Hearing of the Senate Banking, Housing and Urban Affairs Committee - The Role and Impact of Credit Rating Agencies on the Subprime Credit Markets

Statement

SEN. REED: I'm going to call the hearing to order, and 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 of have expressed significant concerns about problems of the subprime mortgage 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 traunches of residential mortgage-backed securities. The recent wave of downgrades has 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 rating agencies and 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. Increasing complexity of structured products like mortgage-backed securities and CDOs, collateralized debt obligations and the perceived lack of transparency in this sector 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 multi-billion dollar structured finance industry. 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 used to determine pension investment guidelines and capital requirements for financial institutions.

All of these factors indicate that the credit rating agencies have substantial responsibilities for proving 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 a process of structuring our MBS products through their close interactions 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' increasing 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 Bernieri (sp), the pioneer of NBS, 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 ratings services, and in the end the SEC is the regulator of the capital market. It is the one who can touch this stuff and make a difference.

So I'm eager to hear about the SEC's activity in this area. Last year under the leadership of Senator Shelby, Congress passed a 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 the general description of these procedures and methodologies for the determining credit rating. We are interested in learning how the recently adopted rules will help address investor concerns. And of course, we want to hear from the credit rating agencies about why there are so may downgrades of -- or NBS 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've 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 this cases which were not recalled in this particular situation. Significant 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 doing so to enhance and restore investor confidence in the capital markets.

And 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.

Senator Shelby.

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SEN. REED: Well, 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've seen in the marketplace?

MR. COX: No, Mr. Chairman, at this juncture it's 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 underway.

But it's 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's the right way.

Particularly, as Senator Schumer pointed out, in a market that's constantly becoming more complex, we've got to recognize that the statistical models that are used, the stress tests that are applied, are constantly being re-evaluated and updated. And so there's 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.

SEN. REED: Mr. Chairman, among your responsibilities -- and you listed how aggressively you've been pursuing them, which is to try to prevent the 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. And how do you accomplish that unless you're able to go in and look at the substance of their procedures and methodologies?

MR. COX: Well, as I say, I think that you and the Congress have struck the proper balance here, because --

SEN. REED: Well, (we ?) strike the balance, which I think, at least in terms of discussion, that's on the table.

MR. COX: Yes, of course. And in implementing the law and adopting our rules earlier this year, fleshing this out, we came to the tentative conclusion, similarly, that we have ample authority to disgorge information from the credit rating 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'll have in the marketplace a better idea of what they're worth. It will also affect the way that people use the ratings. I'm sure we will hear soon a full-throated defense from the ratings 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.

SEN. REED: Given the scope of your responsibilities, do you have a plan for regular examination of these credit rating agencies? Does that examination involve both the Office of Compliance and Inspection and the Division of Market Regulation?

MR. 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.

SEN. REED: And what are your instructions to these examiners? What are they looking for?

MR. COX: Well, first, they're focused on the bread and butter of what the statute requires of these agencies. We want to look at their resources, the sort of 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-by-night 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's 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 rating agencies and those whose products we are rating are either non-existent or within the rule.

And then, lastly, we take a look at -- although not lastly in importance -- we take a look at unfair and abusive practices. This stems from the pro-competitive charter that you have given the SEC. And 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 the power that I think you want us to have.

SEN. REED: Well, the possibility exists, given that scheme, is 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're consistently wrong in their ratings, they would still pass your test.

MR. 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?

SEN. REED: Thank you very much, Mr. Chairman.

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SEN. 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'll begin with Ms. Tillman first, is that you indicate and you take very seriously, there is a code of conduct in your firm, and same as your firm. Do you believe that independent of whatever we do, that code of conduct should 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, frankly. That should be obvious.

And second, we've 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 that -- 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 don't 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 rating 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 go next.

SEN. REED: I think the assumption should be for a short -- a suitable period of time.

MS. TILLMAN: A suitable period of time, yes.

SEN. REED: As is imposed upon us.

MS. TILLMAN: Right, so in general it's not something that you know, I, you know, think couldn't work. But again I haven't thought through what the implications would be relative to the business.

And in terms of your second question, relative to structuring debt, we don't 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'd like to make a point clear that our criteria is absolutely transparent to all 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 loan 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're looking for relative to the way Standard & Poor's looks at, you know, the different, almost 70 different characteristics if you will on every loan that is put in a pool.

