt 6633 Sfmt 6633 28059.TXT SBANK4 PsN: SBANK4
33

tential conflicts. I am also just a little worried about asking tough

questions. If you ever show up as someone who is responsible for

asking for a rating, you might get in trouble with these guys. The

conflict works both ways.

The questions I have are really three parts, and different ones

of you will work. First of all, I think it is the Investment Company

Act that is the governing statute with regard to oversight of the

rating agencies. Is that how you all understand it? Is there any

pattern, regular or random, of the SEC or other regulatory authorities ever coming in and checking the kinds of questions that one

might ask about whether your ratings actually match up or you are

actually following through on the calculations that you make? Is

there any outside observer to the processes that go on?

The second question I have, really on an entirely different issue

but an important one, I would love to have people’s written responses if they do not have time to answer here. Do any of you believe that requiring stock options to be expensed is a sound policy

and one that allows you to have a sense of the underlying economic

fundamentals of a company? Or are you handicapped if that were

not the case? I would love to hear your views on that.

And third, I have a particularly parochial question. A number of

you—S&P, Moody’s, and Fitch—I believe all decided to opine on

New Jersey’s Homeownership or Predatory Lending Act that was

implemented, signed into law in May 2003, and I just want to clarify that after some toing-and-froing that you all think this is an act

which is not inhibiting markets and it is on sound footing. I would

be more than happy to accept that in written form, but I want to

make it clear there continues to be a debate in my State about

whether the Predatory Lending Act is too far reaching, somehow

handicapping mortgage markets. And I think you all, either in public writing or other, have said that you are satisfied with where the

law is, but I would like to hear it.

So, first of all, I will go through and ask on the oversight process,

because I think it is the most general of the questions about who

is watching whom and is there any check and balance to the rating

agency activity. Is the SEC doing its job? Stock option expensing.

And then the predatory lending issue, if you have time. I will start

with Mr. McDaniel.

Mr. MCDANIEL. Thank you, Senator. To answer your first question, yes, Moody’s does file under the Investment Adviser Act. We

are periodically inspected by the Securities and Exchange Commission.

Senator CORZINE. When is the last time?

Mr. MCDANIEL. The last time was approximately 18 to 24

months ago.

Senator CORZINE. Not since the WorldCom and Enron scandals?

Mr. MCDANIEL. Yes, it was following Enron, and I think it was

following WorldCom, but I would have to come back to you with a

specific date.

With respect to expensing stock options, Moody’s Corporation,

the parent of Moody’s, does expense stock options.

Senator CORZINE. I would like to know, by the way, when the

previous review by the SEC was.

34

Mr. MCDANIEL. I will have to make that available to you. I do

not know when the prior inspection before that was. As I said,

Moody’s Corporation does expense stock options.

In terms of whether the expensing impairs our ability to conduct

credit analysis, I think the question is really not whether the options are expensed per se, but whether there is enough information

for us to evaluate the cost of the stock options in a company that

we are looking at from a credit rating perspective. So as long as

there is sufficient disclosure to be able to work back to what the

costs are, we are able to work with that.

Senator CORZINE. I take it you think there are real costs.

Mr. MCDANIEL. Yes, we do. Because I am not an expert on the

Predatory Lending Act, I would request that Moody’s submit information to you in writing on that.

Mr. KAITZ. Sir, I can give you an opinion on the first question

on the oversight of the rating agencies. Our testimony is pretty

clear on this. We believe it is wholly inadequate. It has been 10

years since the SEC has taken any action, and it is time for them

to do something. So we hope that this hearing is the start of the

Senate taking some firm action, to get the SEC to act on oversight

of the rating agencies.

On the other two issues I have no opinion.

Mr. JOYNT. On the first question, I do not believe there is another regulatory body that would come in and inspect us in any

kind of way, at least not in the United States. However, we have

frequent contact with people that use our ratings, like the Federal

Reserve and the FDIC, where they expect us to come present to

them and talk to them about how we run our business and also,

of course, our opinion on many important issues to them. Outside

of the regulatory framework, we would do the same thing in the

United States and everywhere with important institutional investors. So, I think there is a lot of public market scrutiny of us, if

it is not directly a regulatory response. And then, of course, internationally, more international regulators have become involved in

meeting with the rating agencies, in the United Kingdom the FSA

and in France, their regulatory body as well, and others, as a part

of the IOSCO process, the securities regulatory process, CESR

process that was mentioned earlier, and then individually as well.

Senator CORZINE. When is the last time you have had an SEC

review?

Mr. JOYNT. I do not have that information, but I will be happy

to provide it to you.

Senator CORZINE. Actually, the last two would be interesting.

Mr. JOYNT. No problem.

Senator CORZINE. Thank you.

Mr. JOYNT. Again, I am not an expert on the predatory lending

either, and I would be happy to provide written answers on both

the other questions.

Senator CORZINE. Thank you.

Mr. HARADA. As a foreign rating agency, R&I is registered with

SEC as an investment adviser pursuant to the Investment Advisers

Act of 1940, and, if we have a very substantial change of the corporate structure, we will make a report to the SEC under the requirements of the Investment Advisers Act. And apart from such

35

kind of contact with the SEC, as the Japanese rating agency we

have very close contact with FSA in Japan with regard to the

IOSCO Code of Conduct Fundamentals, and the recent Basel II for

the capital adequacy requirements as well.

Mr. GREEN. Senator, I think the oversight of the credit rating

agency process is the credibility of the report itself. What is being

bought by either issuer or investor or dealer is the credibility of the

particular rating agency, and that is one reason why we are calling

for greater competition in opening up the designation so that there

is more competition, and that will ensure that the marketplace is

measuring the credibility in a more competitive environment.

We also do believe that transparency of the historical record of

the rating agencies is very important to that process. On stock options, the Bond Market Association, I do not believe, would necessarily have an opinion, but on the predatory lending issues, there

is no question that we have an opinion. We oppose predatory lending, but we have opposed the concept of assigning liability, which

creates uncertainty in the securitization process around certain

noninvestment grade lending that goes on across the country. And

we believe very strongly that clarity of the liability is very important for underwriters to be able to accept the liability that they are

willing and knowledgeable of accepting, and that has entered into

the credit rating agency process when various States, and in certain cases localities, have passed various ordinances and statutes

that have created uncertainty in that market process. We have testified both, I think, before this Committee and certainly before the

House Committee as well on the issue of providing some kind of

national standard so that we can deal with the predatory lending

issue without creating these uncertainties in the marketplace leading to rating agencies not giving ratings in certain high-cost-loan

situations, which I believe is the case in New Jersey. So it would

be our hope that we could work with this Committee in trying to

adopt some standard that helps deal with this issue.

Senator CORZINE. Mr. Green, I believe that my point was that I

think the law was modified to deal with the assignee, not to the

perfection of everybody’s wants but in a way that the rating agencies were comfortable. And that is what I want to get on record,

because it does set a pattern that we can discuss when we deal

with it on a national level, if that were, in fact, the case.

Mr. EGAN. We are not a registered investment adviser. We have

advised the SEC that if we are awarded the NRSRO designation—

also, we think of it as the ‘‘no room/standing room only.’’ That is

the only way I can remember it quickly. But we would register.

We do, however, have some outside observers regarding the quality and timeliness of our ratings. In fact, there have been two recent independent studies. One was conducted by the Kansas City

Federal Reserve Board, and I quote from it: ‘‘Overall’’—and they

wanted to know is there stickiness at the investment grade versus

noninvestment grade level, and they said, ‘‘Overall, it is robustly

the case that S&P regrades from BBB minus’’—which is the lowest

rung of investment grade—‘‘moved in the direction of EJR’s earlier

ratings. It appears more likely that this result reflects systematic

differences between the two firms’ rating policies than the number

of lucky guesses by Egan-Jones Ratings.’’

36

And then there is another study, a joint one by Stanford and the

University of Michigan. This is in my written testimony. ‘‘We believe our results make a strong case that the noncertified agency’’—

Egan-Jones—‘‘is the leader, and the certified agency’’—Moody’s—‘‘is

the laggard.’’ We have huge competitive pressures on us. S&P,

Moody’s, after they failed with Enron and WorldCom, Moody’s operating income over the last 4 years has grown about 250 percent.

They do not have the pressures. We do, and we have to get to the

truth quickly, and it shows it with these independent studies.

Your other question—expensing stock options, we do not care.

We can handle it either way. We are sophisticated enough to deal

with it, and I do not have a comment on the predatory lending

practices.

Ms. CORBET. Senator, to your original questions as well, we are

governed by the Investment Advisers Act, and the last SEC inspection was in 2002, but it was post-Enron, and we will get back to

you as the previous review. That said, we often talk to the SEC

about our policies and procedures and subjects covered by any and

all inspections.

On the point regarding stock options, we do view them as costs,

and they are taken into consideration in terms of our credit analysis.

And, finally, we, too, would be willing to submit a written form

of our view on predatory lending and particularly the New Jersey

statute.

Senator SARBANES. [Presiding.] I think we have two Members

who have not yet had a first round.

Senator BUNNING. That is correct.

STATEMENT OF SENATOR CHARLES E. SCHUMER

Senator SCHUMER. Thank you, Mr. Chairman, Mr. Ranking

Member—Mr. Acting Chairman.

[Laughter.]

Senator SARBANES. Do not get carried away.

Senator SCHUMER. I hope soon we will strike that ‘‘acting’’ and

get rid of the adjective.

Anyway, I want to thank everyone for their testimony. I just

want to make a brief statement and then ask a few questions.

I appreciate the opportunity to examine the credit ratings industry. I think that is a good idea. Many of the companies we are talking about have been around for close to a century. They provide a

vital service to our capital markets by sharing their opinions on the

credit worthiness of a particular company or the risk of default on

a security. These companies aid small and large investors alike in

making informed decisions to better serve individual investment

needs.

I understand that some concerns have been raised regarding the

transparency surrounding the ratings process and the information

that rating agencies make available to issuers and the public atlarge. I have always believed in transparency and disclosure. These

elements are fundamental to every industry, and so I am joining

others here in encouraging the SEC to develop an oversight regime

that clarifies the steps needed to be taken to provide greater transVerDate 11-MAY-2000 17:55 Jul 12, 2006 Jkt 025856 PO 00000 Frm 00040 Fmt 6633 Sfmt 6633 28059.TXT SBANK4 PsN: SBANK4
37

parency, but I do believe this must be done with a level of care to

ensure that the responsible regulatory policies are put in place.

While I do support regulation, I have to be clear I do not support

the SEC altering the business model or the rating products that

these companies utilize. The regulation of these entities should not

mean dictating the content of their businesses. Credit rating agencies serve a special purpose to the capital markets, providing relevant information in the form of opinions to contribute to fair and

efficient markets.

Looking at regulatory policies, as we do that, it is important to

remember that these companies are just, you know, these companies do just that—give their opinions. I strongly oppose an oversight structure that would allow market participants to sue in the

event that they disagree with the ratings or a company fails to live

up to that rating. I think that would be a mistake.

I will end here. I look forward to hearing the SEC’s plans for the

credit rating agencies. I hope they will move more quickly than

they have so far. And while I have not had a chance to speak at

length about the issue of competition, I am also interested in how

the SEC plans to encourage more competition in an industry that

provides an important service to our capital markets.

My first question is for you, Mr. McDaniel. You stated in your

testimony, as high-profile corporate frauds in recent years have

demonstrated, if issuers abandon the principle of transparency,

truthfulness, and completeness in disclosure, neither rating agencies nor any other market participants, including regulatory authorities, can properly fulfill their roles.

I agree with you, obviously. I have always believed disclosure is

vital to any industry’s success. In light of the recent corporate scandals, from Enron to WorldCom, we have seen the firsthand dangers

of nondisclosure. What specific steps has your company taken to

improve the quality of information you receive from companies in

order to conduct responsible rating analysis. Obviously, some of

these companies sent you false information. I do not blame you for

that. That is really not ultimately your job, but what are you doing

to assure that that does not happen again?

Mr. MCDANIEL. Thank you, Senator.

The most critical action we have taken in the post-Enron environment, in order to try and better vet the information that we are

receiving from companies, is what we call our Enhanced Analysis

Initiative. We have hired over 40 specialists in, accounting financial disclosure, off-balance sheet risk transference, and corporate

governance, who do not have separate rating responsibilities for

companies. Their job is to sit alongside our credit-rating analysts

in meetings with the companies, and outside of meetings with the

companies and provide their particular expertise to demonstrate

and find better insight into the information we are receiving to ask

more probing questions about the information we are receiving

and, as a result of that process, hopefully, to find more vulnerabilities in the information we are receiving.

Senator SCHUMER. Would you like to answer that, Ms. Corbet?

Ms. CORBET. Sure, Senator. Thank you.

As well, Standard & Poor’s has also expanded a number of initiatives, in terms of analytical information. They include additional

38

specialized forensic accounting expertise, which includes new chief

accountants in both the United States and in Europe.

Also, we have, at the request of investors, expanded our liquidity

analysis and our recovery assessment and have published it in our

ratings analyses.

We have, also, enhanced the use of quantitative tools and models

in both the ratings and the surveillance process, and we have increased our commentary on issuers and industry sectors.

Senator SCHUMER. Mr. Joynt.

Mr. JOYNT. We, also, have hired additional expertise, and centralized in our credit policy and credit research area, a function

that allows us to look across all the analytical areas and make sure

that we are consistently seeking all the best-quality information.

I think there are two parts to the information. One is publicly

disclosed information. We have been encouraging deeper and wider

public disclosure of information. And the other is our own ability

to go in and meet with companies and collect information on our

own. So we have materially strengthened our training from the top

to the bottom of the analytical organization, so that when we have

the ability to go interview companies, we can screen and interview

better than ever.

Senator SCHUMER. Next question. Mr. McDaniel, there has been

some talk here about what happened with MCI.

Senator SARBANES. Why do we not take that question——

Senator SCHUMER. I do not mind waiting. Jim has been waiting.

Senator BUNNING. Fine. I have been waiting a while.

Just so there is no misunderstanding about the question I was

asking, I am going to ask all of you to respond in writing.

Do any of your company’s officers or employees sit on any corporate boards or Government boards or agencies like the NASD,

like the New York Stock Exchange, like Nasdaq, like the SEC? And

I would like that information for the past 20 years.

Senator SARBANES. Do you include directors within the phraseology of officers and employees?

Senator BUNNING. Officers and directors.

Thank you very much, Mr. Chairman.

Chairman SHELBY. [Presiding.] I have a few questions. Ms.

Corbet and Mr. Joynt, I will direct it to you, and then anybody else

can comment if you want to.

Recent press accounts have detailed the practice of rating agencies providing unsolicited ratings to issuers. The ratings agency

will issue an opinion based on publicly available information, such

as SEC filings, without talking to the issuer or reviewing relevant

confidential information. If a ratings company can issue an opinion

without the issuer’s permission and cooperation, then what is the

incentive for an issuer to pay for a rating? How does an unsolicited

rating benefit investors if it is not based on complete information?

Ms. Corbet.

Ms. CORBET. Thank you, Senator.

Indeed, as a publisher of information, we will rate and issue,

without request, if really two factors; the first, if there is meaningful market interest, and this largely depends on——

Chairman SHELBY. And how do you define that.

39

Ms. CORBET. This largely is defined on terms of size and significance of the issue.

Second, if there is adequate public disclosure to support the initial analysis and then the ongoing surveillance. Just to qualify, it

does not necessarily mean that there is not communication with

the issuer or discussion with the issuer. We do believe that the

market benefits from our objective opinions even if we are not paid.

And we will always indicate in our credit opinions when a rating

is unsolicited.

Typically, in developed markets, where ratings are well-accepted,

unsolicited ratings are a very small percentage of the overall business, but entry into new markets and new asset classes largely

start with unsolicited ratings.

Chairman SHELBY. Mr. Joynt.

Mr. JOYNT. We have had a program of initiating Fitch-initiated

ratings, also, for issuers or issues we feel have significant interest

to the investor community broadly or investors that are interested

in Fitch’s opinion.

I think regarding the quality of the rating, we can rely on the

public disclosure as being adequate for a reasonably knowledgeable

bond rating agency to reach a good conclusion in almost all situations. So, if we did not feel like we had enough public information

to be able to arrive at what we thought was a reasonable rating

conclusion, we would not issue or initiate a rating.

It is true that we feel there is significant benefit from meeting

with management. We call management and ask to meet with

them, but it is not required to meet with management nor to reach

a reasoned conclusion.

Chairman SHELBY. But your information would be incomplete.

Mr. JOYNT. Pardon me?

Chairman SHELBY. Your information would not be complete,

would it?

Mr. JOYNT. I think, if the public disclosure of information companies in the United States that we expect investors to be able to

make their own conclusions based on that being adequate disclosure, I would think that we would be knowledgeable enough to

reach a reasonable conclusion.

Chairman SHELBY. Mr. Egan.

Mr. EGAN. This is a very subtle area, and it is important that

it be understood properly.

Chairman SHELBY. Lay it out, then. Take your time.

Mr. EGAN. I will not hesitate. None of our ratings are solicited.

We do not get paid by the issuers. They do not come in and solicit

it, and we do not want to get paid. They have offered to pay us,

and we say, no, we do not want any payment from issuers. Again,

that is a conflict of interest.

And so we rely on public information. Companies offer to provide

us with nonpublic information, but there are two problems with

that: Number one, it does not help us in getting to the rating on

a timely, accurate basis and, number two, it increases our liability;

that is, we worry about how that information is used. In the case

of the auto companies, they said we will give you the whole slew

of nonpublic information, and we said, no, make it public and give

it to us, and we would be happy to review it. So that is one aspect.

40

The second aspect is, with the firms that get most of their compensation from issuers which is S&P, Moody’s, Fitch, and DBRS,

we have some real problems with their approach to this area. And

it was detailed in a November 24 article in The Washington Post.

I refer to this as the ‘‘hobnail boots’’ approach to marketing. It goes

through how, in the case of Hannover Re, Moody’s was not paid by

Hannover Re. S&P was paid. And Moody’s went to Hannover Re

and said, ‘‘We are going to rate you. You do not have to pay us,

initially, but we would appreciate it if you did.’’

And Hannover Re said, ‘‘No, we do not have any need for it at

all. Moody’s rated them.’’

And they went back another 6 months later.

Chairman SHELBY. Did they get a good rating?

Mr. EGAN. They got an okay rating. It was one notch below S&P,

but it did not stay there. They went back 6 months later, ‘‘Please

pay us,’’ and Moody’s took a negative action. They went back another 6 months later and said, ‘‘Well, we have new people. Please

pay us again.’’ They did not get paid. They took another negative

action, and another negative action, and another negative action all

the way to the point where they are noninvestment grade. This is

Hannover Re. They are still rated at investment grade by S&P.

Finally, Hannover Re said, ‘‘This is absolutely ridiculous. It is

hurting our stock price, and so we will pay you Moody’s.’’

Chairman SHELBY. Did the rating improve after they paid them?

Mr. EGAN. I think they put it on positive outlook and I think

they are heading up.

Senator SCHUMER. So it improved.

Mr. EGAN. It improved, and nothing else major had happened in

the meantime. And I am sure, if you speak to the analysts, they

will say, well, four things happened here, there and there, but the

reality is nothing really happened. So, I refer to it as the ‘‘hobnail

boots’’ approach because, again, there is no place else to go. S&P

and Moody’s have incredible influence in the marketplace, and they

are using this unsolicited rating process to extend their monopoly.

It is different in our case or in other firm’s cases that are not paid

by the issuer.

So, when you are handling this issue, be careful how it is applied. In the case where the companies are regularly getting paid

by the issuer, they will abuse it.

There is another case where they abused it, where they had a

rating, and this is in the case of Allied Signal. Allied Signal acquired a company, Grimes Aerospace. It had a rating, but Allied

Signal wanted to buy in those bonds cheaply, and so it asked the

rating firms to withdraw the rating on Grimes, so that they could

buy the bonds more cheaply. That is if there is not a rating, there

were a number of institutions that cannot hold it. We rated it to

help out those investors, but we do not have the market power of

S&P and Moody’s. So the corporation was able to buy the bonds

more cheaply than they would have. So it is amazing the steps that

they go through to enhance their business position.

Chairman SHELBY. Mr. Harada, do you want to come in here?

Mr. MCDANIEL. Mr. Chairman.

Chairman SHELBY. Just a minute. I will get to you.

41

Mr. HARADA. As far as the rating of R&I is concerned, in principle, we do not to carry out any unsolicited rating. In principle, we

are now conducting solicited rating.

But there is same possibility that we might conduct some unsolicited ratings. Because, if there is some very influential issuers

that exist, and also they disclose very substantial degree of information, and if the investors have strongly asked us to rate this

very big corporation in that case, although it is a very much exceptional case, we might carry out such an unsolicited rating, but we

have not yet such concrete example at this moment.

Chairman SHELBY. Thank you.

Mr. McDaniel, you wanted to comment.

Mr. MCDANIEL. Yes, Mr. Chairman. I just wanted to point out

that the information that was just communicated with respect to

Hannover Re was not accurate, and I think that the Committee

should be aware of that.

Chairman SHELBY. Corrected. Corrected.

Mr. MCDANIEL. We had a solicited rating relationship, a paid relationship with Hannover since 1999. We did not downgrade any

of Hannover’s debt until 2001, and there was never any linkage between paying and the maintenance of ratings at any level. That

would be a violation of our ethics. It would be subject to severe

sanction, in my opinion dismissal, of any individual who did that.

Senator SARBANES. Was your rating of Hannover, the initial rating solicited or unsolicited?

Mr. MCDANIEL. The initial rating was unsolicited.

Senator SARBANES. And when was that?

Mr. MCDANIEL. In 1998.

Senator SARBANES. So you started rating them on an unsolicited,

unpaid basis; is that correct?

Mr. MCDANIEL. They received a financial strength rating on an

unsolicited, unpaid basis in 1998. They decided, through Hannover

Finance, to access the bond markets, in 1999, and approached

Moody’s for a rating, which we gave.

Senator SARBANES. And they paid.

Mr. MCDANIEL. Yes.

Senator SCHUMER. Wait. Let me just make that clear, if I might.

Chairman SHELBY. If I could, let Mr. Kaitz, and then I will call

on you, Senator.

Mr. KAITZ. Obviously, they have to answer these questions, but

this is clearly an issue that needs to be addressed by the SEC. You

only have three rating agencies.

They have no place else to go. We represent the issuers. The reason I am testifying here today, as the President and CEO, is because there is not anyone in our organization who is going to get

up here and testify and be concerned about what is going to happen to their bond rating. I mean, this is a serious issue here that

has to be addressed. We need transparency. When these are unsolicited ratings, the public needs to know they are unsolicited ratings because they only have access to public information.

So there are a lot of issues involved here where, hopefully, either

the Senate is going to get involved or the SEC really has to clarify

this issue.

Chairman SHELBY. Senator Schumer.

42

Senator SCHUMER. What Mr. Egan said is very serious. So, what

you are saying is you gave an unsolicited rating in 1998. They then

paid you in 1999.

Mr. MCDANIEL. For a different bond rating.

Senator SCHUMER. Bond rating.

Mr. MCDANIEL. They had a financial strength rating in 1998.

Senator SCHUMER. And your rating went down after they paid

you, not up.

Mr. MCDANIEL. In 2001, that is correct.

Senator SCHUMER. So are you alleging that——

Mr. EGAN. The article——

Senator SCHUMER. Wait. Let me just ask the question because

this is serious stuff, and it is easy to throw it around. You are a

competitor of theirs.

Mr. EGAN. Right.

Senator SCHUMER. And you want to break into the big leagues

and so let us make sure——

Mr. EGAN. We are already there.

Senator SCHUMER. Okay. You want to break into the bigger

leagues.

[Laughter.]

Again, this is serious.

Mr. EGAN. Right.

Senator SCHUMER. Are you alleging that they change the rating

based on whether they were paid or not?

Mr. EGAN. I am referring to a November 24, 2004, article——

Senator SCHUMER. I am not asking what The Washington Post

wrote, okay? I am asking because we all deal with reporters all the

time.

