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50–357 2009

S. HRG. 110–931 

THE ROLE AND IMPACT OF CREDIT RATING 

AGENCIES ON THE SUBPRIME CREDIT MARKETS 

HEARING 

BEFORE THE

COMMITTEE ON 

BANKING, HOUSING, AND URBAN AFFAIRS 

UNITED STATES SENATE 

ONE HUNDRED TENTH CONGRESS 

FIRST SESSION 

ON 

EXAMINING THE CIRCUMSTANCES, THE INTEGRITY OF THE RATINGS 

PROCESS, THE OVERSIGHT OF THE SEC, AND WHETHER STATUTORY, 

REGULATORY, OR INDUSTRY CHANGES ARE ADVISABLE IN LIGHT OF 

SIGNIFICANT DOWNGRADES TO THE CREDIT RATINGS OF SECURITIES 

IN THE SUBPRIME MARKETS 

WEDNESDAY, SEPTEMBER 26, 2007 

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

( 

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


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(II) 

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS 

CHRISTOPHER J. DODD, Connecticut, Chairman 

TIM JOHNSON, South Dakota 

JACK REED, Rhode Island 

CHARLES E. SCHUMER, New York 

EVAN BAYH, Indiana 

THOMAS R. CARPER, Delaware 

ROBERT MENENDEZ, New Jersey 

DANIEL K. AKAKA, Hawaii 

SHERROD BROWN, Ohio 

ROBERT P. CASEY, Pennsylvania 

JON TESTER, Montana 

RICHARD C. SHELBY, Alabama 

ROBERT F. BENNETT, Utah 

WAYNE ALLARD, Colorado 

MICHAEL B. ENZI, Wyoming 

CHUCK HAGEL, Nebraska 

JIM BUNNING, Kentucky 

MIKE CRAPO, Idaho 

JOHN E. SUNUNU, New Hampshire 

ELIZABETH DOLE, North Carolina 

MEL MARTINEZ, Florida 

SHAWN MAHER, Staff Director 

WILLIAM D. DUHNKE, Republican Staff Director and Counsel 

DEAN V. SHAHINIAN, Counsel 

JOSEPH R. KOLINSKI, Chief Clerk and Computer Systems Administrator 

JIM CROWELL, Editor 


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(III) 

C O N T E N T S 

WEDNESDAY, SEPTEMBER 26, 2007 

Page 

Opening statement of Senator Reed ...................................................................... 1 

Opening statements, comments, or prepared statements of: 

Senator Shelby .................................................................................................. 3 

Senator Schumer .............................................................................................. 4 

Senator Sununu ................................................................................................ 6 

Senator Casey ................................................................................................... 7 

Senator Brown .................................................................................................. 8 

Senator Bunning ............................................................................................... 9 

Senator Menendez ............................................................................................ 10 

Senator Allard ................................................................................................... 11 

Senator Martinez .............................................................................................. 13 

WITNESSES 

Christopher D. Cox, Chairman, Securities and Exchange Commission .............. 14 

Prepared statement .......................................................................................... 47 

John C. Coffee, Adolf A. Berle, Professor of Law, Columbia University School 

of Law .................................................................................................................... 27 

Prepared statement .......................................................................................... 53 

Michael Kanef, Managing Director of the Asset Finance Group, Moody’s Financial Services .................................................................................................... 29 

Prepared statement .......................................................................................... 74 

Vickie A. Tillman, Executive Vice President for Credit Market Services, 

Standard & Poor’s ................................................................................................ 30 

Prepared statement .......................................................................................... 108 

Lawrence J. White, Arthur E. Imperatore Professor of Economics, Leonard 

N. Stern School of Business, New York University .......................................... 32 

Prepared statement .......................................................................................... 135 


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(1) 

THE ROLE AND IMPACT OF CREDIT RATING 

AGENCIES ON THE SUBPRIME CREDIT 

MARKETS 

WEDNESDAY, SEPTEMBER 26, 2007 

U.S. SENATE, 

COMMITTEE ON BANKING, HOUSING, AND URBAN AFFAIRS, 

Washington, DC. 

The Committee met at 9:34 a.m., in room SD–538, Dirksen Senate Office Building, Hon. Jack Reed presiding. 

OPENING STATEMENT OF SENATOR JACK REED 

Senator REED. Let me call the hearing to order. 

I want to thank Chairman Cox for joining us this morning. I particularly want to thank Chairman Dodd and Senator Shelby for 

their leadership on this issue. Both have expressed significant concerns about problems with the subprime market and have raised 

serious questions about the role that credit rating agencies have 

played in the current situation. 

According to the FDIC, since the beginning of June 2007 the 

credit rating agencies have downgraded more than 2,400 tranches 

of residential mortgage-backed securities. The recent wave of downgrades have caused some investors to lose confidence in both the 

integrity and reliability of these ratings. 

This hearing provides us with an opportunity to examine the role 

of the credit agencies in structured finance products and consider 

their impact on financial markets. 

Back in April I chaired a Subcommittee hearing examining the 

role of securitization, where witnesses testified that problems in 

the subprime asset market area were confined to a small part of 

the market. Of course, since then we have learned that the fallout 

from the subprime turmoil was and is deeper and broader than we 

were led to believe. As a result, it seems that securitization not 

only distributes risk but that it can hide it as well. 

Credit rating agencies play a critical role in capital markets. The 

agencies can enhance or reduce investor confidence depending on 

the information they provide. The increasing complexity of structured products like mortgage-backed securities and CDOs, 

collateralized debt obligations, and the perceived lack of transparency in this investor appears to have made investors more dependent on the rating agencies to perform quality analysis. In that 

sense, the agencies have become gatekeepers for the multibilliondollar structured finance industry. 


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Furthermore, the credit rating agencies are the only market participants who make it their primary focus to evaluate and disseminate information and the importance of their central roles is further affirmed and supported by rules such as those that are used 

to determine pension investor guidelines and capital requirements 

for financial institutions. All of these factors indicate that the credit rating agencies have substantial responsibilities for providing 

timely and accurate information to other market participants. 

With the complexity and volume of new types of securities being 

created, the rating agencies are uniquely situated in the process of 

structuring RMBS products through their close interaction with the 

issuers. These close relationships have led many to question the integrity of the process. Former SEC Chairman Arthur Levitt has 

said that the credit rating agencies’ decreasing dependence on revenues from structured finance products creates a conflict of interest 

that undermines their ability to provide fully independent ratings 

assessments. They are, in his words, ‘‘playing both coach and referee in the debt game.’’ 

Finally, Lou Ranieri, the pioneer of MBS, suggested in 2006 that 

the mortgage-backed security sector was ‘‘unfettered in its enthusiasm’’ and ‘‘unchecked by today’s regulatory framework.’’ 

He further stated that ‘‘We have a quasi-gatekeeper in the rating 

services and in the end the SEC is the regulatory of the capital 

market. It is the one who can touch this stuff and make a difference.’’ 

So I am eager here about the SEC’s activity in this area. 

Last year, under the leadership of Senator Shelby, Congress 

passed the Credit Rating Agency Reform Act that gave SEC more 

regulatory and oversight authority over credit rating agencies. In 

June 2007, the Commission adopted implementing rules. These 

rules require a Nationally Recognized Statistical Rating Organization, an NRSRO, to disclose a general description of its procedures 

and methodologies for determining credit ratings. We are interested in learning how the recently adopted rules will help address 

investor concerns. 

Of course, we want to hear from the credit rating agencies about 

why there were so many downgrades of RMBS in such a short period of time. We want to know what did they fail to anticipate and 

what have they learned from recent events? How are they updating 

their models to account for changes in the market and the complexity of structured products. 

I hope everyone here today recognizes the seriousness of this 

issue. We have been down this road before. After Enron we addressed the relationships among corporate managers, auditors, and 

analysts. I worry whether there may have been lessons learned 

with respect to the importance of independent objective analysis in 

those cases which were not recalled in this particular situation. 

So steps need to be taken and all options are on the table. Ultimately our goal is to strike the right balance between voluntary 

and regulatory actions and, in doing so, to enhance and restore investor confidence in the capital markets. 

Before I call on Chairman Cox, I would like to recognize Senator 

Shelby, the ranking member, and other members of the Committee 

for their statements. 


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Senator Shelby. 

STATEMENT OF SENATOR RICHARD C. SHELBY 

Senator SHELBY. Thank you, Mr. Chairman. 

Until the highly publicized failures to warn investors about the 

impending bankruptcies at Enron, WorldCom, and other large companies, credit rating agencies operated under the regulatory radar 

screen for decades in spite of their important role in capital markets. 

In recent months, widespread attention has been devoted to 

downgrades of credit ratings on structured financial products, particularly subprime residential mortgage-backed securities. Numerous reasons have been offered for why the rating agencies got it 

wrong. Some have suggested the rating agencies awarded high ratings to curry favor with the large investment banks. Others have 

criticized the rating agencies for playing an active role in structuring these complex deals, which presents a number of conflict of 

interest concerns. 

The purpose of this hearing is to explore these and other questions. 

In the 109th Congress, as Chairman Reed mentioned, the Banking Committee conducted a comprehensive review of the market in 

which the rating agencies operate. This investigation revealed an 

extremely concentrated and anti-competitive industry. Two of the 

most profitable public countries in the U.S. operated what has been 

called a partner monopoly, each controlling approximately 40 percent of the industry’s revenues and issuing 99 percent of corporate 

debt ratings. This virtual absence of competition was repeatedly 

cited as a major factor leading to ratings of inferior quality and 

practices deemed to be abusive and anti-competitive. The business 

model of the debt issuers paying for their own ratings also led some 

to question whether the rating agencies could effectively manage 

the inherent conflicts of interest. 

The Committee’s examination, culminated in the passage of the 

Credit Rating Agency Reform Act of 2006, as Chairman Reed alluded to. The Act is not quite a year old so it is premature to judge 

its impact. Moreover, SEC regulations implementing the Act have 

only been in place for a few months. 

The centerpiece of the Act replaced the opaque SEC staff licensing system with a more transparent and open registration system 

that will result, we hope, in a greater number of Nationally Recognized Statistical Rating Organizations, or NRSROs. 

The Act also provided the SEC with broad authority to supervise 

the rating agencies. The Commission may examine registered rating agencies for compliance with the rules passed pursuant to the 

Act, such as the management of conflicts of interest, adherence to 

disclosed procedures and methodologies for determining ratings 

and recordkeeping requirements. I look forward to hearing about 

the examinations currently underway, the first such exams conducted pursuant to the Act. 

In light of recent difficulties, I would also like to know if the 

Commission has all the authority, Chairman Cox, it needs to conduct vigorous oversight of the rating agencies. I understand this is 

a very complex analytical discipline. The process of rating strucVerDate Nov 24 2008 01:28 Jan 12, 2010 Jkt 050357 PO 00000 Frm 00007 Fmt 6633 Sfmt 6633 E:\HR\OC\E357.XXX E357

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tured financial instruments can be confusing and very difficult to 

comprehend. 

What is not difficult to comprehend, however, is the fact that 

some specific ratings were just plain, plain wrong and the subsequent downgrading actions by the rating agencies have had a serious impact on a significant sector of our financial system. 

It is my hope that we will be able to use today’s hearings to explore what a rating is, what it is not, how it is determined, and 

what leads an agency to change its rating. Finally, we will want 

to hear what went wrong. If there have been lessons learned, what 

are they? And what can be done to make sure it does not happen 

again? 

I would like to thank all of the participants appearing here 

today, especially Chairman Cox. Welcome again to this hearing. 

You spend a lot of time. 

Thank you, Mr. Chairman. 

Senator REED. Thank you, Senator Shelby. 

Senator Schumer. 

STATEMENT OF SENATOR CHARLES E. SCHUMER 

Senator SCHUMER. Thank you, Mr. Chairman. 

I want to thank you and Senator Dodd and Senator Shelby for 

holding this timely hearing, and thank Chairman Cox for being 

here. 

I guess we can look at the subprime crisis in two ways, or in two 

parts really. First, how do we deal with the present problem, the 

2 million homeowners who are likely to go into foreclosure? I believe that involves two things: one, finding people who can do workouts for the people on the edge of foreclosure. There is no one 

around so for so many of these people. Senators Casey, Brown, and 

I have put $100 million in the transportation appropriation to do 

that but we need more. 

Second, money for financing of these new refinancings. And there 

we are looking, some of us anyway, FHA reform has passed this 

Committee. That will affect a smaller number of homes. But getting Fannie Mae and Freddie Mac involved one way or the other 

will make a great sense. 

We also have to look at how to prevent this crisis from occurring 

again, how to prevent the poor people who were taken advantage 

of from being taken advantage of again. To that end some of us, 

I have proposed dealing with the mortgage brokers, the unlicensed 

mortgage brokers, who many of them are fine people and many of 

them are rapacious people who deserve future regulation, and punishment in a certain sense, although probably there is no law to 

do it for what they have done. That deals with the individual borrower, where the crisis started. 

But there is also the problem of how, with so many of these 

mortgages that were done on a bad basis, that were almost impossible to be repaid, that investors just scooped them up. And there 

we have the look, No. 1, at that credit rating agencies because you 

cannot expect an individual investor to know the details of these 

complex regulations, these complex packages whether they be 

mortgages or derivatives or anything else. We really depend more 


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and more, as society gets more complicated we depend more and 

more on credit rating agencies. 

And the fundamental question here is what went wrong? What 

went wrong? I met with the head of one of the agencies and they 

were telling me nothing went wrong. I will tell all of the representatives of companies that I have worked with and defended in the 

past, they are good New York companies, to say nothing went 

wrong, that is not going to fly. It defies common sense. 

These were not AAA rated packages, just shown by what has 

happened now. But the point is they were not AAA rated because 

many of the mortgages in them were not repayable to begin with. 

Now maybe the agencies will say it was not our job to do that. 

But that, too, defies what we think a credit rating agency should 

do. 

And so I think we have to explore this. This is one of the untold 

chapters so far in the subprime story, how the risks associated 

with subprime mortgages were underestimated and then swept 

under the rug by eager investors. And that is why this hearing is 

so important. 

One of our witnesses spoke about the potential distorted incentives that result from the fact that most—at the Joint Economic 

Committee we had a hearing on this. One of our witnesses spoke 

about the potential distorted incentives that result from the fact 

that most rating agencies are paid by the companies they rate 

rather than by investors who use the ratings. Chairman Reed 

pointed out, I think very aptly, that the last crisis we had in terms 

of accounting problems there was the same problem. The accountants were paid by the people who were getting the ratings from 

them. 