Once that's packaged, I think there seem 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 risks, but they are also -- we don't -- the ratings doesn't speak to suitability of the investment, what 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.

SEN. REED: Let me just get to the point, because my time is limited.

MS. TILLMAN: I'm sorry.

SEN. REED: So that 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 dialogue. We have an open dialogue 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 doesn't fit with our criteria, what we do is tell them why it doesn't fit with our criteria --

SEN. REED: And how to make it fit. I mean --

MS. TILLMAN: No, no sir, we don't tell them how to make it better. That's up to them to make the determination as to whether they want to change the structure, change the pool, change the overcollateralization.

SEN. REED: Well, I appreciate that. I don't want to be abrupt, but I want Mr. Kanef to get a chance on the other question that I --

MS. TILLMAN: Sure.

SEN. REED: But 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 dialogue.

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'd 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 -- from the issuers and the investment bankers about their transactions that we may not have otherwise known. And 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.

And I guess the last point I would make -- I know that you're 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 dialogue happens across the rating spectrum, not just in structured finance.

SEN. REED: Well, thank you. We will have a second round because of the -- I don't know about the quality of the questions, but the quality of the answers.

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SEN. REED: Thank you, Senator Menendez.

I propose several more questions. If my colleagues would want to stay, that's fine. But I'm -- we'll make this brief.

Just -- Professor Coffee, I was listening to Chairman Cox and he seemed to suggest that he'd be amenable to posting information about performance of the rating agencies. You suggested in your testimony that the SEC could calculate five-year cumulative default rates, 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 approach. It's -- essentially I'm saying that sunlight is the best disinfectant. I'd 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 more favorable to it. If we just had one screen where we saw the default rates on structured finance and a small pension fund out in your home state could look at that screen and realize that the seven new agencies were all rating this below investment grade --

SEN. REED: Mm-hmm.

MR. COFFEE: And that old agencies were rating it at investment grade --

SEN. REED: Mm-hmm.

MR. COFFEE: -- they'd have some pause for concern and the default rate really is the output. All I'm saying is that the proof is in the pudding and I'd 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?

SEN. REED: And given your review of the legislation that Senator Shelby authored, do they have the authority to do this today?

MR. COFFEE: I thought we had a very interesting sentence of dialogue in which that question was asked by Senator Shelby of Chairman Cox. And Chairman Cox said -- quite properly, in my judgment -- that it's highly ambiguous. The statute is framed in terms of basically input data -- what were your processes? What are your methodologies? You might have great processes, but if you consistently get it wrong I think you should forfeit your status as an NRSRO. It's like an umpire who might have great training, but he can't tell the difference between a strike and something that's five feet wide of the plate. That's where I think we should act.

SEN. REED: I noticed -- and my quick review of the statute is that the agency -- the commission has the authority to actually revoke the status if there's not managerial and financial resources producing consistent ratings over time.

MR. COFFEE: That does focus on the input data.

SEN. REED: Exactly.

MR. COFFEE: It's a very hard for a agency to prove that you didn't have a good staff or you didn't work hard. I would just say if you're consistently wrong that's a basis for forfeiting your status.

SEN. REED: Right. 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 what -- if Jack is right that it's going to take new legislation I worry that who knows where new legislation with respect to the bond rating firms -- and I'm 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 don't know -- who else might pay -- let the markets figure this out. In the old regime they couldn't, and they were forced to heed the NRSROs. That kind of forced participation -- you know, restrictive entry -- would -- 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.

SEN. 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 was the notion that for corporate debentures -- corporate debt -- it's a pretty straightforward analysis if you look at the company's sheet. As you mentioned the company could come to you and say, "If we borrow $5 million what are you going to do?" That's a pretty straightforward transaction.

In these new instruments, they're highly complicated. In fact, people I -- that I respect suggest that it's very difficult to understand even if you devote a lot of time and attention. Should it -- that the red flags, i.e. a Triple A on a corporate debt of Mobil Oil in the mind of a pension fund as -- was the same as a Triple A on one of these esoteric mortgage funds? Were you safe in making that sort of it's 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's Triple A it's the same stuff. I'm buying Mobil debentures at Triple A and I'm buying, you know, whatever -- you know, Life Mortgage Company of the World CDOs. Wasn't that a sort of in a -- looking back was that something that should have been much more clearly designated in your ratings?