Senator SARBANES. Especially Senator Schumer.

Senator SCHUMER. Especially me, exactly.

[Laughter.]

Senator SARBANES. I could not resist that.

Senator SCHUMER. I am serious here. I am happy to deal with

reporters. I want to know are you, Mr. Egan—you did not mention

The Washington Post article——

Mr. EGAN. I certainly did.

Senator SCHUMER. When you gave your little peroration here

about this company——

Mr. EGAN. You can check the record. I did say the November 24

article of The Washington Post. I have a copy of the article right

here.

Senator SCHUMER. Yes, I have it in front of me, too.

Mr. EGAN. We were not directly involved in Hannover Re.

Senator SCHUMER. Right.

Mr. EGAN. We were directly involved in Allied Signal and

Grimes——

Senator SCHUMER. I did not ask that. I am asking you, in Hannover Re, are you alleging that the payments that were made affected the rating, are you, Mr. Egan, of a competitive company?

Mr. EGAN. I am referring to——

Senator SCHUMER. I did not ask what you are referring. I asked

are you alleging that? You are a rater. You know these things. You

43

have a pretty sharp view of this, and I understand that. That is

capitalism.

Mr. EGAN. Right.

Senator SCHUMER. But I am asking you are you alleging that the

payments affected their ratings, yes or no?

Mr. EGAN. I will respond in this way. We were not involved in

Hannover Re. When I started, when I raised this issue, I referred

to The Washington Post. I can say that there have been many instances where it is hard to draw the conclusion that the payments

do not affect the rating.

The latest example of this was a—well, there are constant examples of it, and you do not have to follow the market for very long.

Senator SCHUMER. But I listened to you, and it seemed to me

pretty clear that you were saying this happened, this happened,

and you were implying that there was a relationship. That was my

sitting here. I heard your whole statement.

Mr. EGAN. It is hard to draw anything else.

Senator SCHUMER. But now you are not saying that there was a

relationship.

Senator SARBANES. You do not know.

Senator SCHUMER. You are saying you do not know. That is

right.

Mr. EGAN. No. It would be difficult to draw any other conclusion,

when they were not paid, and then all of a sudden they were paid,

they were not paid, and they took a series of negative actions, and

the other rating agency did not take the negative action, that there

is a high probability that the payment had something to do with

it. And I was referring to The Washington Post article.

Now, there have been other instances where it is difficult to draw

the conclusion, when they are getting paid millions of dollars for

ratings, they delay in taking an action, that that does not have

some impact, despite all the Chinese Walls and everything else.

In fact, in the case of the equity research analyst, that was the

core issue, that they were getting paid via investment banking fees,

was it Citigroup and Salomon Brothers were getting paid, via investment banking fees, for a much more bullish opinion than what

they truly believed. That is the core issue here.

Senator SCHUMER. Yes, it is the core issue, and the bottom line

is you are saying you have no proof of it. You just think it might

occur; is that fair to say?

Mr. EGAN. It would be hard to draw any other conclusion based

on the evidence.

Senator SCHUMER. Do you agree with that, Ms. Corbet, about

what Moody’s did on——

Mr. EGAN. No one else will who is getting paid on the other side.

Senator SCHUMER. Yes, okay.

Go ahead. Do you agree?

Ms. CORBET. No, I do not agree.

Senator SCHUMER. Could you explain that.

Ms. CORBET. Well, I think Mr. McDaniel outlined specifically

that rating downgrades actually happened after they were paid.

Senator SCHUMER. After they were paid, yes. I do not get it.

44

Mr. EGAN. I referred to the article, and it suggests that it was

not getting paid after. You, also, have to be careful about what rating is paid——

Senator SCHUMER. Mr. McDaniel, were you paid in 1999 by this

company?

Mr. MCDANIEL. Yes, we were paid for the bond rating.

Senator SCHUMER. And did you then lower their rating on whatever it was after that?

Mr. MCDANIEL. Let me be as clear as I can. We had two ratings

outstanding, a financial strength rating and a bond rating. The financial strength rating was initially assigned on an unsolicited

basis and remained an unsolicited rating. The bond rating was assigned on a solicited basis or a requested basis, and both ratings

continue to be outstanding, both ratings were downgraded in 2001.

Senator SCHUMER. So why did you not mention that, Mr. Egan?

Mr. EGAN. I was referring to——

Senator SCHUMER. When you went through your little litany, you

did not mention that the same company, after they were paid,

downgraded the rating. You said they upgraded it after they were

paid probably later, right, in 2003 or something?

Mr. EGAN. This is an issue. Let me read from The Washington

Post.

So we told Moody’s, ‘‘Thank you very much for the offer. We really appreciate it.

However, we do not see any added value,’’ said Herbert Haas, Hannover’s Chief Financial Officer at the time. As Haas recalled it, a Moody’s official told them, if Hannover paid for a rating, it could have a positive impact on the grade.

This is from The Washington Post.

Haas, now Chief Financial Officer at Hannover’s parent company, Talanx AG,

laughed at the recollection. ‘‘My first reaction was this is pure blackmail.’’ Then, he

concluded that, for Moody’s, it is just business. S&P was already making headway

in Germany and throughout Europe in rating the insurance business. Moody’s was

lagging behind and Haas thought Hannover represented a fast way for the credit

rater to play catch-up. Within weeks, Moody’s issued an unsolicited rating on Hannover, giving it a financial strength rating of Aa2, one notch below that given by

S&P. Haas sighed with relief. Nowhere in the press release did Moody’s mention

that it did the rating without Hannover’s cooperation, but Haas thought it could

have been worse.

Then, it got worse. In July 2000, Moody’s dropped Hannover’s rating outlook from

stable to negative. About 6 months later, Moody’s downgraded a notch to Aa3.

Meanwhile Moody’s kept trying to sell Hannover its rating service. In the fall of

2001, Zeller, Hannover’s Chairman, said he bumped into a Moody’s official at an industry conference in Monte Carlo and arranged a meeting for the next day at the

Cafe de Paris. There, the Moody’s official pressed his case, pointing out that the analyst who had been covering Hannover, a man whom the insurer disliked, had left

Moody’s. Zeller still declined Moody’s services.

Senator SCHUMER. But they were paid by this company in 2001.

Is that not the point? You are going on after this, but they were

paid at some point. They were not, I mean, do you want to respond,

Mr. McDaniel?

Mr. EGAN. This article suggests that it was not paid.

Senator SCHUMER. Let us get the truth.

Mr. EGAN. It has, ‘‘Two months later—’’

Senator SCHUMER. Wait. Let us get the truth. Excuse me.

Mr. EGAN. ‘‘Two months later, Moody’s cut the insurer’s ratings

by two notches.’’

Senator SCHUMER. Excuse me. Let me just ask Mr. McDaniel.

45

Chairman SHELBY. Let us put the article in the record in its entirety.

Senator SCHUMER. Yes. But I just want to give Mr. McDaniel, I

mean——

Mr. MCDANIEL. Perhaps the most constructive thing that

Moody’s can do, I should say, when we read this information in the

Post, we were more concerned, I think, than anybody else because

there were actions alleged in that article that were violations of our

policies, practices, and ethics. I think that perhaps the most constructive thing we can do is to submit a written report of our investigation of that to the Committee, if you would find that helpful.

Senator SARBANES. That is a good idea.

Chairman SHELBY. That would be a good idea. If you do that, we

will accept it.

Senator SARBANES. Mr. Chairman.

Chairman SHELBY. Senator Sarbanes.

Senator SARBANES. Let me just say, Mr. Egan, you, of your own

knowledge, do not know about, I mean, you are just citing a story

in the Post.

Mr. EGAN. Yes, and I said that at the beginning.

Senator SARBANES. All right. I think we should be clear about

that.

Mr. EGAN. I am familiar with Allied.

Senator SARBANES. Yes, a different case.

Mr. EGAN. I was, personally, involved in Allied.

Senator SARBANES. Now, the Chairman has asked for the article

to be put in the record, and I think, Mr. McDaniel, you should be

able to put in whatever report you have——

Chairman SHELBY. Absolutely. Anything you want to put in, we

will——

Senator SARBANES. —that deals with the record.

Mr. MCDANIEL. We conducted an internal investigation, and I

would be happy to make it available.

Senator SCHUMER. I have just one question.

Senator SARBANES. That may lay out a different——

Senator SCHUMER. Excuse me. And did the article—you have

read it—did the article mention that they paid you, rather, in

2001?

Mr. MCDANIEL. No. While I do not recall the whole article, but

I do not know what it said with respect to that.

Senator SCHUMER. Did it, Mr. Egan? You are familiar with it.

Senator SARBANES. If we are going to pursue this, let us be clear

about this. You were getting paid for one rating, but not getting

paid for another rating; is that correct?

Mr. MCDANIEL. That is correct, yes.

Senator SARBANES. That is right. And the rating that was downgraded was the rating you were not getting paid for?

Mr. MCDANIEL. Both ratings were downgraded.

Senator SARBANES. Both ratings, all right.

Mr. Kaitz, I want to put a question to you. You said earlier that

if you drop the rating system, that would be the worst thing you

could do. And I want you to elaborate on that. I take it what you

mean by that is that those who have already the rating are so far

46

ahead of the game that if the ratings were dropped, there would

be no way anyone else could become a competitor; is that correct?

Mr. KAITZ. Yes, Senator, that is correct because the ratings have

been embedded in insurance regulation, mutual fund regulation,

and potentially pension fund. So it is so embedded in regulated industries, if you did away with the designation, I think it would be

a permanent barrier to competition for anyone to break into that

market.

Senator SARBANES. And then the question is how would somebody else get into the competitive pool. At the moment, at least

they have maybe a chance to get in the pool by being given the designation; is that correct?

Mr. KAITZ. Yes.

Senator SARBANES. I take it that is what you are seeking, Mr.

Harada; is that correct? Are you seeking that designation?

Mr. HARADA. Yes, we are seeking the designation.

Senator SARBANES. Yes, and you are seeking it, Mr. Egan.

Mr. EGAN. Yes, and we are also seeking that the industry be

cleaned up, that the conflict of interest be addressed.

Senator SARBANES. Let me ask this question. I want to ask the

people of the panel, anyone who wants to respond to this, do you

think that the SEC has the power and the authority to regulate the

rating agencies?

Mr. KAITZ. Well, the SEC—I hesitate to quote anything from The

Washington Post at this point——

[Laughter.]

Senator SCHUMER. They are sometimes right.

Mr. KAITZ. Yes, I know. It makes me a little bit nervous, but it

appears that they are saying, no.

Senator SARBANES. I want to ask the rating agencies whether

they think the SEC has the authority to regulate them.

Ms. Corbet.

Ms. CORBET. In my view, I think they have the appropriate authority with respect to the NRSRO designations, but we have publicly said that we would like that designation criteria to be more

transparent.

We think that we are not in favor of any additional regulatory

oversight that would increase the barriers to entry or to compromise the independence of the ratings process. Furthermore, we

think that any further regulation might have the potential of encouraging standardization and deferring the diversity and innovation within the credit rating industry.

Senator SARBANES. So does that mean you think that they cannot take any measures that affect how you do your activities?

Ms. CORBET. We think that what they currently have in terms

of oversight in the NRSRO designation process is sufficient.

Senator SARBANES. Mr. Joynt, what do you think?

Mr. JOYNT. As a technical matter, I am not sure whether they

have the authority, but we would be fully—and have been—responsive to all requests for information, changes in our practices. We

have had open discussion and dialogue with them.

Senator SARBANES. Mr. McDaniel.

47

Mr. MCDANIEL. The Commission, I certainly believe, has the authority to define what a NRSRO is and to identify the standards

that would accompany a NRSRO.

As to the scope of authority in areas of the content of the work

we do, I think that we would work as constructively as we can with

the Commission.

Senator SARBANES. You think they have the authority to effect

that?

Mr. MCDANIEL. I am sorry, sir?

Senator SARBANES. Do you think they have the authority to, in

effect, pass on those practices and establish standards for it?

Mr. MCDANIEL. I believe that they do simply because the NRSRO

designation is a SEC designation, and they determine who is one

and who is not one.

Senator SARBANES. Was it only to determine who is a NRSRO or

can they also affect the practices of an entity that has been so determined?

Mr. MCDANIEL. Well, they could, as far as I understand, they

could determine what the criteria are to be a NRSRO, and if a rating agency chose not to follow that criteria, it could be de-designated or delisted.

Senator SARBANES. No, I know. But the criteria to become designated may differ from overseeing the practices once you have

been designated, otherwise it is a sweetheart deal for you all, is it

not? You get designated. So now you get the special status conferred upon you by the SEC, a rather unique status.

Mr. Kaitz says, well, we cannot drop the designation because, if

you do that, the ones who have already been designated, it is all

theirs. There is no way anyone can compete with them. So we have

to keep the designation, which has given you a very privileged position, and I just want to make certain because I think the SEC

needs to move in this area—I think there are some problems, and

they need to address them—that we are then not going to run into

the argument, by those who have been favored by the designation,

who say, well, you cannot really address our practices. I mean, it

would seem to me to almost follow logically that if they can give

you this designation and establish this special status for you, that

encompassed within that grant of a privileged position would be

the authority to pass on your practices to assure that they are adhering to appropriate standards.

Now, do you disagree with that?

Mr. MCDANIEL. I think I would agree with Mr. Joynt that the

matter of technical authority is one that I am probably not best positioned to opine on, but we would certainly work to adhere to

standards that are promulgated. We have already publicly announced that we will adhere to the international standards promulgated by the International Organization of Securities Commissions.

Senator SARBANES. Do you think the Commission can inspect

your agency in terms of your practices and what you are doing to

be assured and to assure the public that they are proper, objective,

and meeting all standards?

Mr. MCDANIEL. They do inspect us. They have periodically in the

past, yes.

48

Mr. JOYNT. Again, whether they have the technical authority, I

do not know, but we are fully responsive to them, and we would

be happy to have them——

Senator SARBANES. I just want to make sure that if the SEC

moves with something, you are not going to then rise up and say,

‘‘Oh, no. You do not have the power or authority to do that.’’ That

is what I am trying to ascertain here today.

Now, I take it, Mr. McDaniel, you would not say that. You would

say, well, they do have it.

What would you say?

Mr. JOYNT. The only question that has come up regarding practices and outside influence for the rating agencies that I am aware

of is managing or attempting to manage the content of the rating

process itself, which we believe is a pretty important independent

responsibility of ours. And so outside of that, other aspects of the

process, and the number of employees, and the way they would

conduct an inspection or they have so far, and all of the issues they

have presented to us that we have been fully open to, I think I am

comfortable with.

Senator SARBANES. Ms. Corbet.

Ms. CORBET. We cannot opine in terms of what their specific

legal counsel may have advised them as to whether or not they

have authority, but, again, we are subject to inspections currently

by the SEC, and we believe that the current NRSRO designation

process, with the amendments that we support, is sufficient, in

terms of regulatory oversight.

Senator SARBANES. We will see how this develops. We will have

the SEC in here at some point, and we will proceed down the path.

But, obviously, there are a number of problems, which you all have

recognized here at the table.

Senator SCHUMER. Mr. Chairman, I do have one more question.

Chairman SHELBY. Senator Schumer, go ahead.

Senator SCHUMER. It is not related to, but I wanted to get your

opinion. Since you are rating agencies and you give unsolicited

opinions, I wanted to get your opinion on another issue, which is

the Federal budget.

The President released his fiscal year 2006 budget. It projects

that the debt held by the public as a percentage of GDP will rise

and then level off to about 39 percent in 2010. But this is a fundamentally misleading budget, in my judgment, because it leaves

off major proposals that we know are going to be in there. Adding

the President’s Social Security proposal, permanent tax cuts, cost

of the war in Iraq and Afghanistan will bring the debt held by the

public to close to 50 percent of GDP by 2015, if not higher.

So here is my question. Deficits are rising, debt is rising, yet according to the CBO Director, Mr. Holtz-Eakin, these deficits are

structural, meaning we will not be able to grow our way out of

them.

If a private company were in the same situation as the Federal

Government, with this greatly increasing debt, namely, exploding

debt in the case of a private company as a share of sales, with no

expected future revenue stream to pay back the debt, how would

the leading credit agencies rate it?

Chairman SHELBY. I think that is a hypothetical question.

49

Senator SCHUMER. It is.

[Laughter.]

Mr. Chairman, it is becoming less hypothetical.

Chairman SHELBY. I do not think they answer hypothetical questions—I hope not.

Senator SCHUMER. Any rating agency want to make a comment

on that?

Chairman SHELBY. I will answer it. It will be AAA graded.

[Laughter.]

Senator SCHUMER. Oh, yes. Well, then, Mr. Chairman, I would

urge the SEC not to certify your firm to rate the agencies.

Chairman SHELBY. Well, I am going to be with the Government,

like you.

[Laughter.]

Thank you, Senator.

We will continue to examine the issues here that were raised this

morning. We will hear, as Senator Sarbanes just said, we will hear

from Chairman Donaldson, among others. Credit rating agencies,

such as yours, play a very prominent role in the markets. And it

is important, I think, that we fully understand the range of issues

that confront you and the SEC here.

A couple of things, observations brought up here today: Possible

conflicts of interest—let us be honest with each other—lack of competition. I think those are two things that have to be explored further, but that will be another day, but we thank you for the hearing today.

[Whereupon, at 12:41 p.m., the hearing was adjourned.]

[Prepared statements, response to written questions, and additional material supplied for the record follow:]

50

PREPARED STATEMENT OF SENATOR JIM BUNNING

Thank you, Mr. Chairman. I would like to welcome all of our witnesses here

today. I applaud Chairman Shelby for holding this important hearing on the role

of the Credit Rating Agencies in the Capital Markets.

As you know, this is a issue I have been working on for some time. In the Sarbanes-Oxley legislation I inserted language to direct the SEC to study credit rating

agencies. In light of the events that have happened over the course of the last few

years, I think this is a very important and needs further examination.

Credit ratings have become an important investor tool in the financial markets.

The average American investor relies heavily on ratings that the four Nationally

Recognized Statistical Credit Organizations (NRSCO’s) make. NRSCO’s have special

access to the companies they deal with and they can have private conversations

with companies’ management that analysts cannot have. They can see financial information about companies that is not public, and SEC exempted them from the

Regulation Fair Disclosure (FD). In short, they have insight into the financial wellbeing of a company average investors do not have. The markets expect you to anticipate what happens and to also warn people if something is producing a red flag.

As we have seen, in the case of Enron and others, these extra advantages are not

always enough for the NRSCO’s to issue ratings that properly reflect a company’s

true investment value or credit worthiness. I know that NRSCO’s rely heavily on

the information that companies provide them. But, in light of the Enron fiasco, the

NRSCO and the other credit rating agencies have a major obligation to look beyond

what is given to them by any corporation. Also, the average investor has the right

to know what procedures NRSCO’s use to determine a credit rating. Right now,

there is no transparency in the process. For all investors know, you could be pulling

a rabbit out of a hat.

I look forward to hearing from all of our witnesses and getting their opinions and

expertise on the questions facing us.

—————

PREPARED STATEMENT OF SENATOR DEBBIE STABENOW

Mr. Chairman, thank you for holding this important hearing. I look forward to

working with you on many such issues during the 109th Congress.

The role of credit rating agencies in our Nation’s economy can not be overstated.

Like individuals, companies, cities, counties, and States rely on their credit worthiness to determine if they can borrow money and at what interest rate. If there are

problems in the process used to determine creditworthiness, then we should address

them. The matter is too important to be left to fester until a crisis occurs.

The matter that most concerns me today is the possibility that conflict of interests

may exist at the rating agencies—for instance, a rating analyst trading on confidential information or a rating agency senior executive sitting on a corporate management board.

I am also concerned that rating agencies may be billing clients for work they do

not perform. There are reports, for instance, that companies occasionally receive

bills for ratings on upcoming equity and debt issues that they did not request. In

the 1990’s, there were cases in which Michigan school districts were billed for such

unrequested ratings and while compared to corporate ratings these bills may be

small, they represent a big problem to the school superintendent that is trying to

find money in the budget to pay for text books. An unexpected bill of this sort trickles down to the taxpayer in the form of higher tax levies for repayment of school

bonds. We clearly have an obligation to do what we can to make sure the system

is working properly and that taxpayers and consumers are not taken advantage of.

I look forward to hearing from our witnesses today, determining what problems

exist, and how we can best address them.

—————

PREPARED STATEMENT OF KATHLEEN A. CORBET

PRESIDENT, STANDARD & POOR’S

FEBRUARY 8, 2005

Mr. Chairman, Members of the Committee, good morning. I am Kathleen A.

Corbet, President of Standard & Poor’s (S&P), a division of The McGraw-Hill Companies, Inc. On behalf of S&P and S&P Ratings Services, the S&P unit responsible

for assigning and publishing credit ratings, I welcome the opportunity to appear at

51

this hearing to discuss the important role of credit rating agencies in the capital

markets. By way of background, I joined S&P as President almost one year ago.

While I may be a new face at the table today, I have spent more than 20 years in

investment management where I was responsible for fixed income research and

bond portfolio management for institutional and mutual fund investors. Accordingly,

my comments this morning are based on my perspective as S&P President, as a capital markets participant and as a former rating agency customer.

Today, I would like to address five topics: (1) S&P Ratings Services’ rigorous and

market-tested ratings process, which is designed to ensure our ratings are objective,

independent, transparent, and credible; (2) S&P Ratings Services’ Code of Practices

and Procedures which, along with other similar measures, addresses potential conflicts that may arise in the ratings process; (3) S&P Ratings Services’ responses to

recent corporate misconduct; (4) S&P Ratings Services’ support for greater transparency in the Securities and Exchange Commission’s (the Commission) NRSRO

designation process and for reduction of barriers to entry in the credit rating industry; and (5) S&P Ratings Services’ responsiveness to U.S. and international markets

and regulators with respect to the ratings process.

Background on S&P Ratings Services and the Nature of Credit Ratings

Before turning to these topics, I would first like to provide some background on

S&P Ratings Services. S&P Ratings Services began its credit ratings activities almost 90 years ago, in 1916, and today is a global leader in the field of credit ratings

and risk analysis, with credit rating opinions outstanding on approximately $30 trillion in debt representing 745,000 securities issued by roughly 42,000 obligors in

more than 100 countries. S&P Ratings Services has established an excellent track

record of providing the market with independent, objective, and rigorous analytical

information in the form of credit rating opinions. A rating from S&P Ratings Services represents our opinion, as of a specific date, of the creditworthiness of either

an obligor in general or a particular financial obligation. Unlike equity analysis, a

credit rating opinion:

• is not recommendation to buy, sell, or hold a particular security; • is not a comment on the suitability of an investment for a particular investor or

group of investors; • is not a personal recommendation to any particular user; and • is not investment advice.

More detail on the nature of our rating opinions is available on our website:

www.standardandpoors.com.

Credit ratings are an important component of the global capital markets and over

the past century have served investors extremely well by providing an effective and

objective tool to evaluate credit risk. Credit ratings provide reliable standards for

issuers and investors around the world, facilitating efficient capital raising and the

growth of new markets. Indeed, credit rating opinions have supported the development of deeper, broader, and more cost effective global debt markets. S&P Ratings

Services has made significant contributions to this development by taking credit research into new markets and new asset classes; it is through this process that there

is more information, a wider array of tools for understanding credit risk and far

greater transparency in the marketplace today than ever before.

Critical to a credit rating agency’s ability to serve this role in the market is its

commitment to, and achievement of, the highest standards of independence, transparency and quality. At S&P Ratings Services, these principles are the cornerstones

of our business and have driven our longstanding track record of analytical excellence. Indeed, studies on rating trends have repeatedly shown that our ratings are

highly effective in alerting the market to both deterioration and improvement in

credit quality. For example, over the past 15 years, less than 1 percent of issuers

initially rated in the ‘‘AAA’’ category have defaulted while approximately 60 percent

of those initially rated in the ‘‘CCC’’ category have failed to meet their obligations.

Moreover, out of 36 S&P rated issuers that defaulted in 2004, every one was rated

in speculative grade categories prior to default, and most from inception.