And so the question is is this a conflict of interest? First the rating agencies market their rating services to the issuers who, of 

course, want better ratings. Could this be creating a tendency to 

inflate ratings in the marketplace? 

And second, rating agencies typically get paid after the issuer decides to accept the rating. Well, on its face, that one just seems ripe 

for potential conflicts of interest. 

So when the rating agency has done a thorough objective job of 

rating a security, the issuer can pull its business if it does not like 

the rating. Up until the 1970’s, it was pointed out at our Joint Economic Committee hearing, all of the original credit rating agencies 

were funded by investors. It is the investors that care the most 

about the independence of the credit rating analysis, the integrity 

of the evaluation of credit quality, and the timely review of ratings. 

In the 1970’s, a switch in payment structure took place and 

today the bulk of the major rating agencies, rating related income 

now comes from fees charged by issuers. So the question looms, 

should the structure be changed? Or should there be two types of 

agencies out there, one that is paid for by investors and one that 

is paid for by the issuer? 

Are there conflicts of interest in the other model, the investor related model? And do those conflicts of interest outweigh the conflicts of interest we potentially have seen here? We should discuss 

whether we should promote the entry of serious viable investor 

funded rating agencies to compete against rating agencies that are 


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purely paid by the issuers or to provide incentives for today’s rating 

agencies to go back to their roots and have investors pay for the 

ratings. 

I do not know the answer to that question. I have not made up 

my mind. But it is certainly worth exploring, both to see if we 

should move to a new model, and also to help us shine a light on 

what went wrong in the past. 

I look forward to the witness’s testimony. 

Thank you, Mr. Chairman. 

Senator REED. Thank you, Senator Schumer. 

Senator Sununu. 

STATEMENT OF SENATOR JOHN E. SUNUNU 

Senator SUNUNU. Thank you very much, Mr. Chairman. 

I think, insofar as the credit rating agencies are concerned, their 

role in rating these securities is signaling the markets as to what 

the level of risk inherent in the securities is. The markets use that 

to price the risk. 

What we have seen really over the past 18 months, changes in 

the financial services markets, indicates that in many areas of financial services the pricing for risk was inaccurate, that there was 

not an appropriate premium placed on risk. Not just in mortgagebacked securities but in other areas of the market as well. We have 

seen the financial services industry and financial instruments respond to that. 

What we want to do today is to get a better understanding of 

how the rating services priced or estimated risk in these securities, 

whether they looked at the securities clearly, effectively, indifferently in the way that a rating agency should and to better understand what the impacts of re-rating, downgrading, or upgrading 

those securities has been. And to find out whether the legislation 

we passed last year will help address whatever problems may have 

existed in the rating agencies themselves. 

That was, I think, good legislation. I think it has been broadly 

supported as laying the groundwork for better assessing performance of credit rating agencies and also encouraging greater competition among credit rating agencies. And those that misprice risk 

or misgrade securities should be punished in the marketplace. 

However, I think it is important that we look at this, the problems here, with an understanding of what the larger fundamental 

economic problem is. And that is a collapse of the housing industry 

in the real estate market. Housing inventories are now at a 10 

month supply. It is very likely that those inventories will go even 

higher as the sales situation in the housing market further deteriorates. And that, in turn, is at least in part what is driving foreclosures, reduction in price sales, loss of equity and creating an untenable financial situation for hundreds of thousands if not millions 

of consumers. 

So we want to make sure we do not do anything, even as we take 

all of these steps, we do not want to do anything that ultimately 

will restrict consumer credit where credit should be made available 

and we do not want to discourage the securitization of mortgages 

because that is very important to making credit available to those 

that are trying to purchase a home or refinance a home. And we 


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certainly do not want to discourage the ability of those who hold 

mortgages to go to the homeowner and work out a modification and 

write down part of that mortage so that someone can stay in their 

home. 

And bad legislation, bad regulation, could possibly do any one or 

all three of those things. Again, in an environment where it is 

much more likely than not that we are moving from 10 months of 

inventory to 12 months of inventory to 14 months of inventory over 

the next six to 9 months, I think we need to be very thoughtful and 

cautious in making any changes to the regulatory structure so that 

we do the right thing for all of those that are in the most difficult 

of situations with regard to their homes. 

Thank you, Mr. Chairman. 

Senator REED. Thank you, Senator Sununu. 

Senator Casey. 

STATEMENT OF SENATOR ROBERT P. CASEY 

Senator CASEY. Mr. Chairman, thank you very much and I appreciate the opportunity to participate in this hearing. 

Chairman Cox, we appreciate your presence here and your testimony, which we will hear. 

I have just a brief statement. First of all, with regard to what 

brings us here, which is the crisis that is in the subprime problem 

we have across the country. I think the evidence now is irrefutable 

that this is a real and substantial problem for families. But as we 

know now, it has had an impact on credit and other financial measures across the world. So this is a major challenge. Part of this 

challenge is examining the role played by and the impact that our 

credit rating agencies have. 

I have to say in a personal way I have had some experience dealing with rating agencies as the Auditor General and State Treasurer of Pennsylvania. But in particular, when I was the State 

Treasurer, I remember waiting with great anticipation about 

whether or not a rating agency would give an investment grade 

rating to our tuition account program which I was in charge of and 

I had said I would make reforms to. And I could not, as a public 

official, reform or reintroduce that tuition account program that so 

many families depend upon without having the seal of approval, so 

to speak, of a rating agency. 

So I realize that as a public official, and I know I speak for probably lots of public officials and agencies, the importance we place 

upon that rating in terms of determining whether we can market 

or certify or at least point on a positive note to a program. So it 

is critically important and I realize the role that those agencies 

play in our system. 

But I think this question raises—or I should say this crisis raises 

some real questions about conflict of interest. It raises questions 

that we also encountered, I think our country encountered, in the 

lead up to the enactment of Sarbanes-Oxley. Like what happens 

when an entity is doing consulting services for entities that are involved with or seek ratings from that same entity? 

There are a lot of questions and we will be asking those today. 

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it Rating Agency Act is only a 2006 act. So we should not be precipitous in our judgments. 

But I think that when an act is in place, even for a year, I think 

it bears scrutiny and examination, especially in light of this crisis. 

So we want to make sure, Chairman Cox, that you have the resources that you need and also the authority that you need. We 

may determine that the authority is substantial and adequate but 

we want to make sure that that is among the many questions that 

we ask of you today and ask the panel that will follow you. 

Thank you very much. 

Senator REED. Thank you very much, Senator Casey. 

Senator Hagel. 

Senator HAGEL. Mr. Chairman, thank you. I do not have a statement and look forward to Chairman Cox’s testimony, as well as our 

witnesses on the second panel. 

Thank you. 

Senator REED. Thank you very much. 

Senator Brown. 

STATEMENT OF SENATOR SHERROD BROWN 

Senator BROWN. Mr. Chairman, thank you. Senator Shelby, 

thank you. Chairman Cox and other witnesses, it is good to see you 

again, Chris. Thank you for joining us to offer your insights. 

The Federal Reserve Bank of Cleveland this week held a conference in Pittsburgh on how to reclaim vacant properties. But the 

big question on the minds of the hundreds of local officials and others attending was where to find the money to tear these properties 

down. It is not just a house here and there. Whole neighborhoods 

in my State and the States many of you represent have been devastated. In many areas the only workout left is at the business end 

of a bulldozer. 

Chairman Schumer held a hearing earlier this year that focused 

on one neighborhood in Cleveland. One of the witnesses had a 

chart showing the loans of Argent Mortgage, a top lender. The purported value of these properties was two or three times the real 

value of these homes. On paper, the loan-to-value ratio for these 

loans might have been consistently 90 percent. But in the real 

world the ratio was 150 or 180 percent or even higher. More than 

a quarter of the loans Argent made over the last 4 years have already resulted in foreclosure. 

The current crisis is not simply the invisible hand at work. A lot 

of very visible hands peddled these loans to the people of Cleveland 

and elsewhere. I doubt that Adam Smith anticipated a financial 

product that was mass marketed and designed to fail on a slow 

fuse. Yet at every hearing on this topic we have heard that nobody 

was at fault. Not the brokers, not the lenders, not the issuers, apparently not the rating agencies. Evidently, we are witnessing the 

immaculate deception. 

I am sorry but, as Senator Schumer said, I do not buy that. Everyone is at fault. And everyone includes Congress. Congress needs 

to act quickly to enact the type of borrower protections contained 

in the legislation that Senators Schumer and Dodd have introduced. We also need to figure out how to get the financial markets 

to provide faster punishment for bad actors through pricing or 


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plain lack of access to capital. It is not enough that these companies only go bankrupt because by that point they have left a trail 

of destruction in their path. 

The benefit of structured finance is the dispersion of risk. But 

today responsibility is dispersed, as well. We need to figure out to 

maintain responsibility through both legal and economic means. 

I appreciate the ideas that some of today’s witnesses have suggested. It seems to me we can and we should try to refine the data 

that goes into rating products so that each actor is scrutinized on 

an ongoing basis with those available details. 

It may be, as our witnesses will testify, that it takes some time 

to decide whether an overall trend is in place. But it should take 

much less time to determine the outliers like Argent Mortgage and 

price them out of business. 

We can talk clinically about credit enhancement steps, such as 

the over-collateralization of security, but there is nothing excess 

about that collateral to the homeowner who lives in it. We must 

be much more careful in what we do. 

Thank you, Mr. Chairman. 

Senator REED. Thank you very much, Senator Brown. 

Senator Bunning. 

OPENING STATEMENT OF SENATOR JIM BUNNING 

Senator BUNNING. Thank you, Mr. Chairman. 

First of all, I would like to welcome Chairman Cox, who is my 

good friend. 

As easy as it would be to blame one bad actor in the housing 

markets, that is not the case. Numerous groups contributed to the 

mess, though some contributed more than others. 

At the top of the list is the Fed and its former chairman and now 

author, Alan Greenspan. This hearing is not about the Fed or its 

role in the housing bust, but understanding Greenspan’s Fed monetary policy is key to understanding what happened next. 

In 2000, Mr. Greenspan kept raising interest rates in the face of 

a slowdown, driving the market and the economy into a recession. 

In order to undo the problem created by tight money, he then went 

too far the other direction, taking rates as low as 1 percent. That 

easy money encouraged excessive risk-taking. 

Even though Mr. Greenspan knew it would lead to problems, he 

did nothing about it. With mortgage rates dropping to all-time lows 

housing became hot and people rushed in. Things were going great 

until about 2005, when rising interest rates and housing prices appreciation overcame the abilities of borrowers to afford the house 

they wanted. 

But instead of accepting that the good times were coming to an 

end, borrowers and lenders looked for ways to keep the party going. 

What they found was a breakdown in responsibility and common 

sense by regulators, lenders, investors, brokers, and borrowers. 

By 2005 everyone believed they had figured out the way to take 

the risk out of the lending to home buyers, even those with poor 

credit. How was this miracle pulled off? By packaging loans into 

bonds that were given a gold star by the rating agencies and sold 

to investors seeking higher returns. The banks, rating agencies, 


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and everyone else in the middle got a nice fee and washed their 

hands of the loans. 

Let me be clear that everyone involved in the process shares the 

blame for today’s mess, including the borrowers. But we are here 

to talk about the rating agencies and their roles. 

As I just mentioned, the rating agencies sat right in the middle 

of the scheme and enabled the whole thing to happen. Their ratings created a sense of security and gave investors the green light 

to buy mortgage-backed bonds. But oddly enough, I find myself in 

agreement with Chairman Greenspan when he said last week that 

the rating agencies did not know what they were doing. The rating 

agencies simply got it wrong. 

In fact, downgrading of mortgage-backed securities have already 

surpassed the level from the last housing downturn and are almost 

certain to increase further. That kind of mistake matters when 

your decisions are relied on by the entire market. 

Important questions need to be answered. Why and how were the 

rating agencies so wrong? Why did the marketplace rely on them 

so heavily? How much risky lending did the generous ratings enable? Can their ratings be relied on in the future? 

Even the rating agencies will admit that their business models 

represent a conflict of interest. They get paid a substantial fee by 

the person wanting to get rated, who then uses that rating as a 

reason to buy their product. That is like a movie studio paying a 

critic to review a movie and then using a quote from his review in 

the commercials. 

Senator Shelby was right when he led this Committee to pass 

the Credit Rating Agency Reform Act last year. Under that act, we 

are finally going to get a look at how the agencies operate and how 

they try to manage their conflict of interest. More importantly, the 

public is going to get information that is accurate. 

Chairman Cox, your Commission has just finished the rules and 

registered the first seven agencies. The information you learn from 

them will help us determine whether further regulation is needed 

or whether the market will be able to take their ratings for what 

they are worth in the future. 

Thank you, Mr. Chairman. 

Senator REED. Thank you, Senator Bunning. 

Senator Menendez. 

OPENING STATEMENT OF SENATOR ROBERT MENENDEZ 

Senator MENENDEZ. Thank you, Mr. Chairman. 

Well, here we are, 6 months after our first hearing to examine 

the subprime crisis, and we are still seeing the effects of the fallout. As far as I am concerned, unfortunately, the storm is not over. 

In fact, in some respects it still seems to be picking up wind. 

Home sales dropped yet again last month and yesterday one of 

the Nation’s largest homebuilders reported its worst ever quarterly 

earnings. This means much more than a ripple effect on our markets. It means Americans are still losing their homes. 

We still have to get to the bottom of the crisis and, as far as I 

am concerned 6 months into this, time is running out. 

Today we have a chance to examine one piece of the subprime 

puzzle. It is only one piece, however. I will reiterate a point I have 


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made before at some other hearings, we have to look carefully at 

everyone who has had a hand in this chain from the point a loan 

is signed by the borrower until it is sold on the secondary market. 

The cracks in the system cannot be patched up with a few 

tweaks here and there, and I am convinced that the market cannot 

fix this alone. Until we have uncovered all of the root causes of 

what led to the tsunami in this market, it remains ripe for more 

turmoil. 

As a member of this Committee over the past few months, I have 

heard all of the players duck their responsibility and point the finger at anyone but themselves. This has become a game of hot potato and it has to stop. 

If you ask me, everyone is responsible and should be held accountable. The fact is these loans had a real impact on real lives. 

We are not just talking about lower annual earnings or stock prices 

that have dropped. We are talking about people whose dreams 

have been shattered. We are talking about homes being taken 

away. We are talking about disintegration for some of what is, in 

essence, the American dream. 

And yet no one, no one, is willing to step up and say what hand 

they had in the process. So while I do not believe this is just about 

placing fault I think we cannot lose sight of the larger picture, and 

that is that we still have not gotten to all of the root causes of this 

fallout. I hope the Committee will not seek to presume that the 

marketplace is going to take care of all of this. I hope that that will 

not be the view of the committee and that, in fact, we must act. 

