1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION 2 (REVISED 01-17-03) 3 4 5 6 HEARING ON THE CURRENT ROLE AND FUNCTION 7 OF CREDIT RATING AGENCIES IN THE OPERATION 8 OF THE SECURITIES MARKETS 9 10 11 12 13 Thursday, November 21, 2000 14 9:00 a.m. 15 16 Washington, D.C. 17 18 19 20 21 BEFORE: HARVEY PITT, Chairman 22 PAUL ATKINS, Commissioner 23 CYNTHIA A. GLASSMAN, Commissioner 24 HARVEY GOLDSCHMID, Commissioner 25 ROEL CAMPOS, Commissioner 1 PARTICIPANTS: 2 3 YASUHIRO HARADA 4 Senior Executive Managing Director 5 Rating and Investment Information, Inc. 6 7 STEVEN W. JOYNT 8 President and Chief Executive Officer 9 Fitch, Inc. 10 11 JAMES A. KAITZ 12 President and Chief Executive Officer 13 Association for Financial Professionals 14 15 AMY B.R. LANCELLOTA 16 Senior Counsel 17 The Investment Company Institute 18 19 JACK V. MALVEY 20 Managing Director and Chief Global Fixed-Income Strategist 21 Lehman Brothers Inc. 22 23 ERWIN W. MARTENS 24 Managing Director 25 Putnam Investments, LLC 1 LARRY G. MAYEWSKI 2 Executive Vice President and Chief Ratings Officer, Ratings 3 Division, The A.M. Best Company 4 5 RAYMOND W. MCDANIEL 6 President 7 Moody's Investor Services, Inc. 8 9 STEPHANIE B. PETERSEN 10 Senior Vice President 11 Taxable Money Fund and Municipal Research 12 Charles Schwab & Co., Inc. 13 14 BARRON H. PUTNAM, Ph.D. 15 President and Financial Economist 16 LACE Financial Corporation 17 18 PAUL SALTZMAN 19 Executive Vice President and General Counsel 20 The Bond Market Association 21 22 STEVEN L. SCHWARCZ 23 Professor of Law 24 Duke University School of Law 25 1 DAVID L. SHEDLARZ 2 Chief Financial Officer 3 Pfizer Inc. 4 5 NEAL E. SULLIVAN 6 Partner 7 Bingham McCutchen LLP 8 (on behalf of Rating and Investment Information, Inc.) 9 10 JEROME B. VAN ORMAN, JR. 11 Vice President, Finance and CFO, North American Operations 12 General Motors Acceptance Corporation 13 14 J. BEN WATKINS, III 15 Director, Division of Bond Finance 16 State of Florida 17 18 SEC STAFF: 19 Bob Colby 20 Larry Harris 21 Tom McGowan 22 Michael A. Macchiaroli 23 John McCarthy 24 Annette L. Nazareth 25 1 C O N T E N T S 2 PAGE 3 4 Session I: THE CURRENT ROLE AND FUNCTION OF 5 CREDIT RATING AGENCIES 6 Annette L. Nazareth, Director, Division of 7 Market Regulation 8 8 9 Session II: INFORMATION FLOW IN THE CREDIT 10 RATING PROCESS 11 Lawrence E. Harris, Chief Economist, Office 12 of Economic Analysis 64 13 14 Session III: POTENTIAL CONCERNS REGARDING THE 15 ROLE OF CREDIT RATING AGENCIES (CONFLICTS 16 OF INTEREST/ABUSIVE PRACTICES) 17 John A. McCarthy, Associate Director, 18 Office of Compliance Inspections and 19 Examinations 129 20 21 Session IV: POTENTIAL BARRIERS TO ENTRY/REGULATORY 22 TREATMENT 23 Robert Colby, Deputy Director, Division of 24 Market Regulation 179 25 1 P R O C E E D I N G S 2 CHAIRMAN PITT: Apparently the fog has delayed some 3 of our panel. I think we're ready to begin, so good morning. 4 I'd like to welcome everyone to the second round of the 5 Commission's rating agency hearings. And if today's hearing 6 is anything like the last one, I'm certain everyone will find 7 the time spent worthwhile, and certainly not boring. 8 As I noted in my introductory remarks at the first 9 hearing, rating agencies have been providing opinions on the 10 creditworthiness of issuers of securities and other financial 11 obligations for nearly a century. And during this time, the 12 importance of these opinions to investors and other market 13 participants and the influence of these opinions on the 14 securities markets has increased exponentially, particularly 15 with the increase in the number of issuers and the 16 introduction of new and complex financial products. The 17 globalization of the financial markets also has served to 18 expand the role of credit ratings to jurisdictions beyond 19 just the United States. 20 So today credit ratings affect securities markets 21 in a number of important ways, including an issuer's access 22 to, and cost of, capital, the structure of financial 23 transactions, and the ability of fiduciaries and others to 24 invest in particular securities and instruments. In 25 addition, regulators such as the Securities and Exchange 1 Commission have increasingly used credit ratings as a 2 convenient surrogate for the measurement of risk, in 3 assessing investments held by regulated entities. 4 Because of the impact of rating agencies on the 5 investing public, and our capital markets, we announced in 6 March that we would engage in a thorough examination of 7 ratings agencies, to ascertain facts, conditions, practices, 8 and other matters relating to the role of rating agencies in 9 the U.S. capital markets. Since then, the Sarbanes-Oxley Act 10 has directed us to conduct a study of the rating agencies, so 11 there's a confluence between our initially announced hearings 12 and our legislative mandate. 13 These hearings represent the culmination of months 14 of effort by the staff and the Division of Market Regulation, 15 our Division of Investment Management, and our Office of 16 Compliance Inspections and Examinations. I'd like to thank 17 the staff for their tremendous efforts in organizing these 18 hearings. I'd also like to thank the members of our panel 19 for taking the time to appear with us today. They do so 20 donating their time and their thoughts and their expertise to 21 us, and we're very grateful to each of you for taking that 22 time. 23 And now I'll turn these proceedings over to Annette 24 Nazareth, director of our Division of Market Regulation, who, 25 along with Bob Colby, has been a driving force behind 1 organizing these sessions. Annette? 2 MS. NAZARETH: Thank you, Chairman Pitt. I, too, 3 would like to welcome all of you to the Commission's second 4 credit rating agency hearing. I found our first hearing, 5 held just this past Friday, to be extraordinarily productive. 6 As you may know, that hearing followed the same format that 7 we're going to use today, and our panel was comparably 8 balanced. 9 Participants in our first hearing engaged in a 10 lively and candid dialogue that shed light on many of the 11 difficult and important issues concerning the role of rating 12 agencies in our securities markets. If today's discussions 13 are comparably forthright and substantive, I have no doubt 14 that our hearings will have achieved their goal of providing 15 the Commission with valuable real world insights as it 16 pursues a variety of important objectives relating to credit 17 rating agencies. 18 Several initiatives currently are under way at the 19 Commission that will benefit from these hearings. For 20 example, the Commission has been directed by Congress to 21 conduct a study of the role and function of credit rating 22 agencies in the operation of our securities markets. This 23 directive was issued in Section 702 of the recently enacted 24 Sarbanes-Oxley Act of 2002, which also directs the Commission 25 to submit a report on the study to the President and Congress 1 by January 26, 2003. 2 It is our goal and expectation that these hearings 3 will enable us to parse, in a more meaningful way, the areas 4 of consideration set forth in Section 702. Specifically, 5 these areas include the role of credit rating agencies in the 6 evaluation of issuers of securities; the importance of that 7 role to investors and the functioning of the securities 8 markets; any impediments to the accurate appraisal by credit 9 rating agencies of the financial resources and risks of 10 issuers of securities; any measures which may be required to 11 improve the dissemination if information concerning resources 12 and risks when credit rating agencies announce credit 13 ratings; any barriers to entry into the business of acting as 14 a credit rating agency and any measures needed to remove such 15 barriers; and any conflicts of interest in the operation of 16 credit rating agencies, and measures to prevent such 17 conflicts, or ameliorate the consequences of such conflicts. 18 Another goal of these hearings is to assist the 19 Commission in determining how its regulatory framework should 20 best be applied to credit rating agencies. For over 25 21 years, the Commission has been using credit ratings from 22 nationally recognized statistical rating organizations, also 23 known as NRSROs, in Commission rules and regulations. 24 During this time, the Commission has considered a 25 number of issues related to credit rating agencies, including 1 the need for direct oversight authority over credit rating 2 agencies, and the appropriate role of ratings in the federal 3 securities laws. Nonetheless, there remain a number of 4 difficult issues, many of which are reflected in Section 702 5 of Sarbanes-Oxley, that the Commission would like to review 6 before formally considering possible changes to the rules and 7 regulations regarding rating agencies. Our agenda today 8 reflects these issues. 9 Before I introduce today's participants, I will 10 briefly mention some details concerning our schedule. This 11 morning, we'll have two sessions. We'll begin with our 12 opening session, with brief introductory remarks from each of 13 the hearing participants, and we'll then discuss in some 14 detail the current role and functioning of credit rating 15 agencies. This session will last 90 minutes and will be 16 followed by a 15-minute break from about 10:30 to 10:45. 17 Our second session this morning will explore the 18 information flow in the credit rating process. That is, how 19 rating agencies obtain and use information in the rating 20 process, and how, and what type of information is 21 communicated publicly and privately to issuers of credit 22 ratings. At 12:15 we'll break for lunch for about an hour 23 and 15 minutes, and we'll resume with our afternoon program 24 at 1:30. 25 This afternoon from 1:30 to 3:00, we will focus on 1 concerns regarding the role of credit rating agencies, such 2 as potential conflicts of interest and abuse of practices, 3 and our final panel from 3:15 to 4:45 will address potential 4 barriers to entry in the rating business, and the appropriate 5 degree and manner of regulatory oversight of rating agencies. 6 As you see, we have a very ambitious agenda to 7 cover in a relatively short period of time. So with that out 8 of the way, I'd like to introduce each of the participants, 9 and then circle back for any opening remarks that you may 10 wish to make. First, I would like to introduce our 11 Commissioners who are here today. In addition to Chairman 12 Pitt, who again, we're very grateful took the leadership role 13 in calling for these hearings, we have Commissioner Atkins, 14 Commissioner Goldschmid, Commissioner Campos, and 15 Commissioner Glassman. We also have some staff at the table 16 today. We have Bob Colby, Larry Harris, and Tom McGowan. 17 And John McCarthy from OC will be joining us a little bit 18 later. So I'd like to introduce -- again, briefly 19 introduce our group of participants, and then I'll come back 20 and give each of you an opportunity, if you wish -- it's not 21 required -- but if you wish to make an opening statement. I 22 notice our first panelist was intended to be Steven Schwarcz. 23 He's a little bit delayed. He's a professor from Duke 24 University School of Law. 25 We have Barron Putnam, who is the president and a 1 financial economist with LACE Financial Corporation. We have 2 also, a little bit delayed, David Shedlarz, who is chief 3 financial officer of Pfizer; Stephanie Petersen, who is with 4 Taxable Money Fund and Municipal Research at Charles Schwab; 5 Jerome Van Orman, who is vice president, finance, and CFO, 6 North American operations of General Motors Acceptance 7 Corporation; Larry Mayewski, who is executive vice president 8 and chief ratings officer of the ratings division of A.M. 9 Best Company; Erwin Martens, who is a managing director of 10 Putnam Investments; Paul Saltzman, executive vice president 11 and general counsel of the Bond Market Association; Raymond 12 McDaniel, who is the president of Moody's Investor Services, 13 Inc.; Steven Joynt, who's president and chief executive 14 officer of Fitch; Amy Lancellota, who is a senior counsel 15 with the Investment Company Institute. 16 I guess we have one other person who's late. Is 17 that right? Jack Malvey will be joining us. He's a managing 18 director and chief global fixed-income strategist at Lehman 19 Brothers. We have James Kaitz, who is president and chief 20 executive officer of the Association of Financial 21 Professionals. We have Yasuhiro Harada, who is senior 22 executive managing director of Rating and Investment 23 Information, Inc.; Neal Sullivan, who's a partner at Bingham 24 McCutchen, who's here on behalf of Rating and Investment 25 Information; Ben Watkins, who is director of the state of 1 Florida division of bond finance. 2 I thank you all very much for making the time to 3 spend the whole day with us. So I'll turn back and start 4 with Mr. Putnam, and give you an opportunity to make an 5 opening statement. 6 MR. PUTNAM: Thank you. I greatly appreciate the 7 opportunity to be able to come and discuss these issues with 8 you. First, I'd like to talk about the application process 9 for NRSRO status. I believe, in our case, anyway, it can be 10 greatly expedited. I think the -- if the SEC recognizes that 11 there is, indeed, need for competition in this industry, then 12 it should do all it can to help new entrants into the 13 industry itself. I don't feel that my company, LACE 14 Financial Corporation -- I feel we need all the current 15 standards, and the past standards for NRSRO status. However, 16 those standards are tight for a relatively new company trying 17 to enter into the business. 18 And I think, at best, you could take more of a 19 positive approach to helping applicants gain status. In 20 other words, if you feel there's a problem with their 21 application, you should be clear and up-front with them, and 22 tell them as such. I also feel there should be more 23 transparency in the whole process. 24 In our case, over the eight years that we had our 25 application in at the SEC, we received two letters. The 1 first letter in 1992 acknowledged we had submitted our 2 application. I might add that we tried to obtain -- join 3 that process two years even prior to that period. And then 4 eight years later, we received a telephone call from Mr. 5 McGowan here, stating that our application was denied. 6 I had to ask him to, in fact, send us a letter 7 stating the denial. I also asked for the reason for the 8 denial. And we never really received a clear reason for the 9 denial, as such. So I basically feel that the greatest 10 barrier for entry into this industry is the SEC itself. 11 The net capital rules dissuade brokerage houses on 12 Wall Street to hold securities of NRSRO companies, because 13 there's a penalty as such. The application process is in 14 fact a barrier. Without NRSRO status, it is very, very 15 difficult to compete with the likes of Moody's, Standard & 16 Poors and Fitch. They're a tough bunch. They have very good 17 name recognition and such. But if you don't -- if you're not 18 on a level playing field, it's very difficult. 19 About 10 years ago, when Thomson Bankwatch received 20 NRSRO status, they were our main competitor. Now think 21 Fitch, to some degree, in what we do. When they received 22 that status, our company just stopped growing, and we really 23 haven't grown much since that time. And if you -- and that's 24 really a 10-year delay in trying to come up with a competitor 25 to compete with the larger rating agencies. And I think you 1 need to do this, if you feel competition is needed. 2 Now, that's not something for me to suggest. There 3 are others here for that purpose. But you need to help the 4 applicants that come to your door if they are, in fact, 5 credible rating agencies. I think I do believe in the NRSRO 6 criteria. I think that you need to make sure that you have 7 quality people rating financial institutions as a whole. 8 They have to not only -- and they have to have the 9 credibility. To me, credibility is everything. And if you 10 don't have it, you shouldn't be in the business. 11 Just one other remark. As to whether the industry 12 should be regulated. I do think that some regulation is 13 needed. I think there needs to be a group of persons, or an 14 institute, in fact, that someone, like particularly the small 15 investor, can complain to, and someone that can look into 16 those complaints. And in fact, if they're very serious, 17 refer them to such places as the Justice Department. 18 I think this is very important. But I think you 19 have to be very careful in regulating the industry in how you 20 do it. That it, itself, doesn't become a barrier to entry. 21 Thank you. 22 MS. NAZARETH: Thank you. Stephanie? 23 MS. PETERSEN: Thank you. On behalf of the Charles 24 Schwab Corporation and its affiliates and subsidiaries, 25 including U.S. Trust Corporation, collectively referred to as 1 Schwab, I thank the Commission for giving me an opportunity 2 to participate in these hearings. 3 Schwab has approximately 8 million active 4 customers, most of which are individual retail investors. 5 These customers place their assets in a wide variety of 6 financial products, including 57 proprietary mutual funds, 7 known as Schwab funds, aggregating more than $140 billion in 8 total assets. 9 Within that 57 there are 19 money market funds, 10 aggregating approximately $120 billion, and several bond 11 funds totaling about $3 billion. Separately, through our 12 U.S. Trust subsidiary, customers may invest in one of 29 13 funds, with approximately $12 billion in assets. 14 There are two principal areas with Schwab where the 15 rating agency data is used on a consistent basis; management 16 of the various Schwab and Excelsior funds, as well as 17 recommending individual fixed income securities to our 18 customers. 19 As you know, the rating agencies have a prominent 20 role in the fixed income markets, from contributing to the 21 efficiency of the market, to setting standards for risk and 22 credit structures. Within the money market arena, the SEC 23 has given NRSROs a quasi-regulatory role by incorporating 24 their ratings into rule Rule 2a-7. Further, ratings have 25 become more widely used as triggers that can affect 1 marketability of some securities. 2 With more than $120 billion in money fund assets 3 under management, we at Schwab closely track the ratings and 4 opinions each NRSRO publishes on more than 3,000 securities. 5 Our experience has generally been a positive one, with rating 6 agency analysts adding valuable information and insight to 7 our own independent credit monitoring process. I, it's our 8 ability to understand and anticipate the changes in the 9 rating agencies' views as one of the key factors in 10 maximizing returns for our customer assets. 11 This is not only true for a specific credit, like a 12 bank or an asset-backed security. It's important in 13 monitoring the creditworthiness of other deals, such as those 14 where rating triggers may cause an issuer to lose funding, or 15 be forced to increase reserves or capital to maintain a 16 certain credit rating. 17 While our experience has been generally very good, 18 we believe that there are opportunities for improving the 19 overall effectiveness of the rating agency system. I agree 20 with Mr. Putnam, in that increased competition is an area to 21 be focused on. Over the last several years, mergers have 22 reduced the number of NRSROs from seven to three. This 23 consolidation has all but eliminated price competition for 24 both issuers, and users of the date, and significantly 25 reduced the opportunity for hearing various points of view. 1 Opening the market to additional NRSROs, perhaps by 2 allowing others to enter, entirely or on a niche basis, would 3 allow for other views to be heard and recognized. 4 Introducing additional NRSROs may also serve to increase the 5 competitiveness of pricing and overall market efficiency. 6 The second big area for us is transparency. Again, 7 I know you've heard this from many others, but we'd like to 8 get a better feel for the actual information that the 9 agencies use as a basis for establishing or changing ratings 10 at the time that they're initially given, or as they change. 11 What we've noticed of late is that there seems to be a cliff, 12 where ratings change instantaneously, as opposed to taking 13 advantage of putting things on watch or outlook, to give us 14 some idea of the general direction. 15 And lastly, accountability. It would be helpful 16 and enlightening to see disclosure of exactly how well each 17 agency anticipates the changes in creditworthiness of the 18 entities and securities that it rates, as well as the 19 relative timeliness of any changes. Thank you. 20 CHAIRMAN PITT: Before we move on, Dr. Putnam, I am 21 curious about when you were notified about a rejection of 22 NRSRO status. 23 MR. PUTNAM: That was about in 2000. I'm not sure 24 exactly the date. I can go back and find that out. The 25 division of market regulation probably knows that date. I'm 1 sorry, I don't know the month, but it was in the year 2000, 2 sir. 3 MS. NAZARETH: Why don't we go next to Mr. Van 4 Orman, and then we'll give Mr. Shedlarz a couple minutes to 5 get settled in. 6 MR. VAN ORMAN: Good morning. My name is Jerome 7 Van Orman. I am vice president of finance for General Motors 8 Acceptance Corporation in Detroit, Michigan, as well as chief 9 financial officer of its North American automotive financing 10 operations. In a prior executive position, I served as vice 11 president of borrowings for GMAC, responsible for GMAC's 12 global funding activities. I'm a member of GMAC's liability 13 risk committee, and have been an active participant since 14 1986 in GMAC's semiannual meetings with U.S. and Canadian 15 rating agencies. 16 I have submitted a written statement discussing 17 commercial paper credit ratings. In my statement I argue 18 that in today's U.S. money and capital markets, there is a 19 credit cliff in the commercial paper market, which does not 20 exist to the same extent in the term debt capital market. 21 From personal experience, I can say that it is possible for 22 an A minus-rated company to more easily issue five-year notes 23 than 30-day commercial paper. 24 In my opinion, the current rating agency practice 25 of tightly linking or correlating commercial paper rating 1 tiers with term debt ratings tiers has contributed to the 2 credit cliff situation. Put another way, the effect of 3 comparable short- and long-term credit ratings on the 4 availability and cost of funds across the yield curve in 5 today's credit markets is inconsistent with attendant 6 negative consequences for the financial system and the 7 economy. 8 I believe the credit rating agencies should 9 consider changes to existing commercial paper rating 10 practices, to help alleviate the credit cliff situation. I 11 wish to thank the SEC for conducting this hearing, and 12 eliciting the views of market participants. I appreciate the 13 opportunity. 14 MS. NAZARETH: Thank you. Should we circle back to 15 Mr. Shedlarz? Would you like to make a statement? 16 MR. SHEDLARZ: Surely. Thank you. The best laid 17 plans are always tripped up by fog, even in Washington. So I 18 apologize for being late. Good morning, I'm David Shedlarz, 19 chief financial officer and executive vice president of 20 Pfizer, Inc. 21 The credit agency process is of substantial 22 interest to our company, both in terms of financing and in 23 the investment arena. In terms of financing, Pfizer remains 24 one of the few industrial companies awarded the highest 25 triple A rating. The triple A rating is an integral part of 1 our debt financing strategy. Our company has in excess of 2 $10 billion in borrowings, issued in a variety of 3 instruments, with maturities ranging over the next seven 4 years, with the principal and interest payable in multiple 5 currencies, and trading both in the United States, as well as 6 in the international markets. 7 On the investment side, Pfizer's financial asset 8 portfolio exceeds $15 billion. It is comprised of financial 9 instruments, with over 200 in individual counterparties based 10 throughout the world. Rating agencies provide one of the 11 primary tools for specifying risk parameters for investment 12 activities. 13 The SEC has specifically exempted nonpublic 14 information given to rating agencies from the requirements of 15 FD. We are aware of the potential concern that this has 16 raised over how the agencies might justify ratings based on 17 nonpublic information. We believe that the current ongoing 18 dialogue between the rating agencies and the issuers that 19 employ their service benefits from this exemption, in 20 allowing the rating agencies to confirm perspectives 21 developed from an analysis of SEC filings, press releases, 22 and other sources of information. 23 The financial market's recovering from a period of 24 unprecedented deterioration in the credit quality of 25 investment-grade obligors. This experience has led many to 1 wonder about the timeliness and predictive accuracy of the 2 rating process itself. At the same time, there is growing 3 transparency in the market, in terms of the pricing of any 4 particular facility or credit. More and more practitioners 5 are using the results of analytical assessments to either 6 substitute or complement the traditional rating agency 7 assessment. 8 We, of course, are closely following the rating 9 agencies, as they adapt their process to evolving in a very 10 dynamic marketplace. We are participants, and the change in 11 dialogue that the rating agencies are having with -- 12 entities, and regarding concerns attendant in supplying 13 relevant nonpublic information to facilitate the process. 14 And we also welcome the opportunity to participate in the 15 SEC's panel today. 16 MS. NAZARETH: Thank you. Mr. Mayewski. 17 MR. MAYEWSKI: Good morning, my name is Larry 18 Mayewski. I am executive vice president and chief rating 19 officer at A.M. Best Company. Before I offer a few brief 20 comments, and a little background on A.M. Best, I just 21 want to thank the Commission for the opportunity to be here 22 today, and hopefully, I will be able to bring some value to 23 today's deliberations. 24 As way of background, the A.M. Best Company 25 celebrated its 101st anniversary as the premier global rating 1 agency and information source for the insurance industry last 2 year. The A.M. Best Company is privately held. It was 3 established in 1899 by Alfred M. Best. We are currently 4 located in Oldwick, New Jersey, and employ 550 people 5 approximately. 6 For over 100 years we have been providing the 7 public and financial services community with comprehensive 8 and unbiased information on insurance companies. We began 9 rating the financial strength of property insurers in 1906 10 and life insurers in 1928. Prior to February of 1999, A.M. 11 Best only assigned financial strength ratings to insurers. 12 However, in February of 1999, we began assigning and 13 publishing ratings on debt, preferred securities, and 14 commercial paper issued by insurers and insurance holding 15 companies. 16 We believe the expansion of our rating activities 17 into the securities rating arena is a logical and natural 18 extension of what we've been doing, in providing financial 19 strength ratings and reports on insurance companies to 20 investors, policy holders, and analysts. 21 Today we assign interactive financial strength 22 ratings on over 3,600 insurers worldwide, and rate over 450 23 securities issued by approximately 115 insurers or insurance 24 holding companies. Our financial strength and securities 25 ratings of insurers are widely recognized by virtually all 1 parties involved in insurance matters. 2 In May of this year, A.M. Best formally applied for 3 recognition as an NRSRO. And once again, on behalf of A.M. 4 Best, I would like to thank the Commission for the 5 opportunity to participate in these hearings. 6 MS. NAZARETH: Thank you. Mr. Martens? 7 MR. MARTENS: Yes. Good morning, my name is Erwin 8 Martens. I am the chief risk officer at Putnam Investments 9 in Boston. Putnam Investments is one of the largest mutual 10 fund managers in the United States. We manage over $250 11 billion in assets. We have 13 million plus institutional and 12 retail clients throughout the United States and overseas. 13 As the chief risk officer, I'm responsible for risk 14 management pertaining to fund management itself, as well as 15 counterparty risk management pertaining to the trading of 16 derivatives, over-the-counter derivatives, as well as 17 operational risk. We are intensive users of the rating 18 agency information across the board. We manage funds that 19 range all the way from money market funds through fixed 20 income, through the equity sphere. We have coverage in 21 domestic, as well as international areas, and as well as 22 emerging market funds. 23 We have found our relationship with the rating 24 agencies to be very fruitful. We do maintain our own 25 independent assessment of issuers, and we use the rating 1 agency information to augment our approaches. I would echo 2 the fact that recently there have been significant 3 developments on the analytical side, in terms of advancing 4 the science pertaining to rating agency work, and we feel 5 that that's been very beneficial to the industry. 6 MS. NAZARETH: Paul Saltzman? 7 MR. SALTZMAN: Thank you. My name is Paul 8 Saltzman, and I'm executive vice president and general 9 counsel of the Bond Market Association. We are the global 10 trade association that represents banks and broker-dealers 11 active in the international fixed-income markets. And I'd 12 like to echo other thoughts of my fellow panelists here, to 13 commend the staff and the Commission on these hearings. 14 As you will see from our statement, one of the main 15 points that the association believes can be brought to bear 16 is increased transparency. We are very comfortable with the 17 current regulatory framework, although we do believe that 18 rating the NRSRO designation process, as well as an 19 understanding of ratings and what they're used for, can be 20 more transparent, and our submitted paper suggests a few 21 things in that regard. 