The Credit Rating Process

At the heart of this market-tested and accepted track record is a process by which

S&P Ratings Services arrives at a particular credit rating. Our rating and editorial

process begins with analysts being assigned to a particular issuer. The analysts

gather economic, financial, and other information directly from the issuer, from public filings and from other sources deemed to be reliable. As part of our rating process, we press issuers to respond to comprehensive questions that help our analysts

develop a full picture of the issuer’s true credit quality. That said, our analysts are

not auditors and do not perform an audit of information provided by a rated comVerDate 11-MAY-2000 17:55 Jul 12, 2006 Jkt 025856 PO 00000 Frm 00055 Fmt 6621 Sfmt 6621 28059.TXT SBANK4 PsN: SBANK4
52

* Held in Committee files.

pany: Indeed, one important informational component is the public information

available about an issuer. Accordingly, we support the actions taken by Congress

in enacting the Sarbanes-Oxley Act of 2002 to strengthen the process by which financial information is audited and provided to the market. Our analysts also rely

expressly and necessarily on issuers to provide timely and accurate information. We

may, depending on the circumstances, decline to issue a rating or even withdraw

an existing rating if an issuer refuses to provide requested information.

Our rating analysts examine information carefully as it is gathered. When sufficient information to reach a rating conclusion has been received and analyzed, we

convene a rating committee comprised of S&P Ratings Services personnel who bring

to bear particular credit experience and/or expertise relevant to the rating. A lead

analyst makes a presentation to the rating committee that includes an evaluation

of the issuing company’s strategic and financial management, its business and operating environment, an analysis of financial and accounting factors and the issuer’s

business and financing plans. Our rating committee meetings involve serious and

lengthy discussion that includes frank, and often animated, exchanges.

Once a rating is determined by the rating committee, the issuer is notified and

S&P Ratings Services disseminates it to the public. Along with the rating, we publish a narrative rationale explaining to the marketplace the key issues considered

in the rating.

Similarly, when a rating change occurs, our analysts report on the change and

the rationale for it. We have a longstanding policy of making our public credit ratings and the basis for those ratings broadly available to the investing public as soon

as possible and without cost. Public credit ratings (which constitute 99 percent of

our credit ratings in the United States) are disseminated via real-time posts on our

website, and through a wire feed to the news media as well as through our subscription services. Members of the investing public receive credit ratings at the same

time as subscribers.

Management of Potential Conflicts of Interest

S&P Ratings Services has a longstanding commitment to ensuring that any potential conflicts of interest do not compromise our analytical independence. To that end,

S&P Ratings Services has had in place for many years a significant number of policies, procedures, and structural safeguards. In September 2004, these policies and

procedures were updated, aggregated into one document, and released publicly in

S&P Ratings Services’ Code of Practices and Procedures (Code of Practices and Procedures). The Code of Practices and Procedures provides, for example, that:

• rating opinions must be assigned by rating committees, not by an individual;

• at least two analysts must attend all meetings with the management of an issuer;

• analysts are not to be compensated based upon the ratings assigned to issuers

they cover;

• analysts are prohibited from engaging in negotiations with issuers about fees or

other business matters; and

• analysts are prohibited from engaging, directly or indirectly, in any Standard &

Poor’s activities with respect to nonratings businesses, including any cross marketing of nonratings services.

Consistent with the recent ‘‘Code of Conduct Fundamentals’’ published by the

International Organization of Securities Commissions (IOSCO), S&P Ratings Services’ Code of Practices and Procedures requires strict separation of marketing and

analytical activities and contains tight restrictions on securities ownership and trading so as to minimize any conflicts of interest in the conduct of the credit ratings

process. The Code of Practices and Procedures, which we have previously provided

to the Committee, is available on our website and is attached to this testimony (see

Appendix 1).*

S&P Ratings Services has also established strong infrastructure designed to safeguard the integrity of our credit rating process. Our Analytics Policy Board, chaired

by S&P Ratings Services’ Chief Credit Officer, monitors and ensures consistent application of our criteria and methodologies. The Analytics Policy Board also examines significant downgrades to determine if any changes in criteria or methodology

are warranted.

S&P Ratings Services believes that these measures contribute to our objectivity

and independence and the market’s acceptance of S&P Ratings Services as a credible publisher of credit ratings. Indeed, in the Commission’s January 2003 ‘‘Report

on the Role and Function of Credit Rating Agencies in the Operation of the Securities Markets,’’ prepared pursuant to Congress’ direction in the Sarbanes-Oxley Act

53

1See Daniel M. Covitz and Paul Harrison, Testing Conflicts of Interest at Bond Ratings Agencies with Market Anticipation: Evidence that Reputation Incentives Dominate, The Federal Reserve Board Finance and Economics Discussion Series (December 2003), at 1, 3. 2 In a statement attached to his Oct. 5, 2004 Cooperation Agreement, Enron’s former Assistant

Treasurer Timothy Despain admitted, among other things, that ‘‘[i]n communicating with representatives of the rating agencies, I and others at Enron did not truthfully present the financial

position and cashflow of the company and omitted to disclose facts necessary to make the disclosures and statements that were made to the rating agencies truthful and not misleading.’’ Similarly, in his January 14, 2004 Plea Bargain Agreement, former Enron CFO Andrew S. Fastow,

stated, among other things, that ‘‘[w]hile CFO, I and other members of Enron’s senior management fraudulently manipulated Enron’s publicly reported financial results. Our purpose was to

mislead investors and others about the true financial position of Enron and, consequently, to

inflate artificially the price of Enron’s stock and maintain fraudulently Enron’s credit rating.’’

(emphasis added).

of 2002 and following an extensive review of credit rating agencies, the Commission

found that market participants generally believed that any potential conflicts of interest have been ‘‘effectively addressed by the credit rating agencies.’’ Likewise, two

Federal Reserve Board economists recently concluded after intensive study that

S&P Ratings Services and the other rating agencies consider their reputations in

the marketplace to be of ‘‘paramount importance’’ and, in fact, are ‘‘motivated primarily by reputation-related incentives.’’ 1

Response to Recent Corporate Misconduct

The unprecedented corporate misconduct that has been revealed in recent years

has resulted in constructive responses by market participants, including rating

agencies such as S&P Ratings Services. Like many other market participants, S&P

Ratings Services was misled by parties who committed fraud. In the Enron case,

for example, key Enron personnel have now expressly admitted their role in deliberately misleading S&P Ratings Services and other rating agencies. It was their intention, they said, to defraud the rating agencies by making false representations

and failing to disclose material facts related to Enron’s financial position and

cashflow.2

While at S&P Ratings Services we continuously review and enhance our processes, these events led us to examine our practices from top to bottom. We have concluded, after careful thought and examination, that our credit rating process works

well and effectively. This view is reflected in many of the public comments filed with

the Commission, IOSCO, and the Committee of European Securities Regulators, or

‘‘CESR’’. Indeed, in April 2003 testimony before the House Subcommittee on Capital

Markets, Insurance and Government Sponsored Entities, the Director of the Commission’s Division of Market Regulation, observed that ‘‘in general the credit rating

agencies have done remarkably well.’’

The recent cases of issuer misconduct underscore how important it is to the ratings process that issuers provide accurate and reliable information to the marketplace and S&P Ratings Services. S&P Ratings Services believes that the initiatives

of Congress and the Commission to improve the quality, transparency, and timeliness of disclosures by public companies such as those included in the SarbanesOxley Act were an important and necessary response to these instances of corporate

misconduct. Such measures should promote timely and accurate disclosure by

issuers. Recent accounting standard initiatives should likewise result in better accounting information available to the market, including S&P Ratings Services.

As part of our commitment to continuous improvement and in order to ensure ratings are responsive to evolving market needs, S&P Ratings Services has recently

initiated a broad range of actions that support our mission to provide high-quality,

objective, and rigorous analytical information to the marketplace. These initiatives

have included:

• additional specialized forensic accounting expertise including new chief accountants in both the United States and Europe;

• expanded liquidity analysis and recovery assessment in our ratings analyses;

• enhanced use of quantitative tools and models in the rating and surveillance process;

• increased commentary on issuers and industry sectors;

• enhanced focus in our criteria and practice on the role of corporate governance

practices in credit ratings analyses;

• expanded training programs; and

• consolidated and updated codes of policies and practices.

We will, of course, continue to take appropriate steps to enable us to continue to

provide rigorous analytical information to the marketplace.

54

SEC Regulatory Oversight

The concept of a Nationally Recognized Statistical Rating Organization (NRSRO)

was first utilized by the Commission in 1975. S&P Ratings Services was designated

as an NRSRO in 1976 (though did not affirmatively seek that status) and is now

one of four designated NRSRO’s. The Commission is currently in the process of reviewing the NRSRO system and considering possible changes. The initial phase of

this review included the Commission’s January 2003 report mentioned earlier, prepared pursuant to Congress’ direction under the Sarbanes-Oxley Act. Following this

report, the Commission issued a Concept Release in June 2003. One of the key questions raised by the Concept Release is whether to continue the use of the NRSRO

framework and, if so, how best to designate NRSRO’s. Based on the public comments by market participants, which generally favored retaining the system, the

Commission may well conclude that abandoning the NRSRO concept could increase

costs to the capital markets and disrupt current efficiencies in the regulatory system, without any increase in investor protection.

If the Commission does retain the NRSRO system, S&P Ratings Services believes

that the Commission should provide greater transparency in the designation process

and reduce regulatory barriers to entry into the credit rating industry—a view expressed in many public comments. One way to accomplish this goal would be to extend NRSRO status to firms that limit their rating opinions to particular sectors

of the capital markets or particular geographic regions. S&P Ratings Services supports increased competition in the credit rating industry. We believe, however, that

the key criterion for designation must continue to be that a firm is widely accepted

by users of credit rating opinions as a provider of credible and reliable ratings.

The Commission is also considering whether and to what extent it should enhance

regulatory oversight of NRSRO’s if the designation system is retained. S&P Ratings

Services believes that it is imperative for the Commission to avoid overly intrusive

supervision of NRSRO firms, particularly supervision that may suggest a substantive role for Government in either the business operations of credit rating agencies or the ratings process itself. Because there is no one model or methodology for

producing sound credit rating opinions, regulatory regimes focused on the credit rating decision process could have a number of adverse effects, including:

• compromising the independence of the credit ratings process;

• encouraging firms to standardize their approaches and thereby deterring diversity

and innovation in credit analysis;

• creating the impression that rating opinions have governmental approval; and

• encouraging issuers to provide less information to credit rating agencies.

Moreover, regulatory oversight involving governmental intrusion into how and

why a rating agency forms a particular rating opinion could chill the robust analytical process that has served the markets extremely well for nearly a century for fear

of governmental ‘‘second guessing.’’ Governmental intrusion also risks interfering

significantly with the strong First Amendment protections that courts have applied

to the ratings process of gathering and analyzing information, forming opinions, and

disseminating those opinions broadly to the marketplace.

International Review of Credit Rating Agencies

The capital markets are increasingly global in nature and the same is true of the

credit ratings business. As a result, IOSCO and CESR (as requested by the European Commission) have initiated their own independent reviews of credit rating

agencies. S&P Ratings Services has been an active participant in these reviews and

believes that many of the initial conclusions of these bodies, and the public commentary they have received, can and should inform the consideration of these issues

by this Committee, the Commission, and others.

As noted, IOSCO released its ‘‘Code of Conduct Fundamentals’’ for rating agencies

this past December. After months of deliberation and an extensive market comment

period, IOSCO determined that its Code of Conduct Fundamentals should be flexible, allowing rating agencies to incorporate its principles into their own respective

codes of conduct, but not creating rigid, universally applicable regulations. Roel

Campos, SEC Commissioner and the Chairman of the IOSCO Task Force, said that

IOSCO’s flexible approach would be ‘‘more effectively enforced than would be the

case if IOSCO had drafted a universal code for all credit rating agencies to sign on

to.’’ Commissioner Campos explained that a degree of flexibility was appropriate because rating agencies vary considerably in size, business model, and rating methods.

S&P Ratings Services agrees that IOSCO’s flexible approach will both preserve the

independence and integrity of the credit rating process around the world and better

serve investors and the marketplace as a whole far better than rigorous regulation.

55

CESR is preparing a response to the European Commission’s request for advice

concerning credit rating agencies. At a public hearing held by CESR in Paris last

month, the overwhelming majority of participants, including representatives of

issuers and users of ratings, called on CESR to advise the European Commission

to allow market forces to operate and not to impose intrusive regulation. In particular, most of those speaking at the meeting expressed support for an approach

which allows rating agencies to develop their own practices and procedures based

on the IOSCO Code of Conduct Fundamentals and expressed concerns that detailed

regulation would increase barriers to entry.

Conclusion

History reflects that credit rating opinions and credit rating agencies have served

the markets extremely well for nearly a century. The key drivers of this success

have been the independence and objectivity of credit rating agencies. S&P Ratings

Services believes that its policies and procedures, established through decades of experience and innovation, address the potential challenges to that independence and

objectivity. Great care should be taken to ensure that the principles and structures

that have so greatly benefited the market for so many years are not compromised.

On behalf of S&P Ratings Services, thank you again for the opportunity to participate in these hearings. I would be happy to answer any questions you may have.

—————

PREPARED STATEMENT OF SEAN J. EGAN

MANAGING DIRECTOR, EGAN-JONES RATINGS CO.

FEBRUARY 8, 2005

Chairman Shelby, Members of the Committee, good morning. I am Sean Egan,

Managing Director of Egan-Jones Ratings Company, a credit ratings firm. By way

of background, I am a Co-Founder of Egan-Jones Ratings Co., which was established

to provide timely, accurate credit ratings to institutional investors. Our firm differs

significantly from other ratings agencies in that we have distinguished ourselves by

providing timely, accurate ratings and we are not paid by the issuers of debt, which

we view as a conflict of interest. Instead, we are paid by approximately 400 firms

consisting mainly of institutional investors and broker/dealers. We are based in the

Philadelphia, Pennsylvania area, although we do have employees that operate from

other offices.

The rating industry is in a crisis. At a time when the capital markets have become increasingly reliant on credit ratings, the ratings industry is suffering from

a State that is hard to characterize as anything other than dysfunctional. The problems are:

Severe consolidation—Department of Justice personnel referred to the industry as

a ‘‘partner monopoly’’ since S&P and Moody’s control over 90 percent of the revenues and do not compete against each other as two ratings are normally needed for

issues;

Conflicts of interest—issuers payment for ratings create conflicts of interest that

are similar to those experienced by the equity research analysts;

Freedom of speech defense—there is no downside to bad rating calls by the two

dominant firms.

Manifestations of the flawed structure are:

Failure to warn investors about problem credits such as Enron, the California

utilities, WorldCom, Global Crossing, AT&T Canada, and Parmalat.

• Enron was rated investment grade by the NRSRO’s 4 days before bankruptcy,

• The California utilities were rated ‘‘A-’’ 2 weeks before defaulting;

• Worldcom was rated investment grade 3 months before filing for bankruptcy;

• Global Crossing was rated investment grade in March 2002 and defaulted on

loans in July 2002;

• AT&T Canada was rated investment grade in early February 2002 and defaulted

in September 2002; and

• Parmalat was rated investment grade 45 days before filing for bankruptcy.

• Losses from the Enron and WorldCom failures alone were in excess of $100 billion, thousands of jobs, and the evaporation of pensions for thousands. It is likely

that some of these failures could have been avoided had the problems been identified and addressed sooner. (Enron was left with only Dynergy as an acquirer by

the time the alarm was sounded.)

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Under-rating credits—such as Nextel, American Tower, and Thyssenkrupp were

assigned credit ratings which were too low, thereby significantly increasing their

cost of capital and restricting growth.

Insider trading—CitiGroup and probably other institutions were given advanced

information about the Enron downgrade. Additionally, S&P and Moody’s request advance information about transactions and other major events which creates opportunities for insider trading. S&P analyst Rick Marano and his associates traded on

confidential information relating to the acquisition of ReliaStar and American General.

Investor fraud—the NRSRO rating firms pulled their ratings on an Allied Signal

entity so Allied could repurchase debt more cheaply;

Issuer coercion—forcing issuers to pay rating fees (see The Washington Post article

for a description of Hanover Re actions and Northern Trust comments to SEC)

http://www.washingtonpost.com/wp-dyn/articles/A8032–2004Nov23.html;

Punishment ratings—see the municipality lawsuits; and

Expansion of monopoly—expansion into consulting and corporate governance ratings despite rating failures.

Despite the recent credit rating debacles, S&P and Moody’s revenues and earnings

have continued to grow because of their lock on the market (Moody’s operating earnings have increased 230 percent over the past 4 years) and the lack of normal

checks and balances. To put the industry structure in perspective, it is as though

there were only two major broker-dealers for corporate securities and the approval

of both were required before any transactions could be completed.

The arguments used to by the NRSRO’s to defend their actions and inactions are

the following:

‘‘Issuer Misdeeds’’ (they did not tell us)—S&P, Moody’s, and Fitch claim they did

not assign the correct rating because WorldCom, Enron, et al. did not provide accurate information. We believe it is a pathetic state when major rating firms are unable to recognize when an issuer and its executives are desperate to keep their firms

solvent; it was public knowledge that Bernie Ebbers owed WorldCom more than

$400 million. Fraud is present in most failures, and the rating firms (at least those

recognized by the SEC) should be able to detect the majority of egregious cases.

‘‘Little Incentive’’ (the Jack Grubman defense)—another argument used by the current NRSRO’s to defend their actions is that any single issuer represents only small

portions of their overall revenue bases. However, revenues produced by equity analysts Jack Grubman and Henry Blodget were likewise only a small portion of

CitiGroup’s and Merrill’s revenues. Furthermore, when large investment banks are

pressing the rating firms to hold off on any rating action, it becomes difficult not

to listen.

‘‘Our Reputation is Key’’ (the Arthur Andersen defense)—Arthur Anderson argued

that it would not do anything untoward because it would hurt the firm’s reputation.

Likewise, the current NRSRO’s argue that they would not risk their reputation for

any one issuer. However, since most issuers believe their ratings are too low and

the lack of competition provides little downside for inaccurate ratings, there are few

checks in the industry.

‘‘Committee Approach’’ (the Lemming defense)—a final defense normally proffered

for the flawed industry is that unlike the investment banks, the NRSRO’s use a

committee approach for assigning ratings, which is harder to manipulate. Unfortunately, one analyst typically covers a firm and during rating committees what superiors want is probably clear.

To reform the ratings industry, we recommend the following changes:

(1) Recognize some rating firms which have succeeded in providing timely, accurate ratings—The problems with the current system are: (a) improving firms have

been penalized by paying too much for capital, and (b) investors have been hurt by

not obtaining warning of deteriorating firms. The recognition of some firms that

have succeeded in providing timely, accurate ratings would be of great benefit.

(2) Wean rating firms of issuer compensation—the crux of the equity research analysts’ scandal is that analysts were paid by issuers via investment banking fees,

thereby corrupting the investment analysis. The same conflicts exist in the credit

rating industry. Studies from the Kansas City Federal Reserve Bank and Stanford

University and the University of Michigan support the superiority of nonconflicted

firms.

(3) Adopt the Code of Standard Practices for Participants in the Credit Rating

Process issued by the ACT, AFP, and AFTE—the proposed guidelines will assist in

increasing the transparency and credibility in the ratings industry.

57

(4) Prohibit rating firms from obtaining inside information—the rating firms

should not be given preferential treatment over other financial analysts.

(5) Sever ties between rating firm personnel and issuers and dealers—the ex-chairman of Moody’s should not have served as a director of WorldCom nor should ratings firm personnel be tied to broker/dealers or broker/dealer industry associations

such as the NASD.

Broker/dealers were fined $1.4 billion for the issuance of conflicted equity research. In contrast, the SEC has been studying the rating industry since the early

1990’s and has not yet made any substantive changes. The SEC has provided a false

sense of security by giving its seal of approval to conflicted firms. If the SEC is unable to implement these changes rapidly, we recommend it withdraw from providing

NRSRO designations and protecting the currently recognized firms from competition. Perhaps a board made up of users of credit ratings (excluding broker/dealer

affiliated firms) is best able to assess the competency of rating firms.

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

Global Crossing, and WorldCom failures (we did not rate Parmalat). Furthermore,

we regularly identify improving credits; most of our ratings have been above S&P’s

and Moody’s over the past 2 years (thereby providing issuers with more competitive

capital). Our success has been recognized by the Federal Reserve Bank of Kansas

City which compared all our ratings since inception in December 1995 to those of

S&P and concluded:

‘‘Overall, it is robustly the case that S&P regrades from BBB- moved in the direction of EJR’s earlier ratings. It appears more likely that this result reflects

systematic differences between the two firms’ rating policies than a small number of lucky guesses by EJR.’’

Source: Research Division, Federal Reserve Bank of Kansas City, Feb. 2003

Link: http://www.kc.frb.org/publicat/reswkpap/RWP03–01.htm.

Stanford University and the University of Michigan drew similar conclusions:

‘‘we believe our results make a strong case that the noncertified agency [EganJones] is the leader and the certified agency [Moody’s] is the laggard.’’

Link: aaahq.org/AM2004/display.cfm?Filename =SubID—1213.pdf&MIMEType

=application percent2Fpdf.

In August 1998, we applied for recognition by the SEC as a ratings firm (that is,

NRSRO status). We continue to provide information to the SEC and hope eventually

to be recognized.

Timely, accurate credit ratings are critical for robust capital markets. Investors,

issuers, workers, and pensioners will continue to be hurt by the flawed credit rating

industry until someone addresses the basic industry problems. I would be happy to

answer any questions.

—————

PREPARES STATEMENT OF MICAH S. GREEN

PRESIDENT, THE BOND MARKET ASSOCIATION

FEBRUARY 8, 2005

Thank you, Chairman Shelby, for the opportunity to testify today on credit rating

agencies. My name is Micah S. Green and I am the President of The Bond Market

Association. As you know, the Association represents securities firms and banks

that underwrite, distribute, and trade debt securities in the United States and internationally—a global market estimated at $44 trillion today. The Association speaks

for the bond industry worldwide, advocating its positions and representing its interests in New York, Washington, London, and elsewhere. The Association also works

with bond issuers—companies, governments, and others who borrow in the capital

markets—and investors in fixed-income products from across the globe.

Our members account for approximately 95 percent of U.S. municipal bond underwriting and trading activity. The membership also includes all primary dealers in

U.S. Government securities, as recognized by the Federal Reserve Bank of New

York, and all major dealers in U.S. agency securities, mortgage- and asset-backed

securities and corporate bonds, as well as money market and funding instruments.

In recent years, the Association has sponsored both the American and the European

Securitization Forums. These are affiliated organizations that focus on the rapidly

growing securitization markets in the United States and Europe. Another Association-sponsored organization, the Asset Managers Forum, brings together institutions

that are active in the bond market as investors to address major operational, acVerDate 11-MAY-2000 17:55 Jul 12, 2006 Jkt 025856 PO 00000 Frm 00061 Fmt 6621 Sfmt 6621 28059.TXT SBANK4 PsN: SBANK4
58

counting, public policy, and market practice initiatives. The comments here reflect

the collective views of the Association and our forums.

The Bond Market Association is deeply involved in investor education. Although

most bond markets are dominated by large, sophisticated institutional investors, it

is our strong belief that retail investors must have sufficient background and data

to not only make informed investment decisions but also to realize that allocating

their assets in a diversified manner is an important investment strategy. Last week,

the Association launched an updated version of our award winning investor education website, Investinginbonds.com. The site provides investors with background,

news, data, and commentary on the bond markets in addition to bond prices. Included in this information is the very important credit rating that is attached to

most fixed-income investments.

We welcome the opportunity to testify here today on the role of credit rating agencies in the capital markets. The past 15 years have seen dramatic growth in the

number of issuers and the range and complexity of fixed-income securities. The importance of credit ratings to investors and other securities market participants has

increased proportionally. The role of rating agencies is critical to the efficient functioning of the fixed-income markets. It is both important and useful for this Committee to focus on an industry that plays such a vital role in the capital markets.