MS. TILLMAN: Well, I can't speak to Moody's statistics on what Professor Coffee has outlined but in the same time frame that Professor Coffee was talking about Moody's statistics our statistics relative to the lowest investment grade, Triple B, in terms of its default rate was probably around 2 (percent), 2-and-a-half percent. In that same time frame our corporate ratings default rate were around 2-and-a-half to 3 percent. So in terms of what we were looking at we didn't really see these huge distinctions around, you know, 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 know, you can look at a corporate bond default -- you can look at an ABS -- you can look at an RBS and we will continue to make sure that those are publicly available. But if you look at the defaults rates relative to structured debt versus corporate debt, actually structured debt has been over the -- since 1978, okay, actually performed better than corporate debt. So, you know, again, part of --

SEN. REED: But does that --

MS. TILLMAN: Let Mr. Kanef respond to the rest of --

SEN. REED: But that structured debt, particularly residential structured debt, a lot of that was guaranteed mortgage-backed securities by Fannie and Freddie and --

MS. TILLMAN: No, we actually don't rate those.

SEN. REED: Don't rate those all?

MS. TILLMAN: No.

SEN. REED: All right -- good. I want to make sure --

MS. TILLMAN: We rate the non-agency debt.

SEN. REED: -- want to make sure we're doing apples and apples.

MR. KANEF: Mr. Chairman, could I respond as well, sir?

SEN. REED: Yes, you may -- please.

MR. KANEF: Thank you. 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, and 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 bucket are very, very similar. So that there are differences based on specific products in specific time period but over a longer term you find that in fact the performance is very similar.

SEN. REED: Professor Coffee, you have a comment?

MR. COFFEE: I don't have any stake in this debate between Moody's and Standard and Poor's. All I would suggest is if the institutional investor out there who doesn't have its own staff could see the default rates disclosed on one SEC screen and could see a 17 percent default rate I don't think they would buy that security at any price.

SEN. REED: Let me ask another question about methodology because you've said your methodology is fully available on the Web -- you can see it. Did anyone ever come to you and say your methodology is all screwed up with respect to these exotic mortgages, for example? I'm told that for a long period of time some of the NSROs were not including the debt-to-income of the borrowers in their models which to me is a 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. COFFEE: I guess this is -- 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'd like to correct that.

SEN. REED: No, that's your --

(Cross talk.)

MR. COFFEE: For the sub prime RNBS 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.

SEN. REED: Fine.

MR. COFFEE: With respect to your question, though, if I could respond -- we actually do receive significant amount of feedback on our methodologies -- Some positive, some negative -- and we try to incorporate that which we feel helps move the process forward.

SEN. REED: Let me ask you another question with respect to methodology. Do you similarly publish the methodology of surveillance activities? The frequency of your reviews, the information, the specifics? And how detailed is this? If this is and I -- if this is general, you know, 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. COFFEE: We -- Senator, we do publish and we have published methodologies of our servicing process -- pardon me, our surveillance process. It is always a balance between how -- exactly what to include in that methodology for publication to ensure the people actually get to read through it. I don't know exactly -- I guess I can only say that we do make that available and we're certainly willing to discuss questions that market participants have about that.

SEN. REED: Let me ask the final questions because you've 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 traunches including several -- was there any public transparency on the actual instruments you were rating?

MS. TILLMAN: Oh, absolutely. I mean, I think that's one of the main things that we make available is why the different traunches are rated a specific way, and that goes into the transparency in terms of what we provide. The other thing I'd like to add -- and I believe Moody's does the same thing but I'll let Mr. Kanef speak to himself -- we have investor councils, we have issuer councils, we have councils -- we speak to the investment community, and sometimes when we're -- in terms of what our methodologies are so there can be a discussion.

Again, this is away from any transactions so that we have a dialogue and get input from the community in terms of what it is that we're doing, and in fact when we're thinking of a major criteria change relative to specific types of bonds we put out a RFP to the community to get input to it and to see what their -- and it's not just to the investment bankers -- it's to a larger broader community that extends beyond that in terms of, you know, what do you think about the way we're thinking, you know, because we can't operate really insular around a lot of the stuff that we're doing. And so that process in itself takes on and really is an open dialogue around, you know, they -- more than happy to tell us that we're crazy around what our thoughts are. They don't hold back. But that dialogue in itself does take place as well.

SEN. REED: Well, 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. And 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'd like to send to us please do so. At this time I would adjourn the hearing.

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