22 Ratings are also ubiquitous, certainly in the 23 fixed-income market, but it's also important to understand 24 that they are simply one part of an overall mix of 25 information that both the investment, and bank, and broker- 1 dealer community rely upon. I look forward to participating 2 in the hearings today. Thank you. 3 MS. NAZARETH: Thank you. Mr. McDaniel? 4 MR. MCDANIEL: Thank you. I'm Ray McDaniel, the 5 president of Moody's Investor Service. On behalf of my 6 colleagues from Moody's, I thank the Securities and Exchange 7 Commission for the opportunity to participate in today's 8 panel. Moody's believes that this examination will encourage 9 best practices in our industry, and will support the 10 integrity of the service that we provide. 11 Ratings and rating agencies have, obviously, been 12 visible participants in the capital markets, especially over 13 the past year. As such, and now as market participants 14 formally contribute their observations and opinions about 15 ratings, it's useful to acknowledge the competing views. For 16 example, in various commentaries, I believe the Commission 17 has now heard that rating agencies are too slow in lowering 18 ratings or deteriorating credits; rating agencies are too 19 quick to lower ratings, and otherwise cause healthy companies 20 to fail, or cause them harm; rating agencies rate issuers too 21 high, because we're compromised by receipt of fees from 22 issuers; and rating agencies rate issuers too low, because 23 we're overly conservative and reactionary. 24 In Moody's opinion, the commentary has been 25 thoughtful and in good faith, but the diversity of views 1 highlights the proliferation of users, uses, and expectations 2 that have been placed on ratings. Let me, therefore, offer 3 Moody's view on what a Moody's rating is, and how a Moody's 4 rating should be used. 5 Moody's ratings provide predictive opinions on a 6 borrower's likelihood to repay debt in a timely manner. Our 7 ratings reduce information asymmetry between borrowers and 8 lenders, and fulfill their role through broad, free 9 dissemination to the general public. Our methodology is 10 based on analysis of financial statements, together with 11 management, industry, and macroeconomic information. And 12 compared with alternative measures of credit risk, our 13 ratings are relatively stable, because they attempt to 14 respond not to transitory events, but rather, to more basic 15 and lasting changes in creditworthiness. 16 Certain characteristics of our ratings, including 17 public dissemination, predictive content, breadth of 18 coverage, and objectivity, have encouraged the use of ratings 19 as proxy tools across a wide range of functions, employed by 20 numerous groups, with different intended goals. We, 21 therefore, believe that the decision to study and, 22 potentially, to act to improve the quality of ratings 23 necessarily hinges on the ultimate goal of the rating system, 24 and the adequacy of market mechanisms already in place which 25 advance the realization of that goal. 1 We hope and expect that any formal adjustments to 2 industry oversight or structure align with our existing 3 market service objections. We have succeeded as a business, 4 and have served the financial markets for 102 years. We have 5 done so first inside the U.S., and now internationally, in 6 jurisdictions that license rating agencies, and in those that 7 do not, and against the landscape of continuously and rapidly 8 evolving financial markets. 9 We are dedicated to offering the best quality 10 credit assessments available globally, and our published, 11 verifiable track record indicates that we've done a good job. 12 I look forward to participating in today's panel, and again 13 thank you. 14 MS. NAZARETH: Thank you. Steven Joynt? 15 MR. JOYNT: Thank you for having me come and 16 participate today in this panel discussion. We have 17 exhibited our ten-page letter describing many of our views, 18 so I'll try to make my introductory comments relatively 19 brief. 20 My name is Steven Joynt. I'm president and chief 21 executive officer of Fitch Ratings. Our roots trace to Fitch 22 Publishing Company, which was established in 1913. Fitch was 23 first recognized as an NRSRO in 1975. Since 1989, when the 24 company was recapitalized, and a new management team was 25 brought in, Fitch has expanded significantly through both 1 internal growth, and through mergers with other smaller 2 NSRSOs. 3 Our goal has been to create a global, full-service 4 rating agency competent in producing independent research and 5 ratings, with a fundamental analysis focus, providing 6 competition, and promoting investor choice. Fitch Ratings 7 has made, and is making, an important contribution as an 8 NRSRO, and provides many public benefits. Fitch Ratings has 9 400,000 ratings available publicly to all securities 10 investors. Fitch has created original research, new analytic 11 models, and promoted greater transparency in the ratings 12 industry. 13 Fitch Ratings has an open website, with press 14 releases, ratings, presale reports, and general research, all 15 available for free. We believe that investors value our 16 rating, because the ratings provide a convenient, reliable 17 way to assess the credit quality of an investment. 18 Through the years, ratings have been increasingly 19 used in regulation. And while the use of ratings in 20 regulation has not been without controversy, we believe that 21 regulators rely on NRSRO ratings for the same reason that 22 many investors do. They're easy to use, there's a widespread 23 availability, and there's proven performance over time. 24 Fitch Ratings meets the standard of benchmarking 25 that the market seeks. Default studies of ratings from Fitch 1 show competence in differentiating credit risk, and our 2 ratings transition studies and default results are comparable 3 to other rating agencies. 4 I think it's important to note that 50 percent or 5 more of Fitch's activities and revenues in the last 13 years 6 has come from activity in securitization analysis, and Fitch 7 has an excellent reputation among securitization investors. 8 It may be valuable today to spend more time discussing the 9 role of NRSROs as it relates to securitization and public 10 finance markets, and the implication for those markets, than 11 in last week's session, where more time was spent on 12 corporate credit analysis and corporate ratings. 13 We would suggest there are at least four things to 14 talk about today that could be done better, as you were 15 seeking to discover last week. One is to demand more 16 transparency from issuers, which I know the SEC is working 17 on, and also from rating agencies, which we have been a 18 proponent of. We would not suggest that you throw out the 19 NRSRO designation, or the requirements and the qualifications 20 that go along with it. We think that those are constructive 21 for the market, and it would be destructive, and eliminate 22 competitors, were you to do that. 23 We also feel that ratings are better because of the 24 Reg D exemptions that rating agencies have, and would suggest 25 that you not eliminate them. And I'd be happy to talk about 1 that more later. 2 We also would suggest that you would do better by 3 not allowing NRSROs to discriminate among the other NRSRO 4 ratings, and also that you prohibit anticompetitive conduct 5 among the rating agencies. 6 In summary, Fitch Ratings feels the NRSRO system 7 has provided value, and that Fitch is a competent, 8 independent, and valuable global rating agency, but we appear 9 here today open to all suggestions on how to improve our 10 industry's performance and our performance. Thank you. 11 MS. NAZARETH: Thank you. Amy Lancellota? 12 MS. LANCELLOTA: Good morning. I'm Amy Lancellota, 13 senior counsel of the Investment Company Institute. The ICI 14 is the national association of the American investment 15 company industry. We, too, commend the SEC for holding these 16 hearings. We believe they will provide a better 17 understanding of the role of credit rating agencies in our 18 nations securities markets, and will assist in evaluating the 19 adequacy of existing regulation of those agencies. 20 NRSRO ratings play a significant role in the 21 investment decisions of retail and institutional investors. 22 The Commission and other regulatory agencies also rely upon 23 these ratings as assessments of investment risk for 24 regulatory purposes. In view of the NRSROs' importance in 25 the marketplace, and significant reliance by investors and 1 regulators on the ratings, the ICI believes that they should 2 be subject to greater regulatory oversight. 3 The designation of NRSRO status should be the 4 beginning, and not the end, of the SEC's oversight. No- 5 action letters designating agencies as NRSROs leave it to 6 them to self-police their own activities. But because of the 7 financial impact that withdrawal of NRSRO designation could 8 have on a rating agency, the NRSROs have a strong 9 disincentive to report any such changes in circumstances. 10 In addition, the investment advisor registration 11 and regulatory scheme applies awkwardly to NRSROs, and does 12 not provide adequate regulatory oversight. Therefore, to 13 improve the system, we recommend the following: 14 First, the SEC should more vigorously monitor 15 compliance with the criteria it employs in the initiation 16 designation of an NRSRO. To accomplish this, the SEC's 17 inspection staff should schedule more frequent examinations 18 of the NRSROs, and they should focus on whether the agencies 19 have the necessary national recognition, staffing, resources, 20 structure, internal procedures, and issuer contacts to serve 21 as NRSROs. 22 Second, there should be greater transparency of the 23 NRSROs' operations and methodologies. The SEC should require 24 NRSROs to disclose various types of information, such as 25 their policies and procedures addressing conflicts of 1 interest. 2 Third, the SEC should establish a periodic public 3 comment and review process, something perhaps modeled along 4 the lines of what the FCC does with respect to their 5 broadcast license renewal process, under which licensees must 6 periodically reapply, and the FCC solicits public comment on 7 the licensee's performance. 8 It seems that the best way to ensure that an NRSRO 9 continues to meet the most critical attribute for an NRSRO, 10 which is that it is a nationally recognized issuer of 11 credible and reliable credit ratings by the users of those 12 ratings, would be to periodically solicit public comment on 13 that particular rating agency. 14 And finally, we believe that NRSROs should be 15 accountable for their ratings. In addition to being free 16 from all but minimal regulation, the rating agencies are also 17 relieved of any legal accountability for their ratings. The 18 broad exemption from liability under Section 11 of the 19 Securities Act means that NRSROs are not held to a negligence 20 standard of care. The rating agencies also maintain that 21 they are members of the media that are providing their 22 opinions, and thus claim that they can only be liable if 23 their conduct can be said to have been reckless. 24 To implement our recommendations, the Commission 25 should evaluate its existing regulatory authority. Should 1 they determine that the regulatory authority is insufficient 2 to impose a more effective regulatory structure on NSRSOs, we 3 recommend that the Commission seek such authority from the 4 Congress. Thank you. 5 MS. NAZARETH: Thank you. 6 MR. MALVEY: Thank you for inviting Lehman Brothers 7 to participate in this fascinating discussion. I hope that 8 I'll be able to offer some worthwhile insights about the role 9 of rating agencies across the global debt capital markets. 10 For over the past 27 years, including the past 19 11 on the sell side, I've worked as a credit analyst, head of 12 investment grade credit research, corporate bond strategist, 13 and chief global fixed-income strategist at Lehman. In the 14 spirit of openness, I should also state that I worked as a 15 rating analyst at Moody's from June 1978 through November 1983. 16 In my role, the rating agencies have been an 17 indispensable contributor to the tremendous growth of the 18 global fixed-income market over the past century. Based 19 primary in the agencies' credit quality classifications, 20 trillions of dollars of capital have been successfully 21 channeled to economically worthy purposes. 22 The long-term performance of the rating agencies 23 over the past century has been admirable. Numerous academic 24 studies have confirmed a very high correlation between 25 aggregate credit risk and ratings. There are no mortals or 1 institutions with perfect clairvoyance. As economists and 2 market strategists can well attest, forecasting the future 3 can be difficult. Likewise, ratings cannot be perfect 4 predictors of ultimate credit risk for every single issuer. 5 After each major corporate bankruptcy or sovereign 6 default, markets engage in a natural bout of second-guessing. 7 This is a healthy exercise. Through such post mortems, 8 credit diagnostics are improved. In my view, additional 9 regulatory oversight of rating agencies in unnecessary. 10 Through the years, the rating agencies have consistently 11 demonstrated a zeal to enhance the rating methodology, and 12 depending upon its nature, further regulatory oversight might 13 introduce new subjectivities to the rating process that could 14 lead to the misallocation of capital. 15 The credit markets may well benefit from the 16 presence of additional officially recognized rating agencies. 17 In turn, we would favor the Commission's willingness to more 18 quickly designate applicants as NRSROs. In the end, the 19 markets should determine which rating agencies should be 20 relied upon for the most accurate sorting of credit risk. I 21 look forward to the following discussion. 22 MS. NAZARETH: Thank you. Mr. Kaitz? 23 MR. KAITZ: Good morning. I'm Jim Kaitz, president 24 and CEO of the Association for Financial Professionals, and 25 we appreciate the opportunity to be here today. AFP 1 represents approximately 14,000 finance and treasury 2 professionals employed by over 5,000 organizations. The 3 organizations represented by our members are drawn generally 4 from the Fortune 1000, and the largest of the middle market 5 companies in a wide variety of industries. Our members are 6 significant users of rating agency information, and have a 7 sizeable stake in the outcome of the current debate 8 surrounding credit rating agencies. 9 Many of our members are responsible for issuing 10 short- and long-term debt, and investing corporate cash and 11 pension funds for their organizations. Our members have 12 consistently indicated to us that they are concerned about 13 the information provided by information agencies. 14 In response to our members' concerns, AFP conducted 15 a survey to learn their views on the quality of credit 16 ratings, and the regulation of rating agencies by the SEC. 17 The results of the survey, which were released earlier this 18 month, show that a significant number of corporate 19 respondents do not believe that their companies' ratings, or 20 the ratings of the companies in which they invest are 21 accurate or timely. 22 AFP believes that the credit rating agencies are 23 vital to the efficient operation of capital markets, and is 24 pleased that the SEC is examining the role played by rating 25 agencies, and the regulation by the SEC. We hope that these 1 hearings will bring to light opportunities to increase 2 competition in the market for credit ratings, and improve the 3 quality of the information provided by credit rating 4 agencies, for the benefit of issuers and investors in the 5 securities markets in the United States. Thank you. 6 MS. NAZARETH: Thank you. Mr. Harada? 7 MR. HARADA: Thank you very much. Good morning. 8 Rating and Investment Information, Inc. and I appreciate the 9 opportunity to participate in this hearing on credit rating 10 agencies organized by the SEC. We believe that the area 11 identified in the Sarbanes-Oxley Act for consideration 12 deserve thorough examination for the benefit of the investing 13 public and the healthy growth of the global capital market. 14 We are honored to be part of this process. 15 As the largest rating agency in Asia, providing 16 rating services to issuers and investors worldwide, R&I 17 provides ongoing rating services to 795 issuers, including 18 104 non-Japanese entities in connection with 4,625 issues. 19 R&I's rating process and issuers' analysis are geared toward 20 one purpose. That is to ensure credible and consistent 21 ratings. 22 As an example of R&I's demonstrated ability to 23 provide consistently high credit quality ratings, Morgan 24 Stanley Dean Witter Japan has rated R&I as the best overall 25 rating agency in yen-denominated securities for the last two 1 years. Morgan Stanley studies agencies' rating methodologies 2 -- the correlation between the security rating and the spread 3 over the Japanese government bond in the secondary market, 4 and finally, the persuasiveness of the rationale supporting 5 the firm's rating. 6 R&I is proud of its 25-year track record, 7 demonstrating its consistent relation between the default 8 ratio and these ratings. Today R&I is a respected 9 independent source of the financial information for the 10 overwhelming majority of the U.S. broker/dealers and the 11 financial institutions that conduct operations in Japan, and 12 provides a variety of the rating services to U.S. and foreign 13 companies. 14 Ratings services strictly serve to increase the 15 efficiency of the capital market by providing useful credit 16 risk references. The demand for the reliable rating has 17 dramatically increased as the global integration of the 18 capital market has progressed in recent years. The rating 19 agency must meet such demand in a way that contributes to the 20 sustained growth of the market. 21 Although a rating agency with the expertise in a 22 particular area, such as R&I, already provides rating 23 services to the U.S.-based financial institutions, the 24 current U.S. regulatory framework discourages many issuers 25 and investors in the United States from realizing the benefit 1 of the expanded source of the expertise, simply because they 2 have not been recognized by the SEC. 3 As the SEC has determined to rely on ratings in 4 many of these regulations, R&I acknowledges the need for some 5 regulatory growth for the SEC to recognize highly qualified 6 rating agencies. But the current no-action process should be 7 replaced. The application procedure proposed by the SEC in 8 1997 is a step in the right direction. It provides a formal 9 procedure with specific criteria in order to be recognized as 10 an approved rating agency. We concur with most of the 11 criteria proposed. 12 Nevertheless, we are concerned that the national 13 recognition criterion imposes a barrier for a rating 14 organization that has an established record but has not been 15 nationally recognized in the opinion of the staff of the SEC. 16 Investors and issuers alike must be allowed to have 17 ready access to high quality ratings by the agencies that 18 have demonstrated their ability to provide consistent and 19 reliable ratings. Additionally, the SEC procedure must 20 permit the approval of the rating agency with a demonstrated 21 expertise in the discrete area of the rating services. 22 Finally, in order to ensure the timely designation, 23 the application procedure should have a specific time 24 schedule of the SEC action. We hope today's discussion will 25 assist the SEC in the effort to bring the U.S. regulatory 1 framework commensurate with the current demand of the global 2 capital market. Thank you very much. 3 MS. NAZARETH: Thank you. Next I'll ask Ben 4 Watkins. 5 MR. WATKINS: Good morning. I'm Ben Watkins, with 6 the division -- director of division of bond finance for the 7 state of Florida, and our primary business function is to 8 borrow money on behalf of the state. And as such, we have 9 ongoing interaction with rating agencies. 10 Perhaps the most meaningful contribution that I can 11 make this morning is to contrast the municipal market with 12 other sectors of the fixed-income industry, because they're - 13 - and to highlight some of the significant differences that 14 are important to understand from a regulatory perspective. 15 First and foremost, the nature of the municipal 16 market is just different. The organic makeup of the 17 municipal market is unique, and it reflects a tremendous 18 diversity of the issuer base and the securities that they 19 issue. Over 50,000 issuers make up the municipal market, 20 with over 150,000 different bond issues outstanding for those 21 50,000 issuers. And they come in all different shapes, 22 sizes, and colors. Everything from large, frequent issuers, 23 who are relatively sophisticated in accessing the capital 24 markets, to very small and infrequent issuers, who don't have 25 the same experience and familiarity with the process. 1 Q In addition to the disparity of size and 2 sophistication of issuers, you also have different segment -- 3 the issuer base is made of both general governments, and 4 conduit issuers. General governments being made up of 5 states, cities, counties, towns, school districts. Versus 6 conduit issuers, which are authorities such as industrial 7 development authorities, housing authorities, hospital 8 authorities and the like, who I characterize as corporate 9 borrowers in the government markets. They are typically 10 single-purpose entities who enjoy the benefits of tax-exempt 11 financing, and exemptions from the securities regulation. My 12 perspective in the discussions this morning is going to be 13 from a general governmental issuer. 14 Secondly, the dynamics that led to the blowup in 15 the corporate markets and precipitated Sarbanes-Oxley and the 16 forum here today simply do not exist in the municipal market. 17 There is no profit motive for governments. There is no 18 incentive to have things appear as they are not. 19 Secondly, the command and control structure is 20 decentralized. The governing boards of these governmental 21 issuers are public bodies, elected officials, whose 22 proceedings and deliberations are open to the public, and 23 whose decisions are subject to public scrutiny. So it is a 24 very transparent process, with checks and balances in place. 25 And lastly, the default rate in the municipal 1 market for general governmental issuers is extraordinarily 2 low. Over the last 20 years, the default rate has ranged 3 from 100th of 1 percent up to four-tenths of one percent, 4 depending on the type of bond we are talking about. And that 5 is a significant difference between governmental bonds and 6 other sectors of the municipal market. 7 The rating agencies have played a central role in 8 the municipal market, by serving as a gatekeeper, in a sense, 9 and assuring the quality of paper that's distributed in the 10 municipal markets. Also, the rating agencies, through their 11 surveillance activities, provide significant meaningful 12 information to the secondary market. 13 The default risk in the municipal market is further 14 reduced by the tremendous growth in the use of bond 15 insurance. Last year over half of all new issues brought to 16 the municipal market were credit enhanced with bond 17 insurance. These firms have very qualified analysts who 18 evaluate credit risk, and do ongoing surveillance, 19 independent of the rating agencies, who are truly motivated 20 because their employers have capital at risk. Also, 21 analytical staff exists in the mutual fund industries as 22 proxies for retail investors. 23 So there are multiple layers of protections in the 24 municipal market, and significantly, inherently less risky 25 securities embedded in the structure of the municipal market. 1 So although this is a little off center from the primary 2 purpose of the meetings here today, I think it's important to 3 understand some of the distinctions and the differences from 4 a regulatory perspective. 5 MS. NAZARETH: Thank you. I think these remarks 6 have been very helpful. I'm also impressed with the fact 7 that a number of you seem to have listened to the last 8 hearing that we had, and have made some good suggestions on 9 areas that we might focus on, that would be a little bit 10 different than the last time, or perhaps to have a little bit 11 more emphasis. I've heard more interest again in talking 12 about securitized products, the municipal market. Perhaps we 13 can have a little more focus in our conversations on issues 14 of accuracy and timeliness, greater transparency of issuers, 15 and rating agencies themselves. If we can, we would like to 16 talk a little more than perhaps we did last time about 17 potential anticompetitive practices and the like. 18 But to get started, I thought it would be useful 19 for us to hear -- again, it's hard to do briefly, but try to 20 be brief -- from the rating agency representatives here about 21 what the process is for issuing and monitoring credit 22 ratings, again, keeping in mind that we would need you to 23 distinguish between the types of products. We did hear a lot 24 in the last hearing about the corporate markets. So by all 25 means, we would be interested in hearing, to the extent that 1 your firm does provide ratings for municipals or securitized 2 products, as well, and what procedures your agency uses to 3 rate the different types of issuers. 4 Why don't I just go in order, and start with Mr. 5 Putnam. 6 MR. PUTNAM: Well, LACE Financial really is kind of 7 a small company that specializes in the rating of financial 8 institutions, and the criteria that we use, developed a long 9 time ago out of the Federal Reserve Board, and with the other 10 agencies, I chaired the committee that put together the 11 rating system for the Fed, the FDIC, and the comptroller of 12 the currency. And it was all a surveillance program. It was 13 new technology that came into being that day, where we had 14 standardized items and definitions for items, and we used 15 regulatory reports. 16 We like regulatory reports, mainly because, one, 17 they're signed by the -- usually the chief financial officer 18 of the institution, and if they're not correct, or if they're 19 -- people can go to jail over these, particularly if they do 20 not fulfill these requirements correctly. So we have a lot 21 of -- we take as long as value from these particular reports. 22 But we follow every other type of releases. We 23 take the releases on the larger banks. We also rate foreign 24 banks, and have done so for about 15 years now, and receive 25 any information we can from these institutions, as well as 1 from SEC filings and things of that sort. But we do not 2 charge banks to rate them. That's why -- that's where we're 3 different from the existing NRSRO companies. And I think 4 that's always been a problem in our application process. We 5 just come at it from a different angle. 6 The process that we use is, going through, and just 7 like any standard financial analysis that one does, we use 8 the computer a lot, but we have three financial analysts that 9 go over every rating before it's established. But you go 10 through the balance sheet and income statement, like any 11 analyst would, and determine an overall financial soundness 12 rating. 13 Now, we do this -- and this is something, I think, 14 where we add benefit, particularly for bank -- for issuing 15 bank ratings -- that we do this quarterly. So that you can 16 see a trend in the rating process. If -- our ratings go from 17 A to E, and if you see it fall from A, B, C or so, investors, 18 it's a warning. It's a warning that the condition is 19 declining. 20 We re-rate every quarter. We do not go through and 21 just confirm a rating. We go through the total rating 22 process each quarter. Now, one of the -- I think one of the 23 products that we're providing to Wall Street now is, is a lot 24 of these structured preferreds for community banks, and that 25 -- they're getting involved in this. And what we're doing 1 is, the whole issue -- we're following this issue every 2 quarter for these -- in other words, the pool. It's a pool, 3 and we take a look at every member of that pool, and 4 reevaluate it every quarter, so that they know exactly what 5 the problems they have are within that pool. 6 So I don't know if I'm completely answering the 7 question. I don't want to take too much time. 8 MS. NAZARETH: That's very helpful. Thank you. 9 COMMISSIONER GLASSMAN: I have a question before 10 you move on. If you're not charging the issuers, how do you 11 get paid, and why did you choose that model? 12 MR. PUTNAM: Well, Cynthia, we did this because the 13 -- I'm, as you know, from the Fed, and I was in the division 14 of bank supervision and regulation, and I had trouble doing 15 that. I always felt that there was a bias when money is 16 exchanged for a rating. That may or may not be the case, but 17 I had that feeling. And I felt that if my product is good 18 enough, people will pay for it. In other words, they pay for 19 the services that we provide. I believe the other agencies 20 also charge for their ratings in some capacity or not, but 21 they also charge to issue that rating. We just don't charge 22 to issue that rating. 23 Now, we may charge on a special, when it's not part 24 of the formal rating process, but we issue -- we have issued 25 over a period of time about a million financial soundness 1 ratings over the 18 years that we've been in business, and 2 we've never had any serious problems, never had a threat of a 3 lawsuit, never had a complaint from a regulator, as such. 4 MR. COLBY: Mr. Putnam, could I ask how large is 5 your organization? 6 MR. PUTNAM: It's not large at all. We have 10 7 financial analysts. The SEC has been out, and actually 8 visited our headquarters in Frederick. 