Credit Rating Agencies and the Fixed-Income Markets

All investments involve risk. One important type of risk associated with certain

bonds and other fixed-income investments is credit risk—the chance that a bond will

default, or the issuer will fail to make all interest and principal payments under

the bond’s terms. A credit rating is essentially an opinion offered by a rating agency

on the credit risk of a bond. The credit rating process employs both quantitative

tools and subjective judgment. In addition to analyzing a company’s balance sheet,

for example, credit ratings may also take into account subjective forecasts of the

issuer’s ability to generate revenue in the future. An investor can determine objective factors such as a security’s coupon, maturity, call features, and covenants from

the issuer’s mandated disclosure. Analysis of an issuer’s credit quality, however, involves individual judgments about a variety of complex financial and other information. A credit rating is a valuable complement to an investor’s own credit analysis

precisely because it is both expert and independent. Credit ratings also guide the

market’s pricing decisions. Bonds with lower ratings are viewed as riskier than

higher-rated bonds by investors who demand a yield premium as compensation for

this risk. Conversely, higher-rated bonds will offer a relatively lower yield as a reflection of their stronger credit standing. In addition, ratings play an important role

in market regulation.

Rating agencies in general, and certainly the more established agencies, approach

the rating process in similar ways. Rating analysts are grouped by market, such as

corporate, asset-backed, or municipal bonds, and industry or sector, such as financial services or transportation and rating decisions are made by committee. As part

of the process of gathering information, rating agency personnel maintain regular

contact with issuers and also rely on regulatory filings, news, and industry reports,

among other information. Nonpublic information, such as proprietary business forecasts, also may be available to rating agencies under promises of confidentiality and

under an exemption from the Securities and Exchange Commission’s (SEC) Regulation FD. The Association strongly supports maintaining this exemption.

Rating agencies generally inform issuers and investors of their rating methodologies for particular asset classes. These are detailed descriptions that provide useful

information to issuers and investors, and also help the rating agencies ensure the

consistency of their ratings even when different rating analysts are involved.

Once ratings are published, they are available to all market participants and the

public. To receive a detailed analysis of the rationale for the rating decision, however, generally requires a fee-based subscription. These subscription fees and the

fees paid by the issuer for the rating itself are the principal revenue sources for

most rating agencies. The ratings assigned by the three major firms by category are

shown in the chart below.

59

1One basis point equals 1/100th of a percentage point.

2 A majority of outstanding municipal debt is beneficially owned by individuals through mutual funds and individual holdings, but investment decisions for a majority of outstanding municipal bonds are made by professional money managers.

Capital market participants make use of rating information and interact with rating agencies differently depending on their role in the market. For issuers of fixedincome securities, credit ratings typically have a direct effect on the rate at which

they can borrow in the capital markets. As noted above, investors will assign a risk

premium on lower-rated securities to reflect the higher chance of default. The premium translates into a higher interest rate on the issuer’s debt, or an increase in

the cost of capital.

To better appreciate the relationship between ratings and yields it is important

to consider how the market prices bonds. With few exceptions, prices for fixed-income products are quoted as a number of basis points 1 over a benchmark such as

U.S. Treasury securities of a comparable maturity, the London Interbank Offered

Rate (LIBOR), the rate on interest rate swaps of comparable duration or some other

benchmark that represents an investment perceived to be free of credit risk. The

amount that the return on a given investment exceeds the return on the benchmark—a bond’s ‘‘credit spread’’—represents the risk premium investors receive as

a result of the degree of risk, principally credit risk, the investment carries. Higher

rated bonds have a smaller spread than lower-rated bonds of the same maturity.

As the chart below shows, the correlation between rating and spread is historically

consistent. It is a trusted metric that promotes market efficiency as it allows a participant to commoditize partially what are disparate assets. A bond dealer asked for

a quote on a corporate or municipal security, for example, will look not only at any

recent trades for the same security but also at the current yield on similar bonds

that have a similar credit rating.

Bond investors are overwhelmingly comprised of mutual funds, pension funds, endowments and asset management firms, and other institutions that employ sophisticated, professional money managers.2 As of the end of 2003, less than 10 percent

of all bonds outstanding in the United Stataes were held directly by individual investors, although in the tax-exempt municipal bond market that figure is about 35

percent. Institutional investors often conduct their own credit analysis of issuers but

also rely on credit ratings as part of their overall risk analysis.

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3 An investment grade rating is defined as at least a BBB rating offered by Fitch Ratings or

Standard and Poor’s or a Baa rating offered by Moody’s. A sub-investment grade rating, also

known as high-yield or speculative grade, is defined as any rating below investment grade. Some

institutional investors purchase a mix of investment grade and sub-investment grade bonds and

some specialize in sub-investment grade exclusively. 4 International Convergence of Capital Measurement and Capital Standards, Basel Committee

on Banking Supervision, June 2004. Page 35. The six criteria include objectivity, independence,

transparency, disclosure, resources, and credibility.

It is common for some institutional investors to have in-house rules limiting investment in any fixed-income security that does not have at least an investment

grade rating.3 Similarly, most States have laws dictating the permitted investments

of insurance companies on the basis of credit rating. Some States require two ratings. The National Association of Insurance Commissioners (NAIC) maintains a list

of rating agencies whose ratings are acceptable for this purpose.

Broker-dealers also use credit ratings to supplement proprietary credit analysis.

They also advise issuers of the effect of ratings on the cost of capital. Credit ratings,

of course, are also important to investors with whom broker-dealers interact in the

marketplace. In September 2004, the Corporate Debt Market Panel sponsored by

the National Association of Securities Dealers (NASD) released a report recommending the disclosure of credit ratings immediately prior to an investor’s decision

to buy or sell a bond as well as upon confirmation of a trade.

Credit ratings are also used in the regulation of broker-dealers and different types

of institutional investors. One notable example is the Securities and Exchange Commission’s net capital rule, which requires broker-dealers to maintain specified minimum capital levels to support their assets or customer liabilities. Since 1975, the

net capital rule has imposed different capital charges for assets depending upon

whether (and at what level) the assets are rated by what the SEC defined as a ‘‘Nationally Recognized Statistical Rating Organization’’ or NRSRO. Higher-rated securities receive a lower capital charge than lower-rated securities. Similarly, SEC-registered money market funds are permitted to invest in short-term debt securities

that receive one of the two highest NRSRO ratings. Investment grade ratings can

also provide an issuer with the option of short-form SEC registration in some cases.

The Bank for International Settlement’s Committee on Banking Regulation stipulates the use of credit ratings in assessing the capital charges for banks under the

new Basel Capital Accord, Basel II. Basel II articulates a set of criteria a firm must

satisfy in order to qualify as an External Credit Assessment Institution (ECAI)

which allow its ratings to be used in this calculation.4

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5 Report on the Role and Function of Credit Rating Agencies in the Operation of the Securities

Markets, U.S. Securities and Exchange Commission, January, 2003. Rating Agencies and the Use

of Credit Ratings Under the Federal Securities Laws, S.E.C. Concept Release June 2003.

* Held in Committee files.

TBMA Response to United States and European Regulatory Proposals

Recently, regulators in the United States and Europe have stepped up their focus

on rating agencies and raised the prospect of changes in the current approach to

regulatory oversight. The Association’s view on the regulation of credit rating agencies is simple:

• We believe that the criteria adopted by regulators for approving NRSRO’s or

ECAI’s should be flexible enough to allow increased competition between a larger

number of entities, while ensuring that designated rating agencies have the expertise to produce accurate ratings. In the United States, this means eliminating

the current requirement that a rating agency be widely recognized, rather than

accepted in a defined sector of the market.

• We believe credit rating agencies should have policies and procedures to ensure

the independence of the credit rating process.

• We believe credit rating agencies should publish their rating methodologies for

various types of securities, so that both issuers and users will understand the

agencies’ requirements and standards, and so that different rating analysts in the

same agency will produce consistent ratings.

• We do not believe that regulation of the credit rating process is necessary or desirable, since Government regulation would tend to result in less diversity of opinion

and would be less responsive to new product developments.

• We believe issuers should be given an opportunity to correct factual misstatements in rating agency reports, but not to appeal rating designations outside the

rating agency.

• We believe rating agencies should publish information on the historical accuracy

of their rating assessments.

As the capital markets develop and mature globally, the need for a measured approach by regulators toward the conduct of rating agencies grows in importance.

The Association does support those actions by regulators—such as modifying the criteria for NRSRO designation—that we believe will help enhance competition among

rating agencies. We do not support steps that would limit the independence of rating agencies to determine their opinions of the creditworthiness of issuers.

For more than a decade, the SEC has contemplated a rulemaking to address the

credit rating industry, the role it plays in the securities market and how it should

be regulated. A 1994 concept release led to a proposed rule in 1997 that would have

set new criteria for NRSRO status. The SEC did not act on the proposal but in 2003

issued a report 5 in accordance with the Sarbanes-Oxley Act followed by a concept

release. The concept release addressed questions of NRSRO regulation, potential

conflicts of interest between rating agencies and issuers and competition within the

industry. (The Association’s 2003 response to the concept release is attached in appendix 1.) *

In response to the concept release, the Association filed a comment letter endorsing the NRSRO designation with some clarification to address competition and other

issues. Generally speaking, the Association acknowledges the important role rating

agencies play in the capital markets. All market participants—investors, dealers,

issuers (and their advisors), and regulators—count on rating agencies as reliable

sources of analysis whose judgments are sound. A number of statistical studies show

a correlation between strong ratings and a low probability of default. At the same

time, rating agencies cannot be expected to evaluate risk perfectly. Their analysis

relies on the integrity of an issuer’s disclosure.

In 2004, the International Organization of Securities Commissions (IOSCO), of

which the SEC is a member, proposed a code of conduct for rating agencies, which

was followed by a request from the European Commission for public input on how

the code of conduct should be implemented. In response, the Committee of European

Securities Regulators (CESR) produced a consultative paper suggesting a range of

regulatory approaches based on the IOSCO principles. In our comments to CESR,

The Association’s position on the regulatory proposals dealing with the credit rating

process in the United States and Europe is centered on the fundamental issues of

competition and market conduct. (The Association’s response to both IOSCO and

CESR can be found in appendix 2.) *

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Competition

Some observers have questioned whether the credit rating industry is as competitive as it should or could be and suggest that inappropriate barriers to entry exist.

In the United States, the nature of the NRSRO designation is often brought up as

a factor in this debate. The Association supports the retention of this designation.

We have also called for greater clarity in the SEC’s approval policy and the elimination of the requirement that a rating agency be ‘‘widely accepted’’ in order to gain

the designation. The Association certainly welcomes additional entrants to the marketplace from any part of the globe. Increasing competition among qualified rating

agencies could only benefit issuers, investors, and the market generally.

The Association responded to the 2003 concept release with suggestions for improving the transparency of the designation process. Increased transparency will aid

public understanding of the process and improve the ability of other rating agencies

to gain the NRSRO designation leading to enhanced competition in the industry.

The SEC should adopt a formal and standardized application process. Applications

should be public and the subject of public comment. Applicants likely to receive an

adverse decision should have the option to withdraw their applications to prevent

the release of proprietary information. The SEC’s reasons for accepting or rejecting

an application should be explicitly stated and existing NRSRO’s should also complete the application process to ensure uniform treatment.

At present, the SEC primarily considers whether an agency is ‘‘widely accepted’’

when deciding whether to grant NRSRO status. Other factors such as an agency’s

financial resources, staff experience, independence, and rating procedures are also

considered. The Association believes the ‘‘widely accepted’’ standard should be relaxed in the cases where a rating agency meets all other criteria but happens to

specialize in only a single market or industry or geographic sector. The NRSRO status of such a rating agency could be limited to its area of expertise. This will reduce

barriers to entry and enhance competition. An obvious way to increase the number

of agencies whose ratings are widely accepted is to approve niche credit raters

which can then—after gaining experience and market acceptance—expand to cover

a broader range of industries and securities.

In Europe, CESR has listed barriers to entry that exist in the credit rating field

and asked how regulators should address them. The credit rating industry is difficult to penetrate for new firms. Much of the value the market assigns to credit

ratings is based on reputation and track record, something new entrants necessarily

lack. This dynamic, however, is not unique to the rating industry and CESR itself

has described barriers as ‘‘natural.’’ It also has not created a market failure or a

condition in which a segment of issuers goes without service. The flexibility of an

IOSCO-type code-of-conduct approach, as opposed to detailed regulation of rating

agency business practices, will facilitate the entrance and expansion of new credit

rating agencies in the market.

The NRSRO designation serves a unique purpose in SEC regulations for which

a substitute is either not available or not practical. Using credit spreads or internal

credit ratings as alternatives to NRSRO ratings for computing net capital requirements is possible, for example, but would add significant costs. In addition, in the

case of internal ratings it could result in the nonuniform treatment of the same assets by different firms.

Rules of Conduct

The day-to-day operations of rating agencies should never be controlled by regulation. With respect to both the United States and Europe, specific rating methodologies and standards of due diligence should not be mandated by regulators. The

rating process is subjective in some respects and cannot be evaluated for appropriateness by a Government agency. The Association does believe it would be appropriate for rating agencies to disclose internal statistics on the accuracy of their ratings. Government mandates of rating methodology, however, could be construed as

a Government approval of securities that receive high ratings from designated rating agencies. It would also effectively eliminate differences in the analysis of competing rating agencies and undermine the value of independent credit analysis.

Similarly, while conflicts of interest between rating agencies, issuers, and subscribers may exist, it would not be appropriate for regulators to prescribe specific

methods for dealing with the issue. A more favorable approach—and one the IOSCO

code now requires—would be for rating agencies to adopt policies and procedures

to address and disclose potential conflicts of interest, such as issuer and subscriber

influence and the potential misuse of public information. It is the view of some institutional investors—particularly with respect to structured finance products—that

such policies and procedures should be designed to discourage participation in the

practice known as ‘‘ratings shopping,’’ a situation in which an issuer employs a ratVerDate 11-MAY-2000 17:55 Jul 12, 2006 Jkt 025856 PO 00000 Frm 00066 Fmt 6621 Sfmt 6621 28059.TXT SBANK4 PsN: SBANK4
63

1Section 3(a)(41) of the Exchange Act was added by the Secondary Mortgage Market Enhancement Act of 1984, Pub. L. No. 98–440, § 101, 98 Stat. 1689, 1689 (1984). 2 H.R. Rep. No. 994, 98th Cong., 2d Sess. 46 (1984) (appending Statement of Charles C. Cox,

Commissioner, Securities and Exchange Commission, to the Subcommittee on Telecommunications, Consumer Protection, and Finance of the House Committee on Energy and Commerce,

Mar. 14, 1984).

ing agency based on real or perceived differences in methodology that could result

in more favorable ratings.

Conclusion

The Association is pleased to offer the above comments on credit rating agencies.

As we have noted, the credit rating industry plays an important and unique role

in the capital markets. It is also an industry whose integrity is effectively ensured

by market discipline. Rating agencies that appear biased or corrupt or supply dishonest analyses would find their services without value. Regulators can best ensure

the credit rating industry remains robust and independent by endorsing a principles-based approach to industry oversight, like the IOSCO Code, that supports

competition but does not dictate specific methodologies or other rules of conduct.

Regulators need to address the barriers to entry by clarifying the criteria for designating NRSRO’s and changing the ‘‘widely recognized’’ requirement so niche players

can enter the market.

—————

PREPARED STATEMENT OF YASUHIRO HARADA

EXECUTIVE VICE PRESIDENT, RATING AND INVESTMENT INFORMATION, INC.

FEBRUARY 8, 2005

Thank you, Chairman Shelby, Ranking Member Sarbanes, and Members of the

Senate Banking Committee for your kind invitation to present testimony at today’s

hearing entitled ‘‘Examining the Role of Credit Rating Agencies in the Capital Markets.’’

We are very pleased to offer our thoughts on this topic as well as some more specific information about the challenges faced by our firm, Rating and Investment Information, Inc. (R&I), a credit rating agency headquartered in Tokyo, as we have

sought to clear the hurdles necessary to become an effective new competitor in the

United States market. Even though R&I is the most recognized credit rating agency

in Japan and the broader Asian markets, obtaining designation in the U.S. as a

‘‘Nationally Recognized Statistical Rating Organization’’ (NRSRO) has been an exercise in delay and disappointment.

Background Regarding Credit Rating Agencies as NRSRO’s

Investors and market professionals historically have used securities ratings issued

by credit rating agencies to gauge the creditworthiness of a particular issue. The

SEC significantly expanded the traditional use of ratings in 1975 when it adopted

Rule 15c3–1 (the Net Capital Rule) under the Securities Exchange Act of 1934 (Exchange Act). The Net Capital Rule incorporated credit ratings by NRSRO’s in certain of its provisions. Rather than use securities ratings as a measure of creditworthiness, the Net Capital Rule created the NRSRO concept to measure liquidity.

Currently, there are four rating agencies designated by the SEC as NRSRO’s for

purposes of the Net Capital Rule.

Since 1975, however, the use of NRSRO ratings in the Federal securities laws and

regulations has expanded considerably beyond a measure of a security’s liquidity,

as has reliance on those ratings by investors and the marketplace. The term

‘‘NRSRO’’ remains undefined in SEC regulations, and the informal process for determining who is an NRSRO remains unchanged—a credit rating agency seeking

NRSRO status must ‘‘apply’’ to the SEC’s Division of Market Regulation for a noaction letter. Meanwhile, both Congress and the SEC have on numerous occasions

incorporated the NRSRO concept for other purposes, primarily as indicia of a security’s creditworthiness—the historical and predominant use of securities ratings.

Congress, for example, employed the term NRSRO when it defined ‘‘mortgage related security.’’ 1 However, Congressional reliance on the term used in SEC rules is

significant because it reflects a recognition that the ‘‘term has acquired currency as

a term of art.’’ 2 The SEC also has incorporated the term ‘‘NRSRO’’ in various

rulemakings under the Securities Act of 1933, the Exchange Act, the Investment

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3The SEC currently employs the NRSRO concept in the following rules: 17 CFR 228.10(e),

229.10(c), 230.134(a)(14), 230.436(g), 239.12, 239.33, 240.3a1–1(b)(3), 2401.10b–10(a)(8),

240.15c3–1(c)(2)(vi)(E), (F), and (H), 240.15c3–1a(b)(1)(i)(C), 240.15c3–1f(d), 242.101(c)(2),

242.102(d), 242.300(k)(3) and (1)(3), 270.2a–7(a)(10), 270.3a–7(a)(10), 270.3a–7(a)(2), 270.5b–3(c),

and 270.10f–3(a)(3). 4Letter from Antitrust Division of the U.S. Department of Justice in the matter of File No.

S7–33–97 Proposed Amendments to Rule 15c3–1 under the Securities Exchange Act of 1934

(Mar. 6, 1998).

Company Act of 1940, and the Investment Advisers Act of 1940 for purposes well

beyond those originally intended under the Net Capital Rule.3

Flaws in the NRSRO Process

In order to compete effectively in the U.S. market, a designation by the SEC as

an NRSRO is a critical factor in the industry. In addition to the NRSRO application

process having little regulatory guidance and/or an established timetable for agency

decisionmaking, the specific entry barrier for R&I and other companies is the SEC

requirement that a new NRSRO be ‘‘nationally recognized.’’ In essence, this means

that the rating agency must be ‘‘widely accepted in the United States’’ as an issuer

of credible ratings by predominant users of such ratings before it can gain such a

designation to enter the U.S. market. As can be seen, this is a circular test. It was

precisely this circular standard which the Antitrust Division of the U.S. Department

of Justice singled out in 1998 as likely to preclude new competitors in this credit

rating market.4 Moreover, concern about the lack of new competitors in this market

led the Justice Department to recommend to the SEC in 1998 that NRSRO designation be specifically awarded to some foreign rating agencies.

R&I’s NRSRO Application

As noted, R&I is the largest and most recognized Asian rating agency. It is

headquartered in Japan, the second largest economy in the world. R&I is a respected independent source of financial information for the overwhelming majority

of United States broker-dealers and financial institutions that conduct operations in

Japan, and provides a variety of ratings services to United States and foreign companies. Market participants particularly appreciate that R&I calculates and publishes a ‘‘broad-definition default ratio’’ based on a 27-year record which indicates

the probability that an issuer that has been given a publicly released rating will

fall into default within that given period of time. R&I’s ratings are regularly announced and published by the leading financial electronic and print media in Japan,

and in the United States as well.

In regard to your Committee’s specific request for a discussion of our agencies’ internal ratings process we present the following overview of the R&I rating team’s

procedures. The rating team is responsible for reviewing financial information regarding the issuer and the terms of the instrument to be issued. The team reviews

both publicly available information and confidential information obtained from the

issuer. Teams generally review the financials of the issuer from the prior 5 years,

as well as forecasts for the next 3 years.

R&I staff, including at least one senior analyst, will visit the senior management

of the issuer as part of a detailed due diligence exam of the issuer. This on-site due

diligence examination typically lasts several days. During the visit, the team meets

with the chief executive officer of the issuer, holds various meetings with senior executives in the areas of finance, planning and development, production, sales, and,

where applicable, may schedule an inspection of plants and/or other facilities. The

meetings include both issuer presentations and detailed, extensive interview sessions with senior management. Particular attention is focused on the issuer’s

cashflow and overall financial stability. Each rating team considers industry trends,

sector volatility, and any relevant geopolitical or economic risk. The rating team also

conducts intercompany comparisons, taking into consideration any relevant geopolitical, currency, or economic risk.

Once the initial analysis is complete, each team’s written report is scrutinized in

R&I’s intensive committee review process. The team’s report and recommendation

initially is submitted to the Rating Committee. R&I has three classifications of Ratings Committees: The Plenary Committee, the Standing Committee, and the Subcommittee. The Plenary Committee is the most senior committee and serves as an

‘‘appellate’’ body for the other committees, addressing any controversial or novel rating that is under consideration by the other committees. The Standing Committee

evaluates the majority of the proposed ratings, and the Subcommittee reviews ratings that are less likely to change than other ratings, such as ongoing ratings of

previously rated issues or issuers. R&I management is generally prohibited from

participating in the Rating Committee. In exceptional circumstances, and only with

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5Press Statement, ‘‘Financial Oversight of Enron: The SEC and Private-Sector Watchdogs,’’

Chairman Joe Lieberman, October 7, 2002. 6 House Committee on Financial Services, Subcommittee on Capital Markets, Insurance and

Government Sponsored Enterprises, ‘‘Rating the Rating Agencies: the State of Transparency and

Competition,’’ hearing on April 2, 2003, and ‘‘The Ratings Game: Improving Transparency and

Competition Among the Credit Ratings Agencies,’’ held on September 14, 2004. 7 ‘‘End the Government-Sponsored Cartel in Credit Ratings’’ by Alex Pollock, AEI Financial

Services Outlook, January 2005.

express authorization of R&I’s Board of Directors, R&I senior executives may observe the Rating Committee meetings, but cannot vote on any matter discussed by

the Rating Committee.

For over a decade, R&I and its predecessors have engaged the SEC in an effort

to receive NRSRO designation. This began in October 1990, when the Japan Bond

Research Institute (JBRI) submitted a letter to the SEC requesting designation as

an NRSRO. In January 1991, Nippon Investors Services, Inc. (NIS) submitted its

request for NRSRO designation. While there was some interaction with the SEC following these applications neither entity received a formal response from the SEC.

On April 1, 1998, NIS and JBRI merged to form R&I and in July 1998, R&I submitted a follow-up letter to the SEC requesting that R&I be designated as an

NRSRO. This led to some discussion with the SEC staff after which R&I submitted

an amended request for NRSRO designation in January 2002. The 2002 request was

limited in scope in that R&I sought to be recognized as an NRSRO solely with respect to yen-denominated securities. R&I’s expertise in yen-denominated securities

is recognized throughout the world’s financial markets and by the leading financial

institutions in the United States. There is past precedent for the SEC to designate

limited-purpose NRSRO’s including the designation of two agencies, in particular,

IBCA and Thompson BankWatch, Inc., as NRSRO’s for limited purposes. Such recognition on a limited-basis was considered appropriate if a rating agency could demonstrate that it possesses unique expertise in rating particular securities, or securities of particular currency denomination. As a practical matter, investors and the

marketplace will be significantly deprived of the full benefit of this expertise unless

the rating agency is recognized as a NRSRO, at least with respect to those securities

issues in which the rating agency has expertise.