Finally, while the credit rating agencies may not be at the center 

of this chain, they are still a link. The question is, in my mind, 

which I hope we will explore today—I certainly intend to do—is 

how much did the credit rating agencies affect the process and the 

end result? Did they provide less than accurate information? Did 

they react too slowly to changes in the market? And above all, did 

they become enablers of the now crisis? Did they do so by compromising ratings by potential conflicts of interest? 

I am not quite sure how you go about doing the rating and then 

going ahead and advising how to package it so you get the best ratings possible. I am not quite sure that that is really in the interest 

of other than those who wanted to package these products and get 

the best possible ratings. I am surely not convinced that that was 

appropriate by any stretch of the imagination. 

So I am looking forward to that testimony to hear how it was 

proper to have the very essence of what would be a conflict be pursued as a normal course of business. 

Thank you, Mr. Chairman. 

Senator REED. Thank you, Senator Menendez. 

Senator Allard. 

OPENING STATEMENT OF SENATOR WAYNE ALLARD 

Senator ALLARD. Thank you, Mr. Chairman. 

First of all, I would like to thank you for holding this hearing. 

Earlier this year we held a Securities Subcommittee hearing to 

learn more about the role of securitization in the subprime markets, so we had a very interesting discussion. Credit rating agencies came up a number of times at that hearing so this will be a 


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good opportunity, I believe, for the Committee members to follow 

up on many of those matters that were raised during our Securities 

Subcommittee meeting. 

Credit rating agencies or Nationally Recognized Statistical Rating Organizations play an important role in our financial markets. 

Confidence in those ratings has been shaken following a number of 

downgrades of residential mortgage-backed securities. In fact, just 

in July and August, Standard & Poor’s issued 1,544 downgrades of 

residential mortgage-backed securities. 

The downgrades and lack of confidence have dramatic consequences. Besides the direct consequences in the financial market, 

the situation has curtailed securitization, which has made it more 

difficult for families to buy a home. 

Now former Federal Reserve Chairman Alan Greenspan has 

been quoted a number of times. I will give a more complete quote 

to the Committee. He issued a sharp rebuke in a newspaper article 

earlier this week. He said he believes that the volume of structured 

finance products will decrease. He said, and I quote ‘‘People believed they—’’ meaning the credit agencies ‘‘—knew what they were 

doing, and they do not’’ said Greenspan. ‘‘And then, quoted again, 

‘‘What kept them in place is a belief on the part of those who invested in that was that they were properly priced. Now everyone 

knows that they were not and they know they cannot really be 

properly priced. ‘‘That is one of the things I want to follow up in 

my question is that last statement. 

In a foreshadowing of these concerns, Congress enacted the Credit Rating Agency Reform Act of 2006. Unfortunately, the law is still 

being implemented. But I am hopeful that once it is in place it will 

foster a stronger more robust system with better accountability in 

order to prevent this situation from recurring. 

At today’s hearing we will hear about a number of concerns, 

some that have already been mentioned by my colleagues here on 

the Committee. But I again would like to highlight that what I see 

as a potential Achilles’ heel of this entire system is that credit ratings are not paid for the work of researching, analyzing, and creating a rating. Rather they are paid for the actual rating. It does 

not matter how much work they did or did not do that went into 

determining the rating. It is if the client does not like the final rating, they can walk away without paying a dime. 

The analogy that I can think of is if you are an accountant and 

you are doing the tax forms for somebody and you do not come up 

with the right tax balance, you would not expect them not to pay 

the accountant. I think if you want credit ratings to be accountable, 

I think you base it on the time and research and effort that goes 

into the program, not on the results and whether you like the results or not. So I think we need to check into that more closely during this hearing. 

I find this startling, especially when you put into other housing 

market context. For example, just like credit ratings, a number of 

entities rely on appraisals. Lenders use the appraisal in underwriting homes. Buyers use the appraisal in making their decisions, 

and so forth. To give the appraisal integrity, we value the objectivity of the appraiser. He or she is paid for the professional service 


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of appraising a home, not just a specific number at the end of the 

process. 

Similarly, what if home inspectors were not paid for conducting 

the inspection but only for delivering the desired report on the end? 

So there are numerous examples that we can use where this is not 

a desirable business practice. 

So I am hopeful that the FCC will be closely examining this issue 

as part of its ongoing work. We have a good lineup of witnesses, 

I know, that have a great deal to say. And I look forward to their 

testimony. 

Thank you, Mr. Chairman. 

Senator REED. Thank you, Senator Allard. 

Senator Martinez. 

OPENING STATEMENT OF SENATOR MEL MARTINEZ 

Senator MARTINEZ. Mr. Chairman, thank you very much. I will 

be very brief. 

I just wanted to say that I agree with my colleague from New 

Jersey that there is an awful lot of people or entities involved in 

this process. The outcomes are horrible. 

We saw a tremendous wave of home ownership, particularly 

among minority families, first-time home buyers, that are now facing the flip side of that coin as they face the potential for foreclosure. 

During the good times it is very difficult to focus on the problems 

that exist within the industry and the problems have existed and 

have been obvious. It is very difficult to convince anyone that there 

is broker abuse when the good times are rolling. It is equally difficult to convince anyone that RESPA, the Real Estate Settlements 

and Procedures Act, is deeply flawed and must be reformed, earnestly performed. Not during the good times, no one wants to think 

about that. We still have to look at that. It is part of the ongoing 

review that we should be doing as to all things that need to look 

in the whole industry. 

The Government-Sponsored Enterprises have a weak regulator. 

We have known that. These are enormous entities with the credit 

backing, presumed credit backing, of the U.S. Government. They 

can be tremendously at risk. Yet we have a weak regulator providing the oversight for these GSEs. We have got to have GSE reform. They may be part of the solution to the problems we currently face, but GSE reform also must be a part of it. 

So along with that I also believe that the rating agencies are part 

of the process and part of the circle of all that we need to examine 

and look at. I look forward to hearing the testimony of the witnesses. I will not prejudge whether, in fact, the current crisis is one 

that can be solved by us here in the Congress acting. It may be 

that, difficult as it is, we do not have the power to reverse the excesses of the past years. 

But I do look forward to hearing the testimony from the witnesses today and probing into this important area of what it is we 

have to review, which includes the rating agencies as well. 

Thank you for the hearing, Mr. Chairman and Ranking Member 

Shelby, we look forward to the testimony from the witnesses. 

Senator REED. Thank you very much, Senator Martinez. 


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Chairman Cox, thank you for joining us today and we all await 

your testimony. Thank you. 

STATEMENT OF CHRISTOPHER D. COX, CHAIRMAN, 

SECURITIES AND EXCHANGE COMMISSION 

Chairman COX. Thank you very much, Chairman Reed, Senator 

Shelby, and members of the Committee. 

I am pleased to be here today to discuss the important the Securities and Exchange Commission is doing concerning credit rating 

agencies. 

When Congress gave the Commission statutory authority in the 

Credit Rating Agency Reform Act of 2006 to oversee credit rating 

agencies registered with the Commission, you explicitly found that 

Commission oversight would serve the interests of investor protection. And that it would foster competition, accountability and transparency in the industry. 

The rating agency act grants the Commission broad authority to 

examine all books and records of an NRSRO. This broad examination authority permits the Commission to examine every NRSRO 

on a periodic basis for compliance with the Commission’s new rules 

governing rating agencies that we put into effect since the enactment of the law, including rules addressing conflicts of interest and 

rules prohibiting unfair, coercive or abusive practices. 

The law makes it clear that the commission’s otherwise broad 

authority does not extend to the regulation of the substance of the 

credit ratings or the procedures and methodologies that a ratings 

agency uses to determine its credit ratings. In striking this balance, the legislation gives the Commission responsibility for promoting competition in the credit ratings industry and for policing 

ratings agency activities, including in particular conflicts of interest, as has been mentioned by virtually every Senator speaking 

this morning. 

At the same time, the law declares that it is not our role to second-guess the quality of their ratings. 

The rating agency act is still just months old and it set out an 

aggressive schedule for implementation. The Commission is ahead 

of that schedule. The SEC proposed six new rules on February 2nd 

of this year, just 4 months after the law was signed. We adopted 

the final rules on May 23rd, months ahead of the June 26th—pardon me, more than a month ahead of the June 26th statutory deadline. And earlier this week the Commission issued orders granting 

registration under the rating agency act to seven credit rating 

agencies. Each of these applications was swiftly reviewed, evaluated, and determined within the 90-day timeframe specified by the 

act. As a result these seven new registered credit rating agencies 

are now subject to both the provisions of the act and the Commission’s final rules implementing it. 

In recent months, the credit rating agencies have been heavily 

criticized for their ratings of structured finance products, especially 

subprime residential mortgage-backed securities. Critics have faulted the rating agencies for assigning ratings that were too high and 

for failing to lower those ratings sooner, as the performance of the 

underlying assets deteriorated. 


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There has also been criticism that the agencies have failed to 

maintain appropriate independence from the issuers and underwriters of those securities. 

For their part, the rating agencies generally have stated that the 

incidence of mortgage delinquencies in 2006 far exceeded their 

original credit loss expectations. That was particularly so, they 

said, for subprime mortgages. They have also point out that in the 

past their expectations have turned out to be more conservative 

than the actual loss experience. They have noted several factors 

that seemed to have caused the unexpected losses this time around, 

including fraud in the mortgage origination process, deterioration 

in loan underwriting standards, and lending standards that became more restrictive very quickly, which in turn made it ever 

more difficult for over-leveraged borrowers to refinance. 

As of today, the SEC has not formed a firm view on any of these 

purported reasons that have been advanced by the credit rating 

agencies for what has happened. But we are carefully looking into 

each of them in the context of an overarching examination the 

Commission has begun with respect to these rating agencies that 

are active in rating residential mortgage-backed securities. 

This examination, which is being conducted on a nonpublic basis, 

was commenced in response to the recent events at the mortgage 

markets. In particular, the Commission is examining whether the 

ratings agencies were unduly influenced by issuers and underwriters to publish a higher rating. This examination is also focusing on the NRSROs followed their stated procedures for managing 

conflict of interest that are inherent in the business of determining 

credit ratings for residential mortgage-backed securities. In this regard, the examination will seek to determine whether the rating 

agencies’ role in the process of bringing RMBS to market compromised their impartiality. 

In addition to the Commission’s examination that I have just described, the President has requested that the President’s Working 

Group on Financial Markets examine the role of credit rating agencies in lending practices, how their ratings were used, and how the 

repackaging and selling of assets—the securitization process—has 

changed the mortgage industry. As a member of the President’s 

Working Group, the SEC is taking a leading role in this study. 

The Commission is also a member of the Credit Rating Agency 

Task Force created by the International Organization of Securities 

Commissions. In that connection, we recently chaired an IOSCO 

meeting at which the rating agencies that are most active in rating 

residential mortgage-backed securities made presentations to the 

SEC and the securities regulators of several countries, focused on 

their role in developing structured finance products. 

Mr. Chairman, I appreciate the opportunity to provide this Committee with this update on the Commission’s oversight of credit 

rating agencies, and I look forward to answering your questions. 

Senator REED. Thank you very much, Chairman Cox and let me 

begin. 

You make the point that you do not feel the statute gives you the 

authority to examine the substance of the credit ratings or the procedures and methodologies. Would you want that authority, given 

the situation we have seen in the marketplace? 


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Chairman COX. No, Mr. Chairman, at this juncture it is my judgment that you and the Congress have struck a sound balance. We 

have a great deal of authority that we are on the very front end 

of exercising. It may be that more needs to be done in this area. 

We may learn that as a result of our examinations now under way. 

But it is very easy to see in the abstract what would become of 

competition, what would become of the market, what would become 

of the substance of the ratings themselves if they just disintegrated 

into following a Government regulation on how to do it. There 

would be no innovation. There would be no potential for improvement. Or at least there would be a real collar on that because we 

would have determined a priori here is right away. 

Particularly, as Senator Schumer pointed out, in a market that 

is becoming more complex we have got to recognize that the statistical models that are used, the stress tests that are applied, are 

constantly being reevaluated and updated, and so there has got to 

be room for that. 

Still whether or not ultimately the business practices, the resources that are being applied, and the outputs are all within the 

range that Congress in the law and the SEC in practice consider 

reasonable, I think do fall within the statutory authority that you 

have given us. 

Senator REED. Mr. Chairman, among your responsibilities, and 

you listed how aggressively you have been pursuing them, which 

is to try to prevent self-dealing and conflict of interest which I 

think is appropriate, but it seems to me, too, you have to have an 

interest in—as the statute describes—that these agencies are consistently producing credit ratings with integrity. 

How do you accomplish that unless you are able to go in and look 

at the substance of their procedures and methodologies? 

Chairman COX. As I say, I think that you and the Congress have 

struck the proper balance here because—— 

Senator REED. We should restrike the balance which I think, at 

least in terms of discussion, that is on the table. 

Chairman COX. Yes, of course. 

In implementing the law and adopting our rules earlier this year 

and fleshing this out we came to the tentative conclusion, similarly, 

that we have ample authority to disgorge information from the 

credit ratings agencies, to make it public in appropriate circumstances so that the market can judge and better understand 

what the methodologies look like, so that rather than putting a collar on innovation we have a lot more hot white light focused on 

how this is done. That will affect the pricing of the services offered 

by the ratings agencies because we will have, in the marketplace, 

a better idea of what they are worth. 

It will also affect the way that people use the ratings. I am sure 

we will hear soon a full throated defense from the rating agencies 

of what they have done, in part because they think people are trying to use the ratings for purposes for which they were originally 

not intended. The more disclosure, the more transparency there is 

here, the better the market is going to be able to deal with that. 

Senator REED. Given the scope of your responsibilities, do you 

have a plan for regular examination of these credit rating agencies? 


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And would that examination involve both the Office of Compliance 

and Inspection and the Division of Market Regulation? 

Chairman COX. The very short answer to that question is absolutely, yes. The further answer is that we are in the midst, as I 

described, of just such an examination right off the bat with the 

law fresh on the books. 

Senator REED. What are your instructions to these examiners? 

What are they looking for? 

Chairman COX. First, they are focused on the bread-and-butter 

of what the statute requires of these agencies. We want to look at 

their resources. The threshold questions that we also consider at 

the time, which is very recent, 48 hours ago, when we issued an 

order to register initially these seven agencies. Are you a fly-bynight operation or are you serious? Do you have the resources that 

are necessary to do a thorough job of this? What kinds of people 

do you have? What kinds of backgrounds and experience do they 

have? What is your management structure and so on? What are 

your financial resources? 