9 COMMISSIONER GOLDSCHMID: How -- 10 MR. PUTNAM: Well, in the first place, the source 11 of the information is regulatory data that we get from the 12 Feds on computer tape, but we will -- all the larger 13 institutions submit releases. We get their releases and 14 such, the same as the other agencies do. And we visit banks, 15 more when there's financial problems than anything else. We 16 don't visit them if it's in good condition. We just don't do 17 that. 18 MS. NAZARETH: Okay. Thank you. Larry Mayewski: 19 MR. MAYEWSKI: Thank you. The A.M. Best Company, 20 obviously, from my opening comments, is a specialist in the 21 insurance arena. We assign financial strength ratings, and 22 we assign securities ratings to insurers and insurance 23 holding companies. Under the securities umbrella, we 24 obviously are looking at debt, preferred securities, 25 commercial paper, and more recently some structured 1 transactions and securitizations. 2 The process is a very rigorous process. It 3 incorporates all publicly available information. All of the 4 filed documents, statutory filings, GAAP filings, and any 5 other filings that are public. It also involves interactive 6 discussions with management on every company that we rate. 7 So we meet with, generally, the CEOs and CFOs of all of the 8 companies that we assign rating opinions to. 9 Clearly there's a lot of information flow we get 10 out of the management meetings that we believe is important 11 to a credible rating. We rate companies formally once a 12 year, but we monitor them throughout the year. They're under 13 constant surveillance. But even companies that are under 14 constant surveillance, even if there's no changes, we will 15 once a year put out a public affirmation of that company, to 16 indicate we've completed, again, the thorough review of that 17 company. 18 We do charge for our ratings. We believe that 19 clearly the bottom line for any rating agency is credibility. 20 If, in any way, shape or form that's a conflict there and it 21 affects a company's credibility, you're basically not in the 22 rating business. And the A.M. Best Company only started 23 charging, I would say, less than 10 years ago for its 24 ratings. Prior to that it was based on a subscription model. 25 But clearly, with some of the competitors getting into the 1 business, that opened the door, from A.M. Best's perspective, 2 to start charging for its ratings. 3 MS. NAZARETH: Thank you. 4 MR. COLBY: Could I ask you the same question? How 5 large is your organization? 6 MR. MAYEWSKI: We have 550 people involved in 7 Oldwick, New Jersey. Just under 200 of them involved in the 8 rating analysis process. 9 MS. NAZARETH: Thank you. Ray McDaniel? 10 MR. MCDANIEL: Thank you. For company and 11 municipal ratings, the process would typically be initiated 12 by contact with Moody's from either the issuer or a rating 13 advisor working in an intermediary institution or a financial 14 advisor in the municipal sector. That would be followed by a 15 submission of financial information and collection by Moody's 16 of financial industry market information about the company. 17 We would designate a rating team, which, in the 18 initial stages, would include a lead analyst. And that lead 19 analyst would be chosen based on the industry that the 20 company requesting a rating is operating in. And the lead 21 analyst would have a backup analyst, and both would be 22 operating under the guidance of a managing director. 23 Following the designation of the rating team, we 24 would typically meet with the company and its advisor. The 25 meeting would take place either at the company's offices or 1 at Moody's, or both. And that would be followed -- there 2 would be a discussion of the company's financial profile, its 3 position in the industry, its -- the financial statements 4 that it has filed, its management strategy, et cetera. 5 The analyst takes that information back, and 6 conducts what we would call a fundamental analysis of the 7 company, and creates a written rating recommendation. That 8 written rating recommendation then is taken to a rating 9 committee. The rating committee has a discussion and debate 10 about the recommendation for the company, and that concludes 11 with a vote. And the majority vote wins. 12 And finally, that vote is memorialized, and we 13 write a press release, which includes both the rating, and 14 our rationale for the rating, which we would share with the 15 company, and with the company's advisors. 16 In the structured finance asset securitization 17 area, the process is, in some respects, the same, and in some 18 respects different. The main difference is that because in 19 an asset securitization, the issuer or the special purpose 20 company typically does not yet exist, there is an iterative 21 process in which there's a discussion between the Moody's 22 analysts and the sponsor or its advisors as to the 23 appropriate structure and necessary collateral to achieve the 24 rating levels desired by the sponsor of the securitization. 25 MS. NAZARETH: Thank you. Steven Joynt? 1 MR. COLBY: May I just ask the same question? 2 Number of financial analysts? 3 MR. MCDANIEL: The number of financial analysts at 4 Moody's is about 800. Our total Moody's Investor Service 5 staff is about 1,700. 6 MR. JOYNT: The number of analysts at Fitch -- 7 MS. NAZARETH: Let's get it out of the way, right 8 up-front. 9 (Laughter.) 10 MR. JOYNT: I think it's about 700, with a total 11 employee count of about 1,200. I think we have 650 employees 12 in the U.S., maybe a little bit more, the remainder 13 internationally. We have about 200 in Europe, most of them 14 in London. From our merger with Duff & Phelps, we have, I 15 think, 180 in Chicago. The remainder of our staff -- or the 16 majority of our staff -- analytical staff -- is in New York, 17 and then spread around Asia, Latin America, and other places. 18 I'll try not to repeat everything that Ray has 19 said. I have -- my past -- I was with Standard & Poors for 20 12 years. Our vice-chairman, Claire Cohen, was with Moody's 21 for probably more years than Ray has been with Moody's, and 22 has been with us for 12 years. And other executives in our 23 team have been with the rating agencies. So we think the 24 process that we follow is very comparable to other rating 25 agencies, and it's a good process. 1 We also have a lead and a backup analyst approach 2 to analyzing companies and municipalities, and in structured 3 finance. The ratings are also done by a committee of people. 4 We try to bring specialists in from whatever the appropriate 5 area is, to sit down, whether it's in public finance and we 6 need a GO specialist, and a hospital specialist, and somebody 7 that specializes in the region of the Southwest, or in 8 corporates, where we need a specialist in commercial banking 9 and investment banking and mortgage banking financial 10 disclosure the large, complicated financial institutions that 11 we rate today. 12 I might add one thing about the committee process 13 itself, and that's that there is an appeal process in the 14 company that says that, if we sat on a committee -- and 15 people have a variety of views, and you know, committees are 16 a changing thing, there could be 12 people, of which six are 17 very junior and are there to learn how things work in the 18 process. 19 But of the voting members and the senior people 20 that would sit on the committee, if there's any one 21 individual that has a strong exception to the conclusion of 22 the majority, they are able to appeal it on to a higher 23 person, the more senior person in that department. And 24 there's sort of a chain, depending on how serious the appeal 25 is, and how great the exception is to the final decision, all 1 the way up to the chief credit officer of our company -- and 2 myself. So it rarely happens, but it's happened on occasion, 3 and it happens more as you go farther down. 4 And when I say, "a major exception," if the 5 committee sat and had to decide, and some of the votes were A 6 plus, or A, or A minus, I doubt there would be a major 7 exception there. But if two senior members of a five-person 8 committee felt strongly that this credit should be 9 noninvestment grade, while three others felt it should be 10 triple B minus, that might be something that they would take 11 to a higher authority, or recompose another committee of more 12 senior people with broader expertise, or bring in some 13 others. So I think that's also helpful in the process if 14 that's available. 15 Regarding -- I'd like to just focus on 16 securitization for a minute, then, because I do think that 17 process is very different. And I'd ask you to think about 18 this as we talk during the rest of the day about some of the 19 issues, the issues of Reg FD, do we get confidential 20 information, and when? 21 You know, often you think just about corporations, 22 but for example, in securitization, we receive a lot of 23 pooled data and information from General Motors, Ford, and 24 many other asset-backed issuers. We receive property 25 information and rent rolls from commercial mortgage real 1 estate developers that are putting together commercial 2 mortgage securitization. We receive FICO scores on asset- 3 backed issues, and for mortgage-backed transactions. 4 So we usually get a large portfolio of data, which 5 one could consider to be the private data of the company 6 that's putting together the securitization, and provided to 7 our analysts in order to analyze the default probabilities 8 and the appropriate credit support levels in analyzing these 9 transactions. 10 That's a complicated job. It requires us to have 11 more modeling expertise, more mathematical expertise. It's 12 not what you would typically think of when you think of a 13 rating agency rating a company, and an industry analyst with 14 a certain kind of expertise. So I point that out as maybe a 15 different perspective for you to think about as we consider 16 some of these issues. 17 Also, I would say, as it relates to a committee 18 process for securitization, that even more of the information 19 is embodied in the analyst, his model, and his thinking. So 20 it's not quite as even a committee process. So therefore, we 21 bring to that committee process most of the expertise 22 resident within one area, and we have to challenge ourselves 23 about how much of the decision we're making because of the 24 quantity -- or the qualitative -- the quantitative analysis 25 of the information, versus what qualitative judgment we might 1 bring to that about the servicer or the originator. The 2 company aspect of it. There is a qualitative aspect, so we 3 do have -- we do service ratings. So they're not traditional 4 bond ratings, as you might be thinking about for corporates. 5 They're ratings that go out and analyze the capability of 6 these servicers and monitoring these financial assets that 7 are being put into these pools. And so we have different 8 kinds of ratings for that. Above average, high. Each of the 9 rating agencies has more than just the array of ratings that 10 we've talked about that are the bond ratings themselves. So 11 there is a qualitative aspect to that part of the process, as 12 well. 13 COMMISSIONER GLASSMAN: Could I just ask before we 14 move on to Mr. Harada, because you've talked a lot about 15 models, and things like that, how do you surveil or test your 16 models, the appropriateness of your ratings over time? Is 17 there a sort of continuous process that goes on? Or a 18 periodic evaluation? How does that work? 19 MR. JOYNT: Sure. There's a -- well, the original 20 models are created from a broad perspective. Let me use 21 residential mortgage as an example, because it's a place that 22 Fitch distinguished itself when we first started in 1989 and 23 1990. We completed a brand new study of default experience 24 in the mortgage market in Texas. And based on that, and 25 extrapolations from that, we reached the conclusion about 1 what credit support levels we thought were appropriate in 2 mortgage-backed securities. Those levels were different from 3 the levels of the other two rating agencies. 4 We did -- we presented that research to investors. 5 It gained credibility with investors. They started asking 6 for our opinion on our rating on those securities. In the 7 beginning, in addition to Moody's and Standard & Poors. And 8 subsequently, in replacement of one or the other over the 9 last 13 years. 10 So we had to start first with our original research 11 tested against investor expectations, and presenting our 12 research to them. So since then, of course, every week, 13 month, and year, those expectations are tested against the 14 actual results in the market. So residential mortgage market 15 performance has been exceptional, so there haven't been great 16 tests. Commercial real estate mortgage markets have been 17 exceptional, so there haven't been great tests in the market. 18 In the asset-backed area, there have been some 19 tests in subprime. And we can talk about that more later. 20 And so the adjustments that are made in the model, and the 21 credit expectations would be based on the results that we see 22 over time. And so adjustments today I would tell you have 23 been in asset-backed, very little in commercial and 24 residential. Does that address that? 25 MS. NAZARETH: Yes, that's helpful. Thank you. 1 COMMISSIONER GLASSMAN: Before we go on, can I just 2 ask a follow-up question to Ray and Steve? This is to put 3 numbers of analysts and some numbers of analysts in some 4 context. Do you have subgroups? For example, a sub group on 5 financial institutions and a subgroup on insurance? And if 6 you do, how many analysts are in those groups? How many 7 financial institutions analysts do you have? 8 MR. MCDANIEL: The organizational answer is that we 9 do have subgroup. Our broad business unit organization is 10 structured finance, public finance, or municipal finance, 11 corporate finance, and financial institutions. Then, within 12 those broad categories, we would have smaller teams that 13 follow banking, insurance, nonbank financial institutions, et 14 cetera. We also have industry teams on the corporate side. 15 To be honest with you, I can't quote you the number of 16 analysts in each of the subteams off the top of my head, but 17 I would be very happy to get that information to you. 18 COMMISSIONER GLASSMAN: I'd appreciate that. 19 MR. JOYNT: I also will have -- I'll take a guess, 20 so I'll have trouble. I'll be happy to provide you with 21 specific information, but in public finance, I think we have 22 around 70 employees, almost all of which are analysts. So 23 I'd say at least 60 analysts. In commercial real estate, 24 probably 50. In asset-backed research analysis, probably 40. 25 Same in residential mortgage. Right around those numbers. 1 And corporate, I think the total number of analysts we have 2 probably approaches 120. And there's probably at least 25 in 3 financial institutions. We have a smaller team in insurance, 4 where our coverage is not as broad as, probably, an investor 5 -- maybe even Standard & Poors. And I'd be guessing. I 6 think the number is around 25. Is that a helpful 7 perspective? 8 COMMISSIONER GLASSMAN. Yes, thank you. 9 MR. MACCHIAROLI: Could I ask a follow-up question? 10 Is there a consistent ratio of analysts to the number of 11 issuers that they rate for issues? Can you tell me what the 12 ratio is? And does it vary among product groups? 13 MR. JOYNT: Actually, that's an excellent question. 14 I often wonder if we're inflating our analyst figures, 15 because we always include a number of the technical people 16 and modelers that we have in our IT department, because 17 they're working on models. So I can never understand how we 18 a third of the size, in terms of ratings of S&P and Moody's, 19 but we have 700 analysts and they have 800. I don't 20 understand it. So something's funny about the numbers. 21 Typically, in the corporates, which is the easiest 22 to answer you, our ratio of analysts to corporate coverage 23 would be about 10 or 12 companies per person. Now, that's a 24 mix of senior and junior people, but that would be the 25 average. 1 It's much more difficult to tell you in 2 securitization. So for example, in our commercial mortgage 3 department, where we have, I'd say, 50 people, we may rate 4 only five transactions in any given month, but those 5 transactions could be, in size, $1.2 billion each, and 6 composed of 60 different properties. And our analysts went 7 out across the country to go analyze those properties, and 8 those specifics, and ran five models, not one model. So it's 9 very difficult to -- in residential mortgage, I believe last 10 month we probably rated 42 transactions of residential 11 mortgages. Commercial 5. And yet the size of the staff is - 12 - is that helpful? 13 COMMISSIONER GLASSMAN: Yes. 14 MS. NAZARETH: Mr. Harada, you've been very 15 patient. 16 MR. HARADA: Thank you very much. As for the 17 numbers of the analysts in R&I, 60 persons are purely rating 18 analysts. Of the total numbers of employees of 140. And 19 just like the Japanese tradition, we do not recruit directly 20 as for the analyst -- rating analysts -- we do not directly 21 recruit from the newly graduated from university. We recruit 22 so-called from the other investment management corporations, 23 or other security firms, investment banks. So that we -- of 24 course, we recruit very few numbers from the university, very 25 few, but most of the people were hired from the other so- 1 called experienced persons, maybe. So that a large share of 2 our work firms has enough professional experience. 3 And as for the relation between the numbers of the 4 corporation and the analysts, in our company, one analyst 5 will take responsibility, in average, of almost 13 or 12 6 companies. And as for the committee in the process of the 7 rating, we established within our firm the independent rating 8 committee. That is, we -- I -- I am the number two ranking 9 officer of R&I, but I couldn't -- I cannot participate in 10 that rating committee, with very few exceptions. With the 11 authority, with the agreement of the board members -- the 12 board of directors -- I can participate in that rating 13 committee, but we cannot -- we don't have any voting power, 14 only purely as the observer I can participate in that rating 15 committee. 16 And in that rating committee, that decision will be 17 made under the basis of the so-called unanimous basis, 18 because this means that one leading analyst could not -- 19 cannot lead all the context, all the discussion of the 20 assessment of the rating. So that we reiterate the 21 discussion. And after the very condensed discussion, we can 22 reach the final decision of the rating. 23 And of course, we also respect very much the 24 dialogue with the issuers, because of course, we have the -- 25 ultimately, we have the right to decide the rating, without 1 any agreement of the issuers, but beforehand, we'd like to 2 continue -- we make a very close dialogue with the issuers, 3 because whether -- in one sense, with the cooperation of the 4 issuers, we can make a very good assessment. 5 Of course, we exchange views very much, and we can 6 obtain the so-called non-public information. Of course. But 7 this is quite different. The cross-correlation is quite 8 different from such an independent rating, because we keep 9 the very much independence of the rating. And because we -- 10 as for the capital structure of the R&I, we -- our majority 11 equity is held by the Nihon Keiza Shimbun -- that is, in the 12 media industry, not the financial industry. 13 So that -- and -- Nihon Keiza Shimbun, leading 14 financial paper, have the so-called private equity company, 15 but they haven't listed their equities in the market. And in 16 the exchange, the equity holder is the members of the -- the 17 board of the members -- or the board -- and members of the 18 journalists. So that we can -- from the point of view of the 19 capital structure, we can keep the independence of the 20 rating. 21 And also, that I -- in order to make a proper 22 rating, the accumulation of the professional knowledge is the 23 most important. So that we -- of course, we assign the 24 analyst to the individual sector. And we make the thorough - 25 - individual sectorial study, and we establish some benchmark 1 or criteria, in sectorial criteria, sectorial benchmark, in 2 order to keep our ratings consistent. 3 And so that after that, we will make a very -- 4 check the so-called default study with our consistency of the 5 rating, whether default study -- we continuously made -- we 6 have made a default study, and we opened up -- we disclosed 7 all the results of default study to the public through the 8 website. And we can keep the very good consistency between 9 the -- a consistent relation between the default ratio and 10 the ratings, because that is -- over 25 years, the rating 11 higher is -- the default ratio is very low. And these 12 consistent relations have kept throughout the 25 years 13 writing history. 14 And as for the structured finance rating, the way 15 of the rating is quite identical to what Fitch -- Mr. Joynt 16 and Moody's. And we share almost the same manners of the 17 assessment of the structured finance. The structured finance 18 is -- the rating of the structured finance is the so-called 19 targeting rating. That is, it would depend upon the so- 20 called tranching of the quality of the borrowers, or the 21 obligations, that we can establish so-called subordinated 22 status and preferred status; with a combination of these 23 preferred status and subordinated status, we can set the so- 24 called rating of that, triple A, or double A, or single A. 25 Also that we -- I think that we share quite the same manners 1 with the -- and for the rating of the structured finance with 2 Moody and Fitch. 3 Thank you. 4 MS. NAZARETH: Thank you. Do we have any follow-up 5 questions? Yes. 6 MR. PUTNAM: Yes. I'd like to comment, 7 particularly to the Commissioners here, that I feel a little 8 at a disadvantage, because I have the smallest number of 9 analysts in the group. But I'd like to point out that it's 10 what you do, what comes out from these analysts that's 11 important. How good are your ratings, okay? Not how many 12 analysts you have per company or such. And I think that's 13 very important. 14 We have provided to the SEC our default rates on 15 banks that failed over a period of time. This was back in 16 1995, I think we submitted, particularly all the banks that 17 went down during the '80s and such. And I believe, even 18 though -- and we had fewer analysts then than we do today -- 19 that no one can match that record. We specialized in this 20 area, and you should take that into account. If you have a 21 small company, it's like a boutique, but it specializes in an 22 area, and has the expertise. It's how good that expertise 23 is, not the number of analysts that you have. Thank you. 24 MS. NAZARETH: Okay. Thank you. I think we'll, as 25 promised, take a 15-minute break and return at 10:50. 1 MR. HARRIS: Let's continue. We're now going to 2 talk about information flow in the credit rating process. 3 I'll motivate our discussion with the following observations. 4 The government, in its statutes and its regulations, has 5 written in the credit ratings formally into our regulatory 6 oversight of a variety of different processes. 7 At the time that that was done, people who drafted 8 those statutes and regulations presumably made the following 9 choice: The said, well, we can -- we need to discriminate 10 among various instruments for the purpose of understanding 11 what's risky and what's not risky. We could specify the 12 instruments ourselves. And, I think, quite fortunately, they 13 decided not to do that. We could hire somebody to specify 14 them for us. And I think many of us probably agree that it 15 was probably wise that the government do that. Or we could 16 free ride on the efforts of existing agencies out there that 17 were making these discriminations. 18 And of course, that's what did happen. And in the 19 process, we created the NRSRO process, and that brings us to 20 this meeting. Our interest is in understanding that process, 21 and it flows from our need in the regulations and the 22 statutes to discriminate among various instruments. And 23 therefore, we're very interested in the ability of the 24 regulations to discriminate effectively with respect to risk, 25 which is normally what these regulations are concerned about. 1 In addition, we have concerns about the quality of 2 information that's available to analysts, in general, for 3 which the credit rating agencies are very involved in the 4 acquisition, collection, processing, and production of 5 information that investors use. We have specifically given 6 some privilege to the credit rating agencies, in general. 7 Not just the NSRSOs, but everybody who is doing credit 8 rating, with respect to Regulation FD. As you are all 9 undoubtedly aware, issuers that reveal information in 10 general, under FD, have to reveal material information to the 11 market, as a whole, but with the exception that they may 12 reveal private material information to credit rating 13 agencies, so that those agencies, presumably, can produce 14 more valuable ratings. 15 And our interest, therefore, in the flow of 16 information stems also from, most generally, our interest in 17 ensuring that investors get the best and most timely 18 information. But more specifically, also in understanding 19 whether the exemption that we've provided to the credit 20 rating agencies is appropriate and fair. 21 So with that preface, we'll now examine the 22 information flow in the credit rating agencies. And I'd like 23 to start off by asking of what value these ratings are to the 24 buy side, and by exploring the value of the ratings, we'll 25 have some sense of what's required by the investors. I think 1 all of us are aware of what's required by the regulations. 2 And in this way, we'll start understanding what's necessary 3 to produce the high-quality information that we hope this 4 industry can provide the public. 5 So we'll start with the buy side. I'll ask Erwin 6 from Putnam, how would the world be different without credit 7 ratings? I mean, how do you use these things? Why are they 8 important to you? 9 MR. MARTENS: This is excellent. This is actually 10 an area -- as the chief risk officer, this is near and dear 11 to me, actually, all of this consumption of information, 12 because we pore through absolutely reams of it every day, to 13 come up with risk ratings for our own portfolio managers. 14 So we encounter an actual flood of information, and 15 we manage over 60 billion in bond area of municipals, as well 16 as corporate and government. We're inundated with 17 information, and we spend a lot of time parsing through it. 18 And I've got some notes here about areas that are very 19 sensitive for us. 20 And one particular area is what we call issuer 21 roll-up. We have a lot of concerns with respect to getting 22 ratings that we deem to be, actually, quite valuable, but 23 then taking a look at them and saying, "In the context of all 24 of the other issuances that we own of this issuer, where does 25 the various issues reside inside of all of our portfolios? 1 And how do we roll them up effectively?" The whole idea of 2 identification of an issuance. Where does it reside in the 3 corporate structure of that particular company? 4 And a perfect example. Say, Ford, for example, or 5 Conseco, or WorldCom, or any of the other bond issuances that 6 have come up into prominence in the last year, be it on 7 price, or be it on corporate governance. How much -- a 8 typical question from an investor is, "How much do you have, 9 where do you have it, and what funds is it is and what 10 different tranches do you have of that issuer? 11 Well, all of a sudden you start taking a look at 12 that, and they'll have very unique CUSIPs, ISINs, CLs, that 13 we go back and try to connect back to the ratings, and take a 14 look and say, "how does this actually come up to a holistic 15 view of what represents our exposure to that particular 16 issuer?" This takes up a lot of just mundane time in 17 tracking down linkages from within the corporate structure of 18 a particular issuer. 19 The other one related, that came up in the first 20 section, was securitization. Now, the issuer may be the name 21 sitting behind the securitization, but really, then, the 22 issue becomes, what's the nature of the collateral that's 23 benefiting that securitized issuance? So now we're in a sort 24 of a conflict. There may be somebody that doesn't have a 25 good rating as an issuer, but they've securitized or enhanced 1 the credit to such a degree that, actually, it's a very high 2 rated securitized product. So now we have a conflict between 3 what the signal is coming from the rating agency on the 4 issuer, but the securitized asset is actually pretty good, 5 because it's been highly collateralized. 6 These are the real nuts and bolts things that 7 affect the buy-side interpretation of a lot of the 8 information that we get coming in the door every day. And 9 for us, that is really the effort to take all of that on an 10 overnight basis, process it all, and get it out in front of 11 the portfolio managers the next morning, so they can make 12 rational decisions based on the signals that we've got coming 13 in. 14 MR. HARRIS: Listening to you, it sounds to me 15 that, for you, the ratings are not nearly as important as the 16 information that the rating agencies are able to assemble 17 that travels with those ratings. 18 MR. MARTENS: Well, the ratings are very important, 19 but I would say, since we are longer term investors, we're -- 20 how we interpret a lot of the information is more on a 21 fundamental basis. Obviously, we have our own independent 22 research people on the equity side, fundamental analysis. We 23 also have fundamental analysts on the debt side. So this 24 accentuates or complements the analysis that we do 25 internally. 