Recent Developments

In early 2002, the Senate Committee on Government Affairs held a series of hearings into the collapse of Enron. In a follow-up staff report on Enron, hearings

focused, among other things, on the fact that there were only three major NRSRO

operating in the United States.5—a situation which continues to this day. As this

Committee is aware, the Sarbanes-Oxley Act of 2002 required that the SEC then

conduct a study of the role of credit rating agencies in the U.S. securities markets

and submit a report regarding its study to the President and Congress.

In November 2002, as part of its study, the SEC held 2 full-days of hearings attended by a variety of academics, credit rating agencies, and consumers of ratings

reports such as investment companies. R&I submitted written comments to the SEC

prior to these hearings. Additionally, I participated in the SEC Roundtable forum

on November 21, 2002. In January 2003, the SEC issued its report which included

its plans to issue a concept release within 60 days of the report to seek comment

on issues that would form the basis of proposed rules with respect to credit rating

agencies. In February 2003, shortly after issuing its report, the SEC approved a

fourth credit rating agency as a new NRSRO. In June 2003, the SEC issued a concept release on credit rating agencies and the administration of the NRSRO application process. R&I promptly submitted its comments on the concept release. Since

publication of the SEC’s concept release, there has been additional public action

with respect to credit rating agencies including two additional hearings in the

House Financial Services Committee,6 a three-part series in The Washington Post

that focused mainly on the lack of competition in the credit rating industry which

appeared in November 2004, and most recently a white paper on the subject published by the American Enterprise Institute.7

Action Sought with Respect to R&I’s Application

It is essential that additional qualified credit rating agencies be recognized as

NRSRO’s to increase the quality of the oversight function that such credit rating

agencies play in the U.S. securities markets. Each additional NRSRO will benefit

investors and the financial markets by improving the availability of important financial information and analysis. Considering the pace and uncertainty of any regulatory change, pending NRSRO applications, including R&I’s application, should

receive prompt attention.

66

Despite the increased interest and attention directed at credit rating agencies

since the submission of R&I’s January 2002 NRSRO request, there has been no appreciable progress with respect to R&I’s application. Eight leading Wall Street investment-banking firms and two major U.S. insurance companies have written to

the SEC to support R&I’s NRSRO designation. R&I understands that the future

regulation of credit rating agencies and the use of the NRSRO designation is in

transition, particularly in light of the concept release and continuing Congressional

hearings; however, without such designation, we operate at a competitive disadvantage every day under the current regulatory scheme. R&I is well-qualified to contribute to the flow of information and expert analysis so valuable to U.S. investors

and issuers. Therefore, the lack of progress on R&I’s application harms both R&I

and investors. If allowed to enter the market, U.S. investors, especially institutional

investors such as insurance companies, would benefit from having an additional

source of proven credit analyses and U.S. issuers benefit from having more providers of rating services in the Samurai bond market. Until such time as a new regulatory scheme is implemented with respect to credit rating agencies (which could

be years away, if ever), we respectfully suggest the SEC should be focusing on approving qualified NRSRO’s. We encourage the Committee to advise the SEC not to

neglect pending NRSRO applications nor require such applicants to await further

rulemaking prior to approval.

Appropriate Type of Regulatory Oversight for Credit Rating Agencies

It would be appropriate and fair to regularly check if rating agencies recognized

as NRSRO’s have been maintaining their original qualification criteria. This can be

accomplished by requiring NRSRO’s to submit reports to the SEC indicating past

performance and continuing qualification. Such submissions should be disclosed to

the public. If the SEC determines that a particular NRSRO fails to satisfy all of

the necessary criteria, such rating agency should be required to immediately rectify

the situation. If, after one year’s probation period, such an NRSRO still fails to all

of the criteria, the NRSRO recognition should be revoked.

The SEC should review an NRSRO’s continuing compliance with the original

qualification criteria. If there is any reason to believe that an NRSRO has failed

to meet any of the original qualification criteria at any time, the SEC should be able

to conduct a review of the particular NRSRO in question. The evaluation of the

overall quality and performance of NRSRO’s generally should be deferred to market

participants.

If the Committee has any questions regarding R&I, its operations, or its application with the SEC for NRSRO status, we would be glad to respond to any requests

for information. We earnestly seek a timely review and a speedy determination regarding R&I’s NRSRO application. Thank you for the opportunity to present these

views.

—————

PREPARED STATEMENT OF STEPHEN W. JOYNT

PRESIDENT AND CHIEF EXECUTIVE OFFICER, FITCH RATINGS

FEBRUARY 8, 2005

Introduction

Fitch Ratings traces it roots to the Fitch Publishing Company established in 1913.

In the 1920’s, Fitch introduced the now familiar ‘‘AAA’’ to ‘‘D’’ rating scale. Fitch

was one of the three rating agencies (together with Standard & Poor’s (S&P) and

Moody’s Investors Service (Moody’s)) first recognized as a Nationally Recognized

Statistical Rating Organization (a so-called ‘‘NRSRO’’) by the Securities and Exchanges Commission (SEC) in 1975.

Since 1989 when a new management team recapitalized Fitch, Fitch has experienced dramatic growth. Throughout the 1990’s, Fitch especially grew in the new

area of structured finance by providing investors with original research, clear explanations of complex credits and more rigorous surveillance than the other rating

agencies.

In 1997, Fitch merged with IBCA Limited, another NRSRO headquartered in London, significantly increasing Fitch’s worldwide presence and coverage in banking, financial institutions, and sovereigns. Through the merger with IBCA, Fitch became

owned by Fimalac, a holding company that acquired IBCA in 1992. The merger of

Fitch and IBCA represented the first step in our plan to respond to investors’ needs

for an alternative global, full-service rating agency capable of successfully competing

with Moody’s and S&P across all products and market segments.

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Our next step in building Fitch into a global competitor was our acquisition of

Duff & Phelps Credit Rating Co., an NRSRO headquartered in Chicago, in April

2000 followed by the acquisition later that year of the rating business of Thomson

BankWatch. These acquisitions strengthened our coverage in the corporate, financial institution, insurance, and structured finance sectors, as well as adding a significant number of international offices and affiliates.

As a result of this growth and acquisitions, Fitch today has approximately 1,600

employees, including over 750 analysts, in over 49 offices and affiliates worldwide.

Fitch currently covers over 4,400 corporations, banks and financial institutions, 86

sovereigns, and 40,000 municipal offerings in the United States. In addition, we

cover over 7,500 issues in structured finance, which remains our traditional

strength.

Fitch is in the business of publishing research and independent ratings and credit

analysis of securities issued around the world. A rating is our published opinion as

to the creditworthiness of a security, distilled into a simple, easy to use grading system (AAA to DDD). Fitch typically provides explanatory information with each rating.

Rating agencies gather and analyze a variety of financial, industry, market, and

economic information, synthesize that information, and publish independent, credible assessments of the creditworthiness of securities and issuers, thereby providing

a convenient way for investors to judge the credit quality of various alternative investment options. Rating agencies also publish considerable independent research

on credit markets, industry trends, and economic issues of general interest to the

investing public.

By focusing on credit analysis and research, rating agencies provide independent,

credible and professional analysis for investors more efficiently than investors could

perform on their own.

We currently have hundreds of institutional investors, financial institutions, and

Government agencies subscribing to our research and ratings, and thousands of investors and other interested parties that access our research and ratings through

our free website and other published sources and wire services such as Bloomberg,

Business Wire, Dow Jones, Reuters, and The Wall Street Journal.

A diverse mix of both short-term and long-term investors uses our ratings as a

common benchmark to grade the credit risk of various securities.

In addition to their ease of use, efficiency and widespread availability, we believe

that credit ratings are most useful to investors because they allow for reliable comparisons of credit risk across diverse investment opportunities.

Credit ratings can accurately assess credit risk in the overwhelming majority of

cases and have proven to be a reliable indicator for assessing the likelihood that a

security will default. Fitch’s most recent corporate bond and structured finance default studies are summarized below.

The performance of ratings by the three major rating agencies is quite similar.

We believe this similarity results from the common reliance on fundamental credit

analysis and the similar methodology and criteria supporting ratings.

68

Through the years, NRSRO ratings also have been increasingly used in safety and

soundness and eligible investment regulations for banks, insurance companies, and

other financial institutions. While the use of ratings in regulations has not been

without controversy, we believe that regulators rely on ratings for the same reason

that investors do: Ease of use, widespread availability, and proven performance over

time.

Although one can use other methods to assess the creditworthiness of a security,

such as the use of yield spreads and price volatility, we believe that such methods,

while valuable, lack the simplicity, stability, and track record of performance to supplant ratings as the preferred method used by investors to assess creditworthiness.

However, we also believe that the market is the best judge of the value of ratings.

We believe that if ratings begin to disappoint investors they will stop using them

as a tool to assess credit risk and the ensuing market demand for a better way to

access credit risk will rapidly facilitate the development of new tools to replace ratings and rating agencies.

Regulatory Review of Rating Agencies

Beginning in 2002, the SEC began a thorough study of rating agencies that included informal discussions with Fitch and the other rating agencies, a formal examination of our practices and procedures, and two full days of public hearings in

November 2002 in which we participated. Following the passage of the SarbanesOxley Act of 2002, the SEC issued its Report on the Role and Function of Credit

Rating Agencies in the Operation of the Securities Market in January 2003. In June

2003, the SEC issued a concept release, Rating Agencies and the Use of Credit Ratings under the Federal Securities Laws, soliciting public comment on a variety of

issues concerning credit rating agencies.

In the international arena, in the summer of 2003, a working group of the International Organization of Securities Commissions (IOSCO), under the leadership of

SEC Commissioner Roel Campos, began its study of the credit rating agencies. Fitch

was an active participant in the IOSCO process that ultimately led to the publication by IOSCO of the Statement of Principles Regarding the Activities of the Credit

Rating Agencies in September 2003 and the Code of Conduct Fundamentals for

Credit Rating Agencies at the end of last year.

Given the importance of credit ratings in the financial market, we agree that

there is a strong need for credit rating agencies to maintain high standards. For

that reason, throughout the past 3 years Fitch has participated actively in the dialogue at the SEC, IOSCO, and on a local level throughout the world about the role

and function of the rating agencies in the worldwide capital markets.

Fitch supports the four high-level principles outlined by IOSCO as announced in

it Principles in September 2003, which the IOSCO Code complements. These four

principles include transparency and symmetry of information to all market participants, independence, and freedom from conflict of interest. We are supportive of the

IOSCO Code and we believe that our present operating policies and practices exemplify the principles of the IOSCO Code and will continue to work with all capital

markets participants to refine ‘‘best practices’’ for the ratings industry. We plan to

publish our formal code of conduct, together with our existing policies that complement it, by the end of the first quarter of this year.

Testimony

Set forth below is a summary of our views on the issues we understand the Committee on Banking, Housing, and Urban Affairs intends to explore at its hearing

‘‘Examining the Role of Credit Rating Agencies in the Capital Markets.’’

NRSRO Recognition Process And Criteria

We believe that the SEC should formalize the process by which it recognizes rating organizations. The application process, specific recognition criteria, and time

frames for action on all applications should be specified in appropriate regulations.

We believe public comment should be solicited on applications and an appropriate

appeal process should be put in place.

The criteria for recognition should include an evaluation of the organization’s resources, its policies to avoid conflicts of interest and prevent insider trading and the

extent to which market participants use the organization’s ratings. Most importantly, however, recognition should be based upon the organization demonstrating

the performance of their ratings over time by publication of actual default rates experienced in rating categories and transition studies showing the actual movement

of ratings over time. When considering a rating organization for possible recognition, we believe the SEC should evaluate the default and transition experience of

each organization’s ratings against a benchmark reflecting the aggregate, historical

default, and transition rates of all ratings issued by rating agencies in the market.

69

Ultimately, we believe that recognition should be reserved for those organizations

that prove the performance of their ratings over time relative to the performance

of other rating systems.

We also believe that the SEC should continue the practice of limited recognition

that acknowledges the special expertise of smaller organizations in selected areas

of specialty or geographic regions such as the prior recognition afforded to IBCA and

BankWatch for their expertise in financial institution analysis.

Fitch does not believe that a criterion for recognition should be adherence to generally accepted industry standards. In fact, such industry standards do not exist in

the case of credit rating agencies and we believe that it would be detrimental to

introduce them. Ratings are opinions, and as such are based on differing criteria,

qualitative and quantitative, in each agency. The market benefits from this diversity

of opinion, and demands it. Requiring that a rating agency abide by strict standards

would create a situation in which each agency would produce the same result on

each credit and there would be no need for competing agencies or any benefit from

competing agencies.

Examination and Oversight of NRSROS

Fitch acknowledges the Commission’s right to revoke the recognition of any

NRSRO that no longer meets the criteria for recognition. Given the importance of

credit ratings in the financial markets, we believe this is an important need. As we

discussed in connection with the criteria for recognition, we also believe that the examination and oversight of NRSRO’s should be principally focused on the performance of a rating organization’s ratings over time relative to the performance of other

rating systems. Accordingly, we believe that the Commission’s principal oversight

function should be to evaluate regularly the default and transition experience of

each organization’s ratings against an aggregate benchmark. Additionally, we also

acknowledge the importance of our adherence to policies designed to prevent the

misuse of inside information and the need of the Commission to ensure compliance

with these important policies.

In addition, we believe that any oversight should be narrowly tailored to recognize

the constitutional rights of the rating agencies, which function as journalists and

thus should be afforded the high level of protection guaranteed by the First Amendment. An excessive amount of interference with the business of rating agencies

would both violate the First Amendment rights of the agencies and remove some

of the flexibility in the ratings process that is critical to objective and timely ratings.

Within this framework, a narrowly tailored oversight scheme specific to rating

agencies should be developed. While the rating agencies currently file voluntarily

under the Investment Advisor’s Act, this is not a ‘‘good fit,’’ as our agencies function

as journalists, providing analysis and opinion, and not as investment advisers. As

the Supreme Court recognized in Lowe, Congress ‘‘did not seek to regulate the press

through the licensing of nonpersonalized publishing activities’’ when it enacted the

Investment Advisors Act, but rather was ‘‘primarily interested in regulating the

business of rendering personalized investment advice.’’ Lowe v. SEC, 472 U.S. 181,

204 (1985). Fitch does not provide any personalized investment advice; indeed, even

Fitch’s nonpersonalized ratings do not make any recommendations to buy or sell

particular securities, but rather simply analyze the creditworthiness of a security,

a point noted by the SEC staff in its June 4, 2003 response to questions from Congressman Richard H. Baker. Fitch is therefore not an ‘‘investment advisory business’’ within the meaning of the Investment Advisors Act and to try to make the

Investment Advisors Act apply to Fitch and other rating agencies would not be productive.

In the same vein, it would be unsound to seek to impose a diligence requirement

on rating agencies either for purposes of creating a private right of action or for

oversight purposes. Even putting aside the significant and in our view insurmountable issues of statutory authority and constitutionality, rating agencies do not now

audit or verify the information on which they rely, and to impose such a requirement would duplicate the work of the various professionals (auditors, lawyers, investment bankers, and fiduciaries) upon whom the law does place certain obligations of diligence and due care.

Conflicts of Interest

Over the years, there has been considerable discussion about the fact that the current NRSRO’s derive a significant portion of their revenue from the ratings fees

charged to issuers of rated securities. Fitch does not believe that the fact that

issuers generally pay the rating agencies’ fees creates an actual conflict of interest,

that is, a conflict that impairs the objectivity of the rating agencies’ judgment about

creditworthiness reflected in ratings. Rather, it is more appropriately classified as

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a potential conflict of interest, that is, something that should be disclosed and managed to ensure that it does not become an actual conflict. We believe the measures

that Fitch uses to manage the potential conflict adequately prevent an actual conflict of interest from arising.

Charging a fee to the issuer for the analysis done in connection with a rating,

dates back to the late 1960’s. Investors, who are the ultimate consumers of the rating agency product, are quite aware of this.

By way of context, Fitch’s revenue comes from two principal sources: The sale of

subscriptions for our research, and fees paid by issuers for the analysis we conduct

with respect to ratings. In this we are similar to other members of the media who

derive revenue from subscribers and advertisers that include companies that they

cover. Like other journalists, we emphasize independence and objectivity because

our independent, unbiased coverage of the companies and securities we rate is important to our research subscribers and the marketplace in general.

Fitch goes to great lengths to ensure that our receipt of fees from issuers does

not affect our editorial independence. We have a separate sales and marketing team

that works independently of the analysts that cover the issuers. In corporate finance

ratings, analysts generally are not involved in fee discussions. Although structured

finance analysts may be involved in fee discussions, they are only the most senior

analysts who understand the need to manage any potential conflict of interest.

We also manage the potential conflict through our compensation philosophy. The

revenue Fitch receives from issuers covered by an analyst is not a factor in that analyst’s compensation. Instead, an analyst’s performance, such as the quality and

timeliness of research, and Fitch’s overall financial performance determine an analyst’s compensation. Similarly, an analyst’s performance relative to his or her peers

and the overall profitability of Fitch are what determine an analyst’s bonus. The financial performance of an analyst’s sector or group does not factor into their bonuses.

Fitch does not have an advisory relationship with the companies it rates. It always maintains full independence. Unlike an investment bank, our fees are not

based on the success of a bond issue or tied to the level of the rating issued. The

fee charged an issuer does not go up or down depending on the ratings assigned

or the successful completion of a bond offering.

Our fee is determined in advance of the determination of the rating and we do

not charge a fee for a rating unless the issuer agrees in advance to pay the fee.

While we do assign ratings on an unsolicited basis, we do not send bills for unsolicited ratings. Any issuer may terminate its fee arrangement with Fitch without fear

that its rating will be lowered, although we do reserve the right to withdraw a rating for which we are not paid or if there is insufficient investor interest in the rating to justify continuing effort to maintain it.

As noted above, Fitch believes that the disclosure of the arrangement by which

an issuer pay fees to Fitch in connection with Fitch’s ratings of the issuer is appropriate. Accordingly, Fitch currently discloses that it receives fees from issuers in

connection with our ratings as well as the range of fees paid. This has been our

practice for sometime.

Another concern discussed by the SEC in the Concept Release is that subscribers

have preferential access to rating analysts and may obtain information about a rating action before it is available to the general public. This concern is completely unwarranted in the case of Fitch. Fitch takes great efforts to ensure that all members

of the public have access to our ratings and may discuss those ratings with our analysts, whether or not those interested parties are subscribers.

All public ratings and rating actions are widely disseminated through our web

sites and international wire services. Except for prior notification to the issuer of

a rating or rating action, Fitch never selectively discloses ratings and rating actions

to any subscriber or any other party. Fitch’s ratings and related publications, including those detailing rating actions, are widely available through our public

websites and wire services free-of-charge and there are no prior communications of

rating actions to subscribers.

Fitch analysts do regularly conduct informal conversations with investors, other

members of the financial media, and interested parties discussing our analysis and

commentary, but as a matter of policy, those conversations can never go beyond the

scope of our published analysis or communicate any nonpublic information. We believe that making our analysts available to anyone interested in discussing our

analysis is a valuable service to investors and the capital markets at large. The contact information for the principal analysts and other key contact people at Fitch is

included in every item we publish for the purpose of facilitating interested parties

posing questions to our analysts. Anyone can call our analysts free-of-charge and

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discuss our analysis with them, whether or not the person is a subscriber to our

subscription services.

From time to time, we also hold free telephone conferences that are available to

anyone interested, at which our analysts will discuss our published analysis and criteria and take questions from the participants. These telephone conferences are

publicly announced in the same manner our ratings and rating actions are disseminated.

We also sponsor conferences throughout the world, as well as participate in conferences sponsored by others (which may sometimes require payment of a registration fee) at which our analysts will discuss our published analysis and criteria. Fitch

publicly advertises these conferences and all are welcome.

In addition, we firmly believe that existing antifraud remedies are sufficient to

deter any inappropriate disclosures by rating agencies to subscribers or any other

parties.

Concern has also been raised about the potential conflicts of interest that may

arise when rating agencies develop ancillary fee-based businesses. Over the years,

revenue derived by Fitch from nonrating sources, including consulting and advisory

services has been minimal. Historically, the bulk of such services related to providing customized ratings, performance, or scoring measures and were usually provided to subscribers of our subscription products, which were not necessarily entities

that we rate.

In the fourth quarter of 2001, Fitch Group, Fitch Ratings’ parent company established Fitch Risk Management, Inc. (FRM), a newly formed company offering risk

management services, databases, and credit models to help financial institutions

and other companies manage both credit and operational risk. Fitch Ratings and

FRM are subject to a ‘‘fire wall’’ policy and FRM has its own employees, offices, and

marketing staff. Fitch Group recently acquired Algorithmics, a leading provider of

enterprise risk management solutions. Algorithmics, part of FRM, is subject to the

same ‘‘firewall’’ policies.

Based on the above-described procedures regarding issuer payment of fees, selective disclosure and ancillary services, Fitch believes that it adequately addresses

any potential conflict of interest. In fact, we believe that the suggestions proposed

in both the SEC Concept Release and the provisions of the IOSCO Code to protect

against conflicts of interest have already been in large part adopted by Fitch. However, Fitch would not oppose narrowly tailored conditions to SEC recognition that

ensure that these standards continue.

Transparency

We believe quite strongly that the process and procedure that rating agencies use

should be transparent. Accordingly, at Fitch, there are hundreds of criteria reports

published highlighting the methodology we use to rate various types of entities and

securities, together with detailed sector analysis on a broad array of sectors, companies, and issues, all available free on our website (www.fitchratings.com). Fitch has

also been a leader in publishing presale reports in the areas of structured finance,

global power, project finance, and public finance, where our published analysis of

various transactions of interest to the market is made available free of charge on

our website prior to the pricing of the transaction. In addition, Fitch makes available free of charge on our website all of our outstanding ratings. We also distributes

announcements of rating actions through a variety of wire services as mentioned

above.

However, certain of our publications and data are only available to our paid subscribers. We commit extensive time and resources to producing our publications and

data and we believe they are valuable to anyone interested in objective credit analysis. In this practice, we are no different from other members of the financial media,

such as Bloomberg, Dow Jones, Thomson Financial, and others that charge subscribers for access to their publications and data services.

While we believe that for the most part credit rating agencies have adequate access to the information they need to form an independent and objective opinion

about the creditworthiness of an issuer, Fitch would welcome improved disclosure

by issuers. As we found in our various published studies of the use of credit derivatives in the global market, financial reporting and disclosure with respect to areas

such as credit derivatives, off-balance sheet financing, and other forms of contingencies vary greatly by sector, and comparability is further obscured by differences

in international reporting and accounting standards.

As the SEC noted in their report, issuers provide rating agencies with nonpublic

information as part of the rating process. The nature and level of nonpublic information provided to Fitch varies widely by company, industry, and country. Nonpublic

information frequently includes budgets and forecasts, as well as advance notificaVerDate 11-MAY-2000 17:55 Jul 12, 2006 Jkt 025856 PO 00000 Frm 00075 Fmt 6621 Sfmt 6621 28059.TXT SBANK4 PsN: SBANK4
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tion of major corporate events such as a merger. Nonpublic information may also

include more detailed financial reporting.

While access to nonpublic information and senior levels of management at an

issuer is beneficial, Fitch can form an objective opinion about the creditworthiness

of an issuer based solely on public information in many jurisdictions. Typically, it

is not the value of any particular piece of nonpublic information that is important

to the rating process, but that access to such information and to senior management

that assists us in forming a qualitative judgment about a company’s management

and prospects.