Next we move on to conflicts of interest. Those are inherent in 

the business, as has been described here. How do you manage 

those? What are your procedures? We have, in our rules, stated ab 

initio that several things are just flat prohibited. We, of course, examine against those and make sure that those rules are being followed, that associations between the credit ratings agencies and 

those whose products they are rating are either nonexistent or 

within the rule. 

And then last, we take a look at—although not last in importance—we take a look at unfair and abusive practices. This stems 

from the competitive, the pro-competitive charter that you have 

given the SEC. 

We will find, I think, over time, whether or not each of our authorities in those three main areas can be embroidered sufficiently 

to give us all of the power that I think you want us to have. 

Senator REED. The possibility exists, given that scheme, that if 

they are reasonably capitalized and their operations are funded at 

an adequate level, and there are no overt conflicts of interest, et 

cetera, but they are consistently wrong in their ratings, they would 

still pass your test. 

Chairman COX. I think that is theoretically correct. One wonders, 

however, if we are doing a much better job of providing transparency, how long that would last in the marketplace. How much 

can you charge for being wrong every time? 

Senator REED. Thank you very much, Mr. Chairman. 

Senator Shelby. 

Senator SHELBY. Thank you. 

Chairman Cox, it is my understanding that the SEC never intended or expected that the National Recognized Statistical Rating 

Organization concept would become so widely relied upon. Given 

all of the problems we have seen over the years in the rating industry, conflicts of interest, a lack of competition, questionable ratings 

quality, abusive practices and so on, is it appropriate to reconsider 

the regulatory reliance on NRSRO ratings? 


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Or let me ask it this way: if you were to create a new system 

today would you design it differently? And if so, how so? Obviously, 

the system is flawed. 

Chairman COX. The answer to the first question is yes. And the 

answer to the second question is almost certainly somewhat different because we would have so much benefit of hindsight. 

The reason I say yes so readily to the first question is that we 

are already doing that within the SEC. We are examining our own 

rules to take a look at whether or not the express mention and reliance upon the NRSRO concept in our own rules is appropriate and 

what its consequences are. 

This all started out in 1975. It has been an accretion of small 

steps. But it has included the Congress making express mention of 

it in the 1934 act. And so I think all of us in the Congress and in 

the SEC would do well to consider whether or not post-enactment 

of this landmark legislation, in a world where we expect there to 

be more competition and more transparency, whether all of that 

was really taken into account in the first instance dating back to 

1975 when we first introduced this concept for purposes of our net 

capital rule. 

Senator SHELBY. I appreciate that. We all, I believe, realize that 

there is something gone wrong here in the rating agencies. 

Chairman Cox, would you support the forfeiture of an NRSRO 

status, either for all securities or a class of securities, by rating 

agencies that fail to satisfy minimum accuracy standards? There is 

some bad stuff out there. 

Chairman COX. That is a difficult question to answer the way 

you put it because our authority to revoke registration or to limit 

it derives directly from the statutory language as it is written. So 

if you are asking me whether we would use our authority in that 

way, given the current statute I think it would be very difficult. 

If you are asking me whether I would urge the Congress to 

amend the statute to give us more clear authority to do what you 

have suggested, I would say that the answer to that question 

awaits a little more induction. We need to learn a little bit more 

than presently we know on the front end of these examinations. 

Senator SHELBY. Professor Lawrence White of New York University, who will testify on the next panel, says—and I quote—‘‘Capital markets have no way of knowing or discovering whether there 

are better, more efficient, and effective ways of assessing the creditworthiness of bond issuers.’’ 

Do you agree with Professor White that there is no more test for 

the rating agencies? Do they lose market share for bad performance? Do inaccurate ratings cost the rating agencies business? Will 

a more competitive ratings market, which we envision, create more 

significant ramifications for inaccurate ratings? 

In other words, if people come out with inaccurate ratings—and 

they have, Enron, WorldCom, the subprime debacle—are they really punished for that? The market punishes most people when they 

are wrong. It seems like the rating agencies are getting by and who 

is getting punished are the people who bought these homes, for the 

most part. 

Chairman COX. Without question one of the major premises of 

credit rating agency legislation that Congress has just put in place 


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is that competition is a remedy to these problems. We are now at 

the beginning of opening up that space to more competition. 

As a footnote, we should observe that anybody can rate bonds but 

not anyone can be an NRSRO. So using this process we will see 

whether or not the space really does open up. And given that we 

might move from an oligopoly to a more full throated competitive 

market, whether or not the transparency that comes along with 

that—because that is another leg that the legislation stands on— 

also provides discipline, including price discipline in the marketplace. 

Senator SHELBY. There is no substitute for transparency and 

competition, is it not? 

Chairman COX. Certainly when we are talking about pricing and 

risk allocation and so on, that is absolutely right. 

Senator SHELBY. Thank you. Thank you, Mr. Chairman. 

Senator REED. Thank you, Senator. 

Senator Casey. 

Senator CASEY. Thank you, Mr. Chairman. Chairman Cox, thank 

you for your testimony and your service. 

I was struck by the juxtaposition of two parts of your testimony 

just for purposes of my first question. The question really focuses 

on I guess the threshold determination that the SEC makes when 

it seeks to commence an examination of the kind we are talking 

about here with regard to the rating agencies. 

The juxtaposition I am focused on is on page two of your testimony, you talk about the criticisms of the rating agencies. Your 

testimony says in part critics have faulted the rating agencies for 

initially assigning rates to those securities that were too high. That 

is one criticism, rates that are too high. Second criticism, failing to 

adjust those ratings sooner as the performance of the underlying 

assets deteriorated. That is the second criticism. And the third that 

you site, the third criticism, maintaining appropriate independence—or for not maintaining appropriate independence from 

issuers. 

Two paragraphs down you tell us what the Commission will examine. You say, in particular the Commission will examine whether the rating agencies were unduly influenced by issuers and underwriters—which seems to connect to that third criticism. And 

then second, you say the examination will focus on whether or not 

the rating agencies followed their procedures for managing conflicts 

of interest. And it goes from here. 

I guess I have two questions. One is in this case or in any case 

how is that threshold determination made as to what you will examine based upon a body of criticism or a body of public information or even other information that the SEC has? 

Chairman COX. The broader canvas of the various criticisms that 

have been made provides the backdrop for what we do. But the 

statute tells us, and our rules that we have adopted in furtherance 

of the statute, tells us precisely in which direction to head. That 

is why we have a focus on managerial, financial resources, on the 

competition piece, unfair and abusive practices and on conflicts of 

interest. 

Senator CASEY. So it is the SEC’s opinion that when you talk 

about—in terms of what the critics have said—that either faulting 


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the rating agencies for assigning too high a rate or not adjusting 

midstream, you think both of those lie outside of the statutory authority that you—— 

Chairman COX. No, I think it is clearly within the statutory authority to the extent that the reasons that we are examining are 

the cause. If conflicts of interest, for example, result in the credit 

ratings agency being too cozy with the person paying and with, 

therefore, the issuer or the underwriter of the security to be rated, 

and that is the reason for the pathology, the particular problem, 

such as too good a rating to start with and not a quick enough adjustment, then we would be right down the center lane of what you 

have authorized us to go after. 

Senator CASEY. I wanted to ask you about the process. Once you 

make a determination about what you will examine based upon 

your statutory or other regulatory authority, what does the process 

entail from that point? How many people are you deploying on 

this? And what is the process? What is the timeline? If you can 

take us through how this process would work. 

Chairman COX. Certainly. One reason that we were able to beat 

the deadlines that you put in the statute was, watching the legislative process, we had fair notice that this might actually be signed 

into law. You had consulted with us during the legislative process. 

So from a budget standpoint, I was able to prepare budgets and 

submit them to the Hill and to OMB and the President that contemplate doing this work. 

Certainly for the next fiscal year we are in good shape, no surprises here. This is a big priority and we are putting people from 

the Division of Market Regulation, from the Office of Economic 

Analysis and the Office of Compliance, Inspections and Examinations on the job. 

I should also add that we are locating many of those people not 

in Washington but in New York, which is the locus of a lot of this 

activity. 

Senator CASEY. My time is running out but maybe I will submit 

a question in writing for the record that speaks to this balance that 

I know we have got to strike, and it is a difficult balance. But I 

am wondering whether or not—we are out of time but I will just 

put it in for the record—that whether or not at the end of your examination, even if you are concerned about and compliant with 

striking the right balance, whether or not the SEC can recommend 

to these rating agencies that even on the question of the ratings 

themselves or changing or altering those ratings midstream, 

whether or not that is not an appropriate role for the SEC to play 

to make recommendations based upon expertise that you could retain or may have residing within the Commission. 

I will sketch that question out and send it to you. 

Thank you very much. 

Chairman COX. Thank you, Senator. 

Senator REED. Thank you very much, Senator Casey. 

Senator Sununu. 

Senator SUNUNU. Thank you, Mr. Chairman. 

Senator Reed and Senator Shelby both mentioned the concern 

about getting the ratings wrong, the degree to which inaccuracies 

in ratings done by the rating agencies should cost market share, 


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the degree to which if you are getting the ratings wrong there 

should be some punishment, some discipline exercised in the marketplace. But all of that presumes that we have good information 

to determine whether or not they got the ratings right or wrong in 

the first place. 

And I think that is an issue that really has not been explored 

to any large degree in all of these discussions. I have the testimony 

here and there are some numbers about default rates and upgrades 

and downgrades but very little comparative information. And we 

are actually in a position where performance can be measured fairly accurately. Because these are ratings designed to give an indication of the likelihood of default. Over time you can determine 

whether, in fact, the securities went into default or companies, if 

it is an equity, went into default. We can actually measure performance. 

It would seem to me that it is relatively easy to calculate accuracy and performance over time, to disclose that information and 

then to naturally compare it. Compare one agency to another. It is 

I think great, as was indicated here, that we have seen the approval of seven agencies and people have talked about the need for 

greater competition in this area. But we would want competition 

to be based on performance. But again, competition based on performance requires that you have accurate performance statistics 

out there. 

My question is to what extent does either the SEC or market 

participants have access to historical default rates, accuracy for 

these securities or others rated by the agencies? And is that made 

available in a way that we can compare performance from one organization to another over time? 

Chairman COX. That has not been the case in the past. It is now 

and will be the case in the future as a result of legislation, as a 

result of our rules. This is a very important change. Giving the 

marketplace this better information will, I think, provide a great 

more useful information than people have ever had before, which 

will in turn affect the way that ratings are used, the way that rating services themselves are priced, and certainly the way that the 

assets that are rated are priced and the risk is assessed. 

Senator SUNUNU. Will data reflecting accuracy and performance 

be made available across different types of securities, asset-back securities, debt instruments, and equities, as well? 

Chairman COX. The ratings performance information is, I believe, going to be provided in a way that will make it susceptible 

to a good deal of intermediation by analysts. So that not only what 

you describe but perhaps a lot more granularity might be possible. 

Senator SUNUNU. Who is going to determine the format of presentation, the statistics and data that will be made available for all 

companies? In other words, is the SEC facilitating this? Or is it 

happening through the rating agencies themselves or through a cooperative effort facilitated by a third party? 

Chairman COX. First, the form NRSRO that is provided under 

our new rules by the rating agencies provides a format—it is a 

forum—for this information. Second, what becomes of that information as people manipulate it and add it, subtract it, divide it, and 

so one is up to the marketplace. 


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This is, however, an area that I should add, we are going to look 

at and see whether or not we cannot constantly find ways to cause 

the information to be reported in the first place so that is more useful to investors. Not only is this the case with respect to the way 

the information is divided up when it comes to us, but also the 

technology that is used to report it. We have an overarching initiative to use computer data tags to attach to the information so that 

it can be much more easily manipulated than presently any SEC 

report can. 

Senator SUNUNU. Is data regarding the rating agencies’ accuracy 

for the 2006 class of subprime asset-backed securities available 

now for all of the agencies that rated those securities? 

Chairman COX. I believe as a result of registration that is the 

case, but let me inquire and make sure. 

[Pause.] 

The additional information I can provide, with staff help, is that 

the firms are now making information publicly available. But if 

there is a failure here we will step in and make sure that it becomes available. 

Senator SUNUNU. I will interpret that to mean not quite yet but 

we all hope it is forthcoming. And I appreciate your willingness to 

help. I think that is very important information to have as part of 

the record of this hearing and I look forward to seeing it. 

Thank you, Mr. Chairman. 

Senator REED. Thank you very much. 

Senator Menendez. 

Senator MENENDEZ. Thank you, Mr. Chairman. Welcome, Chairman Cox. We appreciate your appearance here today. 

On an aside, I had submitted questions from your July appearance and have not received them yet. And I hope we can get answers soon. 

Chairman COX. Senator, just to give you some insight into our 

Commission process, I finished with those answers some time ago 

but they go through a Commission-wide process. I will make sure 

that, with your public urging here, that you have those ASAP. 

Senator MENENDEZ. Thank you, I appreciate that. 

Mr. Chairman, here we are here 6 years after Enron, long after 

we knew the vulnerabilities that existed surrounding credit rating 

agencies. But it seems that we are, in some respects, still at square 

one. Don’t you think that we are behind the curve here? 

I know you just came to the Commission 2 years ago and we just 

passed a law last year. But there were other powers the SEC had 

before this bill. 

Chairman COX. In fact, Senator, the powers that we have and 

had then extend to areas that I think are not the center of the action here. Obviously, we have got anti-fraud authority. We had 

some very minor opportunities to get to the real meat of this with 

respect to those, not all, firms who were registered as investment 

advisers because we could examine their books and records qua investment adviser. 

But not until this legislation did the SEC have the authority to 

inspect and examine credit rating agencies as credit rating agencies. 


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Senator MENENDEZ. I look at the report that the Commission 

issued in January of 2003 as required by Sarbanes-Oxley, and it 

is interesting to note on its final page, amongst the three major 

areas: potential conflicts of interest were listed. There were three 

different categories within that context. 

That is 2003. And here we are in 2007 still talking about potential conflicts of interest. 

Let me ask you this: do you—— 

Chairman COX. Senator, as you know, the conflict of interest 

piece is a centerpiece of the Credit Rating Agency Act and our rules 

now. And so that is very sturdy authority than presently we have. 

So the registrations that brought these are firms within our rules 

as of 48 hours ago give us authority that we just did not have before. 

Senator MENENDEZ. I am only pointing out that in 2003 the 

Commission said that this was a challenge. 

Chairman COX. Yes, we were aware of the problem. 

Senator MENENDEZ. Four years later either it did not seek powers to look at it beyond it, and the Congress did not act before then. 