1 We look to the rating agencies more for a longer 2 term fundamental view, as opposed to point estimators. And I 3 want to point out that one of the things, I think, is, on the 4 interpretation of rating indices, many people look at these 5 as point estimators rather than probabilistic distributions 6 about saying this is the most likely outcome over the next 7 period of time. And I think that there's been a drift to 8 assuming that science is really so precise that that point 9 estimator encapsulates all the last and pertinent 10 information, as opposed to saying, that's a pretty good 11 estimator of where it's likely to be over the next period of 12 time, with a high degree of certainty. 13 MR. HARRIS: I hope that we will be able to address 14 those issues later, as well. 15 MR. MARTENS: Okay. Thank you. 16 MR. HARRIS: Stephanie, would you like to respond, 17 as well, on behalf of Schwab, and in particular, U.S. Trust? 18 MS. PETERSEN: Certainly. Actually, I agree with a 19 lot of the comments that Erwin just made. With regard to the 20 way the ratings are used, the rating agencies serve a very 21 useful purpose, which is, helping the general market 22 understand and appreciate the relative creditworthiness. Not 23 necessarily the absolute, but just the relative 24 creditworthiness. If we didn't have something like that, 25 there would be no common understanding, and the market would 1 be at risk of not understanding what's going on. And 2 consequently, the pricing and other things would be adversely 3 influenced. So having the ratings there provides some 4 foundation. 5 What we're coming up against, with the 6 consolidation among the NRSROs, however, is that the world 7 now has a very limited view, and where there is disparity in 8 the conclusions drawn on creditworthiness among the NRSROs, 9 sometimes that gets reflected in the pricing of securities, 10 sometimes it does not. 11 And if each of the rating agencies is receiving the 12 same amount of information, and they reach different 13 decisions, we on the buy side, who do not have the benefit of 14 getting all of the same information, have to then try to pick 15 and choose among the rating agencies, and the quality of the 16 analysts that are employed to look at and rate those 17 individual securities, to help us formulate what our opinion 18 should be. 19 Because at the end of the day, while the rating 20 agencies have the ability to express opinions, we're dealing 21 with real money, and real client assets. So we have to come 22 to a greater understanding of the quality of the analysis. 23 And that's why earlier I made a comment, that transparency of 24 the process. Every one of the rating agencies has published 25 some version of what their rating policy is, what the 1 criteria is, what information they use. 2 But we also know that you don't always get that 3 whole laundry list of information every time you rate 4 something. Or especially as you're monitoring them on an 5 ongoing basis. And therefore, we have to have a little leap 6 of faith with regard to exactly what information comes into 7 the process. And therefore, our ability to anticipate where 8 the rating agency is going to go has to be based more on what 9 our perception is of the quality of their analysis. 10 So again, we don't want them to go away. That's 11 not the right answer. But I think that being able to 12 increase competition, allow for niche players to have, 13 perhaps, the opportunity to come in and highlight where there 14 might be differences of opinion, based, again, on the 15 information that they're receiving is very important. 16 MR. HARRIS: And I'd also like to ask Jack, of what 17 value are ratings in your business and to your clients? 18 MR. MALVEY: Well, ratings are embedded in the very 19 fabric of the global credit markets. A world without ratings 20 would be almost unthinkable. It would restrict severely the 21 ability of the institutional investors, and individual 22 investors around the world to fully participate in the credit 23 markets. 24 Ponder the dynamics and economics for a moment of 25 the buy side. There are no buy-side firms who have the 1 luxury of Moody's, with 800 analysts, or Fitch, with 700 2 analysts to parse the global credit markets. The rating 3 agencies form a very convenient starting point for 4 institutional investors to begin to then give consideration 5 to, among a certain choice set of issuers, where they 6 possibly want to invest. 7 Ratings, as often highlighted by the agencies, 8 should be viewed as a reference opinion. They're not 9 necessarily an investment opinion. That's really the task of 10 the asset manager. To take the ratings as a starting point, 11 and then decide, within a certain subset of a credit quality 12 grid, whether they want to possibly own a security or sell a 13 security which they already own. 14 So from that function, providing a starting point 15 throughout a global credit market, which, just on the U.S. 16 side, parenthetically let me add, the U.S. side, we have 17 about 800 different borrowers today in the U.S. investment- 18 grade public corporate bond market, and we have about 400 in 19 the high-yield corporate bond market, and when we expand to a 20 global choice set, an order of magnitude about 2,500 21 different institutions. So the agencies form a way to get in 22 and figure out who or what among those 2,500 entities an 23 institutional investor would like to possibly invest in. 24 MR. HARRIS: Thank you. 25 COMMISSIONER GOLDSCHMID: Can I pick up on one 1 point? 2 MR. HARRIS: Please. 3 COMMISSIONER GOLDSCHMID: We're going to talk about 4 it later, but why is it really better to have six or seven or 5 eight to look at, than two or three, in terms of rating 6 agencies? When I pick a movie, to use a perfectly imperfect 7 analogy, I'd like to pick one reviewer I trust, and having 8 seven or eight may make it more confusing. I just want to 9 make sure that I understand the point being made. Stephanie? 10 MS. PETERSEN: I think the real point that we're 11 trying to drive home is that homogenization is not possible 12 in this market. And therefore, if you opened it up to 13 competition, especially among niche players, perhaps, what 14 you might be able to do is, find the kind of differentiation 15 that would allow us to say, "We would like to buy the 16 insurance rating information from Best, we'd like to buy 17 financial institutions from Fitch, we'd like to buy 18 municipals from Moody's, asset-backed securities from S&P." 19 That kind of thing. 20 And right now, we subscribe to a lot of various 21 information sources, although the only ones that we can use 22 or rely on, for regulatory purposes, especially in the money 23 fund arena, are the NRSROs. So we don't have the luxury of 24 being able to look at a broader universe. 25 MR. HARRIS: Okay. I would like to jump over now 1 from the users of the ratings. We'll jump over the ratings 2 agencies, and go to the other side, to the issuers, and ask 3 them what information do they provide to the credit rating 4 agencies, and in general, how do they use the credit rating 5 agencies, either explicitly, or how are they used by the 6 credit rating agencies to provide better information to the 7 public. So let's start with, how about Jerry from GM? 8 MR. VAN ORMAN: Well, we meet twice a year with 9 each of the U.S. rating agencies, and as part of that 10 process, we provide a standard set of information time and 11 again. It changes -- evolves over time. And from that 12 information which we provide, it's used as a basis by which 13 we discuss the issues that are important to the rating 14 agencies. And usually there are follow-up requests for 15 information and the like, commentary that we provide at the 16 time. 17 MR. VAN ORMAN: In many respects, we have a 18 package that we think is a good overview of our business, and 19 then we respond to the three agencies, to the extent that 20 they wish to have more. 21 MR. HARRIS: To what extent is that information 22 that is not presently available to the public? 23 MR. VAN ORMAN: For the most part it is -- I would 24 say it's generally available to the public. We probably 25 provide more detail in the set package I'm talking about than 1 we may in some of our published documents, or even speeches 2 to different groups. 3 MR. HARRIS: And when the analysts meet with you, I 4 presume that they will frequently ask questions, and I 5 imagine, of course, that they're asking about information 6 that's not in the public domain. When they do that, how 7 willingly do you offer it? What is your perception of the 8 value of their questioning of that process in general? 9 MR. VAN ORMAN: Well, I would say that -- you used 10 the adverb "willingly." I mean, there are times when we 11 think, "Oh no." But we will -- we tend to comply with the 12 requests they have, and it's important to us that, at the end 13 of the day, they are satisfied that we have answered their 14 question. 15 MR. HARRIS: Let me ask the same question of David 16 from Pfizer. David, are you finding that you are more 17 comfortable? Or are you willing to provide proprietary 18 information? Do you believe that the confidentiality that 19 you expect of the credit rating agencies can be relied upon? 20 Undoubtedly, in the development of many new products, they 21 must ask many questions like this. 22 MR. SHEDLARZ: Well, the nature of the 23 conversations has changed fairly dramatically over time. And 24 I'll use more contemporary dialogues to kind of get to the 25 answer to your question. While they take a very formulaic 1 approach, in part, in terms of assessing most companies, 2 including Pfizer, as you point out, they also want to get 3 into the richness of what's happening operationally, and what 4 are the enterprise-wide risk factors that they should be 5 concerned about? 6 So I take a look at this formulaic approach. I have a 7 set of numbers. "I want to stress test this," is basically 8 the message they're giving us. And in order to do so, I need 9 to have a clear sense, an open dialogue, and an understanding 10 of your operations, just not a financial characterization of 11 the company. And so you'll spend a fair amount of time 12 confirming perspectives that they have, in terms of the major 13 risk factors, and how far they should stress them. 14 To make it real, they'll focus in on, classically, 15 things like new product availability, new product 16 competition, product liability, environmental liability, and 17 they'll try and dig as deep as they possibly can in terms of, 18 in particular, trying to confirm the relevant range of 19 possible outcomes. So rather than digging into a specific 20 issue, just in the interest of time, to deal with that 21 particular issue. 22 I think it's very targeted, in a utilitarian way, 23 to understand, what's the risk factor around the operating 24 and financial results of the company. And the nature of 25 those discussions, the depth of those discussions, as you can 1 imagine, in the recent past has increased quite dramatically. 2 COMMISSIONER GLASSMAN: I have a question just to 3 follow up. I'm sorry. You're talking about proprietary 4 information, but are you talking about nonpublic information 5 or truly proprietary information? Is it information you just 6 haven't told the public yet? Or is it information that is 7 truly proprietary for competitive reasons, or other reasons? 8 MR. SHEDLARZ: I think it depends on the subject 9 matter, but it can be both. Obviously, talking at great 10 length about some of the liabilities you have would be of 11 great interest to various audiences. Your prospects for new 12 product, and the introduction into the marketplace would be 13 very interesting to our competitors, as well. 14 So you tend to delve into both, but again, they do 15 so, I think, in a very responsible way. Not necessarily to 16 get an advantage on any particular point, but to be in a 17 better position to stress test the assumptions they put in 18 place, and to complement the formulaic approach they have, in 19 terms of understanding your financials, your liquidity, your 20 cash flow capabilities, and other things that they're judging 21 in terms of coming up with their ratings. 22 I actually think it's quite healthy in terms of 23 understanding the operational factors that drive the numbers. 24 MR. HARRIS: In the present Reg FD environment, are 25 these discussions that you would be 1 unwilling to have with analysts in general? 2 MR. SHEDLARZ: Some of the discussions we would not 3 have with analysts, in general. In some cases, in the 4 interest of making sure we're not compromising the company, 5 from a competitive point of view. 6 MR. HARRIS: And I presume that would have applied, 7 as well, before Reg FD; is that correct? 8 MR. SHEDLARZ: That's correct. 9 MR. HARRIS: Okay. 10 MR. VAN ORMAN: Could I add something? 11 MR. HARRIS: Please. 12 MR. VAN ORMAN: As Steve mentioned the 13 securitization area being separate, when the three U.S. 14 rating agencies come in to evaluate our securitization, 15 they're essentially looking at the quality of our assets and 16 our quality, as a servicer. And in terms of the -- in 17 particular, say, the asset quality, we provide much more 18 detailed information in terms of our internal scoring, how we 19 collect than we would in the public, in general. 20 Having said that, that information we provide them 21 in much greater detail for their evaluation ultimately is 22 provided publicly in terms of our loss numbers, our 23 delinquencies. But it's just done in a much greater detail 24 for their purposes. 25 MR. HARRIS: Let me also turn to Ben from Florida. 1 Ben, you represent Florida, working for Florida. And more 2 generally, you represent a class of issuers that are largely 3 transparent. But I was wondering, what is your relationship 4 to the credit rating agencies? What sort of information are 5 they asking of you, and of the various municipalities over 6 which you some relation? 7 MR. WATKINS: Well, in keeping with the theme of 8 the message, once again, the municipal market is different. 9 We -- our relationship and the information flow to the rating 10 agencies, on an ongoing basis, we typically do in the form of 11 a preliminary official statement in connection with a primary 12 market offering of securities. So for every program that we 13 administer, and every time we sell bonds, we send the 14 offering document to the rating agencies for their review. 15 And when we have a new program, we will go into a 16 more extensive analysis of the credit, prepare presentations, 17 sit down and have face-to-face with the rating agencies to 18 explain to them what the underlying credit structure is, and 19 the strength of the credit embedded in the legal documents. 20 There is another dynamic that's important to 21 understand, and that is, we -- in connection with 22 dissemination of information about the state of Florida, 23 generally we do not discriminate among large institutional 24 investors, retail, or the rating agencies. Philosophically, 25 what we want to do is, anything that is important information 1 to the market, we want to disseminate that information 2 simultaneously to everyone, and make that dissemination as 3 broadly as possible, through press releases, postings to 4 websites, and inclusion of that information in the offering 5 documents that we are using. 6 Reg FD and the notion of confidential information 7 just simply does not apply to the public sector. There is no 8 material nonpublic information. So that whole notion that we 9 are giving somehow some competitive advantage to the rating 10 agencies, or they are receiving information that the market, 11 more broadly, is not receiving, just simply doesn't apply in 12 the context of municipal issuers. 13 MS. PETERSEN: Excuse me, may I make a comment on 14 that? 15 MR. HARRIS: Please. 16 MS. PETERSEN: At Schwab, we have the largest 17 single-state money market fund, and we also have the largest 18 national money market fund, so our interest in public finance 19 is rather significant. And I think that the points that Ben 20 has made are very good ones, but the disparity among the 21 issuing community in public finance is great. And 22 consequently, when we on our side of the table need 23 information, we generally have to rely on the rating 24 agencies, because the rating agencies will tell an issuer, 25 "In order for you to maintain your rating, there is a certain 1 amount of information we need. Here's the schedule in which 2 we expect to get it." 3 Some of those issuers are diligent. They're 4 getting the information there. And they figure, as long as 5 I'm providing it to the rating agency, as they do in Florida, 6 we'll post it on our website, we'll make it otherwise 7 available. But if you take a look at a small hospital, if 8 you take a look at some special district financings and 9 things, because of the budget constraints they have, they 10 tend to deal exclusively with the rating agency, or, if it's 11 insured, to deal exclusively with the bond insurer. 12 And consequently, that open line of communication 13 and opportunity for us to get the same information is 14 compromised. That's another place where the rating agencies 15 play an important role at helping to bridge the gap between 16 what information we know is available and how it gets to us. 17 MR. HARRIS: Now, given that many of those issuers 18 are very, very small, is this a sensible arrangement of flow 19 of information? The alternative, of course, being that you 20 and 150 others on the buy side would be asking for the same 21 information, and asking for the same interviews, and 22 essentially overwhelming people who, presumably, aren't 23 entirely equipped to handle that kind of pressure. 24 MS. PETERSEN: Unfortunately, the numbers aren't 25 quite that big, but they're already encountering that. Some 1 of them will tell you that it's bothersome to have five 2 institutions call you with the same questions. But the fact 3 that the retail investor base, especially in public finance, 4 has grown exponentially over the last several years, to the 5 point, I think, that the number is something like 30 percent 6 of all municipal securities are held by mom and pop, means 7 that getting that information out there is even more 8 important. 9 On the institutional side, I'm fortunate that I 10 have some of the best and brightest analysts that, 11 unfortunately, I've pilfered from S&P and Moody's and other 12 places, but nonetheless, that we have the capacity to take 13 that information, do something with it, that the average 14 retail investor does not. So since Schwab also has a 15 significant amount of retail investors who buy individual 16 securities, getting that information out there is important. 17 And I think that the rating agencies stand in the 18 best position to be able to disseminate some of that 19 information, because unlike the corporate side of the 20 business, the municipals do not have EDGAR, you do not have 21 one central repository where there's an absolute requirement 22 for filing certain information at a certain point in time. 23 The MSRB, I believe, is trying to develop that, but they 24 haven't succeeded thus far. So the rating agencies are the 25 best proxy for getting that information. 1 MR. HARRIS: Thank you. 2 MR. WATKINS: I would echo what Stephanie says for 3 the small and infrequent issuer, sort of the midlevel market, 4 in terms of the role that the rating agencies play in 5 connection with gathering the information. They are an 6 important repository of information, if you will, from a 7 whole segment of the market. 8 Another important note to make sort of about 9 information flow is, in the municipal market, under the 10 current regulatory regime, there are annual filings that are 11 required to be made with the NRMSIR system, which is an 12 acronym for nationally recognized municipal securities 13 information repository. There are some difficulties with 14 that system. That rule has been in place since 1994, Rule 15 15c2-12 16 The industry, in recognizing and acknowledging some 17 of the deficiencies in the retrieval of the information from 18 that system, is working in a collaborative, voluntary 19 initiative that we call the MUNI counsel, to come up with 20 some suggestions about how we might, as an industry 21 voluntarily improve that flow of information to the 22 investment community. 23 MR. HARRIS: Thank you. 24 MS. PETERSEN: The downside to the NRMSIRs, though, 25 is the fact that you have to pay for the information, so a 1 retail investor -- there are four NRMSIRs out there, and 2 unless you pay for access to that information, it's not 3 otherwise available. 4 MR. VAN ORMAN: I've been thinking about your 5 question as the conversation -- but to use an example of -- I 6 would -- the analogy I would use is, say, our public 7 documents are the topic sentence, and we provide more 8 paragraphs to the rating agencies. I think this is generally 9 true. 10 For example, GMAC has a large wholesale and dealer 11 loan exposure. The ultimate results from that portfolio, you 12 can see the size of it in our financial statements, you can 13 see the charge-offs, you can see the reserving. What we 14 provide the rating agencies that we don't do in a public 15 document, say, is, we will show them where the larger 16 exposures are, case by case. And I would use that as an 17 example of the greater detail we provide them. And we think 18 that's one of the purposes they serve, is to absorb that for 19 the public. 20 MR. HARRIS: Thank you. And we're going to explore 21 that very shortly, but before we do that, I'd like to ask 22 Paul, on behalf of the members of the Bond Market 23 Association, how do you believe the information flow from the 24 issuers through the credit rating agencies is of benefit to 25 the market and to your members? 1 MR. SALTZMAN: I think, consistent with the message 2 that we're hearing, the rating agencies play a critical role, 3 but the most important message point is that they are not the 4 exclusive investment opinion, or the exclusive source of 5 information. If you look at ratings as simply a tool in the 6 overall mix of information, I think that, then, sets the 7 stage and the framework for everything else that we're 8 talking about. 9 You know, the information flow from the issuer 10 community, whether it be municipal or on the corporate side, 11 is quite good. Our members utilize ratings. As I mentioned 12 in my opening remarks, they're ubiquitous, from everything 13 ranging from being ingrained into the regulatory framework, 14 to being part of the pricing mechanism. It would be a 15 mistake for us to assume that ratings are guarantors of 16 investment performance, or perfect predictors of credit 17 performance. They are an opinion. 18 Not to sort of get too far off the dime, but I 19 guess there have been many remarks here talking about 20 accountability, and how good the ratings are. And I guess I 21 have fundamental problem with that perspective, because, at 22 the end of day, what you're talking about is holding people 23 accountable for an opinion. I don't think we should be 24 thinking about ratings in the context of whether they are 100 25 percent accurate all the time, or whether, in fact, they get 1 it. Because the reality of it is that the accountability 2 goes to the investment community. 3 Look at the story as to how Fitch got started. It 4 got started because, ultimately, it produced added value 5 information to the marketplace, where the investment 6 community and the sell-side community basically said, "We 7 want this." So I think, from my members' perspective, we are 8 very comfortable with the information flow. 9 To the particular point of FD, which, I guess, is 10 underlying some of the discussions here, we continue to 11 support the exclusion from FD. And I think the correctness 12 of that view is highlighted by what the world would look like 13 if you didn't have that exemption. You know, many of the 14 corporate issuers go to rating agencies to seek out views in 15 connection with proprietary transactions, and so forth. If 16 you didn't have that, you would either have a retraction in 17 information to the marketplace, or volatility in the 18 marketplace, because, effectively, the predictor of ratings 19 would not be out there. 20 COMMISSIONER GOLDSHMID: Just a quick follow-up 21 question. I take it the rating agencies create the material 22 information they're given in this context. That's 23 confidential, as a matter of firm policy. Ray, is that fair? 24 MR. MCDANIEL: Yes. At Moody's, all of our staff 25 adheres to a confidentiality policy. We have written 1 agreements about that. And the only use of confidential 2 information is in the application of it to the public rating 3 that is distributed. 4 MR. MAYEWSKI: I would echo Ray's comments on 5 behalf of A.M. Best. 6 MR. HARRIS: Barron, as you've noted, your 7 application to be an NRSRO was not accepted, I guess. The 8 question is this, though Regulation FD offers you the same 9 exemption offered to the NRSROs, have you found that your 10 analysts are facing any resistance when they speak to the 11 various firms that you occasionally do visit? Understanding, 12 of course, that with fewer analysts, and focusing more on the 13 regulatory data, that you may not be out there as often. But 14 are you finding that, though you have the privilege to speak 15 on issues, or to ask to speak on issues that issuers 16 otherwise might be reluctant to speak on, that you're being 17 shut out where you suspect that other credit 18 rating agencies that are NRSROs have privilege? 19 MR. PUTNAM: No, not really. We have the same kind 20 of -- in our company's rules about the use of 21 confidentiality. In fact, it's very restrictive. Only 22 staying with that particular analyst, and the review analyst 23 that's dealing with it. And we don't even keep it on a 24 computer. It's in a file, and it's destroyed after the 25 rating period. But I like -- I always worry about 1 confidential information. It concerns me a great deal. I 2 try and dissuade companies from giving it to us unless they - 3 - unless it's very material in terms of their -- in the 4 rating process. If they feel that somehow this information 5 might significantly affect, or be a major part of going into 6 the rating. I just don't want to know it, if, in fact, it's 7 not clearly something that would affect their rating 8 significantly. 9 COMMISSIONER GLASSMAN: Could I follow up on that? 10 And this is really for all the rating agencies. If you are 11 getting information on a confidential basis that materially 12 affects your rating, is that information that should be 13 disclosed to the public in some way? 14 MR. JOYNT: Could I try to answer that? Because I 15 do think that this question about what we get in the way of 16 what you could consider confidential is not so quantitative, 17 I suppose. A lot of the dialogue that we would have with 18 companies, I believe, isn't collecting facts about the 19 company, it's more understanding their systems, their risk 20 management approach, their risk tolerances. Things that are 21 very debt oriented, not really equity oriented. 22 So while we may get projections from a company -- 23 and you could ask us the question about those projections, 24 and should those be public -- the majority of the information 25 that we get isn't of the factual type. It's qualitative. 1 And so I don't see how one would make that public in that 2 kind of way. 3 COMMISSIONER GLASSMAN: What about in the 4 management discussion and analysis section of the filings? 5 MR. JOYNT: Yes? 6 COMMISSIONER GLASSMAN: Is it appropriate for that? 7 MY JOYNT: Then my answer to that would be, it's 8 how granular do we go in, versus what management can present. 9 So already in their management discussion, they would 10 describe their views on risk tolerance, for example. But if 11 we go in and analyze an investment bank, then we'll be 12 sitting down with people in fixed income, and equity trading 13 areas, and talking about position limits by product area, and 14 how much exposure they're willing to take, what's their 15 tolerance, if they have a loss, do they then adjust interim 16 period to the tolerance that they're allowed to take on an 17 earnings tolerance? There's so much more granular 18 information that allows you to have a perspective, comparing 19 one company versus another, that I'm not sure how they would 20 be able to present all that just is that section. 21 MR. HARRIS: I want to take a very quick survey of 22 our rating agencies, and ask each one about the split of 23 their services, between the public component that is revealed 24 through their websites and their ratings, and so forth, and 25 the subscriber services that they provide. We'll turn to 1 you, Steve. Can you describe the subscriber services that 2 you provide, and describe what the value added is there, 3 relative to the public ratings that you provide at Fitch? 4 MR. JOYNT: Sure. So the majority of our ratings - 5 - of our revenues, 90 percent come from issuer fees, and 6 around 10 percent come from subscription services. And just 7 a little background on Fitch. When we first started, we put 8 all our research -- we had no paid-for subscription services 9 beginning in 1989. For almost 10 years, all research we did 10 was for free. Then we merged with IBCA, and, 11 subsequently, Duff & Phelps and Thomson BankWatch, where their 12 business model was a subscriber-based fees model. We had 13 to accommodate what to do about that, we were presenting all 14 our information for free. 15 Why did we do that? We did that because we were 16 following the model of an NRSRO rating, and we wanted to 17 develop a global rating agency, and we needed the financial 18 capability to do that, and that would require issuers paying 19 fees. So once we've made the transition, we've acquired the 20 companies, we now charge subscribers for our services. 21 So what's the distinction? Our ratings are public. 22 Our press releases are all public. And our rating services 23 are available for anyone to acquire. And I would say that 24 it's again a question of granularity. So we put all our 25 criteria pieces up on our web for free, all our general 1 approaches to analysis. Any press releases we make and 2 public announcements that we make are designed to provide 3 sufficient information to substantiate any rating we do, or 4 any rating change we make. 5 Often in public finance, for example, we do presale 6 reports that are put on the web. And in structured finance 7 areas, presale reports that are put on the web that are free, 8 prior to the sale, for people to review the analysis and 9 information. So in the following of companies, and the 10 surveillance -- the ongoing surveillance of securitizations, 11 there are -- that's where we would be charging for detailed 12 research reports that are acquired by investors, Schwab and 13 others. 