Another factor critical to the adequate flow of information to and from the rating

agencies is the understanding that information can be provided to a rating agency

without necessitating an intrusive and expensive verification process that would

largely if not entirely duplicate the work of other professionals in the issuance of

securities. Thus, as noted by the SEC Report, rating agencies do not perform due

diligence or conduct audits, but do assume the accuracy of the information provided

to them by issuers and their advisors. Since rating agencies are part of the financial

media, we believe that our ability to operate on this assumption, and to exercise discretion in deciding how to perform our analysis and what to publish, is protected

by the First Amendment.

—————

PREPARED STATEMENT OF JAMES A. KAITZ

PRESIDENT AND CEO, THE ASSOCIATION FOR FINANCIAL PROFESSIONALS

FEBRUARY 8, 2005

Good morning, Chairman Shelby, Ranking Member Sarbanes, and Members of the

Committee. I am Jim Kaitz, President and CEO of the Association for Financial Professionals. AFP welcomes the opportunity to participate in today’s hearing on the

role of credit rating agencies in the capital markets.

The Association for Financial Professionals (AFP) represents more than 14,000 finance and treasury professionals representing more than 5,000 organizations. Organizations represented by our members are drawn generally from the Fortune 1,000

and the largest of the middle-market companies from a wide variety of industries.

Many of our members are responsible for issuing short- and long-term debt and

managing corporate cash and pension assets for their organizations. In these capacities, our members are significant users of the information provided by credit rating

agencies. Acting as both issuers of debt and investors, our members have a balanced

view of the credit rating process, and have a significant stake in the outcome of the

examination of rating agency practices and their regulation.

AFP believes that the credit rating agencies and investor confidence in the ratings

they issue are vital to the efficient operation of global capital markets. Before outlining the consequences of inaction, it is useful to provide some background on how

we got to where we are today and summarize AFP’s research on this important

issue.

Background

For nearly 100 years, rating agencies have been providing opinions on the creditworthiness of issuers of debt to assist investors. The Securities and Exchange Commission (SEC) and banking regulators also rely on ratings from rating agencies. In

1975, the SEC recognized Moody’s, Standard & Poor’s, and Fitch, the three major

rating agencies in existence at that time, as the first Nationally Recognized Statistical Rating Organizations (NRSRO). The SEC and other regulators use the ratings

from the NRSRO’s to determine whether certain regulated investment portfolios, including those of mutual funds, insurance companies, and banks, meet established

credit quality standards. As a result, companies that hope to have their debt purchased by these portfolios must have a rating from an NRSRO. From 1975 to 1992,

the SEC recognized four other rating agencies, but each of these entrants consequently merged with Fitch. The SEC did not recognize any new agencies from

1992 until April 2003, when Dominion Bond Rating Service received recognition

from the SEC, becoming the fourth NRSRO.

Some market participants have argued that the NRSRO’s did not adequately

warn investors of the impending failure of Enron, WorldCom, Parmalat, and other

companies. For example, in 2001, the rating agencies continued to rate the debt of

Enron as ‘‘investment grade’’ days before the company filed for bankruptcy. These

failures occurred despite the fact that credit rating agencies (CRA’s) have access to

nonpublic information because of their exemption from Regulation Fair Disclosure

(Reg FD). As a result of the corporate scandals of 2001, Congress, in the SarbanesVerDate 11-MAY-2000 17:55 Jul 12, 2006 Jkt 025856 PO 00000 Frm 00076 Fmt 6621 Sfmt 6621 28059.TXT SBANK4 PsN: SBANK4
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1For complete copies of both survey results visit the AFP website at www.AFPOnline.org.

Oxley Act required the Securities and Exchange Commission (SEC) to conduct a

study on credit rating agencies examining the role of rating agencies in evaluating

debt issuers, the importance of that role to investors and any impediments to accurate appraisal by credit rating agencies. Sarbanes-Oxley also required the study to

determine whether there are any barriers to entry into the credit rating market and

whether there are conflicts of interest that hinder the performance of the rating

agencies.

In January 2003, the SEC released the Sarbanes-Oxley required study, which

identified five major issues that the SEC stated it would examine further: Information flow, potential conflicts of interest, alleged anticompetitive or unfair practices,

reducing potential barriers to entry, and ongoing oversight. Following the study, the

SEC issued, for public comment, a concept release exploring these issues on June

4, 2003. As of this hearing, the SEC has not issued any proposed rules.

In September 2002, AFP surveyed senior level corporate practitioners and financial industry service providers on their views regarding the quality of the NRSROs’

ratings, the role the SEC should take in regulating the agencies, and the impact

additional competition may have on the marketplace for ratings information. In that

survey, many financial professionals indicated that the ratings generated by the

NRSRO’s were neither accurate nor timely.

In September 2004, AFP once again surveyed senior level financial professionals

regarding the accuracy and timeliness of the NRSROs’ analyses and on the potential

role regulators may have in promoting competition among credit rating agencies.1

Key findings of the 2004 AFP Rating Agency Survey include:

• Eighty-seven percent of responding organizations with debt indicate that credit

providers require them to obtain and maintain a rating from at least one of the

four NRSRO’s.

• Many financial professionals believe that the ratings of their organizations are either inaccurate or are not updated on a timely basis.

• A third of corporate practitioners believe the ratings on their organization’s debt

are inaccurate.

• Fifty-two percent of financial professionals indicate that the cost of credit ratings

has increased by at least 11 percent over the past 3 years, including 19 percent

that indicate that costs have increased at least 25 percent over that time period.

• While many responding organizations are confident in the accuracy of the ratings

they use for investments, they are less confident in the timeliness of the same ratings.

• Financial professionals believe the Securities and Exchange Commission (SEC)

should take a greater role in overseeing the credit rating agencies along with encouraging greater competition in the field.

Recently, other organizations have taken steps to address credit rating agency reform issues. The International Organization of Securities Commissions (IOSCO) in

September 2003 issued a Statement of Principles regarding the manner in which

rating agency activities are conducted. In December 2004, IOSCO released Code of

Conduct Fundamentals for Credit Rating Agencies.

In July 2004, the Committee of European Securities Regulators (CESR), at the

request of the European Commission, issued a call for evidence on possible measures concerning credit rating agencies. The Committee intends to approve and publish its final advice to the European Commission in March 2005.

Consequences of Inaction

Why is reforming the credit rating system so important? Along with the SEC and

other regulators that have incorporated the NRSRO designation into their rules, institutional and individual investors have long relied on credit ratings when purchasing individual corporate and municipal bonds. Further, nearly every mutual

fund manager that individuals and institutional investors have entrusted with over

$8 trillion relies to some degree on the ratings of nationally recognized agencies.

Rating actions on corporate debt also have an indirect but sizeable impact on the

stock prices of rated companies.

Debt issuers rely on the credit rating agencies to understand the company’s finances, strategic plans, competitive environment, and any other relevant information about the company in order to issue ratings that accurately reflect the company’s creditworthiness. These ratings determine the conditions under which a company can raise capital to maintain and grow their business. Credit ratings also

allow others that deal with the issuer to make an informed assessment of the issuer

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as a potential trading partner, and are a valuable part of the issuer’s external communications with the market.

While credit rating agencies have long played a significant role in the operation

of capital markets, the Administration’s recent single-employer pension reform proposal would further increase the importance of the NRSRO’s and their impact on

Americans. The proposal would tie pension funding and Pension Benefit Guaranty

Corporation (PBGC) premiums to a plan sponsor’s financial condition as determined

by existing credit ratings. In some cases, plan sponsors would be prohibited from

increasing benefits or making lump sum payments based on their credit rating and

funded status. Such a proposal would further codify the NRSRO designation and

even further empower the rating agencies.

Despite the increasing reliance on credit ratings, even after more than 10 years

of examining the role and regulation of credit rating agencies, the Securities and

Exchange Commission has not has not taken any meaningful action to address the

concerns of issuers and investors. These concerns include questions about the credibility and reliability of credit ratings and conflicts of interest and abusive practices

in the rating process. Chairman Shelby and Members of the Committee, these

issues are far too important for the SEC to remain silent while the world waits for

it to take action.

As I noted earlier, the credit rating agencies and investor confidence in the ratings they issue are vital to the operation of global capital markets. As evidenced in

AFP’s research, confidence in rating agencies and their ratings has diminished over

the past few years. Addressing issues such as the lack of a defined process by which

an agency can become an NRSRO, eliminating potential conflicts of interest, and effective marketplace competition will begin to restore the much-needed confidence in

the credit ratings system.

When the SEC recognized the first Nationally Recognized Statistical Rating Organization (NRSRO) in 1975 without enumerating the criteria by which others could

be recognized, it created an artificial barrier to entry to the credit ratings market.

This barrier has led to a concentration of market power with the recognized rating

agencies and a lack of competition and innovation in the credit ratings market. Only

the SEC can remove the artificial barrier to competition it has created. Therefore,

AFP strongly recommends that the SEC maintain the NRSRO designation and

clearly articulate the process by which qualified credit rating agencies can attain

the NRSRO designation.

Not only has the SEC bestowed a significant competitive advantage, but it has

also failed to exercise any meaningful oversight of the recognized agencies. In nearly

30 years since creating the NRSRO designation, there has been no review of the ongoing credibility and reliability of the ratings issued by the NRSRO’s. The SEC

must improve its ongoing oversight of the rating agencies to ensure that they continue to merit NRSRO status.

The SEC further empowered the rating agencies when it exempted them from

Regulation Fair Disclosure (FD). Through this exemption, the rating agencies have

access to nonpublic information about the companies they rate. Again, the Commission has done nothing to ensure that those who are granted this powerful exemption

do not use the nonpublic information inappropriately. The SEC must require that

NRSRO’s have policies in place to protect this valuable and privileged information.

Again, this should be part of the SEC’s ongoing oversight of the rating agencies.

As highlighted in recent media reports, rating agencies continue to promulgate

unsolicited ratings of debt issuers. Because unsolicited ratings are issued without

the benefit of access to company management or nonpublic information about the

issuer, the resulting ratings are often not an accurate reflection of an organization’s

financials condition. Credit ratings are critical to an organization’s ability to issue

debt and issuers often feel compelled to participate in the rating process and pay

for the rating that was never solicited. The potential for abuse of these unsolicited

ratings by the rating agencies must be addressed by the SEC.

Finally, an NRSRO is also in a position to compel companies to purchase ancillary

services. These ancillary services include ratings evaluations and corporate governance reviews. Further, the revenue derived from these services has the potential to

taint the objectivity of the ratings. You need look no further than the equity research and audit professions to understand why these potential abusive practices

and conflicts of interest must be addressed by the SEC.

Recommendations

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

Association for Financial Professionals, along with treasury associations from the

United Kingdom and France, released a Code of Standard Practices for Participants

in the Credit Rating Process.

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* Held in Committee files.

A copy of the Code is attached to my testimony.* Importantly, the Code contains

recommendations for regulators, as well as rating agencies and issuers. To be clear,

the Code is a private sector response intended to complement rather than replace

regulation

Earlier in my testimony, I touched upon many of the regulatory recommendations

contained in the Code. I would like to take this opportunity to provide more detailed

regulatory recommendations. Specifically, we recommend establishing transparent

recognition criteria based on whether a credit rating agency can consistently

produce credible and reliable ratings over the long-term. Establishing clearly defined recognition criteria is a crucial step to removing barriers to entry and enhancing competition in the credit ratings market.

In the Code, we also urge regulators to require that rating agencies document internal controls that protect against conflicts of interest and anticompetitive and abusive practices, and ensure against the inappropriate use of nonpublic information to

which the rating agencies are privy because of their exemption from Regulation FD.

Regulatory recommendations also include improving ongoing oversight of approved

rating agencies to ensure that NRSRO’s continue to meet the recognition criteria.

For rating agencies, the Code includes suggestions to improve the transparency

of the rating process, protect nonpublic information provided by issuers, protect

against conflicts of interest, address the issue of unsolicited ratings, and improve

communication with issuers and other market participants.

Finally, recognizing that the credibility and reliability of credit ratings is heavily

dependent on issuers providing accurate and adequate information to the rating

agencies, the Code of Standard Practices outlines issuer obligations in the credit rating process. These obligations are intended to improve the quality of the information

available to the rating agencies during the initial rating process and on an ongoing

basis, and to ensure that issuers respond appropriately to communications received

from rating agencies.

A reasonable regulatory framework that minimizes barriers to entry and is flexible enough to allow innovation and creativity will foster competition among existing

NRSRO’s and those that may later be recognized and restore investor confidence in

the rating agencies and global capital markets. Rather than excessively prescriptive

regulatory regimes, innovation and private sector solutions, such as AFP’s Code of

Standard Practices, are the appropriate responses to many of the questions that

have been raised about credit ratings.

Restoring issuer and investor confidence in the credit ratings process is critical

to global capital markets. Chairman Shelby and Members of the Committee, we

strongly recommend that you hold the SEC accountable by demanding immediate

action on the issues that have been raised here today. If the SEC does not act immediately to aggressively address each of the concerns we have outlined, we urge you

act to restore investor confidence in the credit ratings process through action by this

Committee. We commend you, Mr. Chairman, and the Committee for recognizing

the importance of this issue to investors and global capital markets and hope that

this hearing will compel the SEC to act.

—————

PREPARED STATEMENT OF RAYMOND W. MCDANIEL, JR.

PRESIDENT AND CHIEF OPERATING OFFICER, MOODY’S INVESTORS SERVICES, INC.

FEBRUARY 8, 2005

Good morning. I am Ray McDaniel, President of Moody’s Investors Service. Let

me begin by thanking Chairman Shelby, Senator Sarbanes, and the Members of the

Committee on Banking, Housing, and Urban Affairs (the Committee) for inviting

Moody’s to participate in this hearing.

Today, I will briefly discuss Moody’s background, the role and the use of our ratings in the market, our rating process and enhancements we have made to that

process, the competitive landscape in which we operate, some global developments

in our industry, and finally the regulatory environment in the United States.

Background about Moody’s

Rating agencies occupy a niche in the investment information industry. Our role

in that market is to disseminate information about the relative creditworthiness of,

among other things, corporations, governmental entities, and pools of assets collected in securitized or ‘‘structured finance’’ transactions. Moody’s is the oldest bond

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rating agency in the world. We have been rating bonds since 1909. Today, we have

more than 1,000 analysts in 18 countries around the world. Our products include

our familiar credit rating opinions, which are publicly disseminated via press release and made freely available on our website, as well as research and special

reports about debt issuers and their industries that reach more than 3,000 institutions and 22,000 subscribers around the globe.

Moody’s integrity and performance track record have earned it the trust of capital

market participants worldwide. Our ratings and analysis track more than $30 trillion of debt issued in domestic and international markets, covering approximately

10,000 corporations and financial institutions, more than 20,000 municipal debt

issuers, over 12,000 structured finance transactions, and 100 sovereign issuers.

What Moody’s Ratings Measure

Moody’s ratings are expressed according to a simple system of letters and numbers. Ratings forecast the relative likelihood that debt obligations or issuers of debt

will meet future payment obligations in a timely manner. Company ratings are formulated utilizing the traditional techniques of fundamental credit analysis and are

thus based primarily on an independent assessment of a company’s published financial statements.

Moody’s bond rating system, which we have used for 96 years, has 21 categories,

ranging from Aaa to C. Investment-grade ratings include ratings of Aaa, Aa, A, and

Baa. Ratings below Baa are considered speculative-grade. Moody’s ratings are opinions regarding relative expected loss, which reflects an assessment of both the probability that a debt instrument will default and the severity of loss in the event of

default. The lowest expected credit loss is at the Aaa level, with a higher expected

loss rate at the Aa level, a yet higher expected loss rate at the A level, and so on

down through the rating scale. In other words, the rating system is not a ‘‘pass-fail’’

system; rather, it is a probabilistic system in which the forecasted probability of future loss rises as the rating level declines.

Moody’s rating system has over the years extended to other aspects of an issuer’s

creditworthiness, thereby disaggregating the various elements of our analysis and

providing the market with our opinions on those specific characteristics. Two such

examples are:

• short-term ratings—which measure the likelihood that an issuer will be able to

meet its short-term liabilities; and,

• financial strength ratings—which measure the stand alone financial strength of

an entity, excluding any implied or guaranteed third party support

Role and Usage of Ratings

Moody’s believes that the most important function of credit ratings is to contribute to fair and efficient capital markets. Our ratings are one means of communicating relevant information about a bond to potential investors in that bond. At

the same time, the broad, public distribution of ratings by Moody’s helps assure that

our credit opinions are freely and simultaneously available to all investors, regardless of whether they purchase products or services from Moody’s.

Our ratings have 3 intrinsic qualities that have made them useful for a variety

of purposes. First, as I have mentioned, our ratings are publicly and simultaneously

available to all market participants; second, our rating opinions are independently

formed; and third, and possibly most important, Moody’s rating performance:

• can be tested,

• is regularly tested, and

• has been consistently shown to have predictive content.

As a result, ratings have been employed by a diverse collection of investors,

issuers, financial institutions, and regulatory bodies, which have a variety of objectives in their use of ratings. For example:

• Investors use ratings when making investment decisions to help assess a bond’s

relative creditworthiness;

• Debt issuers use ratings to broaden the marketability of their securities and

thereby to improve their access to the capital markets;

• Portfolio managers employ ratings for performance benchmarking and portfolio

composition rules (commitments to specific portfolio investment strategies); and

• Regulators of banks, securities firms, and insurers use ratings to determine investment suitability, measure capital adequacy, and promote market stability.

MOODY’S MANAGEMENT OF THE RATING SYSTEM

The market utility of a credit rating system is highest when ratings effectively

distinguish riskier credits from those that are less risky, when they do so on a comVerDate 11-MAY-2000 17:55 Jul 12, 2006 Jkt 025856 PO 00000 Frm 00080 Fmt 6621 Sfmt 6621 28059.TXT SBANK4 PsN: SBANK4
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1 Junior support analysts typically do not vote. They are however encouraged to fully participate in the discussion as the process is an effective means of training.

parable basis across a wide range of issuers, and when the ratings are widely disseminated. Stability of ratings is also valued in the market, and Moody’s manages

its ratings so that they are changed only in response to changes in relative credit

risk that we believe will endure, rather than in response to transitory events or

shifts in market sentiment.

Having said that, our ratings should not be any more stable than our perception

of fundamental creditworthiness warrants. Moreover, in an effort to provide greater

transparency around possible future changes in ratings, we have developed a series

of additional public signals, called ‘‘watchlists’’ and ‘‘outlooks,’’ through which we

communicate our opinion on possible trends in future creditworthiness and the likely direction of ratings that are under review. A rating outlook, expressed as positive,

stable, negative, or developing, provides an opinion as to the likely direction of any

medium-term rating actions, typically based on a 12–18 month horizon. Most investment grade companies have a rating outlook assigned to them.

If changing circumstances contradict the assumptions or data supporting a current rating, we may place the rating on our watchlist. The watchlist highlights

issuers (or debt obligations) whose rating is formally on review for possible change.

At the conclusion of a review, typically within 90 days of placement on the

watchlist, we will assess whether the issuer’s credit risk is still consistent with the

assigned rating. Although the watchlist is not a guarantee or commitment to change

ratings over a certain time horizon, or even to change them at all, historically about

66 percent of all ratings have been changed in the same direction (and rarely in the

opposite direction) as indicated by their watchlist status.

Through our overall management of the rating system, we believe we have

achieved the balance demanded by the marketplace for a relatively stable product

that also is capable of providing timely public information about possible future

movements in creditworthiness.

Moody’s Rating Process

Let me now describe how we go about rating debt securities issued by corporations. Our ratings and research are produced by our credit professionals generally

located in the region of the issuing entity. Our rating process begins when an issuer

or its representative requests a rating. A managing director responsible for the

issuer’s industry sector will assign the analysis of the corporation to a lead analyst

and back-up analyst. The lead analyst is responsible for compiling relevant information on the issuer. Moody’s analysts rely heavily on publicly available information,

including regulatory filings and audited financial statements. The remainder of the

information comes from macroeconomic analysis, industry-specific knowledge, and

the issuer’s responses to any requests for additional information from the credit analyst. Although issuers may choose to volunteer nonpublic information to inform our

deliberations, they are not required to do so as part of the rating process. In instances where, in Moody’s’ view, there is insufficient information to form a rating

opinion, we will either not rate the entity or withdraw an already published rating.

Once information has been gathered, the lead analyst will analyze the company,

which incorporates an evaluation of, among other things: Franchise value, financial

statement analysis, liquidity analysis, management quality, and the regulatory environment of the industry in which the company operates. Depending on the complexity of the transaction, the analyst may include the expertise of some of our

specialist teams, which I will discuss in more detail later. Based on this assessment,

the lead analyst will draft a rating memorandum. That memorandum is then distributed and discussed in a rating committee, which ultimately is responsible for

taking a rating decision on a majority-vote basis.

The rating committee is typically comprised of the rating committee chair; the

lead analyst, who has researched the company; the back-up analyst; junior support

analysts; and possibly additional analysts or managing directors who have expertise

relevant to the rating decision. During the committee meeting, the lead analyst presents his or her views and discusses the underlying reasoning and assumptions. The

committee then challenges and debates the various points, and after vetting the various issues, it votes.1

When the committee concludes, the issuer is contacted and informed of Moody’s

rating decision. If the issuer has new information which is important and relevant,

the issuer may appeal the rating. Otherwise, Moody’s provides the issuer with a

copy of the draft press release announcing the rating decision. The draft press release will include the rating action and our reasoning. The issuer then has an opporVerDate 11-MAY-2000 17:55 Jul 12, 2006 Jkt 025856 PO 00000 Frm 00081 Fmt 6621 Sfmt 6621 28059.TXT SBANK4 PsN: SBANK4
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2 If an issuer has no rated debt outstanding in the market, it may request that the timing

of the press release coincide with its contemplated debt issuance.

tunity to review the draft press release prior to its dissemination,2 for the purpose

of verifying that it does not contain any inaccurate or nonpublic information. Once

final, the rating is released to the news-wires and made available on our website.

The entire rating process generally takes from 4 to 6 weeks, and sometimes longer

if the credit is particularly complex.

Once a rating has been published, Moody’s monitors the credit quality of that outstanding debt issuance and will alter the rating—through the same rating committee process—should our perception of the issuance’s creditworthiness change.

Issuer Pays Model

Most of Moody’s revenues are generated from issuer fees. Issuers request and pay

for ratings from us because of the broad marketability of bonds that ratings facilitate. Ratings facilitate this marketability in part because many U.S. institutional

investors have prudential investment guidelines that rely in part upon ratings as

a measure of desired portfolio quality. While both issuers and investors rely on our

ratings, issuers are more motivated to pay for ratings than investors because of two

attributes of ratings:

First, there is a substantial difference between issuers and investors in their need

for a rating on any single debt instrument. While ratings promote broad marketability of bonds, investors can select from a wide range of investment alternatives

and are, therefore, more interested in the general existence and application of ratings than in any individual rating. If, for example, a rating is not assigned to a particular bond, in most cases an investor’s motivation to request and pay for a rating

on that bond is low. There are many other rated bonds or investment opportunities

that the investor can choose among.

This relative indifference to individual ratings means that investors would only

be motivated to pay fees for ratings that are delivered on an aggregate, comparative

basis. Such a service, which would have to operate as a subscription service to generate fees, is impractical because of the second principle: The expectation that ratings of public debt will be made simultaneously available to all investors through

public dissemination.

Because ratings are publicly disseminated, investors do not need to purchase ratings, as they are freely available. Public availability, when combined with the

relative indifference of investors versus issuers toward any single rating, allows investors to benefit from ratings as a ‘‘free good’’ by consuming them without a compelling need to support the cost base that produces them. An issuer does not have

the same tolerance as an investor for a missing rating on its bond. It does not have

the same range of choices in accessing capital that an investor has in deploying capital. In order for an issuer to facilitate broad marketability of its bond, it will likely

choose to have a rating on that specific bond.

Conflicts of Interest

The issuer-pays business model has conflicts of interest, as does the investor-subscription business model, and so we have taken important steps to effectively manage and disclose those risks. Issuer fees were introduced over three decades ago.