And so we have actually had warning signs for some time. 

Let me ask you this. It seems to me that credit rating agencies 

are playing both coach and referee in the debt game. They not only 

rate these instruments but they also offer the issuer help in constructing the product in order to obtain a certain rating. For some 

agencies these structured finance deals have accounted for more 

than 40 percent of their total revenues. Isn’t that a problem? 

Chairman COX. It is certainly potentially a problem. If is one of 

the reason that we are examining and it is one of the very points 

that we are examining against. 

Senator MENENDEZ. Let me ask you this: don’t we need more 

oversight? Do you believe that you presently have the authority to 

set standards, monitor and evaluate compliance, discipline rating 

agencies for violations including, in the most egregious cases, revocation of the SEC recognition? Do you believe you have those powers today? 

Chairman COX. Yes, we do. 

Senator MENENDEZ. In that respect, isn’t one of the things we 

should be looking at here is more transparency, the disclosure of 

any services a ratings agency has provided to the company in connection with the issuance or rating of debt, including any consulting on the structuring of the transaction and the amount of fees 

related to those services that were paid to the rating agency? 

Wouldn’t that be something that would be desirable? 

Chairman COX. Indeed, providing such services in addition to 

ratings would fall within the category of identified conflicts of interest. Our current rules require the agency to self-identify those 

conflicts of interest, and beyond that to identify the procedures that 

it has put in place to mitigate those conflicts. 

Senator MENENDEZ. So finally, what is your timeline, Mr. Chairman? What do you see as the timeframe in which the Commission 

will act so that we can all understand what we expect of these 

credit rating agencies so we do not find ourselves in a future debacle of this sort? 


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Chairman COX. The examinations are already underway. And so 

we are talking almost certainly months, not any longer period of 

time. But even during the pendency of the examinations, we are 

going to be learning things in real time. And so I would be very 

pleased to maintain a dialog with this Committee about lessons 

learned on an ongoing basis. 

Senator MENENDEZ. I appreciate that. I think it would be helpful 

for us to know so that we do not wait an inordinate period of time 

if here is something that we can would respond to. 

Thank you. 

Senator REED. Thank you. 

Senator Allard. 

Senator ALLARD. Thank you, Mr. Chairman. 

I agree that we need to get more information to the investors and 

I appreciate your answer in that regard. I just want to make sure 

that they have good information. 

If we are talking about subprime loans, doesn’t that indicate that 

there is some risk there? 

Chairman COX. Indeed. 

Senator ALLARD. Is there a way of the investor knowing what 

portion of the portfolio that they may be investing in is subprime? 

Chairman COX. Almost certainly the disclosures that would—certainly, if these are publicly registered debt instruments. 

Senator ALLARD. How does a company that has subprime loans, 

how do they get some of the higher ratings that we saw say 2 or 

3 years ago? 

Chairman COX. I think that is very dependant on the facts and 

circumstances. As you know, there are a variety of complex instruments that have been and are being designed repackage these securities. Diversification of the risk, a combination of one type of underlying asset with another, tranching, all of these are ways to segment and allocate risk. 

Senator ALLARD. Does the consumer, when they buy a security, 

do they understand—as a general rule, do they understand those 

factors that go into—— 

Chairman COX. I am sorry, who is the ‘‘they’’ in this example? 

Senator ALLARD. This would be your purchaser of stock or investor. Let’s say the investor. 

Chairman COX. One certainly would hope and expect so. But I 

think, looking back, it is also empirically true that everyone here 

ended up with something that they did not want or expect. And 

that certainly includes the investors. 

But the rating agencies themselves underestimated the default 

probabilities and they underestimated the loss that could occur in 

the event of default and overly relied, I think they have tacitly admitted, on historical data that was different from what actually 

happened in this case. 

The investors, perforce, who relied in part on that, on those ratings, were surprised and surely not all of them knew beforehand 

that this is what they were getting into. 

Senator ALLARD. One aspect that I would bring up is the valuation of the home. One of the problems we have had in these home 

failures is that we found that the appraiser—which is regulated by 

the State if they are regulated at all, or in some aspects maybe 


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even their reputation is locally determined. And sometimes whether a bank uses an appraiser or not depends on whether they facilitate that loan being made or not. 

One of the key links is the actual appraisal of the home. Is there 

a way of knowing and identifying whether certain areas of the 

country have a greater problem with appraiser values than other 

parts of the country? And can that be plugged in to the evaluation? 

Do you see that as a problem? 

You understand, I mean, when it is overappraised, your risk is 

higher. 

Chairman COX. I would imagine, because this is a subject that 

is inherently understandable and knowable, that if such data do 

not already exist, they could be readily compiled. And that further, 

putting together better information on the input side would almost 

certainly help is you aggregate the risk information. Senator Martinez earlier mentioned the possibility of RESPA reform as a way 

to improve the inputs. 

Senator ALLARD. I am not sure that can be readily compiled. I 

am trying to figure out how you can compile that. It can be a variable. It can be a pretty extreme variable, I think depending on 

maybe how these markets work out locally. I think it may be—— 

Chairman COX. It may not be readily compilable by you or by me 

right now with what is available. But it just strikes me that if this 

were a priority that things could be arranged so that it would be 

subject to ready compilation. 

Senator ALLARD. The reason I ask is I do want to see us get the 

information to the investor so they know what kind of risk that 

they are taking. One aspect of it is the actual appraisal of the property, the home itself. It seems to me like that would be very difficult to assess and put together and I see a lot a variation happening by region of the country and perhaps even from one time 

period to another time period depending on what the dynamics 

might be in a market in a certain locale. 

Thank you, Mr. Chairman. I see my time has expired. 

Senator REED. Thank you, Senator Allard. 

Senator Martinez. 

Senator MARTINEZ. Thank you very much, Mr. Chairman. 

Chairman Cox, thank you for being here and it is very fine work 

that you are doing. 

I noticed in your testimony that you mentioned that the President has requested the President’s Working Group on Financial 

Markets examine the role of credit rating agencies. As a member 

of that Presidential working group, the SEC has been taking a lead 

role in that study. Can you tell us a little more about what you are 

specifically focusing on in that aspect of your work? 

Chairman COX. Yes, the role of rating agencies in the process of 

bringing these securities to market, the overall economic impact, 

and of course, each of the members of the President’s Working 

Group has a different perspective on this and we have different information. So when we put our resources together from the Fed, 

from the Treasury, from the SEC, and from the CFTC, we have a 

much better picture. And our staff are working on aggregating all 

of that information. 


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Senator MARTINEZ. From the SEC perspective, what is your focus 

as you participate in this analysis? 

Chairman COX. We will be able, certainly, by order of magnitude 

more, post our orders earlier this week, to contribute real-time information as a result of what we are learning in our examinations. 

Senator MARTINEZ. Thank you, sir. That is all I have. 

Senator REED. Thank you, Senator Martinez. 

Chairman Cox, thank you for your testimony and for your service 

at the Commission. I am sure we will be involved in this issue 

going forward and we seek your advice and your counsel. Please do 

that. 

Chairman COX. Thank you very much, Mr. Chairman. The SEC 

looks very much forward to working with you on this issue. 

Senator REED. Thank you. 

I would now like to call forward the second panel. 

Let me thank all of our witnesses on the second panel for joining 

us today. I would like to introduce them and then call upon them 

individually for their statements. 

All of your statements will be made part of the record so you 

may summarize. In fact, we encourage summaries. I would ask you 

all to try to abide by the 5-minute timeline, so that we could engage in questioning after your comments. 

Mr. John Coffee is the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate 

Governance. He is a Fellow at the American Academy of Arts and 

Sciences, and internationally recognized authority on securities. He 

has testified before several Congressional Committees, including 

the Senate Banking Committee. It is good to see you back, Professor Coffee. We always welcome your presence and your testimony. We greatly appreciate his contributions, particularly to the 

drafting of the Sarbanes-Oxley Act, and particularly Title V. Thank 

you, Professor Coffee. 

Ms. Vickie A. Tillman is Executive Vice President of Standard & 

Poor’s Rating Services. Prior to assuming her current position in 

1999, Ms. Tillman was Executive Managing Director of Standard 

& Poor’s Structured Finance Ratings where she had worldwide 

operational and financial responsibility for directing rating activity 

for all S&P structured finance ratings services. Thank you, Ms. 

Tillman. 

Mr. Lawrence J. White, Dr. Lawrence J. White, is the Arthur E. 

Imperatore Professor of Economics at New York University’s Stern 

School of Business and Deputy Chair of the Economics Department 

at Stern. From 1986 to 1989 he served as a board member of the 

Federal Home Loan Bank Board and from 1982 to 1983 he served 

as Director of the Economic Policy Office and the Antitrust Division 

at the United States Department of Justice. He is currently the 

General Editor of the Review of Industrial Organization and Secretary-Treasurer of the Western Economic Association International. 

Mr. Michael Kanef is a Group Managing Director at Moody’s Investor Services, where he has worked since 1997. He is the head 

of the Asset Finance Group, which is responsible for ratings on residential mortgage-backed securities, term asset-backed securities, 


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and asset-backed commercial paper issued in the United States, 

Canada, and Latin America. 

Thank you all for your presence here today. We look forward to 

your testimony. 

Professor Coffee, please. 

STATEMENT OF JOHN C. COFFEE, ADOLF A. BERLE 

PROFESSOR OF LAW, COLUMBIA UNIVERSITY SCHOOL OF LAW 

Mr. COFFEE. Chairman Reed, Ranking Member Shelby, members 

of the Committee, thank you for inviting me. 

Because you have shown in your questions that this is a very informed panel, I am going to delete about five pages of background 

information and get right to the core of my testimony. 

I want to make three proposals. But it summarizes what I say 

in my written testimony to say that the current market for debt 

ratings is one in which there is very little penalty for inaccuracy. 

It is one in which there are strong incentives for optimism and 

grade inflation. There is very little reason to downgrade a rating 

that you have already made. You do that only under pain of great 

embarrassment. 

The result is we have a market in which there is a tendency toward rating inflation and toward stale ratings. I am not suggesting 

that there were demons here. I am going to paint a picture of the 

gatekeeper in this market who is under great pressure and who is 

vulnerable to that pressure. And I think the proposals have got to 

look at how to create countervailing pressure to make this market 

more sensitive to the need for greater accuracy. 

What is causing this? I give a given number of reasons. But one 

distinctive factor in this market is behaving very differently in its 

rating of corporate bonds versus its rating of structured finance 

products. I think that is because structured finance gives new 

power to the investment banks. They are assembling large pools of 

securitized assets. They are repeat players. And they can remove 

their business if they do not get what they like. They have much 

more power than the traditional corporation, which was only 0.01 

percent of the agency’s business. 

Let me document this. The data that the agencies themselves are 

producing show a huge disparity. Moody’s data—and I congratulate 

Moody’s on presenting this data—Moody’s data shows that for its 

minimum investment grade rating, Baa, over a 5-year cumulative 

default period ending in 2005 corporate bonds that received the 

minimum investment grade had only a 2.2 percent default rate. 

The collateralized debt obligations, CDOs, had a default rate of 24 

percent. They both got the same rating. That is a ratio of over 10 

to one. 

Now Moody’s tells me, quite properly, that maybe 2005 was aberrational and they suggested we look at 2006. On that basis the ratings changed slightly. The corporate debt credit default rate for 

Baa was 2.1 percent and the defaults rate for CDOs was 17 percent. 

I do not care whether you look at the 24 percent default rate or 

the 17 percent default rate, this was a default rate on securities 

labeled investment grade. And that means to each Senator who is 

here that there were public pension funds in your jurisdiction, 


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there were also other institutional buyers, universities, hospitals, 

charities, who are thinly staffed and rely on, live or die on—perhaps improperly, perhaps too casually—whether or not the securities had an investment grade rating. That is all they are checking 

before they buy. The market may efficiently price these, but there 

are unsophisticated debt purchasers who are taking more risk than 

they intend because they are buying investment grade ratings that 

have a default rate that would be extreme for a junk bond. That 

is the current problem. 

What can we do? I will also give you one other fact. These gatekeepers are subject to great pressure. Moody’s has told the Wall 

Street Journal, which quoted this just a month ago, that when they 

downgraded debt ratings in July of 2007 this year they experienced 

a market reaction. Their market share in residential real estatebacked CDOs went from 75 percent to 25 percent. That means 

there is extreme pressure on this kind of gatekeeper and it is going 

to keep them from downgrading properly and it gives you stale ratings. 

What should be done? I want to make three quick suggestions. 

One, picking up on what has already been suggested, I think the 

SEC should compute the default rates using its own criteria, not 

letting the agencies do it themselves because they will all use different criteria. It should publish this on a computer screen on a 

real-time basis so for each asset class and for each investment 

grade we will see ratings that the SEC has verified. 

What am I trying to do? I am trying to establish a competition 

based on quality and accuracy. I am trying to create a reputational 

penalty and embarrassment cost because that is the only sanction 

we can really use easily. 

Second, I would suggest, as Senator Shelby already has suggested, that NRSRO status should be forfeitable for extreme inaccuracy. If the debt rating should be 3 percent default rate and you 

have a 20 percent default rate, I would suggest that at some level, 

whether it is 6 percent, 10 percent, or 12 percent, being outside 

that boundary could cost you your NRSRO status. You forfeit it 

until you get it back. 

The last point in just 5 seconds, the real hope in this field might 

be the entry of new competitors who are based on a subscriptionfunded system, not an issuer-funded system. They face an obstacle. 

They cannot get data from issuers. Corporate issuers do not want 

to deal with people they have not hired. They like their friendly allies. I would protect the new competitors who can play a useful 

watchdog role by extending Regulation FD, Regulation Fair Disclosure, so that if a company gave any data to an NRSRO rating 

agency, it would have to give the same data to all other NRSRO 

rating agencies. That is the way to protect the independence of the 

process and protect the objective new input. None of these are costly or intrusive. 

I will leave you on that note. 

Senator REED. Thank you, very much, Professor Coffee. 

Mr. Kanef. 


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STATEMENT OF MICHAEL KANEF, MANAGING DIRECTOR OF 

THE ASSET FINANCE GROUP, MOODY’S FINANCIAL SERVICES 

Mr. KANEF. Good morning, Chairman Reed, Ranking Member 

Shelby, and members of the Committee. 

I am pleased to be here on behalf of my colleagues at Moody’s 

Investors Service to speak about the role rating agencies play in 

the financial markets and to discuss some of the steps that we believe rating agencies and other market participants can take to enhance the effectiveness and usefulness of credit ratings. 

