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

Statement

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SEN. CHARLES E. SCHUMER (D-NY): Well, thank you, Mr. Chairman.

I want to thank you and Senator Dodd and Senator Schumer 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? And I believe that involves two things. One, finding people who can do workouts for the people on the edge of foreclosure. There's no one around for so many of these people. Senators Casey, Brown and I have put a $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'll affect a smaller number of homes. But getting Fannie Mae and Freddie Mac involved, one way or the other, will make a great deal of sense.

But 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 again. And to that end, some of us -- I've 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's no law to do it for what they've done. That deals with the individual borrower, where the crisis started.

But there's 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 scoop them up. And there we have to look, number one, at the credit rating agencies, because you can't 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 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're good New York companies -- to say nothing went wrong, that ain't going to fly. It defies common sense.

These were not AAA-rated packages, just shown by what's 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 wasn't 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's 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, and 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, 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 doesn't like the rating. Up until the '70s, 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 time review of ratings. In the '70s, 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 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 don't know the answer to that question. I have not made up my mind. But it's 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 witnesses' testimony. And thank you, Mr. Chairman.

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