14 MR. HARRIS: I would presume by the very fact that 15 your clients pay for these subscription services, that they 16 believe that there's substantial value added. 17 MR. JOYNT: I think so, yes. 18 MR. HARRIS: Mr. Harada? 19 MR. HARADA: Yes. We don't differentiate the 20 treatment between the subscriber and the public. As far as 21 the rating action on the conclusion, or there's some 22 preemptive action that is -- we adopted a system of a rating 23 monitor. If the situation might change substantially, we 24 give some signal, warning signal, to the market. We call it 25 a rating monitor. 1 And these kind of change of the rating, or the 2 adoption of the rating -- introduction of the rating monitor 3 or the other change, or a confirm of the rating. And as far 4 as these kind of rating action and fundamental contents of 5 the rating, outcome is quite -- is provided to the public. 6 And as for the subscribers, we adopted so-called paid website 7 system, with -- we provide to the subscribers some detailed 8 information behind -- some background information behind our 9 conclusions, or we give the summary information to the 10 subscribers of the sectorial information. 11 That is, some detailed information or future 12 structure of the -- such as one sector, or some of the 13 changes, because we give the structure of change. But as far 14 as these kind of information, we're now providing through the 15 so-called website page, subscription system. 16 But as far as the rating action concerned, or the 17 outcomes of the rating, we provide identically to the public, 18 without any subscription. 19 MR. HARRIS: Thank you. And Ray, can you describe 20 briefly the value-added services that you believe your 21 clients recognize when they subscribe to your services? 22 MR. MCDANIEL: Sure. As far as our research 23 service, and its place in the overall Moody's scheme, our 24 revenue split is very similar to what Steve described for 25 Fitch. About 90 percent comes from issuers who pay fees for 1 ratings, and about 10 percent comes from our research and 2 data services. 3 The services that subscribers purchase from us 4 include data and monitoring, first of all, financial 5 statistics, collateral portfolio information, and structured 6 finance, and research. Our research includes, first of all, 7 our press releases, which contain any rating changes and the 8 rationale for rating changes, and those are made available 9 publicly on our website. 10 And then we are selling the company research, 11 transactional research, our company research. We try to 12 update at least once a year. And what we call special 13 comments. And special comments may include industry 14 analysis, geographic sectoral analysis, on a -- really taking 15 on our credit perspectives from a larger perspective 16 We also make our analysts available to try and talk 17 to the market, including our subscribers, and I believe they 18 value that dialogue, as well. 19 MR. HARRIS: Thank you. And Larry, for A.M. Best? 20 MR. HARADA: I'd like to say that I share the 21 revenue. I'd like to explain that -- of the revenue. About 22 7 percent of the revenue comes from the subscribers. And the 23 rest, 93 percent from the issuers. 24 MR. HARRIS: From issuers. Thank you. Larry, same 25 question for Best? What do the subscribers get? 1 MR. MAYEWSKI: A.M. Best has a long list of 2 publications and products and services, in addition to 3 ratings. About 60 percent of our revenue comes from 4 publications, data, subscriptions. Publications in hard copy 5 and CD version. Data. 6 We take public data and have the largest database 7 on insurance companies, so we're able to slice and dice, and 8 do all kind of segment analysis, and peer analysis with the 9 data. So that's something that generally is very attractive 10 to the marketplace. Aggregates and averages and so on. 11 We also have subscriptions where we have a daily 12 newswire, we have a weekly publication in hard copy, we have 13 a monthly magazine. And online access, also, to information 14 and data. And that's about 60 percent of our revenue. 40 15 percent is in the rating arena, approximately. 16 MR. HARRIS: Thank you. And finally, Barron, is 17 your model exclusively subscriber-based? 18 MR. PUTNAM: Well, I wouldn't say exclusively. I 19 would say about 90 percent, though, of our revenues are 20 derived from selling subscription services. And the data -- 21 we have an alert service, where we alert our clients, 22 basically, to major changes in large bank ratings, country 23 risks. We also rate foreign banks. And these larger 24 institutions -- and this information is generally put on the 25 web site. On our web site. 1 We also -- almost all of our -- 2 MR. HARRIS: When you say, "it put on the website," 3 is it protected by password? Or it's generally accessible to 4 everybody? 5 MR. PUTNAM: Accessible to everybody. And 6 sometimes not the whole release is put on the website. And 7 then we have all of our bank, S&L, credit union ratings, and 8 a majority of the holding company ratings are in a service 9 that goes out to libraries. So it's really quite available. 10 And I think we have -- and most of the large libraries in the 11 country subscribe to that service. So it's available to the 12 general public. And that's something that we do provide on 13 ratings of small companies, that the general public can use, 14 particularly like going into one of these institutions, is 15 making sure their deposits are secure -- 16 MR. HARRIS: Did I cut you off? 17 MR. PUTNAM: No, go ahead. 18 MR. HARRIS: I have another question directed to 19 all of our rating agencies. To what extent do subscribers 20 obtain information on an earlier basis than, say, the public 21 would, if at all? Why don't we just go the other way around. 22 Barron, do your subscribers receive information that the 23 public -- earlier than the public does? 24 MR. PUTNAM: Well, in fact, yes. 25 MR. HARRIS: You mentioned something about an 1 alert. 2 MR. PUTNAM: Yes, that's true. I want to -- I 3 don't want to identify some of these, but we have one of the 4 regulators here in Washington, one of the bank regulators. 5 We provide them with an early warning service for their 6 institutions that they regulate. That's not -- you know, 7 that's just one of the things that they use. 8 But we also do this for the Federal Home Loan banks 9 or their members, and things of that sort. It's generally 10 before what the public gets, because the book that goes to 11 the libraries, even though it contains pretty much the same 12 information, is the published book, and may come out three 13 weeks later. 14 But we also provide to any of the institutions we 15 rate, their rating. And we will always discuss their rating 16 with them, why we've rated them, and the whole thing. And 17 our -- one thing, though, that we have is that our data backs 18 up the ratings. We have the data that's used primarily in 19 the rating process, alongside the rating and the date. 20 I feel it's very important when people rate 21 institutions, that the user of that information knows the 22 primary data that went into that rating. And usually when 23 you get down to it, it's the financials. They're based on 24 the company's financials, and it's usually quarterly 25 financials that go into that. 1 Now, of course, you have releases that go out for 2 other reasons. You know, if a hurricane wipes out all the 3 banks in Honduras or something, we'll put out a release on 4 that. 5 MR. HARRIS: And your buy-side clients who 6 subscribe to these subscriber services, presumably, are 7 getting similar things before it's publicly known. Is that 8 correct? 9 MR. PUTNAM: Well, yes. Our large clients, General 10 Motors is one. Not General Acceptance, but the accounting. 11 And they do receive the alerts. If a company is going to 12 fail -- if we feel a company is going to fail, we will put 13 out an alert to them, telling them to secure their deposit. 14 MR. HARRIS: Thank you. Larry? 15 MR. MAYEWSKI: Yes. Probably at Best we should 16 distinguish between ratings and nonrating services. In 17 ratings, any rating or information that supports a rating 18 action is provided simultaneously to our subscribers and the 19 public. Clearly, we do have subscription services that only 20 subscribers purchase. News products and things of that 21 nature. But as it relates to ratings, we endeavor, and our 22 focus is making sure that that is presented to our 23 subscribers and the marketplace simultaneously. 24 MR. HARRIS: Simultaneously. Ray? 25 MR. MCDANIEL: Yes. Similarly to what Larry just 1 described, our analysts are prohibited from talking about 2 ratings or rating rationales until that information has been 3 made available to the general public. And I would also add 4 that, just because of the nature of the rating process by a 5 rating committee, the analyst, in fact, is not in a position 6 to be able to discuss future ratings. 7 MR. HARRIS: Steven? 8 MR. JOYNT: It would be identical in our case. 9 Ratings and watch lists, and any important action like that, 10 supported by the key rating factors, would not be released -- 11 would be released simultaneously to the public, as well as to 12 any subscribers. 13 MR. HARADA: May I? 14 MR. HARRIS: I'm sorry. 15 MR. HARADA: We share the same manners of the way 16 Fitch and Moody's as far as the timing of the information. 17 MR. HARRIS: Okay. I'm sorry I passed over you 18 there. Okay. So here's the difficult question. Through Reg 19 FD we've granted an exemption to the rating agencies, 20 allowing issuers to share information with rating agencies 21 that they're not required to share with others. And the 22 rating agencies, presumably, use that information, hopefully, 23 to the public's benefit. 24 And we've been told that, in most cases, the 25 alerts, the ratings, and other aggregated information is 1 revealed only to the subscribers when it's revealed also 2 simultaneously to the public, perhaps with some exception for 3 LACE, but I suspect that that's probably a fair 4 characterization, even there. 5 And yet, we know that there's additional 6 information that is offered to the subscribers, for which the 7 subscribers are certainly willing to pay. And so the 8 question is, how should we understand whether this is fair? 9 Is the information that's being offered to the subscribers 10 that is derived from the prospectus that may be obtained 11 through the Reg FD exemption, is that a special privilege 12 that ought to be going out to the public as a whole? Or is 13 my characterization of the potential conflict here off base? 14 And so why don't we first -- I'd like to ask all 15 the issuers, but given it's a difficult question, we'll give 16 them a moment to think about it, and we'll recognize the fog 17 has undoubtedly now lifted on Steven Schwarcz, professor of 18 law from Duke has now finally had a chance to greet us. And 19 lest you be embarrassed by being singled out here, you should 20 know that a good six or seven other people walked in only 21 shortly before you did, for the same reason. So Steven, do 22 we have a problem here with Reg FD, that opinions are being 23 formed for which these firms are profiting, by perhaps 24 selling the extended service, or something like that, that 25 might somehow be related to Reg FD? Should the Commission be 1 concerned about this issue? 2 MR. SCHWARCZ: Well, I'd want to think about that, 3 and look into it further before responding in any detail, but 4 certainly, on its face, there might appear to be an issue 5 that the subscribers would be favored over those who did not 6 have the subscriptions, and they would get the information 7 before the public did. But I really would -- that's more of 8 a visceral thought, and not really a firm opinion. 9 MR. HARRIS: Okay. Let's turn to our agencies now, 10 and ask them why the SEC should not be concerned about this 11 issue. Mr. Harada, I suspect that, since you're not subject 12 to Reg FD, that we can skip over you on this question, and 13 ask Steve here, why should the agency not be concerned about 14 the argument that I just provided? 15 MR. JOYNT: Well, I think the linkage that you're 16 making is one that says the most important information that 17 the subscriber is buying is somehow the confidential 18 information that we receive from the company. And I don't 19 really think that's the case. I think it's the depth and 20 breadth of our analysis of a lot of the public information, 21 as well, the comparative information on one company to 22 another, one securitization to another, one city's finances 23 to another. 24 So I don't make the same linkage that you make. 25 That we would have received, for example, in its most 1 egregious form, next quarter's earnings, and somehow embody 2 that into some thinking, if not disclose it confidentiality 3 to subscribers. That doesn't happen. 4 MR. HARRIS: Ray? 5 MR. MCDANIEL: I would point out two things. 6 First, the research that we are publishing is -- does not 7 contain information -- confidential information that we have 8 collected from the issuer, similar to what Steve just 9 described. And in fact, we send our research reports to the 10 issuers, to make sure that we are not disclosing inaccurate 11 or confidential information improperly. 12 The second thing is, I think it's useful to also 13 consider the public nature not only of our ratings, but of 14 our other signals in the ratings process. The outlooks, and 15 in Moody's case, Watchlist, or from some of the other NRSROs, 16 Credit Watch. That is also a public process, and we handle 17 changes in outlook and watch lists via press release and 18 public dissemination, as well. 19 MR. HARRIS: Larry? 20 MR. MAYEWSKI: Yes. In spirit I would echo Steve 21 and Ray's comments. It really is a case of additional 22 information, but not necessarily related to ratings, and 23 anything we feel needs to be in the public domain that's 24 maybe more depth about a company's operations, and things of 25 that nature, that comes out of our analysis. But nothing we 1 believe that is relevant, per se, to the rating opinion. All 2 that information is released to the public. 3 MR. HARRIS: Barron, did you want to add anything 4 different? 5 MR. PUTNAM: Yes, I really do. 6 MR. HARRIS: Please. 7 MR. PUTNAM: I'm sorry, it's not really different. 8 I really agree with Fitch, but I need to make a point on 9 this, that it's -- what we're releasing early is our 10 interpretation of data that's already out there, okay? A lot 11 of the data that we use may be up on the FDIC website. It 12 could be that we're following an institution because it's 13 been declining over time, and as soon as that data hits the 14 FDIC website, we pull it off and run a rating on it. 15 And if it looks like that thing is going to fail or 16 deteriorate or something, boom, an alert goes out to our 17 clients. And this is very important. Some of these people 18 are, let's say, card issuers. You know, the largest card 19 issuers. Things like that. And it's very, very important to 20 them to get an early warning on the institution possibly 21 failing. But it's our interpretation of data only. 22 I particularly -- I could exist without this 23 confidential information easily. I really don't need to be 24 included or exclude from it. But again, it's our 25 interpretation of information that we are releasing. And the 1 data is always out there for someone else to do it. We just 2 try and beat our competition to the punch. 3 COMMISSIONER GOLDSCHMID: Larry, let me try one 4 more spin on the information question. This may be an 5 unusual and law professor's kind of question, but assume I'm 6 the CFO of a pharmaceutical company that's relatively small, 7 and picking up David's example, we've got a new drug coming 8 on line in a year that we now know is a blockbuster. It's 9 going to sell $4 billion, which, in pharmaceutical terms, is 10 blockbuster level. I've got a B rating. I now tell you 11 about this, and tell you I'm a triple A. What do you do in 12 changing my rating in terms of disclosure? 13 MR. HARRIS: Let me add to that just a little bit. 14 And we're going to ask the buy side the same question, which 15 is, when the rating comes out that seems inconsistent with 16 the underlying facts, what calls do you make to obtain color 17 on what happened? We can start with Stephanie. 18 MS. PETERSEN: I wasn't exactly sure who you were 19 asking the question of. That kind of disparity in the 20 published ratings will always prompt a phone call. And 21 therefore, if the information that's being conveyed, that 22 leads to that kind of disparity is material nonpublic 23 information, I don't want to know that, because I don't want 24 to be in a position of having to, potentially, allegedly, 25 make an insider trade. Even in the debt market, that kind of 1 allegation can stick. 2 COMMISSIONER GOLDSCHMID: No, this is really a 3 rating agency question, because by law, they can't convey to 4 you the material information. 5 MS. PETERSEN: Right. And that's another reason -- 6 COMMISSIONER GOLDSCHMID: And yet, they are going 7 to be changing their rating, and they put out a statement. 8 And the question is, what do you say? Maybe Ray, you're the 9 right one to ask. 10 MR. MCDANIEL: There are certainly cases where we 11 raise and lower ratings, and the reason we do that is that we 12 have incorporated important confidential information into the 13 public rating. And it is not fully explained in the press 14 release. And I know it frustrates the institutional buy-side 15 community, but it's -- the way we operate right now, that's 16 just the rules of the game. 17 MS. PETERSEN: Well, if I could respond, as well. 18 I think that the key issue here is one of our ability to 19 understand and appreciate the quality of the analysis that's 20 being done by the various folks who work for the rating 21 agencies. And again, this goes back to that idea of 22 competition. Because we know that there is a certain amount 23 of information and, hopefully, a better flow of information 24 going back and forth when you have 700 or 800 analysts, as 25 opposed to the fact that I only have seven on my taxable 1 side, and I only have three on my public finance side. 2 So we are forever trying to evaluate the general 3 quality of the analysis put forward. So if, indeed , you 4 develop a rapport with an analyst, or an expectation about 5 the quality of the analysis, if their rating suddenly is 6 significantly different than that published by another 7 agency, we would take for granted that there must be 8 additional information. We would not try to pin down the 9 analyst to tell us exactly what that information is, because 10 we have to honor the confidentiality agreement. 11 MR. JOYNT: If I could just offer a comment also. 12 All CFOs of drug companies think all their drugs are going to 13 be blockbusters. I've never met an auto company executive 14 who didn't think he would sell more cars next quarter than 15 the last quarter. I don't think the ratings move that 16 quickly. They're not that sensitive. There's a healthy 17 degree of skepticism about whether that will be true about 18 this drug company product. 19 Also, the companies themselves have the ability to 20 influence other factors, so if that's going to be a 21 blockbuster drug, then it's likely they'll take those 22 revenues -- extra revenues and earnings, buy another company, 23 invest in another product. So there's a stability about the 24 ratings and the credit quality of a company, that's a lot 25 more significant than the necessary stability about quarterly 1 earnings variables and other things that might be related to 2 what we're talking about. 3 MR. MCDANIEL: I think this gets back to our 4 probabilistic observation. That these are interpreted as 5 very strong point estimators, rather than a distribution. So 6 if one of the agencies -- and I'll give an alternative view. 7 If somebody were to downgrade one of them relative to the 8 other rating agencies, saving money. Not looking into it, 9 but saying, "oh, I need to avoid that name. I don't know 10 why, but the rating agency is pessimistic about it. If I 11 invest less in it, even by not giving inside information, I 12 may save my client money." So it's not always just the 13 upside bias. It can also be a protective bias. 14 So again, the probability distribution idea as 15 opposed to the point estimator is a way that a lot of us 16 interpret it, and say, "the spread has gotten wider, there's 17 more uncertainty around this thing," instead of everybody has 18 got it as a triple A. If everybody's got it as a triple A, 19 the probabilistic range around that is very narrow. 20 Everybody has assigned a similar-like quality. If it's split 21 rated, the distribution is wider, and everybody's got a 22 little bit more apprehension about how certain is that view 23 on that company. 24 MR. HARRIS: For the last few minutes, we've been 25 talking about issues relating to Regulation FD. And before I 1 turn away from that, I'll recognize that I've been calling on 2 people from the buy side, and the credit rating agencies and 3 the issuers, but I have not, perhaps, given full opportunity 4 to the other people -- the panelists at the table. And I was 5 wondering if anybody else wanted to contribute to this 6 discussion at this point. 7 MR. VAN ORMAN: Can I ask a question of your 8 question? 9 MR. HARRIS: Please. 10 MR. VAN ORMAN: Let's take my example. Say, an in 11 depth data we provide to an agency on our wholesale and 12 dealer loans. Let's use that example again. That's 13 information we wouldn't want a competitor to see, for obvious 14 reasons. To the extent that the rating agencies were not 15 exempt from Regulation FD, is your question going to the 16 point that then we could not reveal that information to the 17 rating agencies without doing it in a public document, as 18 well? 19 MR. HARRIS: That might be one implication, 20 although I remind you that my role here is only to discover 21 issues, and bring out opinions. And I will be obtuse as to 22 my own opinion. 23 MR. VAN ORMAN: Given the setting I just 24 established, my view of that is, one would have to think 25 about providing that to a rating agency, because we wouldn't 1 want that data public. 2 MR. HARRIS: Right. 3 MR. VAN ORMAN: And in that case, then there would 4 be an issue with rating agency, how important that was to the 5 rating. And to the extent that it was very important, then 6 we'd have to step back and make a decision in terms of 7 revealing it in a public forum. Maybe I'm picking an extreme 8 case, but I think that would be -- 9 COMMISSIONER GOLDSCHMID: Wearing my old general 10 counsel's hat, or maybe practitioner or professor's hat, one, 11 it may not be material information, so it's not an FD issue. 12 And you always can ask someone to hold things in 13 confidentiality, even if it is material. And then if they 14 trade, then it's much more serious than FD. Then it's an 15 insider trading problem of criminal law, or triple penalties 16 and all the rest that would attach. 17 MR. HARRIS: Thanks for the point. I certainly 18 appreciate it. 19 MS. LANCELLOTA: I have a question. 20 MR. HARRIS: Yes, please. 21 MS. LANCELLOTA: I don't remember the exact 22 language of Reg FD, but I'd be curious to hear from the 23 agencies, that when you receive nonpublic material 24 information, do you use it just in your credit rating 25 process, but you now are into so many lines of business, what 1 do you have set up internally to protect that information 2 from being used for other profitable endeavors? 3 MR. MCDANIEL: Well, from Moody's perspective, the 4 only activity that we engage in other than ratings is 5 publication of data and research. And as I described before, 6 that research would not include confidential information that 7 we have received from an issuer. 8 MR. JOYNT: Well, we are primarily a rating agency, 9 and until recently were only a rating agency. We started a 10 very small risk management business, which I think you also 11 have an acquisition -- and a similar parallel company, I 12 guess, within the broad Moody's framework. 13 MR. MCDANIEL: Within the Moody's corporation, yes. 14 MR. JOYNT: Yes, Moody's. So maybe that was your 15 broader question. But in establishing this subsidiary, 16 which, again, is very tiny, we have isolated the people from 17 the ratings process entirely, from any of the information we 18 gather in the ratings process. So our approach, although we 19 don't have to apply it much at this point is, there's a one- 20 way street. You know, our rating analysts can get any 21 information from our risk management people in order to use, 22 like we would any other service provider. But they're not 23 allowed to get any information from our rating analysts back 24 the other way. 25 MR. MAYEWSKI: I would just add from A.M. Best 1 perspective, we have some very stringent code of conduct 2 guidelines in place, a need to know loop when confidential 3 information comes in. It's the analysts, supervisor, 4 possibly some members of the committee, obviously, that might 5 be discussing a rating. In terms of any information flow 6 from, say, a rating division or to our other areas of the 7 company, publications and other services, we have some very 8 strict standards regarding information flow there. It cannot 9 move from one division to the other. 10 And obviously, if anybody breaks any of those 11 guidelines or laws, policy is, there are obviously 12 significant repercussions. 13 MR. HARADA: R&I also includes a very severe, 14 strict firewall between the information flow between -- 15 confidential information is strictly developed -- is set 16 aside from the ordinary information. And there is -- and 17 also, as far as the personal level, there is a very strong -- 18 we have also introduced a very strict code of conduct. If 19 they were to disclose some confidential information, they 20 would be very strictly punished. That means, fired. So we 21 keep the -- very strictly the confidentiality of the 22 information. And also, that we -- of course, as non-public 23 information is used, that's one of the factors of the -- to 24 understand the credit quality as a whole of the issuers. 25 And for example, there's such a case of a new 1 development or new product, but that kind of fact is 2 construed -- is treated as one of the information to judge 3 for the capability of the R&D process of that type issuer. 4 So that we didn't -- we haven't yet picked up some one 5 particular information as when we decided the rating standard 6 -- rating. Thank you. 7 MR. SCHWARCZ: I just thought I'd ask for a 8 clarification. Some of the speakers indicated that the 9 confidential information is not disclosed in the subscriber 10 services. Some indicated it's not used in the subscriber 11 services. And there is a distinction. Of course, if it's 12 not disclosed, it still could be used, and the consequences 13 could come out in the recommendations. And I'm just 14 wondering whether -- I mean, I would be personally more 15 comfortable if it were not used at all. But is that what I'm 16 hearing? Or do some people actually use it? 17 MR. HARRIS: I think you've identified the exact 18 issue, which is what happens when, either in the subscriber 19 services or otherwise, information is produced that relies 20 upon, but does not disclose the information. Do we have a 21 problem? Having raised the issues, and again reminding you 22 that our job is to identify the issues, and we'll allow the 23 Commission to judge them, let me turn away from private 24 information now to public information. 25 MR. COLBY: Could I ask -- 1 MR. HARRIS: I'm sorry. 2 MR. COLBY: I'm going someplace you're planning to 3 go anyhow. I was still unclear from the users of research 4 what they get when they have a subscription that gives them 5 access to a rating agency. What do they get when they 6 contact those people? We've been talking about specifically 7 private information. I suppose there's also a question about 8 a sense of given ratings have an impact on prices sometimes. 9 Any sort of sense of directional move on ratings? I assume 10 that you do get the ability, and I think Moody's said that 11 there is ability to talk to the analysts, that comes from 12 this subscription. And if so, what do you get when you talk 13 to the analysts? What's the point of talking to them? 14 MS. PETERSEN: Well, generally speaking, most of 15 the subscription services that we have -- one point that I 16 wanted to make is, we can't lose sight of the fact that by 17 giving someone an NRSRO status guarantees that they are going 18 to have a subscriber base, because that status is built into 19 a lot of the regulation. And we then become captives of 20 those agencies. And I can tell you that the price 21 competition among them doesn't exist. If anything, they're 22 all trying to end up charging us the same thing. So there's 23 a great deal of money at stake on the subscriber side for 24 this. 25 What we generally get is access to their websites, 1 which means that we get whatever is published. Some of them 2 have e-mail pushes. If we identify a certain number of 3 companies, or CUSIPs on the muni side, so that we get the 4 information without necessarily having to log into their 5 website. We get access to all of their information. 6 Sometimes it's based on whether we're subscribing to a 7 certain sector within their rating universe or not. 8 And then the access to the analysts. Quite often, 9 it's to get clarification on the issues presented in whatever 10 they stated publicly. It's nothing more than that. There 11 are -- I don't know anybody who can read one set of 12 recommendations, and walk away saying, "I have absolutely no 13 question whatsoever about the interpretation of this 14 information." So we're seeking clarification on certain 15 points. Because again, we do not want to be in possession of 16 material non-public information at any point. 