Moody’s plays an important but narrow role in the investment 

information industry. We offer reasoned independent forward looking opinions about relative credit risk. Our ratings do not address 

market price or the many other factors beyond credit risk that are 

part of the investment decisionmaking process and they are not 

recommendations to buy or sell securities. 

Let me briefly assess the subprime mortgage market which has 

been part of the broader residential mortgage market for many 

years. While subprime mortgages originated between 2002 and 

2005 have generally continued to perform at or above expectations, 

the performance of mortgages originated in 2006 has been influenced by what we believe are an unprecedented confluence of factors. 

These include three key factors. First, increasingly aggressive 

mortgage underwriting standards in 2006 and numerous sources 

also indicate that there have been instances of misrepresentations 

made by mortgage brokers, appraisers, and others. 

Second, the weakest home price environment on a national level 

since the 1960’s. 

And third, a rapid reversal in mortgage lending standards which 

first accommodated and then quickly stranded overstretched borrowers needing to refinance. 

Moody’s response to these increased risks can be categorized into 

three broad sets of action. First, beginning in 2003, Moody’s began 

warning the market about the risks from the deterioration in origination standards and inflated housing prices. And we published 

frequently and pointedly on these issues from 2003 onward. 

Second, we tightened our ratings criteria, steadily increasing our 

loss expectations for subprime loans and the credit protection we 

looked for in bonds they backed by about 30 percent between 2003 

and 2006. While Moody’s anticipated the trend of weakening conditions in the subprime market, neither we nor most other market 

participants anticipated the magnitude and speed of the deterioration in mortgage quality by certain originators or the rapid transition to a restrictive lending environment. 

Third, we took prompt and deliberate action on specific securities 

as soon as the data warranted it. We undertook the first rating actions in November of 2006 and took further actions in December 

2006 and April and July 2007, and will continue to take rating action as appropriate. 

In addition, we are undertaking substantial initiatives to further 

enhance the quality of our analysis and the credibility of our ratings. These include enhancing our analytical methodologies, continuing to invest in our analytical capabilities, supporting market 

education about what ratings actually measure in order to discourVerDate Nov 24 2008 01:28 Jan 12, 2010 Jkt 050357 PO 00000 Frm 00033 Fmt 6633 Sfmt 6602 E:\HR\OC\E357.XXX E357

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age improper reliance on them, and developing new tools to measure potential volatility in securities prices which could relieve 

stress on the existing rating system by potentially curtailing the 

misuse of credit ratings for other purposes. 

We also continue to maintain strong policies and procedures to 

manage any potential conflict of interest in our business. Among 

other safeguards: at Moody’s ratings are determined by committees, not individual analysts. Analyst compensation is related to 

overall analyst and overall company performance and is not tied to 

fees from the issuers an analyst rates. And our methodologies are 

publicly available on our website. And finally, a separate surveillance team reviews the performance of each mortgage-backed 

transaction that we rate and that surveillance is a monthly basis. 

Finally, beyond the internal measures that we undertake at 

Moody’s, we also believe that there are reforms involving the 

broader market that would enhance the subprime lending and 

securitization process. These include the Federal licensing of mortgage brokers, tightening due diligence standards to make sure all 

loans comply with law, and strengthening and enforcing representations and warranties. 

We are eager to work with Congress and other participants on 

these and other measures that could further bolster the quality and 

usefulness of our ratings and enhance the transparency and effectiveness of the global credit markets. 

Thank you. I will be happy to answer your questions. 

Senator REED. Thank you very much. 

Ms. Tillman, please. 

STATEMENT OF VICKIE A. TILLMAN, EXECUTIVE VICE PRESIDENT FOR CREDIT MARKET SERVICES, STANDARD & POOR’S 

Ms. TILLMAN. Mr. Chairman, members of the Committee, good 

morning. 

I am Vickie Tillman. I head the rating activities at Standard & 

Poor’s. 

Recently, there has been much public discussion around credit 

rating agencies and problems in the subprime market and I appreciate the opportunity to clarify S&P’s role in the financial markets, 

to discuss our record of offering opinions about creditworthiness, 

and to assure you of our ongoing efforts to improve. 

While ratings are not guarantees, S&P’s record of evaluating the 

credit quality of RMBS transactions is excellent. As the chart on 

page six of my prepared testimony demonstrates, we have been rating RMBS for over 30 years. During that period of time, the percentage of defaults of transactions rated AAA is 0.04 percent. Even 

our lowest investment grade rating, BBB, has a historical default 

rate of only slightly over 1 percent. 

That said, we at S&P have learned some hard lessons from the 

recent difficulties in the subprime area. More than ever we recognize that it is up to us to take steps so that our ratings are not 

only analytically sound but that the market and the public fully 

understand what credit ratings are and what they are not. Our 

reputation is our business and when it comes into question we listen, we learn, and we improve. 


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Credit ratings speak to one topic and one topic only, the likelihood that rated securities will default. When we rate securities, we 

are not saying that they are guaranteed to repay, but the opposite, 

that some of them will likely default. Even our highest rating, 

AAA, is not a promise to performance but an evaluation of the risk 

of default. 

Recognizing what a rating constitutes is critical, given the recent 

market turmoil has not been the result of widespread defaults on 

rated securities but rather the tightening of liquidity and to a significant fall in market prices. These are issues our ratings are not 

meant to and do not address. 

I want to spend a minute now on how and why ratings change. 

While ratings may not be as volatile as market prices, they are not 

static either. Our view of a transaction can and does evolve as facts 

develop, often in a way that is difficult to foresee. Changes in ratings reflect these developments. This has been the case with a 

number of recent residential mortgage-backed transactions involving subprime collateral. In these transactions a number of the behavioral patterns emerging are unprecedented and directly at odds 

with historical data. 

At S&P we have been expressing in publications our growing 

concerns about the performance of these loans and the potential 

impact on these rated securities for the last 2 years. I have quoted 

a number of them in these publications and in the written testimony. 

We have also taken action including downgrading RMBS transactions more quickly than ever before and updating our analysis in 

terms of increased risk. Moreover, we continue to work to enhance 

our analytical processes by tightening our criteria and increasing 

the frequency of our reviews, modifying our analytical models, completing a recent acquisition that will help further enhance our analytics and our models, and analyzing areas in which we can do 

more, such as a way to enhance the quantity and the quality of the 

data that is available to us. 

We also take affirmative steps to guard against conflicts of interest that may arise out of the fact that we, like most other major 

rating agencies, use an issuer pay model. As the Committee knows, 

this issue was thoroughly debated by Congress during the consideration of the 2006 act. A number of independent commentators, including the head of the SEC’s Division of Market Reg, apparently 

agree that any potential conflict of interest can be managed. 

At S&P our policies and procedures include the fact that analysts 

are neither compensated based upon the number of deals that they 

rate, nor involved in the negotiation of fees. These controls and others are set forth in a code of conduct modeled after the IOSCO 

code. Every employee receives training on this code and must attest to its compliance. 

Equally important, S&P has not and will not issue higher ratings 

so as to garner more business. From 1994 through 2006, upgrades 

on U.S. RMBS ratings outpaced downgrades by a multiple factor. 

This pattern would not exist if S&P deliberately issued high ratings to please issuers. Nor would we have our excellent track 

record of predicting the likelihood of RMBS defaults if our ratings 

were the subject of undue influence. 


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Finally, Mr. Chairman, I would note that the issuer pay models 

helps bring greater transparency to the markets as it allows all investors to have real-time access to our ratings. Unlike under a subscription model, the issuer pay models allow for broader market 

scrutiny of ratings every day. 

Others have questioned S&P structured transactions that we 

rate. Again, my written statement responds to this point in detail 

but let me make our position clear. S&P does not tell issuers what 

they should or should not do. While we may discuss aspects of proposed transactions and our analysis, we do not compromise our criteria. Nor could we, as we make our basis criteria publicly available and deviations from it would be readily discoverable. 

Since my time is running very quick, let me end by reiterating 

our commitment to do all that we can to make our analytics the 

best in the world. Let me also assure you again of our desire to 

continue to work with the Committee as it explores developments 

affecting the subprime market. 

Thank you, and I would be happy to answer any questions you 

may have. 

Senator REED. Thank you very much. 

Dr. White. 

STATEMENT OF LAWRENCE J. WHITE, ARTHUR E. 

IMPERATORE PROFESSOR OF ECONOMICS, LEONARD N. 

STERN SCHOOL OF BUSINESS, NEW YORK UNIVERSITY 

Mr. WHITE. Thank you. 

Mr. Chairman, Ranking Member Shelby, members of the Committee, my name is Lawrence J. White. I am a Professor of Economics at the NYU Stern School of Business. I thank you for the 

opportunity to testify this morning. I am pleased to be here. I am 

going to summarize my statement, which in its full length is available to you. 

As you have already heard this morning, there is a lot of blame 

to go around. I will not repeat the parties, we basically know who 

they are. The bond rating firms are among them. 

What I want to do is summarize how we got to where we are, 

provide some context, and make a plea to the Committee, to the 

Congress. Let’s see what the new legislation can do before we 

enact—before you enact new legislation. 

How did we get here? Back in 1975 the Securities and Exchange 

Commission wanted to establish capital requirements for broker 

dealers, and it wanted to base those capital requirements on bond 

ratings, just as bank and insurance regulators had done in earlier 

decades. But whose ratings should be used for these purposes? To 

its credit, the Securities and Exchange Commission recognized the 

problem of the bogus rating agency that might hand out AAA ratings to everyone, or DDD ratings to everyone. And so it created the 

NRSRO category. 

Unfortunately, the NRSRO category became a protective ring 

around the incumbent bond rating industry. It protected incumbents and restricted entry. As recently as early 2003 there were 

only three NRSROs. And the whole process for administering the 

NRSRO regime was exceedingly opaque. Until the Enron hearings 


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in early 2002, NRSRO was one of the best-kept secrets in Washington. Even today it is certainly not a household phrase. 

The importance of the NRSRO designation can not and should 

not be understated. Regulated financial institutions across the financial sector were and still are required to heed the ratings of the 

NRSROs in deciding what bonds they can and cannot hold in their 

portfolios. In essence, the financial regulators have been delegating 

to third parties, the NRSROs, safety judgments about what is or 

is not appropriate for financial institutions’ portfolios. 

Because financial institutions are forced to heed the NRSROs 

ratings, the bond markets in general must heed those ratings even 

if they were to believe that the NRSRO ratings otherwise have no 

value. 

Senator Shelby earlier mentioned my earlier statements and I 

will repeat them again. There has been no clean market test of 

whether the NRSROs really are providing value to the financial 

markets under the until very recent regime. 

However, we do have the new legislation that is just 1 year old. 

The implementing registrations are just 3 months old. The new law 

was intended, is intended, to bring down the entry barriers in the 

bond rating business, open up entry, create more competition, more 

alternatives, let different business models be out there, and let the 

financial market participants make their decisions as to whose ratings are to be trusted and whose are not to be trusted. 

I would have preferred to have gone farther and to have gotten 

rid of the NRSRO category entirely, but I think the legislation provides a good start in the right direction. 

Accordingly, I urge the Committee to not enact new legislation. 

First, it would be extremely difficult, if not impossible, for legislation to prevent the kinds of mistakes that I believe the bond rating 

firms have made in the recent past. And efforts to do so really run 

great risks of stultifying the industry, of distorting the industry, 

and creating new barriers to entry. 

Second, as I just stated, the new legislation should be given an 

opportunity to work. We need to see what new competition, real 

competition, among rating companies with the different opportunities, different models, different ideas, what that can do. The financial markets, if given the opportunities, I think can make good 

choices. 

And the financial regulators should be given the opportunity to 

rethink this delegation question in light of the new market opportunities for bond rating firms with more bond rating firms out 

there. 

So let’s see what the recent legislation can do before new legislation concerning this industry is considered. 

Thank you again for the opportunity to testify today, and I will 

be happy to answer questions from the Committee. 

Senator REED. Thank you very much, Dr. White. 

Thank you all for your excellent testimony. 

Let me ask a question to both Mr. Kanef and Ms. Tillman. I will 

begin with Ms. Tillman first. 

You indicate and you take very seriously there is a code of conduct in your firm, and the same with your firm. Do you believe that 

independent of whatever we do that, that code of conduct should 


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be strengthened in areas, for example post-employment? When 

someone leaves your firm and goes directly to a client of yours it 

raises the specter—and frankly, that should be obvious. 

Second, we have been told in regard to these particular difficult 

products, structured finance, that the rating agencies were not only 

rating them but they were also helping structure them or advising 

the client as to what they could do, which raises I think an inherent conflict. Should those functions be totally separate or clearly 

disclosed or something in terms of what you can do today short of 

new legislation? 

Ms. TILLMAN. In terms of the first question about employment, 

I mean theoretically, I mean I do not necessarily think that that 

is either right or wrong in terms of whether somebody should be 

restricted. 

From a cost-benefit analysis, being that I do manage the ratings 

business, it may, in fact, have an unintended consequence of allowing us to hire the kind of skilled people that we need if they know 

that their career paths are going to be limited by where they could 

next. 

Senator REED. I think the assumption would be for a suitable period of time, as is imposed upon—— 

Ms. TILLMAN. Right. So in general, it is not something that, you 

know, I think could not work. But again, I have not thought 

through what the implications would be relative to the business. 

In terms of your second question, relative to structuring debt, we 

do not structure debt, structure the transactions. 

If I can be given a few minutes to sort of explain what our role 

is relative to this. First of all, I would like to make a point clear, 

that our criteria is absolutely transparent to all of those in the 

marketplace. They understand it. they see it. The models that we 

use internally to look at the stress testing or look at the probability 

defaults around the loans that are packaged in these, these are 

readily available in the marketplace, as well. 

So there is a lot of understanding around what kind of loan characteristics, what kind of stressing we do in the marketplace. 

So as the originator originates the loan, the investment banker 

works with the originator to package the loan. They already have 

an idea of what kind of loans they are looking for, relative to the 

way Standard & Poor’s looks at the almost 70 different characteristics, if you will, on every loan that is put in a pool. 

Once that is packaged, I think there seems to be a point that 

needs to be made, that this is actually a very sophisticated investment community. Most of these bonds, if not a majority of them, 

are sold to institutional investors or had been sold to hedge funds 

who have their own staffs that not only look at ratings, which 

again is only speaking to credit risk. But the ratings does not 

speak to suitability of the investment, the pricing of the investment. They have their own firms there, their own people that run 

their models. Or they use our models as a benchmark and run 

their own proprietary models before they will make a decision as 

to whether that is an appropriate investment for a particular risk 

appetite. 