Since that time, we believe we have successfully managed the conflicts of interest

and have provided the market with objective, independent, and unbiased credit

opinions. To foster and demonstrate objectivity, Moody’s has adopted and disclosed

publicly certain Fundamental Principles of Moody’s ratings management. Among

them are:

• Policies and procedures which require that analysts participating in a committee

be fully independent from the company they rate—for example, analysts are prohibited from owning securities in institutions which they rate (except through

holdings in diversified mutual funds);

• Analyst compensation is unconnected with either the ratings of the issuers the analyst covers or fees received from those issuers;

• Rating decisions are taken by a rating committee and not by an individual rating

analyst;

• Rating actions reflect judicious consideration of all circumstances believed to influence an issuer’s creditworthiness;

• Moody’s will not refrain from taking a rating action regardless of the potential

effect of the action on Moody’s or an issuer; and

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3Moody’s parent company, Moody’s Corporation, invests excess cash in highly rated shortterm debt securities. All investment decisions are made at the parent company level. 4Daniel M. Covits, Paul Harrison, ‘‘Testing Conflicts of Interest at Bond Ratings Agencies

with Market Anticipation: Evidence that Reputation Incentives Dominate,’’ Federal Reserve

Board, December 2003. 5See generally, Rober W. Holthausen and Richard W. Leftwich, ‘‘The Effect of Bond Rating

Changes on Common Stock Prices,’’ Journal of Financial Economics 17 (1986) 57–89; Edward

I. Altman, Herbert A. Rijken, ‘‘How Rating Agencies Achieve Rating Stability’’, Journal of Banking & Finance 28 (2004) 2679–2714; William Perraudin, Alex P. Taylor, ‘‘On the Consistency

of Ratings and Bond Market Yields,’’ Journal of Banking & Finance 28 (2004) 2769–2788; Gunter Loffler, ‘‘Ratings Versus Market-Based Measures of Default Risk in Portfolio Governance,’’

Journal of Banking & Finance, February 28 (2004), 2715–2746; Credit Ratings and Complementary Sources of Credit Quality Information, by a working group led by Arturo Estrella, Basel

Committee on Banking Supervision Working Papers, No. 3, August 2000; Default & Loss Rates

of Structured Finance Securities: 1003–2003, Moody’s Special comment, September 2004; Default and Recovery Rates of Corporate Bond Issuers, 1920–2004, Moody’s Special Comment, January 2005; The Performance of Moody’s Corporate Bond Ratings: December 2004 Quarterly Update, Moody’s Special Comment, January 2005; Measuring the Performance of Corporate Bond

Ratings, Moody’s Special Comment, April 2003.

• Moody’s does not create investment products, or buy, sell, or recommend securities

to users of our ratings and research.3

The integrity and objectivity of our rating process is of utmost importance to us.

Our continued reputation for objective ratings, as a recent Federal Reserve 4 study

indicated, is essential to our role in the marketplace.

Track Record of Predictive Content

Perhaps the most important litmus test, however, for whether conflicts of interest

are being properly managed is the performance of our ratings. As I said earlier, ratings performance can be and is regularly tested according to measures that are

subject to third party verification. This testing has repeatedly demonstrated the predictive content of our ratings over time. Moody’s and independent academics have

published studies on the relationship between our ratings and credit risk.5 Our annual ‘‘default study’’ consistently shows that higher-rated bonds default at a lower

rate than lower-rated bonds, and that the proportion of defaults varies with the

credit cycle. Moreover, since 2003, Moody’s has been publishing a quarterly ‘‘report

card’’ of our rating quality performance utilizing a range of accuracy and stability

metrics.

Enhancements to the Rating Process

The ultimate value of a rating agency’s contribution to market fairness and efficiency depends on its ability to offer predictive opinions about the relative credit

risk of rated entities. However, I caution that our ratings should not be construed

as investment advice, as performance guarantees, or as a means of auditing for

fraud. Further, the quality of the opinions we provide to the market is in large part

a function of the quality of information to which we have access when formulating

our opinions. As a result, the role rating agencies play in any market is either augmented or hindered by the quality and completeness of the financial information

published by debt issuers.

As high profile corporate frauds in recent years have demonstrated, if issuers

abandon the principles of transparency, truthfulness, and completeness in disclosure, neither rating agencies nor any other market participants—including regulatory authorities—can properly fulfill their roles. As one of the largest consumers

of issuers’ financial disclosure, Moody’s has supported the efforts of this Committee

and the Congress to require truthful financial disclosure.

Nevertheless, while our processes are not intended to systematically detect fraud

nor reaudit financial statements, we recognize that in order to fulfill our role in the

market, our methodologies must evolve with the market and our analysts must stay

abreast of market developments. For almost 100 years, we have been committed to

providing the highest quality credit assessments available in the global markets,

which means that we must continue to learn both from our successes and our mistakes. In this spirit, we have undertaken substantial internal initiatives to enhance

the quality of our analysis and the reliability of our credit ratings. These initiatives

include:

• Analytical specialist teams: We have added over 40 professionals specializing in

accounting and financial disclosure, off-balance sheet risk, corporate governance,

and risk management assessment. These professionals work alongside our analytical teams and do not have direct rating responsibilities. As such, they are able

to devote full attention to their areas of concentration and bring their expertise

to credits that are more complex and which need greater scrutiny.

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6 Natural barriers to entry in the traditional credit rating agency industry where ratings are

publicly and freely provided are:

• The Costly Nature of Executive Time—Debt issuers have a limited use for more than a few

ratings because fundamental credit analysis, and therefore each agency relationship, requires

the issuer’s time and executive resource commitments. This includes preparing and presenting

information, and maintaining that flow of information and communication on a periodic basis. • Network Externalities—Investors desire consistency and comparability in credit opinions.

The more widely an agency’s ratings are used/accepted by market participants the greater the

utility of its ratings to investors, and therefore to issuers. • Broad Coverage—Investors place greater value on an agency’s ratings the broader its rating

coverage and the more widely its ratings are used.

• Track Record—Investors have more confidence in ratings that are assigned by agencies with

publicly established track records of predictive ratings over a period of time. Due to the relatively small number of defaults in the public capital markets, it is difficult to establish quickly

a performance track record.

• Analyst professional development program: Moody’s company analysts must annually complete 40 hours of course work that covers a range of substantive disciplines, including accounting, securitization and risk transfer, liquidity analysis,

and ethics. • Greater use of market information: Moody’s has developed market-based monitoring tools to help analysts maintain close scrutiny over their portfolios. • Global realignment: Moody’s has restructured organizationally along lines of business, rather than regions, to allow analysts covering the same industry to share

information and expertise more easily across borders. • Reinforced centralized credit policy function: The credit policy function at Moody’s

has been augmented to help ensure that credit policies and procedures are efficiently communicated throughout Moody’s and the market, and are uniformly implemented. • Chief credit officers: We have appointed chief credit officers, charged with helping

to ensure rating quality, in our United States and European corporate finance

groups and in structured finance. • Performance metrics: As part of our commitment to predictive ratings, we publish

a quarterly report card on the accuracy and stability of our corporate bond ratings. We publish numerous studies and measurement statistics, which have

shown that overall our ratings, as forward looking opinions, effectively distinguish

bonds with higher credit risk from bonds with lower credit risk.

Level of Competition in the Industry

There are numerous types of credit assessment providers, which compete vigorously for the trust of the market. They include, for example, traditional credit

ratings, subscription-based rating providers, statistically derived ratings that rely

solely on market-based or other financial data, bond research provided by brokerage

firms, credit research performed by banks and other financial firms, and trade credit reporting agencies.

The combination of the public nature of credit ratings and natural barriers to

entry 6 may imply that only a limited number of traditional rating agencies will be

able to operate and thrive under an issuer-pays model. It is possible that only a limited number of agencies (though potentially a shifting group) will attain an issuer’s

business, regardless of the aggregate number of competitors. Therefore, while there

are numerous types of credit assessment providers, the number of large traditional

rating agencies has always been few.

OVERSIGHT OF CREDIT RATING AGENCIES—DEVELOPMENTS IN THE INTERNATIONAL

COMMUNITY

As the Committee is aware, over the past 3 years much regulatory and legislative

attention has been focused on the global financial services industry. Credit rating

agencies have been included in this examination process.

A global cooperative effort over the past 2 years led by the International Organization of Securities Commissions (IOSCO)—a committee comprised of approximately

100 of the world’s securities regulatory authorities, importantly including the U.S.

Securities and Exchange Commission (SEC)—produced and published a code of conduct (the Code) for the credit rating agency industry. The Code addresses:

• The quality and integrity of the rating process; • Credit rating agency independence and the avoidance of conflicts of interest; and, • Credit rating agency responsibilities to the investing public and issuers.

Under each broad section, the Code enumerates specific provisions. While spearheaded by the SEC, the Code was drafted jointly by global regulators, who consulted

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7Moody’s Response to the U.S. SEC Concept Release, July 28, 2003.

dictions. The Code is to be implemented through a ‘‘comply or explain’’ mechanism.

Specifically, rating agencies are to voluntarily adopt the Code, and then publish

their compliance with it or explain why they are unable to satisfy specific provisions. Moody’s has announced that we intend to adopt the IOSCO Code and periodically disclose our compliance with it. Our disclosure would naturally address our

ratings activity in the United States, as well as all other jurisdictions in which we

operate.

In Moody’s view, the Code provides a comprehensive framework for rating agency

disclosure that will better equip the market to assess rating agency reliability.

Moody’s is committed to supporting the IOSCO process and to implementing the

Code. We believe that it fosters greater market transparency and delivers accountability, while simultaneously encouraging a competitive marketplace and information flow. Such an outcome should serve market integrity and investor confidence

without unduly increasing the financial or administrative cost of business for rating

agencies or users of ratings.

Regulatory Landscape in the United States

The Nationally Recognized Statistical Rating Organization (NRSRO) designation

in the United States—which allows regulated entities to use ratings provided by

credit rating agencies that have been so designated—is administered and overseen

by the SEC. To the extent that the NRSRO designation is seen to limit competition,

Moody’s is on record as not opposing its discontinuance.7 We do not believe that our

business depends upon the continuance of the NRSRO system.

By way of background, the use of ratings in U.S. regulation and legislation has

been an evolutionary process. In the 1930’s, bank regulators began using credit ratings in bank investment guidelines. State laws and regulations soon adopted similar

standards for State banks, pension funds, and insurance companies, and additional

Federal regulation followed. In 1975, the SEC introduced credit ratings into its net

capital rule for broker-dealers.

Informally called the ‘‘haircut’’ rule, the net capital rule requires broker-dealers

to take a larger discount on speculative-grade corporate bonds—a ‘‘haircut’’—when

calculating their assets for the purposes of the net capital requirements than for investment-grade bonds. This rule specified the ratings must come from NRSRO’s.

While the term was not defined, rating agencies which had established a presence

at the time were so designated; among them was Moody’s. Over time, the use of

NRSRO ratings has spread into various legislative and regulatory frameworks, including those for the banking, insurance, educational, and housing industries.

It is our view that the use of ratings in regulation and the subsequent necessity

of recognizing or regulating rating agencies should neither alter the rating product

nor increase barriers to competition. Moody’s supports allowing natural economic

forces to guide competition in the rating agency industry. We believe that a healthy

industry structure is one in which the role of natural economic forces is conspicuous,

and where competition is based on performance quality to promote the objectives of

market efficiency and investor protection.

In responding to regulatory authorities globally, Moody’s has consistently supported eliminating barriers to entry caused by, for example, vague or difficult to

achieve recognition standards. More generally, we have supported competition in

the rating agency industry. Increased competition may augment the number and diversity of opinions available to the financial markets; and encourage rating agencies

to improve their methodological approach and better respond to market demands.

On behalf of my colleagues at Moody’s, I greatly appreciate the Committee’s invitation to participate in this important hearing. The obligation to assure that the

U.S. financial market remains among the fairest and most transparent in the world

is one that all market participants should share. I look forward to answering any

questions the Committee has in pursuit of this important goal.

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RESPONSE TO A WRITTEN QUESTION OF SENATOR SHELBY

FROM SEAN J. EGAN

Q.1. Financial Executives International submitted a comment letter on the SEC’s Concept Release about credit rating agencies in

which it recommended: Every 3 to 5 years, the NRSRO should be

subject to an intensive audit to determine whether it remains

qualified for such recognition, and to ensure that it is abiding by

its certifications and documented procedures. The Commission

should have the authority to penalize an NRSRO for ‘‘failing’’ an

audit and those penalties should range from fines to ‘‘disbarment.’’

What is your view on the benefits and costs of the recommendation?

A.1. We are in favor of such a review and have been and continue

to be supportive of the efforts of the Association for Financial Professionals and its international affiliates as reflected in their Code

of Standard Practices for Participants in the Credit Rating Process.

Such a review should assist in evaluating potential conflicts in interest, abusive practices, and protection of nonpublic information.

RESPONSE TO A WRITTEN QUESTION FROM SENATOR SHELBY

FROM MICAH S. GREEN

Q.1. Financial Executives International submitted a comment letter on the SEC’s Concept Release about credit rating agencies in

which it recommended: Every 3 to 5 years, the NRSRO should be

subject to an intensive audit to determine whether it remains

qualified for such recognition, and to ensure that it is abiding by

its certifications and documented procedures. The Commission

should have the authority to penalize an NRSRO for ‘‘failing’’ and

audit, and those penalties should range from fines to ‘‘disbarment.’’

What is your view on the benefits and costs of the recommendation?

A.1. We are in substantial agreement with this recommendation.

As noted in our comment letter, dated July 28, 2003, on the SEC’s

Concept Release on credit rating agencies, we believe an NRSRO

should make an annual certification that it continues to meet the

standards that have been set for recognition as an NRSRO.

We also support the December 2004 IOSCO ‘‘Code of Conduct

Fundamentals for Credit Rating Agencies,’’ which requires each

NRSRO to publish and comply with a Code of Conduct covering

such areas as the quality and integrity of the rating process, the

independence of each NRSRO and the avoidance of conflicts of interest, the transparency and timeliness of ratings disclosure, and

the treatment of confidential issuer information. We believe an

NRSRO’s annual certification should include a certification that it

complied during the previous year in all material respects with its

Code of Conduct (or an explanation of the reasons for any variation

from such Code).

Our July 28, 2003, comment letter also states that we do not believe that NRSRO’s need to be subject to significant additional ongoing examination or oversight, as it is unclear what the purpose

of such examinations would be. In the event periodic examinations

of each NRSRO are undertaken, we do not believe such examinations should involve reviewing individual rating determinations,

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but instead should involve a review of (1) the process by which rating methodologies are developed, (2) adherence to, or amendment

of, rating methodologies, (3) the results of the NRSRO’s back-testing of the accuracy of ratings, (4) the NRSRO’s training program,

and (5) the NRSRO’s procedures for ensuring compliance with its

Code of Conduct, including its procedures for identifying and managing conflicts of interest. We believe it is important for ratings to

be objectively determined, but equally important to ensure that the

SEC does not mandate any particular rating methodology.

The principal question about the costs and benefits of this system

is whether the costs to the SEC of conducting periodic examinations of NRSRO are warranted by the scope of the problem, or

whether the same benefits (in terms of compliance with the

NRSRO designation criteria and the NRSRO’s Code of Conduct)

could be obtained by relying on a certification by the NRSRO’s

Chief Executive and Chief Compliance Officer, with review by its

Board of Directors. We do not believe it would be necessary or costjustified for the SEC to engage in an intensive audit of all aspects

of the NRSRO’s business.

RESPONSE TO A WRITTEN QUESTION OF SENATOR SHELBY

FROM YASUHIRO HARADA

Q.1. Financial Executives International submitted a comment letter on the SEC’s Concept Release about credit rating agencies in

which it recommended: Every 3 to 5 years, the NRSRO should be

subject to an intensive audit to determine whether it remains

qualified for such recognition, and to ensure that it is abiding by

its certifications and documented procedures. The Commission

should have the authority to penalize an NRSRO for ‘‘failing’’ an

audit and those penalties should range from fines to ‘‘disbarment.’’

What is your view on the benefit and costs of the recommendation?

A.1. As a preliminary matter, R&I believes in order to maintain

credibility and public trust in NRSRO’s, a certain degree of oversight and review of NRSRO’s is necessary. However, it would have

negative consequences on the activities of rating agencies if the

Commission were to adopt strict and detailed standards on the way

rating agencies should provide their services. Strict and inflexible

regulatory standards would discourage creative development of new

rating and risk analysis methods and technology. Setting rigid regulatory standards for purposes of oversight and inspection would be

detrimental to the healthy development of the capital market and

should be avoided. The question as to who should bear the burden

of the cost associated with strict and detailed oversight must be

carefully examined.

In this regard, an intensive audit to determine the qualifications

for a NRSRO and to ensure compliance with certifications and documented procedure is inappropriate and unnecessary. An onsight

examination of the soundness of a bank’s assets is different from

auditing the qualifications and compliance of rating agencies as the

latter would be difficult to conduct in a unified and unique manner.

Therefore, regularly checking the qualification criteria can be accomplished by requiring NRSRO’s to submit reports to the Commission indicating past performance and continuing qualification.

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* Held in Committee files.

Such submissions should be disclosed to the public. If the Commission determines that a particular NRSRO fails to satisfy all of the

necessary criteria, then such rating agency should be required to

immediately rectify the situation. If, after one year’s probation period, such an NRSRO still fails to satisfy all of the criteria, then

NRSRO recognition should be revoked.

RESPONSE TO A WRITTEN QUESTION OF SENATOR SHELBY

FROM JAMES A. KAITZ

Q.1. Financial Executives International submitted a comment letter on the SEC’s Concept Release about credit rating agencies in

which it recommended: Every 3 to 5 years, the NRSRO should be

subject to an intensive audit to determine whether it remains

qualified for such recognition, and to ensure that it is abiding by

its certifications and documented procedures. The Commission

should have the authority to penalize an NRSRO for ‘‘failing’’ an

audit, and those penalties should range from fines to ‘‘disbarment.’’

What is your view on the benefits and costs of the recommendation?

A.1. Prudent SEC oversight, including the ability to take enforcement action against recognized credit rating agencies, must be a

component of any reform effort. To that end, conducting a periodic

review of whether a recognized rating agency continues to meet the

established recognition criteria must be an integral part of SEC

oversight. As we stated in our comment letter on the SEC’s 2003

concept release, ‘‘[t]he SEC should revoke NRSRO status for those

rating agencies that fail continually to meet the same criteria used

to determine whether to grant an agency initial NRSRO status.’’

Additionally, we recommended that the SEC review each NRSRO

no less frequently than every 5 years.

In our comment letter, we also stated that the recognition criteria should be based on whether an agency can consistently

produce credible and reliable ratings, not on methodology. Also, the

SEC should require that a credit rating agency seeking the NRSRO

designation document its internal controls designed to protect

against conflicts of interest and anticompetitive and abusive practices and to ensure against the inappropriate use of all nonpublic

information to which rating agencies are privy.

Conducting a periodic review of whether a NRSRO continues to

produce credible, reliable ratings and meet the recognition criteria

will help restore confidence in the credit rating agencies and the

ratings they provide. As with the recognition process, the SEC

must clearly define the revocation or nonrenewal process. Withdrawal of NRSRO status would have a material impact on a rating

agency and the value of all securities it rates. The markets are

best-served if it is clearly known why the SEC took such an action.

On behalf of AFP’s members, I thank you for your commitment

to our Nation’s capital markets. For your information, I am enclosing a copy of AFP’s entire comment letter on the SEC’s Concept Release.* Please do not hesitate to contact me if I can be of further

assistance.

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STATEMENT OF KENT WIDEMAN

EXECUTIVE VICE PRESIDENT, DOMINION BOND RATING SERVICE

FEBRUARY 8, 2005

My name is Kent Wideman, Executive Vice President of Dominion Bond Rating

Service (DBRS). I am pleased to submit these views on behalf of DBRS in connection with this hearing on the role of credit rating agencies in the capital markets.

Because credit ratings have become such an integral part of the global financial

markets, it is imperative that there be a clear understanding of how rating agencies

operate, how they compete and how they should be regulated. As the only rating

agency in the past 13 years to receive an NRSRO designation, DBRS is also pleased

to share its unique perspective on the SEC’s process for making such designations.

Based in Toronto and with offices in New York and Chicago, DBRS was founded

in 1976 by Walter Schroeder, who remains the company’s President. DBRS is employee-owned, is not affiliated with any other organization, and limits its business

to providing credit ratings and related research. DBRS is a ‘‘generalist’’ rating agency, in that we analyze and rate a wide variety of institutions and corporate structures, including government bodies, and various structured transactions. At this

time, we rate over 900 entities worldwide and provide credit research on another

200 companies, with most of the latter based in the United States. DBRS has a total

of 113 employees, 73 of whom are analysts.

Since its inception, DBRS has been widely recognized as a provider of timely, indepth and impartial credit analysis. Our opinions are conveyed to the marketplace

using a familiar, easy-to-use letter grade rating scale. These ratings are supported

by an extensive research product, which includes detailed reports on individual companies, as well comprehensive industry studies. This information is disseminated

through various means, including a proprietary subscription service which is used

by more than 4,500 institutional investors, financial institutions, and government

bodies.

Overview

In order to evaluate the role of credit rating agencies in the capital markets, it

is necessary to have a clear understanding of what a credit rating is and what it

is not. A credit rating is an opinion regarding the creditworthiness of a company,

security, or obligation. It is not an absolute predictor of whether a particular debtor

will default on a particular obligation. Among the many factors DBRS considers in

issuing a credit rating are: A company’s financial risk profile, with particular focus

on leverage and liquidity; the complexion of the industry in which the company operates and its position in that sector; quality of management; core profitability and

cashflow; and other issues which may affect the creditworthiness of the issuer or

instrument in question.

As part of the process, we maintain an ongoing dialogue with the managements

of the companies we rate. Oftentimes, they provide us with information that may

not be publicly available, and we use this information strictly for the purposes of

arriving at an accurate rating decision. Prior to finalizing our decisions, we discuss

our preliminary views with the company, and we allow them to review any releases

prior to public dissemination to assure that our comments are accurate and that we

have thoroughly considered all relevant facts. Ratings are reviewed constantly and

changes are made whenever we are of the opinion that the relative creditworthiness

has changed, positively or negatively.

Credit ratings are a critical assessment tool for investors in fixed-income securities or other debt instruments, as well as for issuers seeking access to the capital

markets. In addition, over the past 30 years, the SEC and other State and Federal

regulators have used the credit ratings issued by market-recognized credible agencies to distinguish among grades of creditworthiness of various instruments and to

help monitor the risk of investments held by regulated entities. As the debt markets

have grown more complex and more volatile, investors, issuers, and regulators have

grown increasingly reliant on the impartial and independent ratings and credit

analyses that the NRSRO’s supply.

The confidence the marketplace and the regulators have placed in these rating

agencies is well-deserved. Academic and industry studies uniformly show a strong

correlation between credit ratings and the likelihood of default over time. We respectfully submit that a few headline-grabbing corporate failures should be seen for

what they are: Aberrations caused by spectacular issuer dishonesty and not signs

of structural defects in the ratings industry or the regulation thereof. Indeed, the

scrutiny to which credit rating agencies have been subjected over the past 3 years

has not uncovered any systemic flaws in the way NRSRO’s operate. There is no

need to dismantle a system that has served the capital markets so well for so long.

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1Testimony of Frank A. Fernandez, Senior Vice President, Chief Economist and Director of

Research, The Securities Industry Association, SEC Hearings on the Current Role and Function

of Credit Rating Agencies in the Operation of the Securities Markets, Transcript of November

15, 2002 Session (SEC Hearings Transcript) at 110; Testimony of Glen Reynolds, CEO,

CreditSights, Inc., Id. at 143.

With this background in mind we address the specific questions the Committee

has raised: (1) the transparency of the ratings process, (2) conflicts of interest, (3)

NRSRO designation, and (4) appropriate regulatory oversight of rating agencies.

Transparency

DBRS considers transparency to be a key factor in the ratings process. In order

to ensure that those who use our ratings understand the bases for our opinions, we

back up each of our ratings with detailed reports. on individual companies and industries. These reports openly convey DBRS’ views on both current ratings and the

direction of ratings. We also hold regular seminars, investor meetings, and conference calls, all of which allow for an open and informative dialogue with the investment community.