17 But if, indeed, the analyst on the rating agency 18 side has received information that, unfortunately, the 19 pharmaceutical company has just received a lawsuit naming it 20 for whatever the biggest plaintiff's case could possibly be, 21 they could put that in there in the form of their rating, but 22 they wouldn't say anything about it in the recommendation. 23 And so that's where we would have to rely on the 24 fact that we know that they get a lot of ongoing information. 25 And sometimes if there's disparity like that, one of my 1 analysts will go onto Lexis-Nexis and take a look to see if 2 there's been a public filing of something. It will prompt us 3 to do additional research. 4 But it doesn't mean that we are calling, with the 5 expectation that the analyst is going to say, "Well, just 6 between you and I, this is really what's going on." That 7 kind of information is not disseminated. 8 MR. HARRIS: Erwin, when your portfolio manager or 9 analysts are talking to the credit rating agency managers and 10 analysts, do you ever discuss values? Do you expect that 11 they discuss values? Do they talk about the difference 12 between what the credit rating would seem to indicate, and 13 what the prices are indicating? 14 MR. MCDANIEL: That's more, I would call it, on the 15 analytic side, where people take a look at these qualitative 16 adjustments, these probabalistic statements. And then take a 17 look at how that jives with where the prices are, relative 18 to, let's say, a triple A curve, or a single A curve. That's 19 sort of a meld between the analytic approach, so this is 20 fairly priced, this is cheap, this is rich, relative to what 21 the qualitative or probabilistic view is, how stable has this 22 been, how much -- how long has it been centric to double A 23 rating. 24 MR. HARRIS: And are those discussions exclusively 25 within your firm, or are those discussions that you're having 1 when you make the phone calls that your subscription 2 facilitates? 3 MR. MCDANIEL: It tends to be more methodological. 4 Like periodically people will check in and say, "Has there 5 been any change, any different view on how you guys think 6 about this rating?" Particularly, you know, the whole group 7 KMV was mentioned, which is a methodology that actually 8 marries the two views almost, in a way. It says, there's an 9 influence here over the long term about where the ratings 10 are, and then there's the prices. 11 And then there's some way to actually take a look 12 at the both and say, "How stable has this been over time, and 13 how does it manifest itself in terms of price. I don't think 14 it's one where we would call and say, "jeez, we got a decimal 15 place off here or something, something must be up. We'd 16 better call the agent -- agency." It's more like 17 periodically we'd check in and say, "If there's any 18 methodological advancements that we're unaware of, is there 19 something going on that we should be incorporating?" 20 But then I'd say we take those inputs, and it's 21 back on our side, as was stated, to make the ultimate 22 decision to buy or sell that asset, given where it is in the 23 market. 24 MR. HARRIS: The buy side, of course, always has 25 ultimate responsibility for their purchase and sales 1 decisions. But help the Commission distinguish between a 2 question of whether you're obtaining investigation analyses 3 or investment advice, versus merely the subscription to a 4 newspaper. Would it be fair to characterize the subscriber 5 relationship as producing information that is tailored 6 specifically to your portfolio, or to your specific 7 interests? 8 MR. MCDANIEL: No, it's one input among many. And 9 I'd echo the point that we actually subscribe to many of 10 them, as a point of validation. We're trying to determine 11 whether there's consensus across a number of sources of 12 information. We then also maintain our own, that mimics, in 13 a lot of ways, the process, albeit it's not in the level of 14 depth that they're able to because of their manpower. 15 So in essence, we are trying to actually plumb the 16 depths of a number of sources, get a validation, and then we 17 would go on and make an investment decision internally. 18 COMMISSIONER GLASSMAN: Can I just follow up with 19 Stephanie on something she said? If I understood you 20 correctly, you said that you feel you have to subscribe to 21 the NRSRO's subscription service. So the implication is, you 22 don't have to subscribe to the agencies that are not NRSROs. 23 MS. PETERSEN: That's right. 24 COMMISSIONER GLASSMAN: Why do you feel that way? 25 MS. PETERSEN: Because under Rule 2a-7, especially 1 with all the money funds that we have, there are several 2 parts within the rule that say that the quality and 3 eligibility of that investment is dependent on us being able 4 to demonstrate that the requisite NRSROs have rated it in a 5 certain rating category. And consequently, if something gets 6 downgraded, there is a certain responsibility on our part to 7 take action, simply because it no longer fulfills that 8 eligibility criteria. 9 COMMISSIONER GLASSMAN: Why can't you just rely on 10 the rating? Why do you have to have the subscription service 11 to do that? 12 MS. PETERSEN: Well, for the most part, especially 13 on the short-term side of the market as opposed to the long- 14 term rating marketplace, there is very little variability in 15 the short-term ratings. And consequently, if you don't 16 subscribe, and you don't understand and appreciate what kind 17 of information the rating agencies are assessing, how they 18 assess it, and that kind of thing, you are not going to be 19 prepared for some of those ratings adjustments. And the 20 attendant reinvestment risk that can go along with having 21 something go from tier one to tier two status can be very 22 difficult to work through if you can't reasonably anticipate 23 that. 24 So the subscription service gives us that kind of 25 background information, so that we can make sure that we have 1 the best possible information, so that we can try to 2 anticipate which direction the ratings are likely to go. 3 MR. COLBY: And how do you get that kind of 4 insight? I just don't understand. Are you saying that the 5 subscription helps you understand how the rating agency 6 analysts think, and how they're going to respond to an 7 external event? 8 MS. PETERSEN: Absolutely. There are several ways 9 that you do it. Number one is, you read whatever more 10 thoughtful and longer publication that gets produced, which 11 usually comes out the first time a security or an entity is 12 rated. And then periodically, based on material information, 13 such as when their annual reports get released. Or on the 14 public finance side, when the caffer is finally released. 15 Then, intermittently, depending upon what other 16 information they're receiving, they may come out with 17 something that says, "gee, it appears that this particular 18 entity is experiencing some difficulty. And therefore, we're 19 going to place it on watch," which signals to us that the 20 rating agency views that the trend that they're seeing is 21 something that may result in a rating change. 22 And so all of that information is useful to us, to 23 help anticipate what kind of investments we make, buy-sell 24 decisions. 25 MR. COLBY: But so far, everything you've said, I 1 think, is public, right? 2 MS. PETERSEN: All the rating agency information is 3 technically public. I think it depends upon whether you 4 subscribe. Because S&P's information -- for instance, if you 5 belong to Bloomberg, you might see an alert -- a headline 6 that says, "S&P changes rating," but you won't get the 7 rationale unless you're actually a subscriber. So if you're 8 just looking at ratings, you might get that public 9 information, but the subscribers get the more in depth 10 analysis, as well. 11 MR. HARRIS: Our time is near the end, and I'd like 12 to make sure that we take full advantage of an extraordinary 13 panel in front of us to ask one final question. Now, this 14 question focuses on public information, and strictly 15 speaking, it is not a question that is specific to the credit 16 rating agency or the issues involved, but one that is of such 17 close importance, that it really should be asked. And that 18 is this. You may have heard it from me last time, if you 19 listened. It's the silver bullet question. 20 If they gave you a silver bullet that you could use 21 to ask the SEC to mandate further disclosure from the issuers 22 that would be of particular use to the buy side, and 23 investors in general, how would you use that bullet? What 24 things should be better disclosed, that presently aren't 25 being disclosed? That information, presumably, could be 1 processed through the credit rating agencies, or it could be 2 processed by anybody else. 3 But given that we're talking about investment 4 information, and we all recognize the incredible importance 5 of the SEC's disclosure programs as providing the raw 6 material that's processed by analysts of all types, whether 7 they're in the credit rating agencies or elsewhere, what more 8 should the SEC be doing in the public interest? Anybody like 9 to take that bullet? For some people, it might not be a 10 bullet. It might be a mortar shell. Would anybody like to 11 take the opportunity to advise the Commission? 12 MR. PUTNAM: I would. 13 MR. HARRIS: Please. 14 MR. PUTNAM: This will probably shake it, but if 15 you standardize some of your data that's coming into the SEC 16 in a standardized form, very much like the Feds do, or the 17 institutions that they regulate, this data could be utilized 18 much more efficiently, and the whole rating process could 19 change dramatically, and be much less costly. 20 MR. HARRIS: I'm pleased to tell you that the SEC 21 is aware of that issue, and we are discussing how to better 22 tag data, and if the data were better tagged, then it could 23 be recovered more easily. And we're very sensitive to that. 24 MR. MCDANIEL: Larry, from Moody's perspective, and 25 I imagine this view is probably shared on the buy side, if we 1 had to select one thing, it would probably be what we are 2 calling triggers. They include rating triggers, but can also 3 include other conditional elements in financial agreements. 4 And it's our understanding that those are not currently 5 disclosed publicly as comprehensively as they might be, and 6 we think that that would probably be of benefit to the 7 market. 8 MR. HARRIS: Anybody else that would like to use 9 their silver bullet? 10 MR. PUTNAM: I would add -- and this is only 11 related to the question. The question is, what further 12 disclosure. I think one of the major disclosure problems of 13 the rating agencies is that of fraud, and information that's 14 not accurate, given to the rating agencies, or omissions. 15 And obviously, to the extent that information is put into 16 public financials and all, there are consequences. But I'm 17 just thinking, if there's any situation where information is 18 given to the rating agencies that a rating is based on, but 19 it's not given in any other way may be confidential 20 information, and that information is misleading. Are there 21 any consequences to the issuer's officers providing that 22 information, because there ought to be. 23 MR. HARRIS: What about for structured products? 24 Should the SEC mandate more comprehensive disclosure of the 25 characteristics of the underlying assets? 1 MR. JOYNT: I'm not very close to what's mandated 2 today. There's a lot of information available. I'm not sure 3 more depth on the information. The question you've brought 4 up is, I think, a very important and strong one. There are 5 some situations today in the asset-backed market, where the 6 quality of the information being provided to everyone is 7 being challenged and questioned. In this morning's Journal, 8 this case of NCFE is prominent in my mind. 9 And so I wonder there whether it's a question we've 10 faced before about accountants, and the accountants and the 11 company, and how they're working. Or whether it just has to 12 do with more granular information that isn't necessarily -- 13 that's presented in a way -- and I hadn't really thought 14 about it in that way. I'm not familiar with any situations 15 where we feel like -- or I can't think of any, but I need to 16 think about this more, whether there are situations where we 17 feel like the information content from management was 18 misleading or erroneous. So we would not have a way to audit 19 that, because, as you know, we don't do that. 20 MR. HARRIS: Right. Paul, would you like to ask 21 anything? 22 COMMISSIONER ATKINS: Just on your last question, I 23 think the Division of Corporation Finance is working 24 closely with the industry, with the Bond Market Association, 25 to try and impose a more standardized disclosure framework 1 into the asset-backed arena, and we're hopeful that that 2 initiative will be published very shortly. So I think the 3 SEC is doing everything that it should be doing, to try to 4 make sure the disclosure is fair, material, accurate, and 5 standardized. 6 MR. HARRIS: I've only been at the SEC for four and 7 a half months, but I'm smart enough to know to close on a 8 good statement for the SEC. 9 COMMISSIONER GOLDSCHMID: Let me give you one more 10 alert in answer to Steven's question. There is a line of 11 cases that say if an issuer uses an analyst as a conduit for 12 misleading information, that certainly can be reached under 13 our traditional antifraud doctrine. 14 MR. HARRIS: Well, thank you very much. We will 15 resume at 1:30. 16 (Whereupon, at 12:26 p.m., a luncheon recess was 17 taken.) 18 MS. NAZARETH: I think professor Schwarcz was the 19 only person who didn't have the opportunity to make his 20 opening statement because of the delays. So before we begin 21 our next session, I thought we'd give you the opportunity to 22 make your opening statement. 23 MR. SCHWARCZ: Thank you. Two minutes? Two or 24 three? 25 MS. NAZARETH: You can take three if you'd like. 1 MR. SCHWARCZ: Three. 2 (Laughter.) 3 MR. SCHWARCZ: Ultimately, I believe that market 4 forces, with a minimum of government action, will allow 5 rating agencies to perform the job for which they're 6 intended, and that economic efficiency alone should be the 7 standard by which rating agencies should be judged. 8 Government regulation could potentially increase 9 efficiency in two ways. One, by improving rating agency 10 performance. And two, by limiting the negative consequences 11 of rating agency actions. Regulation could improve agency 12 performance, I think, only by reducing overall costs, or 13 improving ratings reliability. 14 Presently there's little reason to believe that 15 rating agency fees, which are market driven, are excessive. 16 But of course, were a problem -- then a suggestion I'm going 17 to make at the end about increasing competition, I think, 18 could potentially reduce the costs. 19 Could regulation improve ratings reliability? 20 First of all, I think rating agencies are very concerned 21 about this, because they are very careful of their good 22 names. Their reputation is really their credibility and 23 their value. Nonetheless, the economic downturn has reduced 24 the perceived reliability of ratings by highlighting their 25 relative stability. And the stability, I think, is the key 1 here. 2 Rating agencies should be careful to examine the 3 reason for any downgrading, and especially sensitive to 4 faults on investment-grade debt. But to some extent, 5 instability is inherent in the way ratings are presently 6 interpreted. Say, for example, you have a triple A bond. 7 That bond will retain its triple A rating years in the 8 future, even though there may not be necessarily a 9 reassessment at that time that the bond deserves to be triple 10 A. 11 Now, there is downgrading, but the downgrading is 12 more passive than sometimes active. And one possibility 13 might be to give ratings set life, and then prior to the 14 expiration of the life, to do a complete analysis, and see 15 whether the ratings should continue for another period. 16 There's also a problem with ratings -- a perceived 17 problem with ratings reliability. Rating agencies are 18 conservative in downgrading, and this is because downgrading 19 the bonds of an otherwise healthy company can become a self- 20 fulfilling prophecy. Nonetheless, a rating agency's failure 21 to appropriately downgrade, like the failure in Enron, and 22 more recently in National Century Financial Enterprises, can 23 significantly impair rating agency credibility. 24 This suggests that rating agencies and government 25 need to consider to whom rating agencies should have a 1 primary responsibility. To the issuers, who want stable 2 ratings, or to the investors, the existing investors 3 basically, who want to -- I'm sorry, to issuers and the 4 existing investors, who want the stable rating, or to 5 potential new investors, who basically want the most up-to- 6 date information. 7 And this tension also highlights, I think, the 8 dichotomy between rating agencies on the one hand, and market 9 tests like credit spreads on the other hand. Rating agencies 10 are, and are intended to be, more conservatively stable. 11 Market-based test, such as credit spreads, are more 12 sensitive. However, they're also more prone to false 13 negatives, and that could be problematic. 14 And in this context, one needs to realize that the 15 function of rating agencies is really to reduce information 16 asymmetry. And I emphasize "reduce," because one cannot 17 eliminate that. There will always be problems with ratings, 18 because rating agencies are not perfect and cannot be 19 perfect. 20 Another problem is that ratings do not cover the 21 risk of fraud. Investors, no matter -- even though this is 22 publicized, investors do not recognize this, and it whether 23 or not be economically viable for rating agencies to act as 24 guarantors of fraud. 25 It's unclear how further regulation could help the 1 fraud problems, because companies are already required to 2 produce accurate information, and fraudulent corporate 3 officers can be fined and go to jail. And as Commissioner 4 Goldschmid pointed out this morning, even if the information 5 is given to the rating agency, but not in the financials, 6 there at least is a line of cases that suggests there can be 7 penalties. I think the solution here is to educate investors 8 to the existence of the fraud exception to ratings, so 9 investors themselves would become wary of possible fraud. 10 Another thought is, why are rating agencies 11 different than accounting firms in the temptations that, for 12 example, misled Arthur Andersen? One reason is that rating 13 agencies do not have disproportionately large concentrations 14 of customer fees. In fact, in looking at some of the 15 statements made, I noticed, I think it was S&P that said that 16 its largest concentration is 1 percent or under 1 percent. 17 But a second difference is that, unlike accounting 18 firms, reserve account do not yet have internal conflicts of 19 interest based on fees, such as combining both auditing and 20 consulting businesses with the same entity. And therefore, 21 it may well be useful to examine whether regulation could 22 restrict any such conflicts from developing. 23 Another potential problem is the potential to rate 24 without request. And I know we'll be discussing that this 25 afternoon, so I won't mention that at the moment. But the 1 final negative is that rating agencies are conservatively 2 biased against innovation, for a number of reasons. 3 Competition, I think, might be able to help that bias. 4 Certainly, increased government regulation would not help 5 that bias, because government regulation never made anyone 6 more liberal in doing things, only more conservative. 7 Now, the concern over competition exists, as 8 everyone knows, because at present you only have three 9 NRSROs. And this at least suggests that government should 10 consider balancing the need for a rigorous standard for 11 rating agencies against the need to ensure competition. 12 My recommendation, which is in line with an 13 earlier, but somewhat ignored, proposal by the antitrust 14 division of the U.S. Department of Justice, is to award 15 government designation -- NRSRO designation to foreign 16 recognized rating agencies, and also to subsidiaries of high 17 reputation U.S. firms active in evaluating business and 18 securities of companies. This risk could be further 19 minimized by making any de novo applicant status provisional 20 for some trial period. 21 In this way, the potential anticompetitive effect 22 of NRSRO designation can be reduced without unintentionally 23 creating a climate in which issuers of securities will shop 24 around, to try to buy the highest rating. We certainly want 25 to avoid that perverse incentive. Thank you. 1 MR. McCARTHY: During this session we intend to 2 explore the potential concerns regarding the role of credit 3 rating agencies, particularly the potential for conflicts of 4 interest in the credit rating business, and the potential for 5 credit rating agencies to abuse their power in the 6 marketplace. 7 The Commission staff is presently in the process of 8 examining the role and function of rating agencies in the 9 securities markets, and has focused a lot of attention on the 10 various potential conflicts of interest. Conflicts of 11 interest in the equity research process have been the subject 12 of much recent media attention, such as the pressure on 13 equity analysts to maintain positive ratings on issuers, in 14 order to gain lucrative investment banking fees for their 15 firms. 16 One goal of this session is to discuss the extent 17 to which conflicts such as those that have been alleged in 18 the equity research process present themselves in the credit 19 rating process. And probably more importantly, to identify 20 and discuss any potential conflicts that may be unique to the 21 credit rating process. 22 Accordingly, we request your opinion as to whether 23 potential conflicts of interest in the credit rating business 24 influence the credit rating process. And specifically, I 25 have identified some potential conflicts. And I'll just 1 outline them now. 2 The first one is whether the fact that a credit 3 rating agency is paid by an issuer it rates calls into 4 question the objectivity of the ratings. If so, what about 5 agencies' practice of basing fees on the size of the debt 6 issuance? Does this practice increase the potential 7 conflict, to the extent that the agencies could become 8 dependent on a few large issuers for a disproportionate share 9 of their revenue? 10 Secondly, whether conflicts of interest are created 11 when a credit rating agency provides consulting, or other 12 advisory services to issuers it rates? 13 And third, whether there are any other conflicts of 14 interest in the credit rating business that influence the 15 rating process. 16 I note that a couple of our rating agency 17 participants here today, and at the previous hearing, do not 18 charge issuers for ratings, and thus avoid certain influences 19 of issuers. We would be interested to know their views on 20 whether similar conflicts of interest exist for these 21 subscriber-based firms who could be subject to the influence 22 of subscribers, particularly if the firm is experiencing 23 economic pressures. 24 The NRSROs also maintain substantial power in the 25 marketplace. An NRSRO can directly impact an issuer's cost 1 of issuing debt, and most issuers seek ratings from at least 2 one NRSRO. Accordingly, many commenters have stated that the 3 potential exists for NRSROs to engage in abusive practices, 4 such as improperly pressuring other issuers to pay for 5 ratings. 6 In this regard, I would be interested to hear your 7 comments on questions such as whether rating agencies rate 8 issuers that have not requested a rating, and whether they do 9 this as a means to generate business, whether these -- and 10 they're often termed "unsolicited ratings" -- are less 11 reliable than solicited ratings, and whether the use of 12 unsolicited ratings should be restricted. And secondly, 13 whether rating agencies engage in any practices that are 14 anticompetitive, or otherwise abusive. 15 To the extent that you believe that these conflicts 16 of interest or abusive practices exist in the credit rating 17 business, I welcome your comments on ways to prevent such 18 conflicts, or ameliorate their consequences. Okay. So why 19 don't we -- I'll frame the first conflict, and then open it 20 up to the panel. The first one, does the practice of issuers 21 paying for ratings create a conflict of interest? And if so, 22 what effect does this have on ratings? And also, the related 23 topic, is this conflict exacerbated by frequent issuers of 24 debt, because the rating agencies charge fees based on the 25 size of the issuance? And Ray, why don't I start with you, 1 since I know you've talked a lot about this one. 2 MR. MCDANIEL: Sure. I'd be happy to give you the 3 Moody's perspective on this. I think, first of all, we would 4 agree that there is a latent conflict of interest embedded in 5 an issuer fee-paying model, and I think the burden, then, is 6 on the rating agencies to demonstrate that they can manage 7 those conflicts, and can produce high-quality opinions and 8 maintain objectivity and independence. 9 I think we do that very well as an industry right 10 now. We have at Moody's a set of core principles that we 11 follow, which we have talked about in our written materials, 12 and those core principles deal with the independence of our 13 ratings, the fact that we will not forbear to move a rating, 14 regardless of the effect it may have on an issuer, the fact 15 that ratings are not controlled by any commercial 16 relationship that we may have with an issuer, the fact that 17 we treat confidential information properly. We act 18 judiciously. We operate by rating committee. These are all 19 important principles as far as mitigating some of these 20 conflicts that come from having issuers pay us. 21 We also follow a set of more practical procedures 22 that have to do with prohibiting our analysts from trading or 23 owning securities of companies that they follow, except by 24 way of diversified mutual funds. We work to adhere to fixed 25 fee schedules, and those are known by the applicants. We 1 work to manage any embedded conflicts of interest by having 2 an open-door policy, as far as having analysts go in to 3 managers if they see any concerns or problems. And having a 4 securities trading policy, confidentiality policies, conduct 5 -- business conduct policies, all of which are designed to 6 make sure that the independence and objectivity of our work 7 is preserved. 8 And finally, we have the track record, and it's 9 published. There is predictive content to our ratings, and 10 that track record is available for everyone in the market to 11 review, and, in fact, for independent third parties to test. 12 MR. McCARTHY: Steve, what are your general 13 thoughts on the issuer payment conflict? 14 MR. JOYNT: Sure. I have very comparable comments. 15 Without trying to repeat them all, maybe I'll try to do it 16 more briefly. I do think that culture is the most important 17 thing, and so we've embedded in our culture at Fitch the same 18 conservatism, in which we treat confidential information the 19 same. Important employee protection measures, in terms of 20 their own behavior, including not owning securities in any 21 companies that they're involved with. And we're pretty 22 strict. And we've shared this information, actually, with 23 the Commission. 24 And also the committee process, I think, is very 25 important. So it's a collegial process, a committee process. 1 There isn't a one-person rule, and I don't think one person 2 could get away with undue influence in any particular rating 3 situation, although they can have a lot of influence, and it 4 needs to be protected against. 5 So I don't think we at all avoid the conflict issue 6 with issuers paying. I think we recognize it's there. We've 7 built into our process and our culture important protections 8 against it. And I also agree that I think -- it's not just a 9 Fitch issue, but the industry issue is that we have a very 10 good track record. So there haven't been instances that have 11 arisen of individual performance on the part of the analysts 12 misusing information, or influencing ratings unduly, I don't 13 believe. So I think that's important. 14 MR. MAYEWSKI: From Best's perspective, I would 15 echo Steve and Ray's comments. Very stringent polices, 16 committee procedures, stock ownership issues, no analyst is 17 allowed to own, in the rating division, any stock in an 18 insurance company, outside of mutual funds. Clearly, no one 19 issuer's fee is a significant portion of the organization's 20 total revenue. 21 And in the end, it all boils down to credibility, 22 and the performance of a rating organization ultimately is 23 what will be the judge as to whether they're going to remain 24 in business and be credible. So that is something we have to 25 manage, and each and every day we do our best to manage that 1 effectively. 2 MS. LANCELLOTA: John, can I ask a question? I'm 3 just curious on the compensation structure for your analysts. 4 Whether it's based on the number of issuances rated, or is it 5 just kind of an objective structure of some sort? 6 MR. MAYEWSKI: Compensation of analysts is not tied 7 at all to any issues, size of issues. Nothing to do with the 8 rating fees. It's not related at all to rating fees. It's 9 their performance, and the organization's performance. 10 MR. MCDANIEL: That's true at Moody's, as well. 11 MR. JOYNT: Also at Fitch -- and I think that's a 12 really important of culture. I should have mentioned it. 13 Thank you for bringing it up. We look at the individual 14 analyst's performance against all analysts in a judgmental 15 way. We focus the process of determining bonuses, which we - 16 - and we have a bonus system -- is based on company 17 performance, not on any department's performance. We don't 18 have any -- there's nothing written on a piece of paper that 19 says, "your department and your share of pools" or anything 20 like that. And once people have surfaced recommendations on 21 individual analysts, they're put together into a pool of all 22 directors, and all managing directors, and looked at across 23 the entire company. 