So they go through that process and they present to Standard & 

Poor’s a package of pooled securities—— 


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Senator REED. Let me just get to the point, because my time is 

limited. 

Ms. TILLMAN. I am sorry. 

Senator REED. So there is no collaboration between Standard & 

Poor’s and the issuer, in terms of how the product is structured? 

That you simply take what they present you, evaluate it, and give 

a rating? 

Ms. TILLMAN. We have a great dialog. We have an open dialog 

with the investment bankers. They need to understand what our 

criteria is. We need to understand better what their structure is. 

And if we tell them that it does not fit with our criteria, what we 

do is tell them why it does not fit with our criteria—— 

Senator REED. And how to make it fit. 

Ms. TILLMAN. No, sir. We do not tell them how to make it better. 

That is up to them to make the determination as to whether they 

want to change the structure, change the pool, change the overcollateralization. 

Senator REED. I appreciate that. I do not want to be abrupt but 

I want Mr. Kanef to get a chance and I have another question. 

I think, at least on the surface, there is a suggestion here that 

there is something going on more than simply being presented a 

group of loans or a product, here is our rating, take it or leave it. 

There is this dialog. 

Mr. Kanef. 

Mr. KANEF. Thank you, Mr. Chairman. 

With respect to the first part of your question, I think the British 

actually may call it gardening leave, a period of time before you 

can go to a client. Certainly, I think Moody’s would be willing to 

consider such a thing, as well as other potential changes to our 

code if the SEC or yourselves were to feel that there were some aspects of that code that were not sufficient. Certainly, we would be 

willing to consider the things that you might suggest. 

With respect to your second question, as with S&P, our methodologies and models are publicly available and the parties that are 

participants with respect to the structuring of the deals, the investment bankers and their clients, are very sophisticated. 

The process actually plays two important roles, from our perspective. The first is we gain additional information from the issuers 

and the investment bankers about their transactions that we may 

not have otherwise known. We also are able to provide them with 

feedback as to the way in which our publicly available methodologies, which are very broad, apply to a specific set of facts and circumstances. 

I guess the last point I would make—I know you are running 

short on time—is that this process is really very similar to the 

process that occurs on the corporate side, as well. For example, a 

corporation might come to Moody’s, that Moody’s rates, and say I 

would like to take out a loan for $4 billion. Would that have an impact on the rating of my company? And that sort of dialog happens 

across the rating spectrum, not just in structured finance. 

Senator REED. Thank you. 

We will have the second round because of the—I do not know 

about the quality of the questions, but the quality of the answers. 

Senator Shelby. 


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Senator SHELBY. Thank you, Mr. Chairman. 

Professor Coffee, Professor White, I want to just personally thank 

you for your incisive and unvarnished observations regarding this 

whole ratings business which is obviously flawed and conflicted in 

many, many ways. 

A recent article by an American Enterprise Institute Visiting 

Scholar, Charles W. Calomiris, and a Drexel University Finance 

Professor, Joseph Mason—you might know them—says, and I will 

quote ‘‘Unlike typical market actors, rating agencies are more likely to be insulated from the standard market penalty for being 

wrong, that is the loss of business. Issuers must have ratings—’’ as 

you have pointed out ‘‘—even if investors such as banks, insurance 

companies, and pension funds do not find them accurate. That fact 

reflects unique power that the Government—’’ Dr. White alluded to 

‘‘—the Government has conferred on rating agencies to act, in a 

sense, as regulators.’’ 

Do you agree, Professor Coffee? 

Mr. COFFEE. I think both Professor White and I agree that what 

the NRSRO rating agency is doing is two things. It is providing information and it is providing licensing power. The issuer needs 

that rating, even if the market rating is inaccurate. 

Senator SHELBY. They are delegating the job, in a way, are they 

not? They are delegating their job. 

Dr. White. 

Mr. WHITE. That is thoroughly the phrase that I think is correct, 

delegating to third parties the assessment of the safety, of the portfolio, of their regulated institutions. 

Senator SHELBY. Do both of you professors agree that credit rating agencies have power that no other gatekeeper possesses and an 

NRSRO can sell its services to issuers even if the market distrusts 

the accuracy of its ratings because it is, in effect, licensing the 

issuer to sell its debt to certain regulated investors? 

Mr. COFFEE. I have said that and I still agree with that. 

Senator SHELBY. Do you agree with that? 

Mr. WHITE. Accountants may well have—auditing firms may well 

have similar powers. You said unique. I am not sure this is completely unique. But the power to issue that kind of license. I think 

Professor Partnoy, Frank Partnoy, has used that phrase of licensing. 

Senator SHELBY. Something is wrong in the rating agencies, you 

both would agree? 

Mr. WHITE. Yes. 

Senator SHELBY. Mr. Kanef, a former Managing Director at 

Moody’s, Mr. Mark Adelson—I am sure you know him—recently 

told, and this has been mentioned here already, told the Wall 

Street Journal that investment banks would take their business to 

another rating agency if they could not get the rating they needed. 

He said, and I quote ‘‘It was always about shopping around for 

higher ratings’’ although, he says, euphemisms were used for this 

process such as ‘‘best execution’’ or ‘‘maximizing value.’’ 

Given the highly lucrative nature of this sector, it has been reported that 40 percent of Moody’s total revenues last year came 

from structured finance alone, it seems natural that the banks 


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would have some leverage over rating agencies eager to profit from 

these deals. 

Could you comment on that? 

Mr. KANEF. Thank you, Senator. 

As an initial point, I would reiterate something that we mentioned just previously, which is that our methodologies for rating 

all of these assets are publicly available. They are available on our 

website free of charge. And they are widely distributed. So that 

most parties who have a desire can read the way in which we 

would be rating a transaction. 

Senator SHELBY. Is that the methodology where you are talking 

about structured instruments? 

Mr. KANEF. Yes, that is correct, sir. 

Senator SHELBY. And is that basically, and you correct me if I 

am wrong in my questioning, where you put some so-called better 

mortgages in a structure with some that are probably less desirable 

a rating, and then you tie them all together and you come up with 

some methodology and say in our judgment this is now investment 

grade ratings? 

I know this is a simplification, but isn’t that what you do? 

Mr. KANEF. Yes, I guess it is fair to say that what we do is explain to market participants and to regulators and others the desire to read the pieces, the way in which we will apply analysis to 

derive a rating in structured finance. So that would be a review of 

the pool of assets and a review of the legal structure. 

If I could just make one more statement with respect to rating 

shopping, which is the issue that I think you raised second, 

Moody’s ratings are driven primarily by the desire of the purchasers of securities. We call it a demand/pull model where the 

purchasers of the securities are the ones that are requesting the 

rating. The investment bankers and the issuers that we deal with 

only work with Moody’s and the other rating agencies that they 

choose to work with because of the pull from the investors. 

If the investors lose faith in the rating agencies themselves, that 

demand goes away and the desire for the ratings goes away. 

Moody’s has not been shy about stepping away from markets in 

structured finance where we have not been comfortable with the 

risk that we saw. So for example—— 

Senator SHELBY. Were you comfortable when you issued the rating, though? 

Mr. KANEF. I misspoke, Senator. What I mean to say is there are 

whole markets that we have not rated at all, not from inception. 

So for example, the ABCP market, which is the Asset-Backed Commercial Paper market, in Canada, which we felt had a structural 

flaw in it—— 

Senator SHELBY. Let’s talk about the ones in the U.S. that you 

have rated and profited by rating and then you become uncomfortable later when you see that a lot of those mortgages are non-performing; is that correct? 

Mr. KANEF. Yes, sir. The ratings are not static statements of 

opinion. The ratings are made at inception as a forward-looking 

opinion of the credit risk inherent in a transaction and in the securities issued pursuant to that transaction. As in any forward-lookVerDate Nov 24 2008 01:28 Jan 12, 2010 Jkt 050357 PO 00000 Frm 00041 Fmt 6633 Sfmt 6602 E:\HR\OC\E357.XXX E357

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ing opinion, as the facts that the opinion was based upon change, 

the rating changes as well. 

In fact, we view our role as participants in the market to provide 

current up-to-date rating opinion to the market. So when we see 

changes in the market, either changes in economic situations or 

changes in performance, that were not initially anticipated, we 

change the ratings to communicate that to the market. 

Senator SHELBY. Does it ever bother you in any way that the 

people that you rate these for pay you for rating them? I mean that 

is an obvious conflict to a lot of people that study ethics. 

Mr. KANEF. We acknowledge at Moody’s that there is a conflict—— 

Senator SHELBY. There should be a better way, should it not? In 

other words, there has got to be a better method of not paying you 

to rate bonds and you profit from it and then people now are holding the bag, so to speak, and will so in the future. 

My last question to you, because I hope I will be around for another round but I am not sure. And I have some questions for the 

record. 

Did it bother you when you were looking at these structured 

mortgages, so to speak, so many subprime, that a lot of these mortgage rates would be reset in 2 years, more than likely upward rather than downward, they generally always are? And that payments 

consequently to an individual borrower would go up? 

Now having realized that a lot of people pay very little, if anything, down on these mortgages, having realized or should have realized that the credit of a lot of these people was kind of spotty to 

begin with, does it not defy common sense to think that a lot of 

these mortgages would not go into default, if not before they were 

reset, but certainly after they were reset? Because a lot of these 

people are working folks all over America that I think people have 

taken advantage of. 

Does that bother you at all? Did it bother you when you were 

rating these things? 

Mr. KANEF. Mr. Chairman, do I have time to answer that question? I apologize, Senator. I am just looking at the clock. I do not 

know if I am permitted. 

Senator REED. You are permitted. 

Mr. KANEF. Thank you, sir. 

Senator SHELBY. Are you apologizing to the people that have 

been victimized or are you apologizing for taking the time? 

Mr. KANEF. I am apologizing for taking the time right now. But 

I would like to answer both of your questions, sir. 

The first question you raised was one with respect to the conflicts of interest in the issuer pay model, which is the model whereby the issuer who is seeking the rating pays for the rating. 

Moody’s acknowledges that there are conflicts in this model and 

we have several procedures and processes in place which we believe insulate the ratings process from those conflicts. I know that 

the SEC has newly provided ability to review that and comment 

upon the degree to which we have been successful in limiting those 

conflicts of interest. 

The basis of that is the committee’s decision is not an individual’s decision. So although there will be a lead analyst that interVerDate Nov 24 2008 01:28 Jan 12, 2010 Jkt 050357 PO 00000 Frm 00042 Fmt 6633 Sfmt 6602 E:\HR\OC\E357.XXX E357

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acts with an issuer, there is a committee of five to eight people who 

make the determination with respect to what a rating is. And the 

pay for analysts is not tied to the individual number of deals that 

an analyst rates. It is tied to the quality of the work that that analyst performs. 

Senator SHELBY. But the more deals you handle and the more 

issuers, the more money you get paid; is that right? 

Mr. KANEF. That is fair, but we are a global institution and—— 

Senator SHELBY. That does not mean that you do not get paid 

for what you do. 

Mr. KANEF. That is fair. 

Senator SHELBY. And you do not benefit from your conflicts of interest. 

Mr. KANEF. The other point that I would make is that the other 

models that have been suggested, including the investor pay model, 

also have conflicts of interest. So for example, if you are paid by 

an investor, the investor may wish for you to provide a lower rating 

which would enable them to receive a higher yield on the security 

issued. 

In addition, if an investor pay model is adopted, the benefit of 

the public good of the rating, the fact that the rating is made publicly available to regulators, to governments, to other investors, 

would not necessarily remain in place. 

So there are issues with the other forms of payment for ratings, 

as well as the existing one. 

Senator SHELBY. My time is up but it seems to me that money 

is trumping ethics in this area of ratings. 

Thank you, Mr. Chairman. 

Senator REED. Thank you, Senator Shelby. 

Senator Menendez. 

Senator MENENDEZ. Thank you, Mr. Chairman. 

I want to ask both Ms. Tillman and Mr. Kanef a question I asked 

your companies in April of this past year when we had a hearing. 

Do you think you have any responsibility or are in any way to be 

held accountable for the mortgage market meltdown? A simple yes 

or no would do. 

Ms. TILLMAN. I am not sure it is a simple yes or no, but certainly 

we have stated publicly that the assumptions that we used in the 

2006 originated deals did not meet the expectations. They far exceeded, in terms of early payment loss, what happened. I think one 

thing we do recognize is that while we have used historical information to make predictions of the future, that we have to find better ways of doing it. 

So we certainly understand that some things did not work in our 

analysis and we are looking into what the root causes are and what 

we can do to improve that. 

Senator MENENDEZ. But not meeting expectations is not the 

same thing as saying you performed in every way as you should 

have. 

Ms. TILLMAN. I think in terms of the process and the procedures 

that we followed, we did follow. We gave an independent assessment of what the probability of default was and the risk. 

Senator MENENDEZ. Mr. Kanef. 


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Mr. KANEF. I think that with the information that we had at the 

time that we made these ratings, we provided our best opinion to 

the market of the credit risk inherent in these securities. 

Senator MENENDEZ. So the answer is no. 

Let me ask you this then, you have both discussed changes that 

you have made either to your methodologies or additional data that 

you are collecting to make more informed decisions about ratings. 

If you do not think you had any responsibility—any responsibility—to contributing to the subprime crisis, then why is there a 

need for change now? Could some of these changes have affected 

a different outcome? 

Mr. KANEF. Senator, the rating process is a continually improving one. As we learn new information about the market and about 

the type of information that we have received, we adjust our rating 

process and we continually strive to improve our methodologies. In 

that way we try to ensure that on a going-forward basis all of the 

information that we have is incorporated in the ratings that we 

provide. 

Ms. TILLMAN. I would just agree with Mr. Kanef and say that 

ratings are not static and ratings can be for 7 years, the term of 

maturity over a longer period of time, and things change. One of 

the things that is important to understand is that we rate in 

terms—the initial rating is for the expectation of how we think 

things are going to happen. 

On the surveillance side, we actually get live information of is 

this performing the way our expectations, in fact, expected? So it 

is actual behavior as opposed to what we assumed might have happened. 

As those things change, we look into what are the challenges associated with it or what are the assumptions that we made that are 

causing these things to perform differently. 

Senator MENENDEZ. Ratings certainly are not static. That is for 

sure. On August 21st Standard & Poor’s, in a single day, in a single day, cut its rating on two sets of AAA bonds to a CCC rating. 

And Moody’s also drastically downgraded in late August. 

That was not a slight shift in a rating. Those were pretty massive changes, just like scratching the surface off of a bar of gold to 

find out it is only lead. 

I hope when you talk to us about static that that type of action 

is not the action that you subscribed to in the market not being 

static and that your reviews are not static. 