Although DBRS believes that it is possible to accurately assess an issuer’s creditworthiness using only publicly available information, it is our practice to identify

any reports produced without issuer involvement, in order to provide context to subscribers and the public. Where we have ceased to rate or follow an issuer, we disclose the fact that our ratings are not current.

While DBRS is committed to disseminating its ratings and concise explanations

for its reasons and methodologies publicly, we also believe that credit rating agencies should be entitled to provide more in-depth coverage and analysis to investors

on a subscription basis. In order to ensure that this practice does not harm the financial markets, DBRS has adopted effective controls to prevent the selective disclosure of ratings, rating actions, and other nonpublic information to its subscribers.

Conflicts of Interest

Like the other NRSRO’s, DBRS derives most of its revenue from fees charged to

issuers and also receives fees from investors who subscribe to its credit analyses and

reports. Questions have been raised as to whether this fee structure compromises

the objectivity of credit ratings; in particular, whether the receipt of fees from

issuers presents the potential for rating inflation.

In exploring this topic, it is important to note that the current industry fee structure is the result of the complexity of the debt markets and the desire to have credit

ratings broadly disseminated to the investing public. Performing high-quality credit

analysis is a costly process, and although the public wants access to credit ratings,

they do not necessarily want to pay for it.1 The only way rating agencies can afford

to provide initial valuations and ongoing credit monitoring to the public is to charge

the issuers whose securities they rate.

It is also important to recognize that eliminating fees from issuers would not necessarily eliminate rating agency conflicts of interest. Potential conflicts can arise

from any number of relationships, including those with government bodies, regulators, investors, prospects, and financial institutions. For example, accepting fees

only from investors might still compromise the objectivity of rating agencies since

investors have a strong interest in maintaining high ratings on the securities in

their portfolios. Moving to an exclusively subscriber-funded business model would

also diminish the fairness of the markets, since only those who pay for credit ratings

would have access to them. Eliminating public dissemination of ratings could cause

market confusion by exposing investors to rumors of rating actions and the like.

We also note that although the current industry fee structure has been in place

for decades, there is no evidence that it has had a deleterious effect on the quality

of credit ratings. There are a number of reasons why this is so. Perhaps most important is the fact that rating agencies live and die by the quality of their ratings and

their reputation for objectivity. The fact that credit rating agencies derive substantial fees from issuers is widely known. If an agency were seen to appease any issuer

by supplying an inflated rating, the marketplace would discount that agency’s opinions across its ratings universe. Such a discount would be an economic catastrophe

for the rating agency. Moreover, a rating agency cannot avoid the reputational impact of any conflict of interest by concealing the reasons for its ratings, since ratings

have to be transparent in order to be deemed valuable by market participants.

To safeguard their reputations and ensure the objectivity of their ratings, DBRS

and the other NRSRO’s have developed a range of internal controls to manage potential conflicts of interest. DBRS is independently owned; engages in no business

other than producing credit ratings and related research; and no one issuer accounts

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2The recipient of the 1992 designation subsequently merged with Fitch Ratings.

for a significant percentage of the company’s total revenues. Furthermore, all rating

decisions at DBRS are determined by a committee comprised of the firm’s most senior staff with input from analyst teams that produce initial rating recommendations

and the rationales therefor. This collaborative process effectively neutralizes any

positive or negative bias on the part of anyone individual and supports the goal of

ensuring that ratings are comparable across a wide range of different sectors. In

order to further eliminate an analyst’s or rating committee member’s individual interest in a credit analysis or valuation, DBRS prohibits its employees from purchasing any security issued by companies that it rates or otherwise follows. The

company likewise refrains from buying such securities for its own account. Finally,

DBRS does not compensate its analysts on the basis of any particular ratings or the

amount of revenue generated from issuers within the analysts’ respective areas.

Rather, analyst compensation depends on the experience, skill, and quality of the

analyst’s work, as well as on the company’s general revenues. DBRS believes that

these internal policies effectively address the potential conflicts posed by the current

credit rating agency fee structure.

NRSRO Designation

The SEC introduced the concept of ‘‘Nationally Recognized Statistical Rating Organization’’ or ‘‘NRSRO’’ in 1975, as a means of identifying ratings of market-recognized credible agencies for purposes of applying the broker-dealer net capital rule.

From that modest beginning, the NRSRO concept has spread to other areas of Federal securities regulation, as well as Federal banking regulation, and various Federal and State laws. NRSRO ratings have become so firmly embedded in the U.S.

capital markets that eliminating the NRSRO designation at this point would be

enormously disruptive. That is not to say, however, that there is no room for improvement in the designation process.

DBRS was designated as an NRSRO in 2003, the first and only rating agency to

receive such a designation since 1992.2 In order to receive its NRSRO designation,

DBRS demonstrated that it is widely accepted in the United States as an issuer of

credible and reliable ratings by users of securities ratings. It also established that

it has adequate staffing, financial resources, and organizational structure to ensure

that it can issue credible and reliable ratings of the debt of issuers, including a sufficient number of qualified staff members and the ability to operate independently

of economic pressures or control by the companies it rates. In addition, DBRS demonstrated that it uses systematic rating procedures designed to ensure credible and

accurate ratings; and that it has and enforces internal procedures to prevent conflicts of interest and the misuse of nonpublic information.

Because DBRS believes that the marketplace is the best judge of what constitutes

a reliable credit rating, DBRS also believes that market acceptance is a critical test

for determining whether a rating agency should be designated as an NRSRO. DBRS

further believes that the SEC should continue to examine whether an agency seeking NRSRO designation maintains policies and procedures reasonably designed to

avoid conflicts of interest and to prevent the misuse of material, nonpublic information, and to evaluate whether a rating agency has adequate resources or other safeguards to maintain its independence from the issuers it rates. It would also be

appropriate, in DBRS’ view, for the Commission to evaluate an agency’s commitment to transparency, by assessing the degree to which it makes its ratings publicly

available and discloses the reasons for its ratings.

Although we generally support the criteria the SEC uses to designate new

NRSRO’s, we believe that the current practice of designating such agencies through

a no-action letter process is unnecessarily cumbersome and insufficiently transparent. In lieu of the current procedure, DBRS recommends that the SEC adopt a

formal application process that provides clearly articulated standards and allows for

notice and the opportunity for public comment. Applicants who are not granted an

NRSRO designation within a reasonable period of time should be notified of the reasons for their rejection so that they may improve their operations in the specified

areas and increase their chances of submitting a successful application in the future. DBRS believes that these measures will greatly increase the transparency of

the designation process and enhance investor confidence.

Appropriate Regulatory Oversight

Given the benefit to the financial markets of continuing to have designated

NRSRO’s, DBRS recognizes the need for some form of regulatory oversight on an

ongoing basis. It is critical, however, that such oversight not interfere with the process by which a credit analysis is performed or a rating is issued. Whether credit

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3 IOSCO Technical Committee, Statement of Principles Regarding the Activities of Credit Rating Agencies (September 2003). This document can be downloaded from IOSCO’s On-Line Library at www.iosco.orq (IOSCOPD151). 4 IOSCO’s On-Line Library.

opinions are produced though traditional methods or statistical models, regulators

should neither dictate how a rating is done nor define how the quality of a rating

should be evaluated. Credible, reliable rating agencies may utilize different methodologies, adopt varying outlooks and reach different conclusions regarding the creditworthiness of an issuer or obligation. This richness of opinion contributes to the

safety and soundness of the markets and would be lost if every NRSRO were obliged

to follow the same script. Indeed, ratings diversity increases the ‘‘watchdog’’ function

credit rating agencies play, and their ability to function independently helps to disperse their power. Furthermore, mandatory standardization of the ratings process

would ossify credit risk practice and theory, thereby impeding rating agencies’ ability to evolve with the natural evolution of the marketplace. Credit ratings are under

constant scrutiny by market participants; the regulators should allow the market

to determine whether or not an agency’s credit opinions have value.

DBRS supports the recent efforts of the International Organization of Securities

Commissions (IOSCO)—of which the SEC is a member—to articulate a set of highlevel objectives that rating agencies, regulators, issuers, and other market participants should strive toward in order to improve investor protection and the fairness,

efficiency and transparency of the securities markets, while reducing systemic risk.3

In furtherance of these objectives, in December of last year, the IOSCO Technical

Committee published a Code of Conduct Fundamentals for Credit Rating Agencies.4

These Code Fundamentals address many of the same issues addressed in the

NRSRO designation process. Most importantly, the Code Fundamentals are not

rigid or formalistic; rather they are designed to afford credit rating agencies the

flexibility to incorporate these measures into their internal codes of conduct according to their own business models and market circumstances.

DBRS believes that a sensible regulatory approach might include a requirement

that NRSRO’s adopt codes of conduct along the lines of the IOSCO Code Fundamentals. It might also be appropriate to institute some form of periodic self-assessment

and/or self-certification process under which NRSRO’s attest that they maintain

these internal codes and that they continue to meet the NRSRO designation criteria.

Such a regulatory regime would safeguard the integrity of the credit rating process

and promote investor protection without having a chilling effect on the development

of new credit analysis techniques and practices.

Conclusion

Overall, DBRS believes that the credit rating system as it exists today works well

and has helped foster the growth of the financial markets globally. Improving the

transparency of the NRSRO designation process and implementing an internal conduct code-based regulatory scheme would help ensure the continued success of this

system. We appreciate having the opportunity to share our views with this Committee.

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Credit Raters’ Power Leads to Abuses, Some Borrowers Say

BY ALEC KLEIN, WASHINGTON POST STAFF WRITER

NOVEMBER 24, 2004

Last of three articles

The letter was entirely polite and businesslike, but something about it chilled Wilhelm Zeller, chairman of one of the world’s largest insurance companies.

Moody’s Investors Service wanted to inform Zeller’s firm—the giant German insurer Hannover Re—that it had decided to rate its financial health at no charge.

But the letter went on to suggest that Moody’s looked forward to the day Hannover

would be willing to pay.

In the margin of the letter, Zeller scribbled an urgent note to his finance chief:

‘‘Hier besteht Handlungsbedarf.’’

We need to act.

Hannover, which was already writing six-figure checks annually to two other rating companies, told Moody’s it did not see the value in paying for another rating.

Moody’s began evaluating Hannover anyway, giving it weaker marks over successive years and publishing the results while seeking Hannover’s business. Still, the

insurer refused to pay. Then last year, even as other credit raters continued to give

Hannover a clean bill of health, Moody’s cut Hannover’s debt to junk status. Shareholders worldwide, alarmed by the downgrade, dumped the insurer’s stock, lowering

its market value by about $175 million within hours.

What happened to Hannover begins to explain why many corporations, municipalities and foreign governments have grown wary of the big three credit-rating

companies—Moody’s, Standard & Poor’s and Fitch Ratings—as they have expanded

into global powers without formal oversight.

The rating companies are free to set their own rules and practices, which sometimes leads to abuse, according to many people inside and outside the industry. At

times, credit raters have gone to great lengths to convince a corporation that it

needs their ratings—even rating it against its wishes, as in the Hannover case. In

other cases, the credit raters have strong-armed clients by threatening to withdraw

their ratings—a move that can raise a borrower’s interest payments.

And one of the firms, Moody’s, sometimes has used its leverage to ratchet up its

fees without negotiating with clients. That is what Compuware Corp., a Detroitbased business software maker, said happened at the end of 1999.

Compuware, borrowing about $500 million, had followed custom by seeking two

ratings. Standard & Poor’s charged an initial $90,000, plus an annual $25,000 fee,

said Laura Fournier, Compuware’s chief financial officer. Moody’s billed $225,000

for an initial assessment, but did not tack on an annual fee.

Less than a year later, Moody’s notified Compuware of a new annual fee—$5,000,

which would triple if the company did not issue another security during the year

to create another Moody’s payment. Fournier said Moody’s did not do anything extra

to earn the fee. But the company paid it anyway—$5,000 in 2001; $15,000 a year

later.

‘‘They can pretty much charge the fees they want to,’’ she said. ‘‘You have no

choice but to pay it.’’

Moody’s declined to comment on Compuware, but the firm said it now charges an

annual flat fee of $20,000 for monitoring a corporate borrower to remove any confusion.

Dessa Bokides, a former Wall Street banker who founded a ratings advisory group

at Deutsche Bank AG, said rating firms are continually finding new circumstances

to extract fees. Frequently, she said, they charge clients for many different securities, even if the ratings all amount to the same thing: an assessment of a company’s

finances.

‘‘They are rating every [bond issue] and charging for each [bond issue], but in reality, they are only rating the corporate’’ health, Bokides said. ‘‘It is a great business

if you can get it.’’

For Moody’s, the numbers add up: It rates more than 150,000 securities from

about 23,000 borrowers, whose debt amounts to more than $30 trillion. Its revenue

more than doubled in 4 years, to $1.25 billion in 2003, while its profit jumped 134

percent in that time.

The company said a rating costs between $50,000 and $300,000 for corporate borrowers. Moody’s declined to provide a fee schedule, but according to a list obtained

by The Washington Post, if it is the applicant’s first rating in the past 12 months,

there is an additional $33,000 fee. Then there is the monitoring fee ($20,000), a

‘‘rapid turnaround fee’’ ($20,000) and a cancellation fee (at least $33,000). For

$50,000 more, a client can get an initial confidential rating.

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S&P’s fees are similar, according to a price list obtained by The Post.

The former finance chief of a major telecommunications firm was stunned when

Moody’s and S&P sent their initial bills. Each was six figures, not counting the annual maintenance fee. ‘‘I remember thinking their fees were outrageous,’’ said the

former executive, who spoke on the condition of anonymity for fear of angering the

rating firms. When he asked his banker about the fees, the banker said, ‘‘You have

to pay S&P and Moody’s.’’

So he paid.

‘‘Yeah, it is expensive for a few phone calls and a little analysis,’’ the former executive said. ‘‘But guess what? Especially when you are a public company, your options are limited. Really, you have only got S&P and Moody’s.’’

Many schools and cities take the same view. The credit companies rate their debt

as well, but charge much less, typically in the thousands or tens of thousands, depending on the size of the bond offering. Still, every fee seems to count.

Louis J. Verdelli Jr., a financial adviser to school districts and other localities,

knows as much. A municipality dissatisfied with a credit rater can have a difficult

time getting rid of it, said Verdelli, a managing director of Public Financial Management Inc. of Philadelphia.

If, for example, a municipality stops paying a rating fee, the credit company may

remove its ratings on previous bonds, which could raise questions in investors’

minds and make it harder for the municipality to sell new bonds.

One investment banker in the Southwest said he encountered such a situation.

Several years ago, he began representing a cash-strapped school district. Things had

gotten so bad, the district raised the price of school meals.

To save money, the banker suggested that the district drop one of its two credit ratings. That would save less than $10,000, but would be better than cutting textbooks. Moody’s fee was lower, so the banker decided to drop S&P. That is, until he

heard from S&P. The credit rater gave him an option: Pay $5,000 for S&P’s service,

or it would pull all of its ratings.

The investment banker said he had no choice: He decided to pay for both ratings,

which the school district continues to do. ‘‘We are just paying off Standard & Poor’s,

and we are costing taxpayers an additional $5,000, because we are concerned that

the negative association of their pulling the rating would cost more than $5,000,’’

he said. He spoke on the condition of anonymity, declining to identify the school district for fear of angering the credit raters.

Vickie A. Tillman, S&P’s executive vice president, said, ‘‘We reserve the right to

withdraw our opinion’’ when the firm does not have enough information to reach

a conclusion, and S&P would never ‘‘compromise its objectivity and reputation’’ by

withdrawing it for any other reason.

Some U.S. lawmakers have raised another area of concern: The credit raters have

a privilege but little responsibility under a government rule that gives them access

to confidential information from a company being rated.

The rating companies say they need such inside data. But when they miss financial meltdowns such as Enron Corp., WorldCom Inc. and the Italian dairy company

Parmalat Finanziaria SpA, the raters argue that despite having had insider access

in many cases, they cannot be blamed for investor losses because they cannot detect

fraud. ‘‘The job of insuring the accuracy of those source materials belongs to auditors and regulators,’’ said Frances G. Laserson, a Moody’s spokeswoman.

Rating companies sometimes give yet another perspective about inside information. When rating a company without its cooperation, the credit raters occasionally

say they do not need non-public information. They call such ratings ‘‘unsolicited;’’

others in the industry call it a hostile rating.

Moody’s estimates that less than 1 percent of its ratings are unsolicited. Tillman

said S&P rarely does unsolicited ratings, and generally only if a company borrows

more than $50 million, explaining that the credit rater considers it a public service

to rate major offerings. James Jockle, a Fitch spokesman, said that more than 95

percent of the companies it rates ‘‘agreed to pay our fees.’’

However, corporate officials, investment bankers and others familiar with the rating firms’ strategies say there is a reason unsolicited ratings do not appear common:

Companies approached that way by credit raters usually agree to pay a fee rather

than risk a weak rating made without their cooperation.

An S&P executive, who spoke on the condition of anonymity because the firm

hadn’t authorized her to comment, said that S&P maintains a sales force—what it

calls an ‘‘origination team’’—whose goal is to improve revenue by finding companies

to rate and charge a fee. ‘‘Some of it is cold calling,’’ she said.

Northern Trust Corp., the big Chicago-based bank, said in a recent letter to the

SEC that it ‘‘has been sent bills by rating agencies for ratings that were not requested by Northern, and for which Northern had not previously agreed to pay.’’ In

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his letter, James I. Kaplan, then the bank’s associate general counsel, continued,

‘‘On occasion, we have paid such invoices in order to preserve goodwill with the rating agency, but we feel that this practice is prone to abuse.’’ Northern Trust declined to elaborate.

In 1996, the Justice Department looked into similar unsolicited practices by

Moody’s. At about the same time, a Colorado school district sued Moody’s, claiming

it got an unsolicited negative rating—a hostile rating—because the district had refused to buy the Moody’s service. The Colorado case was dismissed in 1997, after

a judge ruled the rating firm’s statements about the school district were opinions

protected by the First Amendment. Justice took no action, but did fine Moody’s

$195,000 in 2001 for obstructing justice by destroying documents during its investigation.

Fitch also has been criticized for unsolicited ratings. In the late 1990’s, after being

dropped as a paid credit rater of Simon Property Group Inc., the largest U.S. owner

of regional shopping malls, Fitch did an unsolicited rating of the company. Some

mall company officials were dismayed that Fitch did not announce that its rating

was done without Simon’s cooperation.

Fitch said any requirement that it disclose unsolicited ratings would ‘‘inappropriately interfere in the editorial process of the rating agencies.’’

When asked by The Post about unsolicited ratings, S&P’s Tillman said her firm

is ‘‘in the process’’ of changing its policies so investors will be able to tell whether

they are looking at a rating done with a borrower’s cooperation. Moody’s said the

last time it issued an unsolicited rating without identifying it as such was in 2000.

And in October, the company began to publicly identify unsolicited ratings.

Greg Root, a former official of the Canadian rater Dominion Bond Rating Service

Ltd. who also worked at S&P and Fitch, said that making such disclosure is important because, ‘‘when a rating agency does a rating, there is the impression there is

a formal due diligence and that they get non-public information. Investors assume

there is a strong ongoing dialogue.’’

Whether an unsolicited rating is a form of coercion to earn fees is another matter,

Root said: ‘‘It is always a fine line.’’

Moody’s danced along that line when it began its push into Europe in the late

1980’s, according to former company officials. It began writing letters to European

companies, saying it was planning to rate them. Moody’s invited the companies to

participate in the ratings process; however, if they did not, the credit rater said it

felt it had adequate public information to do a rating anyway.

‘‘That was the hook. That is where we were trying to get into the door and send

them the bill,’’ said W. Bruce Jones, now a managing director at Egan-Jones Ratings

Co., a small rival of Moody’s. ‘‘The implied threat was there.’’

Moody’s took a similar approach in mid-1998 when it approached Hannover, the

big German insurance company that provides insurance for other insurance companies, helping to spread the risk in the event of a major catastrophe.

Hannover had become one of the largest reinsurers in the world, with about half

of its business in the United States. Insurers must be able to demonstrate to outsiders that they have the financial strength to make good on their policies. Hannover was already paying fees for that purpose to S&P and A.M. Best Co., a leader

in the insurance rating industry. They had both given Hannover high ratings.

‘‘So we told Moody’s, ‘Thank you very much for the offer, we really appreciate it.

However, we do not see any added value,’ ’’ said Herbert K. Haas, Hannover’s chief

financial officer at the time.

As Haas recalls it, a Moody’s official told him that if Hannover paid for a rating,

it ‘‘could have a positive impact’’ on the grade.

Haas, now chief financial officer at Hannover’s parent company, Talanx AG,

laughed at the recollection. ‘‘My first reaction was, ‘This is pure blackmail.’ ’’ Then

he concluded that, for Moody’s, it was just business. S&P was already making headway in Germany and throughout Europe in rating the insurance business. Moody’s

was lagging behind. And, Haas thought, Hannover represented a fast way for the

credit rater to play catch-up.

Within weeks, Moody’s issued an unsolicited rating on Hannover, giving it a financial strength rating of ‘‘Aa2,’’ one notch below that given by S&P. Haas sighed

with relief. Nowhere in the press release did Moody’s mention that it did the rating

without Hannover’s cooperation. But, Haas thought, it could have been worse.

Then it got worse. In July 2000, Moody’s dropped Hannover’s ratings outlook from

‘‘stable’’ to ‘‘negative.’’ About 6 months later, Moody’s downgraded Hannover a notch

to ‘‘Aa3.’’ Meanwhile, Moody’s kept trying to sell Hannover its rating service. In the

fall of 2001, Zeller, Hannover’s chairman, said he bumped into a Moody’s official at

an industry conference in Monte Carlo and arranged a meeting for the next day at

the Cafe de Paris. There, the Moody’s official pressed his case, pointing out that the

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analyst who had been covering Hannover—a man whom the insurer disliked—had

left Moody’s. Zeller still declined Moody’s services.

Two months later, Moody’s cut the insurer’s rating by two more notches to ‘‘A2.’’

In December 2002, the rating firm put Hannover on review for another possible

downgrade. Somewhere along the way, Haas appealed to his boss to yield.

‘‘I said, ‘Ultimately, you cannot win against the rating agency. Let’s bite the bullet

and pay,’ ’’ Haas recalled. ‘‘But for Willie [Zeller], it was a matter of principle. He

said, ‘I am not going to pay these guys.’ ’’

In March 2003, Moody’s downgraded Hannover’s financial strength rating by two

notches and lowered its debt by three notches to junk status, sparking a 10 percent

drop in the insurer’s stock. S&P and A.M. Best, both of which were privy to the German insurer’s confidential data, continued to give Hannover a high rating.

Industry analysts were confounded. ‘‘The scale of the Moody’s downgrade was a

surprise,’’ said Damien Regent, an analyst at UBS AG, in a research report at the

time. ‘‘There was no new information in the public domain to justify a three-notch

downgrade.’’

Larry Mayewski, A.M. Best’s executive vice president, said he thinks Moody’s has

been using unsolicited ratings to get companies like Hannover to buy its services.

Moody’s declined to comment for this article about Hannover, but in its reports

on the insurer, it said it was concerned that the German company had ‘‘high levels

of financial and operational leverage’’ and a ‘‘high level of reinsurance recoverables’’

due to it. Since then, Moody’s has softened its stance, raising Hannover’s outlook

from ‘‘negative’’ to ‘‘positive.’’ But it still rates Hannover’s debt as junk.

Zeller called the latest downgrade ‘‘ridiculous.’’ But when his company’s stock

dropped sharply, he began to wonder whether he had any recourse.

As in the United States, lawmakers in Germany and elsewhere in Europe have

taken a look at credit raters. But there has been no action. And Zeller is not optimistic about the prospects of change.

‘‘They have built up such a franchise,’’ he said, ‘‘it is difficult, if not impossible,

to do anything against it.’’