24 And one further reflection I would have is that if 25 you look at the compensation across our different departments 1 -- and we do have different departments that are more or less 2 profitable than other ones -- but the average analytical 3 compensation does not have great variability. There's not 4 analysts in departments that are making a lot of money for 5 the company, making $400,000, and other ones in public 6 finance, which are very cautious on fees, making a far less 7 amount. It's just not -- and we're happy to share that 8 information with the Commission. 9 MR. HARADA: As far as conflict of interest, I 10 think that there might be potentially some risks in conflict 11 of interest in that such a rating fee comes from the issuer's 12 expense. But we have already introduced various devices with 13 which we can avoid such kinds of conflicts of interest. Most 14 conflicts are quite similar to those of the Moody's and Fitch 15 has been introduced. 16 But in addition to that, in the field of the 17 education of the analysts, we reiterate very much -- very 18 frequently that our ultimate goal is for the convenience -- 19 for the investors. Our ultimate goal is not the issuers, but 20 the investors. The convenience of investors is our ultimate 21 goal. So that in order to keep such kind of ultimate goal, 22 we pay attention -- make a very strong effort to the 23 accountability. And we always explain the whole rating 24 process, so that if some -- what should I say -- explicitly, 25 so that if there is some risks or there's some conflict of 1 interest, an outsider can identify that such conflict of 2 interest. 3 And also that we have also introduced a firewall 4 between the promotion -- business promotion section and 5 analyst section. We have -- there is no exchange of the 6 information, and no exchange of the human resources, so that 7 we have introduced such a very rather strict firewall between 8 these two sections. 9 Thank you. 10 MR. McCARTHY: Does anyone else have any -- Barron? 11 COMMISSIONER CAMPOS: I have a question. I'd like 12 to direct it at the two individuals who spoke, Ray and the 13 gentleman from -- 14 MR. JOYNT: Steve. 15 COMMISSIONER CAMPOS: Steve. Sorry. And my 16 question is -- I guess it's two hypotheticals that I want you 17 to think through. One is, if we assume that we had a 18 different environment, and we had more than three NRSROs, and 19 we had five or ten, let's say, and if those particular -- 20 second hypothetical -- those particular agencies were 21 dividing up the business, as it were, where we had, 22 essentially, the individual issuers had a choice, and it 23 wasn't always going to end up in two out of the three, 24 essentially, in the regime we have now. Would that situation 25 -- and if we assume that that -- that now you have economic 1 issues, you know, in terms of competition, okay? 2 Would your answer change, in terms of this 3 insulation of conflicts, based on the procedures you have 4 now? Or do you think that, because there might be more 5 pressure economically, maybe your business model is such that 6 the ratings business needed other business, would there be a 7 tension, and would there be some pressure on the integrity, 8 and would there be -- would you be more susceptible, I guess, 9 is the way to frame it, to the issuer desiring the 10 maintenance of a good rating? 11 MR. MCDANIEL: I think, as a starting point in 12 answering that question, we would have to consider whether 13 having five or ten NRSROs would increase the stock of opinion 14 -- credit opinions in the market by two or three times, or 15 whether there would simply be the same number of opinions, 16 but with issuers selecting from among a larger number of 17 rating agencies. I suspect that it would tend to be more the 18 latter than the former, and that raises the question of, what 19 will competition in the industry look like if that is the 20 case. 21 The two forms of competition that -- well, there's 22 three forms of competition that I can think of. There 23 certainly can be competition based on who provides the 24 greatest accuracy over the body of opinions, over a long 25 period of time. There may also be competition on the basis 1 of price, or competition on the basis of ratings, assigning 2 the most favorable rating. 3 And in looking at that, I think the larger 4 agencies, the agencies with significant reputational capital 5 already in this market would certainly act to avoid 6 competition on the basis of ratings inflation, and work to 7 maintain quality in the industry. I know that we would do so 8 at Moody's. But rather than having this raise a conflict of 9 interest in terms of improperly interacting with the issuer 10 community, I would say that the possibility of an unfavorable 11 outcome for the quality of credit ratings overall would come 12 from the possibility of a more compliant alternative being 13 available to issuers. I don't know if that would occur, but 14 that would be the question I would ask. 15 COMMISSIONER GLASSMAN: May I just follow up on 16 that. There were more rating agencies a few years ago. I 17 think the maximum was seven. Was there any difference in 18 that environment than there is now? 19 MR. MCDANIEL: Well, there was some academic 20 research done that indicated that the more marginal players 21 and the new entrants tended to rate more highly than the 22 established players. But again, whether that would occur in 23 the scenario that Commissioner Campos posed in the future, I 24 don't know. 25 MR. JOYNT: I have many things I'd like to say on 1 this issue, but I'll try to stay away from the competition 2 aspects of it, and just stay on the conflicts aspects of it. 3 I don't need the hypothetical. We lived that situation. I 4 was at Fitch, and there were seven rating agencies in 1989 5 and 1990, and we had to try to build -- rebuild the 6 reputation of Fitch. It had not -- a weak reputation for the 7 quality of its research. So we brought in new analysts, we 8 brought a new culture to the organization. The things I 9 described, we started embodying in the company at that point. 10 We had to go out to the institutional investors and 11 convince them that our ratings were accurate, and going to be 12 accurate, and our research was deep and good and strong, and 13 reflective of good credit quality work. So it's not just a - 14 - you just can't put the ratings out there. People won't 15 follow them just because they're ratings from an NRSRO. They 16 have to have great credibility. 17 We also knew we were doing that, and it was going 18 to take a long time to convince people. We weren't going to 19 have a 20-year track record that the two larger ones might 20 have of rating corporate bonds. Although we thought we could 21 establish a good track record over a five- or a ten-year 22 period, which we feel like we have. 23 And it required a big investment. So I think one - 24 - without getting into the competitive aspects, one important 25 thing would be to have a financial commitment to doing -- 1 that allows one to do quality work consistently, avoid the 2 conflict issues, and the trial period that's been suggested, 3 or limited entry based on the expertise in one particular 4 area. I think those would all be constructive ideas towards 5 a time frame at which people could see how an organization 6 acted regarding the conflict issues. 7 COMMISSIONER CAMPOS: Let me push you a little bit 8 more. Is there a number of active credit agencies, let's 9 say, that would have the national recognition category that 10 the marketplace could sustain, before you have competition 11 that endangers, or creates the conflicts that I'm posing? 12 MR. JOYNT: You could ask that of issuers and 13 investors also, not just of the rating agencies, because 14 issuers pay, and investors -- how many rating agency opinions 15 can we actually work with and use. Especially in the context 16 of NRSRO and regulation. So how they use those. 17 But the only answer I can give to you is, I think 18 if you have credible management, and someone looks at the 19 rating agency and says they have the proper procedures, and 20 process, and experienced analysts, and some pretty basic 21 fundamental things, then I'm confident that you could have 22 many organizations that could manage the conflict issue. But 23 it would require, I believe, significant financial 24 commitments. 25 So over time -- I mean, I don't think you would 1 authorize, and people would follow a rating organization that 2 had a very small staff, with limited financial capabilities, 3 and got the benefit of some kind of recognition and 4 regulation that they could misuse, I don't think. 5 COMMISSIONER CAMPOS: So just to make sure, before 6 Ray gives us his opinion about this, when you say, "financial 7 commitment," you mean, have sufficient capital where they're 8 not under distress, and have to, essentially, give in to 9 creating higher ratings from issuers? Is that what you mean? 10 Have a long-term financial capability, where they can 11 withstand economic pressures? Is that what you're getting 12 at? 13 MR. JOYNT: That's what I mean. I wouldn't 14 describe it in the terms of capital, like a proscribed amount 15 or a dollar amount of capital sitting in the firm, but the 16 requirement to sustain the losses, and it may take to build 17 up a reputable business. When we built -- started building 18 Fitch in 1989, it took us four and a half years before we 19 made any money, and I think the total investment was over $40 20 million. 21 So that was a pretty strong commitment, 22 financially, to building our reputation sufficiently so we 23 attracted enough investor interest. We went two years -- 24 almost two years -- well, a little less than two years -- 18 25 months before we, I think, received any issuer fees for our 1 first securitization transaction, and yet we had hired many 2 people, and were doing research and out visiting with 3 investors. So I can't prescribe the amount or the time 4 frame. 5 COMMISSIONER CAMPOS: I was just referring -- I'm 6 not asking you to give me a business plan. I just wanted to 7 make sure that I understood how you were using that term, and 8 that's the way I understood. 9 MR. MCDANIEL: So just to finish up, from Moody's 10 perspective, we certainly saw an environment in the late '80s 11 and early '90s where there were more participants in the 12 industry, and it's my view that industry performance was 13 still quite good during that period. So I don't think 14 there's a magic number of three that is the right number. I 15 think that the questions relate more to, as you have asked, 16 at what point do the benefits that come from the diversity of 17 opinion in the marketplace get outweighed by other factors? 18 And I don't think I can give you a specific number on that. 19 COMMISSIONER CAMPOS: Barron? 20 MR. PUTNAM: I meant to comment earlier. I think 21 you have to realize that there are niche players in this 22 industry. Obviously, -- like we have been rating banks for 23 18 years, and we had been rating them before Moody's and 24 Standard & Poors and, I believe, Fitch, although Thompson was 25 before us in doing that. 1 And to think that maybe our ratings would be higher 2 if we entered the industry to compete, I think, is very 3 wrong, because I believe if you look at our ratings today -- 4 and we don't charge banks to rate them. We sell services, 5 but we don't charge banks to rate them -- that you'll find 6 our ratings are more conservative. They're, on the average, 7 lower than you'll find with the NRSRO companies. And I'd be 8 glad to submit -- probably in the foreign area would be the 9 best areas -- our foreign bank ratings to the SEC. And they 10 could actually make that comparison. 11 So I hope you don't conclude that, if new entrants 12 coming into this industry will be competing by that. We have 13 -- our credibility is on the line, too. I mean, we've been 14 in existence a long time, and you can lose your whole 15 business overnight if you're not credible. It's gone. 16 Especially when you don't charge banks to rate them, you 17 will. 18 MS. PETERSEN: Excuse me. If I could make a 19 comment from the investors side. I'd like to echo everything 20 that was said about the fact that new entrants are not 21 automatically blessed with an immediate triple A reputation. 22 It's something that has to be earned. 23 And as a matter of fact, when a new entrant comes 24 on, even if the investment banker suggests to an issuer that, 25 "Gee, I looked around, and it looks like we could go to 1 market with Moody's and the new XYZ rating," the likelihood 2 is that the market is not necessarily going to say, "okay. 3 It's got two ratings. We feel better about that, and 4 therefore, we're going to give you a better price on your 5 securities." Instead, they're going to say, "Well, it at 6 least has a Moody's rating on it. We know what that is. 7 And depending upon whether or not we agree or 8 disagree with what that rating is, that's the price that 9 we're going to set. It's going to take several more 10 opportunities for that new rating agency to prove itself 11 before you can see a true rating differential. 12 And I think the biggest issue there is that the 13 rating agencies would have to spend a great deal of time 14 talking to the investment banking community, to get the 15 bankers who talk to the issuers to say, "This is an entity 16 that you need to do business with, and here's the reason why 17 I'm putting you in front of them." 18 I think the issue around specialization is 19 something that's been missing ever since Fitch decided to buy 20 IBCA and Thomson BankWatch, because again, given that those 21 entities had NRSRO status, and since, especially under Rule 22 2a-7, as amended, you only need a second opinion in order to 23 find eligibility under the rule for certain investments, 24 taking away the NRSRO status from three or four different 25 agencies means that we are now forced to align ourselves with 1 opinions that might not necessarily, in our opinion, properly 2 reflect the credit quality. And we have to live by the buy 3 and sell decisions that the regulations have promulgated on 4 us, based on rating changes that happen. Especially in the 5 split-rated situations. 6 So I think that the issue presented is not one of, 7 let's just open up the market to competition. It's more a 8 suggestion to the Commission that the requirements for NRSRO 9 status be evaluated so that various players can be elevated 10 to a position where those of us who have to rely on the 11 regulation can look for an opportunity to maximize our 12 investments by getting what we believe to be the best 13 information and the best conclusions in the marketplace. 14 MR. McCARTHY: Why don't we move on to the next 15 conflict, since I think we've deviating a little from the 16 conflict session. It's probably something to talking about 17 next hour. The next conflict that I identified is the 18 conflict of rating agencies marketing additional products to 19 issuers, such as what's commonly called "rating assessment 20 services," or other consulting services. 21 So the NRSROs all provide prerating assessment 22 services, or valuation services for a fee, and typically 23 these are that an issuer will provide a set of facts, for 24 example, a hypothetical merger or acquisition, and present 25 those facts to the rating agency, and then the rating agency 1 would evaluate them, I think, under the same parameters that 2 they would as if the hypothetical facts were real. 3 And then, would again state how they would or would 4 not affect the rating of the issuer. So I just want to -- 5 you know, obviously, this, in my mind, is a conflict of 6 interest. And why don't we start with the rating agencies, 7 to see how they manage that. And then I'll open it up to the 8 rest of the panel. So Steven, if you don't mind starting? 9 MR. JOYNT: Sure. Where do I start on this one? 10 We have very limited rating assessment services. We only 11 actually introduced this service within the last nine months. 12 That was after many investment bankers and issuers came to us 13 and said, "Why don't you have a service? The other two do." 14 The reason we didn't have a service was because we 15 always would be open to giving issuers feedback or investment 16 bankers feedback regarding their rating. So if they called 17 up and said, "I'd like to come in and meet with your 18 analysts, we have some hypotheticals, we're thinking about 19 doing this. How -- what would be the impact on the rating?," 20 we would do that. It was part of our regular process, and 21 it's part of the fee that the issuers pay. 22 So in some senses, bifurcating that into a separate 23 service is just another way to get an additional issuer fee, 24 a separate issuer fee. So it would reflect more time and 25 attention then. So one could argue, paying a separate 1 additional fee for this assessment service now says, "Oh, I 2 want your analyst there on Tuesday at 9 o'clock, and I'd like 3 an answer in a week." And I actually think that's how those 4 services have developed. 5 So I think that represents more of a conflict than 6 the more open style. I think it could be managed quite 7 easily, so I don't -- I haven't seen anything out of that 8 that would indicate that there are major conflicts coming out 9 of the other side of that. The two assessments that we've 10 done -- one we've completed, and one we haven't -- offer no 11 guarantees whatsoever. So here's our views, but many things 12 can change in the market, so they're so highly sort of open, 13 and conditioned that I don't see them as representing major 14 conflicts for our firm. 15 MR. McCARTHY: Ray. 16 MR. MCDANIEL: The rating assessment service that 17 we run is also a very small part of our business, though a 18 bit larger than what Steve just described. It's about 1 19 percent of our revenues in the last year. The reason we 20 offer it is because issuers value reaction to what-if 21 scenarios to important, potentially, business-transforming 22 activities that they may be undertaking. It could be an 23 acquisition. It could be something having to do with an 24 asset sale. 25 And on the other side, investors appreciate rating 1 stability, and avoiding unnecessary rating reversals. So to 2 the extent that we are able to give an issuer feedback such 3 that it knows what is likely to happen to its rating if it 4 pursues a particular hypothetical situation, and the issuer 5 is able, as a result, to make a decision about whether it 6 wants to act or not act, it will not act, in many cases, in 7 ways that cause an unexpected and material change in the 8 rating. 9 But again, I think it's our view that that benefits 10 both the issuer and the investor communities. There are many 11 conflicts around offering that service, though, and we have 12 found that we have had to not offer it in a number of 13 specific situations, because of those potential conflicts. 14 It could be that a company is interested in a takeover of 15 another company that we rate, for example, and we do not want 16 to have that situation where two rated issuers are being 17 subjected to this kind of analysis. 18 And so really, the guidelines -- and we've written 19 fairly extensive guidelines around this, and again, have 20 submitted them to the Commission -- have been designed to 21 enforce a prudential level of oversight from the senior 22 management at Moody's, in deciding when we can accept these, 23 and when we cannot. And in the cases -- in any gray area 24 case, we simply don't accept it, and we don't perform the 25 service. It's not a product development opportunity for us. 1 It's not going to be a significant part of our business. 2 Where we can do it, it is an accommodation to the 3 marketplace. 4 MR. McCARTHY: David, has Pfizer ever utilized 5 these services? And if so, why? What do you see is the 6 advantage to that? 7 MR. SHEDLARZ: Well, not taking a hypothetical 8 situation to Moody's, we have used the services shortly 9 before we're about to transact a particular business 10 development initiative, to understand exactly how the 11 reaction of the rating agencies is going to play out. But 12 not in terms of deciding whether we will or will not do a 13 transaction, or how we'll do it. And in many respects, we'll 14 do the transaction, and we'll live with the consequences, but 15 we want to know what the consequences are before they hit us 16 right in the face. But not in order to make a decision. 17 MR. McCARTHY: And obviously, let's say you utilize 18 the service, they say, hypothetically, it's not going to 19 affect the rating at all. And then you go through with your 20 transaction, and, for whatever reasons, in the meantime it 21 does. I assume that would create tensions or conflict. I 22 assume you're not going to be happy if that happened, right? 23 MR. SHEDLARZ: Well, I wouldn't be real pleased if 24 that happened, obviously, but if circumstances changed where 25 that was warranted, then so be it. I mean, obviously, you're 1 playing into a fluid situation. You're accepting the 2 representation of the company at the time that the company is 3 going through the nature of the transaction, but things 4 change. So if it was on the basis of factors that changed, 5 or environmental conditions, or the nature of a particular 6 transaction, that's something we'd have to live with. 7 I think in many respects, the company makes the 8 rating, not the rating agency. It's the performance of the 9 company. It's the expectation of the company. And it's 10 something we need to live with in terms of their assessment. 11 MR. MAYEWSKI: John, just for the record, I'd like 12 to just add that A.M. Best does not provide consulting or 13 fee-based rating assessment services. We do provide feedback 14 as part of the normal rating process, but we don't have a 15 rating assessment service in place. 16 COMMISSIONER GOLDSCHMID: Consulting is perfectly 17 understandable, as I see it, but let me tell you another 18 story about a different industry, called accounting. Twenty 19 years ago, 70 percent of large firm revenues came from 20 auditing. The latest figures show it under 30 percent. 21 Congress obviously was concerned enough about that to 22 prohibit nine categories recently in Sarbanes-Oxley. To 23 avoid what happened in accounting, is there a reason for any 24 public intervention, given the relatively low level of 25 reserves from consulting? 1 MR. MCDANIEL: From Moody's perspective, as I mentioned, 2 it is not a material part of our business. And so as a 3 business issue, that would not, I think, be over troubling. 4 COMMISSIONER GOLDSCHMID: Would it inhibit you from 5 going much further? 6 MR. MCDANIEL: Well, I think we do a very good job 7 of inhibiting ourselves from going much further, but that 8 will ultimately, I imagine, be your determination. 9 MR. McCARTHY: Well, I mean, assume, as Steven 10 said, before they set up these formal businesses, I assume 11 there was an informal process where you could contact the 12 analyst and say, "Hey, we're thinking about doing XYZ, what 13 would be your views on that?" So is it so much that you saw 14 a business opportunity, and have decided to go down that 15 road? Or is there something? That's why I asked Pfizer. 16 Maybe GMAC can comment. Is there something more valuable to 17 the formal process than, say, what existed previously? Is 18 there something that you think it's very important? 19 MR. VAN ORMAN: From a process point of view, I 20 don't think it's been dramatically different. I think it's 21 one of a number of occasions where the company has wanted to 22 have a contemporary rating out in the marketplace at the same 23 time it's announcing a transaction. And so it's more of a 24 timing issue in terms of assuring that the marketplace is in 25 the best position to assess the merits of a particular 1 transaction, especially when you're making a very large, 2 significant transaction, and it's going to impact the nature 3 of the company. 4 So I think it's more of a timing issue. I don't 5 think the substance of what transpires in terms of the review 6 and the setting of the rating has changed dramatically. But 7 the timing is important. The quality of information 8 available to investors on the basis of having announced, or 9 taken, some action is something that the investment community 10 is looking for. 11 MR. VAN ORMAN: I would just agree with what David 12 said. I'd just be repeating. 13 MR. SALTZMAN: I would just like to, maybe in 14 response to Commissioner Goldschmid, even question the 15 analogy, because it very well may be that the current 16 environment is such that the rating agencies don't derive a 17 substantial portion of their revenue. But I think implicit 18 in your question was, maybe five years from now, it will. 19 And I think the question is, so what? Because the nature of 20 the service that the rating agencies are providing to the 21 marketplace is completely different than the nature of the 22 service that an accounting firm provides with respect to an 23 audit. 24 In an audit environment, you have a single opinion 25 with respect to a company's financial statements, that the 1 investment community is basically forced to rely on. And in 2 a rating agency environment, you have multiple rating 3 agencies. Even in an oligopolistic environment, there still 4 is competition, and I guess we'll get to that in a second. 5 So there are built-in market-based incentives to sort of 6 prevent the conflicts from surfacing, even if the rating 7 agencies were perhaps unduly influenced by a disproportionate 8 revenue stream. 9 COMMISSIONER GOLDSCHMID: Paul, right now there are 10 three, and two of them are needed for most ratings, as I 11 understand it. And so there's an awful lot of power here. 12 And reputational constraints, which are very powerful and 13 real, were there for the accounting firms too. There is a 14 problem here. If these began to be perverted in any serious 15 way, this is an immense, immense market, and we've got to be 16 very careful. I'm not saying intervention is wise, or 17 necessary, but I am enormously concerned that the quality of 18 the ratings remain high. 19 MR. SCHWARCZ: I want to agree with my former 20 corporations professor. 21 COMMISSIONER GOLDSCHMID: There's a conflict. 22 (laughter.) 23 MR. SCHWARCZ: You know, one of the concerns that 24 I've had -- and I mentioned this in my statement -- is that 25 although there aren't any material conflicts now, rating 1 agencies, after all, are business. And if it turns out in 2 the future that other fee-based business becomes material, 3 then there will be conflicts as to how they basically divide 4 their business. The reputational capital of rating agencies 5 right now is important, because ratings are the way that 6 rating agencies make money. But if, in the future, 7 consulting is also a way that rating agencies make a lot of 8 money, then that does diminish the potential reputational 9 capital. 10 And it seems to me that there is an easy fix. The 11 rating agencies are saying, on the one hand, the consulting 12 is not going to be a material part of their business. You 13 know, the SEC is saying, "We're concerned that consulting may 14 become a material part of your business." Why can't there 15 simply be an agreement, whether by regulation or otherwise, 16 that, in fact, consulting will not be a material part of your 17 business? 18 MR. McCARTHY: Are you ready to agree, Ray? 19 MR. MCDANIEL: I think I can agree that consulting 20 will not be a material part of our business. 21 MR. JOYNT: The most complex issue of what me mean 22 by "materiality." 23 MR. McCARTHY: And by "consulting." We're assuming 24 just consulting about rating activities, but there's a 25 broader -- 1 MR. JOYNT: Activities other than rating. There's 2 a broader base of consulting. Risk management services that 3 we talked about before, and there's a large development on 4 the part of, if not Moody's rating company, technically, 5 although the broader Moody's corporation in terms of advisory 6 and consulting services. We certainly wouldn't want to, at 7 Fitch Ratings, preclude ourselves from becoming involved in 8 consulting and advisory services. Especially those near, 9 that we have capabilities in. So I wouldn't quickly concede 10 the point to you, although I'm open to it. 11 MR. MCDANIEL: And I would just like to add, 12 because Steve has raised the consulting services, that occurs 13 through Moody's KMV, which is part of Moody's corporation. 14 In my answers, I am looking at the rating agency. And I 15 think we would anticipate keeping -- we have, and will 16 anticipate keeping a clear division and set of firewalls 17 between the KMV business and the Moody's Investor Service 18 rating agency business. 19 MR. COLBY: Could I ask, and maybe start with you 20 Steve, in the asset-backed securitization business, there's 21 an awful lot of involvement, I've heard over the years, 22 between the rating agencies and the issuer in structuring the 23 pools. And yet there's also sometimes a fee that's based on 24 the size of the offering. Is there a conflict there? An 25 involvement is helping to structure the offering, but also a 1 pay that's dependent on how well the offering goes, in a 2 sense? 3 MR. JOYNT: Not really, actually. If there's any 4 fee based on the size, it would be reflective of the amount 5 of effort that goes into the deal, or the amount of work. 6 It's not -- we can get confused on this issue. Historically, 7 or traditionally, rating agencies have charged corporate 8 based on the size of issues, two basis points, or two and a 9 half, and that also ended up reflecting the size of Ford and 10 GM, and the complexity of analyzing them, versus the size of 11 an industrial company that was small, did $100 million issue 12 and got charged $10,000. 