My main concern, which I still do not get the sense that the rating agencies see themselves as having any responsibility here, I 

still do not get that. I did not get it in April, I do not get it today. 

How many other gold-plated blocks of lead are out there? Are you 

expecting any more downgrades of this magnitude in the coming 

months? 

Ms. TILLMAN. To comment, I do not know which security that 

you are referring to. But if it was one called a SIV-Lite, the structure of those deals are such that if the value of the collateral exponentially changes within a month, then it hits a trigger and therefore causes the deal to unwind very rapidly. We call it a credit cliff, 

if you will. So if it does not meet the value requirements as expected—and we have not seen that happen ever. 


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That has got to be one of the first time, and I have been in the 

business for 30 years, that we have seen the value of the collateral 

within a bond change so quickly within 1 month. 

So if that is the one you are thinking about, the way they are 

structured actually has embedded in it a trigger that requires the 

SIV or the SIV-Lite, which is a structured investment vehicle, to 

unwind. 

Senator MENENDEZ. But you did not look ahead to look at the 

value of that—— 

Ms. TILLMAN. Absolutely, we looked at—— 

Senator MENENDEZ. So you went from AAA to CCC and so your 

judgment sometime had to be pretty faulty. 

Ms. TILLMAN. Well, what I am saying is we have never seen the 

value really unwind and deplete as much as it did in a 1-month 

period. So we do stress it. We do stress it in terms of what happens 

in the event of this and what happens in the event of that. 

Senator MENENDEZ. Let me just follow, if I may—— 

Ms. TILLMAN. In terms of responsibility—— 

Senator MENENDEZ. I have only got a minute left. So let me follow up where Senator Shelby left off, because I think he made 

some excellent points, and I agree with them. 

If, Mr. Kanef, you have 40 percent of your Moody’s total revenue 

last year from structured finance deals, and I listened to your answers to these questions, Ms. Tillman, you said we do not tell them 

what to do. We have a dialog. And Mr. Kanef, you said we have 

a feedback. 

Clearly, someone comes to you and in this dialog, in this feedback, I assume that there are conversations going on to say well, 

if you did this or if the entity comes to you and says what if we 

did this, then you would say we would do X, in terms of rating. Is 

that a fair assumption? 

Mr. KANEF. Yes sir, I believe it is. 

Senator MENENDEZ. So then the dialog and the feedback goes 

into a process in which the entity is molding how they are going 

to present to you in order to achieve a certain rating, a higher rate 

hopefully for their purposes. Is that not a fair statement? 

Mr. KANEF. I think, Senator, that that is a fair statement. I believe that the question is not to what extent that we are responding 

to an issuer’s request for feedback on a proposed structure, but 

what happens to that rating overall over time. Again, the demand/ 

pull model that we operate in means that if our ratings are not 

right over a long period of time we will not be in business. 

I would suggest to you that we have seen very significant adverse economic situations relating to the subprime market this 

year. But for the period from the end of 2001, 2002, 2003, 2004 and 

into 2005, in fact, the subprime RMBS ratings that Moody’s had 

produced performed significantly better than the expectations that 

we had. 

In fact, even in 2006—and we acknowledge that the economic situation, the liquidity situation, and the information that we had 

provided all worked together to cause a very difficult situation for 

those bonds—— 

Senator MENENDEZ. Mr. Kanef, it does not take a rocket 

science—and I will stop here, Mr. Chairman. 


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It does not take a rocket scientist to figure out that if I have no 

document loans, if I have no down payments, if I have ARMs that 

clearly within the income scheme are not going to allow me to be 

able to meet the future, that that security-backed instrument is 

weak in its potential. 

And so I assume that that is part of what you do in your analysis. And yes, maybe your analysis changes over time. But it is the 

initial analysis that drives the marketplace, certainly at the beginning where the hedge funds decided to go and spend a lot of money 

and then fuel the whole process, even though the instruments that 

were being used were clearly weak in terms of its security and its 

underpinnings. 

I just do not understand why we make it so complicated. It 

seems to me it is pretty simple. It just seems to me that some people missed it along the way. And why they missed it is the heart 

of the problem. 

Thank you, Mr. Chairman. 

Senator REED. Thank you, Senator Menendez. 

I propose several more questions, if my colleagues would want to 

stay, that is fine. We will make this brief. 

Professor Coffee, I was listing to Chairman Cox and he seemed 

to suggest that he would be amenable to posting information about 

performance of the rating agencies. You suggested in your testimony that the SEC could calculate a 5-year cumulative default 

rate, put it out there, and do it in a way to give the market another 

benchmark for their decisions. 

Mr. COFFEE. This is not a radical proposal. Essentially, I am saying that sunlight is the best disinfectant. I would like to take credit 

for that line, but I think Justice Brandeis said it first. 

What I want the SEC to do, however, is to compute the default 

rate because each rating agency will use different methodology and 

each will be more favorable to it. 

If you just had one screen where we saw the default rates on 

structured finance and a small pension fund out in your own State 

could look at that screen and realize that these seven new agencies 

were rating this below investment grade and the old agencies were 

rating it an investment grade, they would have some pause for concern. 

And the default rate really is the output. All I am saying is that 

the proof is in the pudding. And I would like to focus us on the output data, what the default rates are, and less on the input data, 

how many hours did you spend agonizing over this problem? 

Senator REED. Given your review of the legislation that Senator 

Shelby authored, they have the authority to do this today? 

Mr. COFFEE. I thought we had a very interesting sentence of dialog in which that question was asked by Senator Shelby of Chairman Cox. Chairman Cox said, quite properly in my judgment, that 

it is highly ambiguous. 

The statute is framed in terms of basically input data. What 

were your processes? What were your methodologies? You might 

have great processes, but if you consistently get it wrong, I think 

you should forfeit your status as a NRSRO. 


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It is like an umpire who might have great training, but he cannot tell the difference between a strike and something that is five 

feet wide of the plate. That is where I think we should act. 

Senator REED. I noticed, in my quick review of the statute, is 

that the agency, the Commission has the authority to actually revoke the status if there is not managerial and financial resources 

producing consistent ratings over time. 

Mr. COFFEE. That does focus on the input data. It is very hard 

for the agency to prove that you did not have a good staff or you 

did not work hard. I would just say if you are consistently wrong, 

that is a basis for forfeiting your status. 

Senator REED. So that might be a change, Professor White, that 

you would at least consider? 

Mr. WHITE. Certainly in the old regime I was consistently advocating a focus on output rather than inputs. In the new regime, if 

Jack is right that it is going to take new legislation, I worry that 

who knows where new legislation—with respect to the bond rating 

firms and I am only focusing on the bond rating firms—would go. 

I think the markets will, with more NRSROs out there, with 

more choices, more alternatives, more opportunity to decide what 

business model, investor pay, issuer pay, I do not know who else 

might pay, let the markets figure this out. 

In the old machine, they could not. They were forced to heed the 

NRSROs. That kind of forced participation, restrictive entry, naturally we would expect to see poor results. We would expect to see 

high prices, high profits, sluggish behavior. And I think we saw 

that sort of thing. 

I want to see what a new more competitive regime can offer. 

Senator REED. Mr. Kanef and Ms. Tillman, again thank you all 

for your excellent testimony. 

One of the issues that was raised, I think by Professor Coffee, 

is the notion that for corporate debentures, corporate debt, it is a 

pretty straightforward analysis. You look at the company’s sheet. 

As you mentioned, a company could come to you and say if we borrow $5 million what are you going to do? That is a pretty straightforward transaction. 

In these new instruments, highly complicated, in fact people that 

I respect suggest that it is very difficult to understand even if you 

devote a lot of time and attention. Should there be red flags, i.e. 

a AAA on a corporate debt of Mobil Oil, in the mind of a pension 

fund, was the same as a AAA in one of these esoteric mortgage 

funds? 

Were you safe in making that sort of its all the same? Because 

frankly, there are hedge funds and private equity people that are 

buying this stuff. But there are also a lot of managers of county 

pension systems and people like former Treasurer of Pennsylvania 

Senator Casey buying this. And they, I would assume, rely almost 

exclusively on well, if it is AAA it is the same stuff. I am buying 

Mobil debentures at AAA and I am buying whatever life mortgage 

company of the world CDOs. 

Was that not—looking back was that something that should have 

been much more clearly designated in your ratings? 

Ms. TILLMAN. I cannot speak to Moody’s statistics on what Professor Coffee has outlined. But in the same timeframe that ProVerDate Nov 24 2008 01:28 Jan 12, 2010 Jkt 050357 PO 00000 Frm 00047 Fmt 6633 Sfmt 6602 E:\HR\OC\E357.XXX E357

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fessor Coffee was talking about Moody’s statistics, our statistics 

relative to lowest investment grade BBB, in terms of its default 

rate was probably around 2 or 2.5 percent. In that same timeframe 

our corporate ratings default rate were around 2.5 to 3 percent. So 

in terms of what we are looking at, we did not really see these 

huge distinctions around the default rates of a corporate bond 

versus a default rate of a structured bond. 

In fact, if you look—and by the way, all the transition and default studies that we do are publicly available and have been publicly available for a very long time. They do go by sector. You can 

look at a corporate bond default. You can look at an ABS, you can 

look at RBS. We will continue to make sure that those are publicly 

available. 

But if you look at the default rates relative to structured debt 

versus corporate debt, actually structured debt has been, since 

1978, actually performed better than corporate debt. 

So again I am not—so I will let Mr. Kanef respond to the rest 

of it. 

Senator REED. But that structured debt, particularly the residential structured debt, a lot of that was guaranteed mortgage-backed 

securities by Fannie and Freddie and others. 

Ms. TILLMAN. No, we actually do not rate those. 

Senator REED. You do not rate those at all? 

Ms. TILLMAN. No. We rate the non-agency debt. 

Senator REED. I want to make sure we are doing apples and apples. 

Mr. KANEF. Mr. Chairman, could I respond as well, please? 

Senator REED. Yes, you may. Please. 

Mr. KANEF. As a preliminary matter, our transition studies, the 

studies of what ratings move up or down to, as well as our rating 

default studies, are also publicly available, as is the data that 

underlies those studies. So we make both of those things available 

to the public, as well. So certainly we are all for sunshine and disclosure. 

With respect to the total structured finance universe, the same 

item that Ms. Tillman was speaking to, Moody’s has a similar result. That is if you look at all of the investment grade structured 

finance issuance and you compare that to all of the corporate investment grade issuance over I think pretty much a 15 year time 

period going back from the present, you find that the overall default rates for the total investment grade buckets are very, very 

similar. So that there are differences based on specific product in 

specific time period. But over a longer term you find that, in fact, 

the performance is very similar. 

Senator REED. Professor Coffee, do you have a comment? 

Mr. COFFEE. I do not have any stake in this debate between 

Moody’s and Standard & Poor’s. 

All I would suggest is if the institutional investor out there who 

does not have its own staff could see the default rates disclosed on 

one SEC screen and could see a 17 percent default rate, I do not 

think they would buy that security at any price 

Senator REED. Let me ask another question about methodology, 

because you have said your methodology is fully available on the 

Web, you can see it. Did anyone ever come to you and say your 


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methodology is all screwed up with respect to these exotic mortgages? 

For example, I am told that for a long period of time some of the 

NRSROs were not including the debt-to-income of the borrowers in 

their models. Which, to me, is an interesting point which now has 

been reincorporated. So to what extent does this public exposure of 

methodologies actually result in any changes or feedback? 

Mr. KANEF. I guess, Senator, I appreciate you raising that point 

because this is something that has been widely reported in the 

press and it is just not a true statement of fact. For the record, I 

would like to correct that. 

Senator REED. No, that is your role. 

Mr. KANEF. For the subprime RMBS transactions that we rated 

in 2006, for over 99 percent of those transactions we received DTI 

or debt-to-income and we, in fact, considered that in our valuation. 

So I very much appreciate the opportunity to change that. 

With respect to your question, though, if I could respond, we actually do receive a significant amount of feedback on our methodologies, some positive, some negative. We try to incorporate that 

which we feel helps move the process forward. 

Senator REED. Let me ask another question with respect to 

methodology. Do you similarly publish the methodology of your surveillance activities, the frequency of your reviews, the information, 

the specifics? And how detailed is this? If this is general, an equation that says we take these five factors into consideration, that 

might be very difficult to match up with a specific investment that 

an investment fund has made or a pension fund has made. 

Mr. KANEF. Senator, we do publish, and we have published, 

methodologies of our surveillance process. It is always a balance 

between exactly what to include in that methodology for publication to ensure that people actually get to read through it. I do not 

know exactly—I guess I can only say that we do make that available and we are certainly willing to discuss questions that market 

participants have about that. 

Senator REED. Let me ask a final question, because you have 

been very patient. That is, a lot of the criticism has been directed 

against the rating agencies but also against the issuers because of 

the incredible complexity of these instruments, with several different tranches including—was there any public transparency on 

the actual instruments you were rating? 

Ms. TILLMAN. Absolutely. I think that is one of the main things 

that we make available is why the different tranches are rated a 

specific way. That goes into the transparency in terms of what we 

provide. 

The other thing I would like to add, and I believe Moody’s does 

the same thing but I will let Mr. Kanef speak to himself. We have 

investor counsels, we have issuer counsels, we have counsels, we 

speak to the investment community. And sometimes when they 

are—in terms of what our methodologies so there can be a discussion. Again this is away from any transaction so that we have a 

dialog and get input from the community in terms of what it is 

that we are doing. 

In fact, when we are thinking of a major criteria change relative 

to specific types of bonds, we have put out an RFP to the commuVerDate Nov 24 2008 01:28 Jan 12, 2010 Jkt 050357 PO 00000 Frm 00049 Fmt 6633 Sfmt 6602 E:\HR\OC\E357.XXX E357

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nity to get input from them, to see what their—and it is not just 

to the investment bankers, it is to a larger broader community that 

extends beyond that in terms of what do you think about the way 

we are thinking. 

Because we cannot operate really insular around a lot of the stuff 

that we are doing. And so that process in itself takes on and really 

is an open dialog around they are more than happy to tell us that 

we are crazy around what our thoughts are. They do not hold back. 

But that dialog, in itself, does take place as well. 

Senator REED. I want to thank you. I think this could go longer. 

The issue is complex and multifaceted. But you have been extraordinarily patient and we thank you for your attendance and your 

testimony. 

The record will remain open for an additional week. There may 

be following on questions from my colleagues. If you have additional information that you would like to send us, please do so. 

At this time, I would adjourn the hearing. 

[Whereupon, at 12:04 p.m., the hearing was adjourned.] 

[Prepared statements supplied for the record follow:] 


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