13 And so in the securitization market, I'd say it's 14 similar to that. There's no success fee, performance fee, 15 big deal, get more money kind of approach. Our largest fees 16 are in commercial mortgage securitization. And that's -- 17 they're typically very large transactions, but the reason we 18 have a very large fee. So $700,000 or $390,000 would be 19 because we have many properties to go -- it's like rating 20 seven deals or ten deals. So that's the reason for the fee. 21 It's not based on some kind of success. I don't see a 22 conflict with that. No. I don't know if Ray does. 23 MR. MCDANIEL: No, I would agree with Steve. 24 MS. PETERSEN: Can I make an observation with 25 regard to this line of questioning? I think the one thing 1 that we need to keep in mind is, a good investment banker is 2 going to have a really good idea of what the ramifications 3 will be of certain transactions. And that's the reason why 4 companies usually employ them at what are probably considered 5 very high fees, for the purpose of making sure that the 6 transaction is completed in an orderly fashion, their 7 accessibility to the market is there. So the idea that the 8 conflict is going to arise because they formalize that 9 process by actually going to the rating agency and asking for 10 their confirmation of it, I think, is something that maybe 11 should happen for some transactions, but I don't know how 12 that could necessarily create an inherent conflict. 13 But having said that, if the rating agencies were 14 to get themselves wound up in a lot of these transactions, 15 and be found to sell their ratings because they're involved 16 in that, they will sustain a hardship in the marketplace, 17 because we will pick up on that. We will start pricing 18 differently, because they will no longer have the reputation 19 for being objective and forthright. And if that happens, 20 it's -- in my mind, it's almost analogous to Arthur Andersen, 21 where an entire firm of, what was it, 80,000 people came 22 crashing down because there was a select group of folks who 23 were found to be operating outside of what people considered 24 to be appropriate under the circumstances. 25 So if you found that the situation at Moody's, S&P, 1 or any of the other rating agencies was severely compromised 2 because a group within that organization was working to, 3 potentially, create problems in the market, I would suspect 4 that the end result would be that Moody's might have to go 5 out of business, or Fitch, or S&P, or any of the other rating 6 agencies. 7 MR. MAYEWSKI: I should add that I've done -- as in 8 independent observer, I've done dozens, perhaps more than 9 dozens, of deals, structured finance securitization deals 10 where I worked closely with the rating agencies, and I've 11 never noticed any conflict of interest whatsoever. 12 MR. VAN ORMAN: Just listening to the flow of the 13 conversation, one thing I'd point out is, while the issuers 14 pay the fees -- and I speak -- since I've been at General 15 Motors, the rating's gone down, it's gone up, it's gone down 16 again. So I've seen a lot of fluctuations in ratings, and 17 I've never detected that the fee we paid had anything to do 18 with the rating itself. 19 I would say, I think what we should consider -- I 20 think, at the end of the day, what General Motors is paying 21 for is the reputation of the rating agency. And in the long 22 term, if the rating agency doesn't do its job to the investor 23 base, it's going to have a problem, and then we won't want to 24 pay them. So I think there's that inherent check and balance 25 on the system. 1 MR. SCHWARCZ: On the reputational side, let me add 2 one thing, which is sort of similar to the last conversation. 3 To the extent that there's been an emphasis on how important 4 reputation is to the rating, and that is true, but there is 5 an area on the margin where that may not be true, and that's 6 in privately placed structured finance deals, where, 7 basically, the information is -- you know, no one else can 8 assess it. And in that case, the rating -- an investment- 9 grade rating of an NRSRO is something that's necessary for, 10 let's say, insurance companies to invest in those securities. 11 And insurance companies don't necessarily care how valuable 12 that rating is, as long as it's investment-grade by an NRSRO, 13 because that allows that rating to comply with the NAIC, 14 National Association of Insurance Commissioner requirements. 15 And they only have to keep that investment as a basket asset. 16 So there is this little narrow sliver of area where 17 one wants to be very cautious. I think that will become more 18 significant when we talk about competition later, because 19 there may later come an argument that, well, you can open up 20 NRSRO ratings to many different entities, and the marketplace 21 will basically price them out if they're not good. But 22 that's not 100 percent so, because you still will have this 23 area of privately placed structured finance securities, and 24 it's relatively a little sliver, but in absolute dollars, 25 it's a very large amount, where even poor NRSRO ratings are 1 highly valued. 2 COMMISSIONER CAMPOS: John, I have a technical 3 question for you and Annette and Bob. Under our factors, in 4 terms of giving the NRSRO designation, do we have as one of 5 the factors a determination of independence by the agency? 6 And if we do, doesn't that allow us to get into these issues 7 if we felt that the designation was at issue? Mike, do you 8 want to do this? Give you a chance to talk? 9 MR. MACCHIAROLI: We've always looked at the 10 entity. In making a determination, we've always looked at 11 all the conflicts of interest that we could. That was one of 12 the first things we looked at. We looked to see what their 13 procedures were for preventing any conflicts of interest. We 14 made sure that they were independent of any -- for example, 15 Standard & Poors is obviously owned by a public company, but 16 we had to make sure that they had built-in protections, to 17 protect them from any kind of influence. And we had to make 18 sure that they won't allow an investment banking firm, for 19 example, to own a rating agency. So obviously, very serious. 20 So we've looked at all those kinds of questions, and that's 21 one of the factors in the criteria. 22 COMMISSIONER CAMPOS: So to follow up on 23 Commissioner Goldschmid's issue, if a development occurred 24 where a significant portion of revenues were outside of the 25 exact, specific ratings effort, then we have the authority to 1 revisit the NRSRO designation, correct? 2 MR. MACCHIAROLI: I would think so. 3 MR. McCARTHY: All right. So why don't we move to 4 the last conflict of interest that I dreamed up. A lot of 5 commenters have alleged that the practice of conducting what 6 everyone terms are unsolicited ratings, but that's not a 7 defined term -- I know that what I consider unsolicited is 8 not what some of the rating agencies consider unsolicited -- 9 but for the most part, where an issuer doesn't ask for -- at 10 the outset, for a rating, a lot of commenters have alleged 11 that this practice whereby they will then send a bill to the 12 issuer, and there's kind of this -- the issuers feel that 13 there's a pressure to pay. 14 Whereas if they don't pay, it may affect their 15 rating. That this unsolicited rating pressure is a conflict 16 of interest. And I'd just like to throw it out there to the 17 panel. How prevalent they think it is, how significant it 18 is, and what, potentially, the Commission could do to address 19 the issues related to unsolicited ratings. And again, I 20 apologize, but let me start with Ray and Steve, and then open 21 it to the panel. So Ray, why don't you start. 22 MR. MCDANIEL: Sure. From our perspective, I think 23 the conceptual value of unsolicited ratings is that they 24 allow for rating agencies to provide comprehensive coverage. 25 That may be valuable for new entrants. It's certainly 1 valuable even for established rating agencies in markets that 2 have not traditionally operated with ratings in place. And 3 that was much more true, say, a decade or so ago in the 4 European market. 5 We engaged in unsolicited ratings for a number of 6 years, and despite the conceptual benefit I would articulate, 7 I can also tell you that, as a practical matter, we received 8 almost uniform condemnation from anyone who decided to voice 9 an opinion on that. And that includes market participants, 10 and even some governments around the world. 11 And so we have, essentially, abandoned the 12 practice. We, as a matter of fact, as part of this overall 13 process, just ran a check, and in terms of the last rating 14 that we have assigned to a first-time rating, where the 15 issuer did not participate, that was a couple of years ago, 16 in fact, in 2000, and we have not done it since then. 17 MR. JOYNT: The only area in which we -- we call 18 them Fitch-initiated ratings for unsolicited ratings -- and 19 the only area in which we've initiated ratings has been in 20 corporates. Corporations. The reason we've initiated 21 ratings there is to expand our coverage to better serve 22 investors. When we go out and see investors, they say, "So 23 you rate one drug company, that's nice, but what's your 24 opinion on the other five drug companies?" And we say, "Oh, 25 we don't have coverage of them." So, "in order to be really 1 valuable to us, we need to know your opinion on all drug 2 companies." And so we have initiated coverage in different 3 industry sectors. 4 And corporates because we can get the information. 5 We believe there is sufficient public information to have a 6 reasoned opinion. So we don't think our opinion is 7 particularly conservative or liberal, and if we don't feel 8 like it's accurate, then we wouldn't -- even though we'd 9 initiated the process of research, we wouldn't release the 10 rating if we didn't feel like we could release an accurate 11 rating. 12 In securitization markets, it's harder to find the 13 information to initiate ratings on your own. In the public 14 finance market, it's harder to find information to start the 15 rating on your own. So it's pretty much limited to the 16 corporate market. Once we -- a corollary question to that, 17 though, would be, once we've started a rating on a company, 18 if the company decided not to pay us any more, would we 19 withdraw the rating? How do we get out of the assignment? 20 Or on a securitization, how do we get out of the rating 21 that's there? 22 And so I think that's a harder question and a 23 little bit different one. Once we've initiated the rating, 24 it's our practice to try to maintain that rating, in the 25 interest of investors and coverage, but all the time, we 1 can't necessarily do that. For U.S. public companies, often 2 we can, but sometimes the information that was available to 3 us from the issuer -- in other words, unpaid, may not 4 continue to be available to us. So that's difficult -- 5 problematic. And I don't know how Moody's would handle that 6 if General Motors decided to no longer cooperate with Moody's 7 and pay. Whether they would drop the coverage, or if they 8 would have to issue an unsolicited rating. 9 Also, one final point would be that we don't send 10 bills. So we initiate the coverage, and we continue to work 11 with the company and encourage them to meet with us, and we 12 encourage them to see the value in our rating, and then start 13 paying us. We've offered them our fee schedule. But we 14 don't just send them a bill. We don't initiate coverage and 15 say, "Here's the bill." We've never -- we do not send them a 16 bill until they agree to have a fee paying relationship with 17 us. 18 MR. MAYEWSKI: And I would just add that Best does 19 not issue unsolicited securities ratings. 20 MR. HARADA: And as far as our big concern, that we 21 don't have any conflicting interest in terms of the 22 unsolicited ratings, because, in principle, we do not conduct 23 unsolicited ratings. We -- normally we conduct solicited 24 ratings, but there are very few exceptions. That is, if the 25 demand from the investors is very strong, that occasion we 1 conduct an unsolicited basis rating. 2 That example is that in Japan, there is a very 3 particular condition. It's a reflection of a very particular 4 condition in Japan, but we rate -- there are three examples 5 of the unsolicited rating. 6 One is the insurance -- life insurance company, 7 because most of the life insurance companies in Japan is a 8 mutual company, so that they do not issue any papers in the 9 market. But the investors have many strong interests. 10 Investors or policy holders have a very strong demand for 11 that rating, so that particularly in this situation, this 12 very strong demand, we rate most of the rating agencies -- 13 insurance agencies -- companies -- with -- unsolicited basis. 14 And the second example is regional government. 15 Some particular condition in Japan, that the regional 16 government has a very -- expressed a very strong reservation 17 against the rating, but the investor -- strong -- demand of 18 the investor for that rating is very strong, so that we 19 conduct on an unsolicited basis. 20 And the third one is falling sovereign ratings. 21 It's also very strong demand from the investors. So that the 22 -- but the manners of the rating is -- of the unsolicited 23 rating -- is quite -- almost similar to that of the solicited 24 ratings, that we make the interview with the management 25 staff, even it is unsolicited rating. 1 But, of course, we do not have the -- we do not 2 establish some confidential clause with the management staff 3 so that they will not disclose that non-public, confidential 4 information, so that there might be some slight difference 5 between -- in that sense, slight difference between the 6 unsolicited rating and solicited rating, so that we indicate 7 that, in case of unsolicited rating, we indicate some letter, 8 that is OB. We add OB in that rating, which indicates -- it 9 expresses that this rating is based upon the unsolicited 10 basis. 11 So that in these manners, we very -- although we 12 conduct it in some limited manners, unsolicited ratings, but 13 the way of the rating is almost similar to that, and the 14 number of unsolicited ratings is very much limited, so that 15 as far as -- our only concern that there is no risk of 16 conflicting interests in terms of the unsolicited rating. 17 MR. PUTNAM: I need to point out here to the 18 Commissioners that all our ratings are unsolicited. So if 19 you decide to do away with them, we're out of business. But 20 don't think so much about me, but about small investors, 21 okay? Because we've done this for 18 years, and we've issued 22 over a million of them. But it's very helpful to small banks 23 wanting access to the capital markets, and this is something 24 we've recently been doing. And these -- it's -- there is no 25 course of conflict, because we don't charge on the other 1 side. But I just want you to know that we do issue 2 unsolicited ratings, and a lot of them. 3 MR. SCHWARCZ: Let me respond to that by saying 4 that there's -- there really is a major distinction between 5 unsolicited ratings in public deals and in private deals. In 6 public deals, one could say that unsolicited ratings is a 7 public good, because investors have a right to know, and most 8 of the information is out there. All you lose is the 9 confidential information. 10 In private deals -- and that's where rating 11 agencies in the past have -- that's the area, and the only 12 area, in which rating agencies have been criticized in the 13 past for issuing unsolicited ratings. And the problem there 14 is that there is insufficient information, because it is a 15 private deal, because it depends oftentimes on the structure 16 of the deal, or on the nature of the deal itself. 17 Now, in that case, I know on pages 16 through 18 of 18 my University of Illinois Law Review article, there's a 19 lengthy discussion of this, that the one rating agency that 20 did this, Moody's, has basically been convinced by the 21 market, as Ray said, to change this. They now -- well, 22 they've stopped, basically, issuing unsolicited private 23 ratings. And even before that -- in the years before that, 24 they were finally convinced by the market to basically, as 25 the gentleman from Japan says, to designate in the rating 1 itself that it is an unsolicited rating. So at least market 2 forces, to that extent, took care of it. 3 MR. MCDANIEL: I would just add that we were 4 criticized for both our public and our private ratings. 5 COMMISSIONER ATKINS: I just wanted to throw one 6 thing into this discussion regarding unsolicited ratings. 7 And it's sort of following in your footsteps there. There is 8 a thing called the First Amendment. And if you are out 9 there, and you want to put your opinion out, regarding a 10 security, I don't see how anyone can really question that. 11 COMMISSIONER GOLDSCHMID: I had an even -- well, 12 the First Amendment is large, but an even larger one that 13 we've touched on -- but before we break, I thought maybe we 14 ought to pin down -- this is a break for coffee -- how good 15 are the ratings, from the standpoint of the issuers and the 16 investors taking an initial one, and then over time? I'd 17 really like to hear how good you think they are. Using Paul 18 Saltzman's definition of risk, and knowing that these are not 19 precise numbers that you can write in stone. 20 MR. MCDANIEL: You mean, the unsolicited ratings? 21 COMMISSIONER GOLDSCHMID: No, generally. 22 MR. MCDANIEL: Generally? 23 COMMISSIONER GOLDSCHMID: But here I want to focus 24 on the issuers, and on investors, the institutional 25 investors. 1 MS. PETERSEN: Okay. I'll take a stab at this one. 2 As I mentioned in my opening remarks, one of the things that 3 helps us create more value for the investors on whose behalf 4 we're investing billions of dollars is our ability to 5 anticipate what the rating changes will be. So it's 6 incumbent upon us to try to get, as best we can, knowledge of 7 how the various rating agencies and the analysts within those 8 agencies do their business. 9 And we do distinguish. There are certain segments 10 of the business where we prefer to see a Moody's rating, or 11 we prefer to see an S&P rating, that kind of thing. And we 12 vote with our dollars. So consequently, I'd have to say that 13 we have come to understand what the trends are. 14 What's been problematic of late, almost since -- I 15 guess post Enron anyway, is that there seems to be a cliff. 16 That some of the rating agencies are not using some of the 17 tools at their disposal, such as Outlook and Watch, to give 18 us a better indication of what the general direction would be 19 on a rating. And instead, you can just wake up one morning, 20 and discover that the rating got downgraded. And 21 potentially, more so then you would have otherwise thought. 22 So I think that we have the capacity to understand 23 and appreciate the quality of the ratings. And they're 24 generally pretty good. But having said that, some are better 25 than others. 1 MR. KAITZ: I would just say that was the subject 2 of one of the questions that we asked our 700 respondents, 3 and our members are both issuers of debt, as well as 4 investors. And in both cases, it came back about 65 percent 5 thought they were accurate on each side. So depending on 6 your perspective, 65 percent is a good grade, or 65 percent 7 is a bad grade. 8 COMMISSIONER GOLDSCHMID: My children would say 9 good, but I -- 10 MR. KAITZ: Yes, well, I have a son in college, and 11 that's not acceptable from him to me, but that came back on 12 the debt, as well as on the investor side. 13 MR. WATKINS: On the municipal side, I think, by 14 and large, the rating agencies get it right. And I would 15 have to say, if there is a bias, the bias is on the 16 conservative side, rather than being more aggressive. And 17 don't get me wrong, I've had my disagreements with the rating 18 agencies, and in many cases, think sometimes they don't get 19 it. But it always has erred on the side of caution, as 20 opposed to being completely sold by the story that we're 21 telling. 22 On the other side, on the surveillance side, with 23 respect to the timeliness and the accuracy, and their real 24 ability to penetrate and have insights into what's really 25 going on in our business is not quite as good. And 1 reiterating what Stephanie said, using some of the sort of 2 interim stats, an anecdotal story is with respect to the 3 timeliness of information. 4 We were put on a change in Outlook, which is the 5 lowest grade of change that there can be. That came in 6 December, post 9/11, and it was a general concern about the 7 economy. Well, by the time we'd gotten to December, a 8 consensus had coalesced about what the economic outlook was 9 going to be, and it wasn't going to be as catastrophic as was 10 being predicted. And in the interim, we had had a special 11 legislative session, and made adjustments to our budget 12 through expenditure reductions, to balance our budget. So I 13 don't think it was nearly as contemporaneous as it could have 14 been. That would have been warranted in October. By the 15 time we got to December, in my judgment, it was stale, and 16 not a good predictor of things coming in the future. But by 17 and large, I think they do a very good job. 18 MR. KAITZ: On the timeliness question, it came in 19 at 40 percent. 20 MR. SHEDLARZ: I think one of the things we have to 21 be cautious about is, judging any company, including the 22 rating agencies, in an unprecedented environment. And I 23 think we're learning now, we could all do a better job of 24 assessing an investment decision, by bringing a whole host of 25 reference points to bear. If we're looking to the rating 1 agencies to be the primary vehicle through which we make 2 investment decisions, and not bring to bear the richness of 3 market information, which moves quickly, in unprecedented 4 environments, I think we're all making a mistake. 5 I also think we're establishing probably a standard 6 for a whole host of institutions, including the rating 7 agencies, which is not possible to meet. So I think we have 8 to be very cautious in terms of -- especially during times of 9 turmoil, unprecedented dislocations, and assuming the we're 10 going to get the penultimate answer from just about anybody. 11 I think what this has taught all of us that make investments, 12 and rely on the agencies in terms of issuers, is one of the 13 things very early on in the discussions today. 14 This is a reference point. It has to be brought to 15 bear with the richness of primary, and other analyses. The 16 investment decision is yours. Don't make the investment 17 purely on the basis of rating agency information. I think 18 that would be remiss in terms of all of us who have to make 19 investments on an ongoing basis. And I don't think any of us 20 do it on that basis. 21 I guess I could point to a whole host of 22 constituencies who didn't pick the trend, who didn't pick up 23 on what was happening in terms of a number of key 24 institutions in this unprecedented time. And so does it 25 point to an opportunity in terms of improving upon the 1 predictive nature of the models that we're using? The answer 2 is, absolutely yes. I think Moody's and others are taking a 3 look at expanding their capabilities in exactly that area, in 4 order to respond to these dynamics. 5 But I'd be cautious about setting a standard in an 6 unprecedented environment, which is probably not achievable. 7 And yes, I think we can say, in retrospect, given what 8 recently happened, timeliness and accuracy could have been a 9 lot better from a whole host of constituents who were 10 involved in trying to assess the situation. 11 I'd just like to add one component to this 12 discussion, and that's price. Because at the end of the day, 13 you can define "good" in one way as how much of a predictor 14 is the rating of default. And I think you're going to get 15 statistics --and perhaps the rating agency folks can support 16 me here -- that are in the high 90s, okay? A very good 17 grade, by anyone's account. 18 And I think when you interview buy-side 19 professionals, and other investment professionals, they're 20 looking at "good" in a different fashion. They're looking at 21 "good" relative to, hey, this double A should have traded 22 here, this single A should have been traded there. And 23 volatility in credit spreads, which have occurred over recent 24 months, have a lot more to do with the accuracy of ratings. 25 And I think that has got to be factored into the mix. 1 And I would echo what David said earlier. There's 2 a lot of information out there, and ratings are simply one 3 part of it. So when you're judging the performance of rating 4 agencies, I would just encourage the Commission to be very 5 creative and broad-minded about what the benchmark is. 6 MR. SALTZMAN: This actually keys into the conflict 7 I had identified in the statement, which is a different 8 conflict, and that is -- and I'm not sure it's even 9 technically a conflict, but there's a question, to whom 10 should rating agencies have a responsibility? Who is, 11 essentially, their client? Is it the issuers and the 12 existing investors, who basically want stability in ratings? 13 Or is it the potential investors, who would like to be up to 14 speed in terms of what's changing? And the risk you have is 15 that you're never perfect. 16 If you say your client, effectively, is the 17 potential investors, and you prematurely downgrade a 18 company's bonds, a false negative, so to speak, well, those 19 potential investors would be warned there may be a problem, 20 but you're going to basically kill the company, or create a 21 self-fulfilling prophecy, whereby the company whose bonds 22 were downgraded now finds it harder to get credit, and its 23 financial condition may actually go down as a result, whereas 24 it didn't deserve to go down. Things like credit spreads 25 basically are much more likely to give you false negatives. 1 And therefore, I think part of the stability of the ratings 2 is really keyed into this issue, to whom should rating 3 agencies look in terms of making a judgmental decision as to 4 whether or not to downgrade? 5 MR. COLBY: We've been waiting a while for somebody 6 to say something positive about the SEC, but since no one is 7 doing it, we'll have to break without it. If we could be 8 back in 15 minutes, which would be 3:20. If anyone wants to 9 know where to find sodas, if you ask one of the staff, 10 they'll show you the key to the map. 11 (A brief recess was taken.) 12 MR. COLBY: When I closed down the discussion from 13 the last item I cut off one person who wanted to address it. 14 Jerry, do you want to say a few words on this before we move 15 on? 16 MR. VAN ORMAN: In terms of the question on the -- 17 how are the ratings, I saw an opening to get into the short- 18 term ratings, which is the gist of my written remarks, so I'm 19 going to take it. 20 In terms of long-term ratings, I think overall my 21 experience has been the agencies, on balance, do a good job 22 at evaluating long-term credit trends without getting hung up 23 on the emotions of day-to-day changes in credit spreads and 24 the like. I think they have a very good balance that way. 25 And certainly my experience, in the four agencies we deal 1 with in North America, is that they treat their jobs in a 2 professional way and are very conscientious. 3 Having said that -- that applies to long-term 4 ratings -- an area of concern I've had for 10 years now is 5 the short-term rating scale. And I think the focus of the 6 rating agencies -- and again, this is a personal opinion -- 7 is strictly -- is for the most part on the long-term rating. 8 They are evaluating a corporation with respect to its long- 9 term rating. And then from that comes a short-term rating. 10 And I think that's too automatic, because it's essentially 11 based upon correlations that have evolved over the last 10 to 12 20 years, and the evolution of the short-term rating scale 13 has not had as many nuances as the long-term scale. I 14 remember 20 years ago there weren't pluses and minuses, for 15 the most part, and now -- well, you can look at a scale. 16 But the short-term rating scales have never really 17 changed. And I think the agencies have been remiss in not 18 evaluating that situation more. Because certainly in those 19 20 years, the commercial paper market has become very 20 important to this country, both as an asset to my money 21 market funds -- and essentially people viewing money market 22 funds as money, so the quality of that asset is very 23 important -- but also in terms of a corporation funding 24 itself. I think not enough attention has been paid to the 25 evolution of the short-term credit tiers, and it's to the 1 point now -- and this is somewhat exacerbated by Rule 2a-7 2 having said that, I think the goals of Rule 2a-7 are very 3 important, and I understand why it exists -- because of the 4 importance of money funds and money. 5 But Rule 2a-7 is based upon short-term credit 6 ratings -- tier one, tier two. And those in turn are based 7 upon long-term ratings that correlate back to those. And I 8 don't think enough thought has been given to that by the 9 agencies, or perhaps the SEC, in terms of knowing what a tier 10 one and tier two rating is. And we've gotten to the 11 situation where an A- credit is a tier two credit almost 12 automatically, and there's a credit click between tier one 13 and tier two. And I know from personal experience it is 14 easier for an A- company to issue five-year debt than it is 15 to issue 30-day commercial paper. 16 I've always thought that absurd. And I'd like to 17 point it out. And in Detroit, I've been on this for 10 18 years; I'm down to talking to the family dog about it. 19 (Laughter.) 20 MR. VAN ORMAN: He's 11, and he's never heard 21 anything but this. 22 (Laughter.) 23 MR. HARRIS: Does anyone want to take up this 24 topic? Anyone want to add anything? 25 I've barked up the wrong tree. 1 (Laughter.) 2 MR. HARRIS: Jerry? 3 MR. COLBY: I would say I imagine if you offer the 4 same rates on the 30-day stuff that you offer on the five- 5 year stuff, you'll have no trouble selling it. 6 MR. VAN ORMAN: Well, actually, if you look at 7 relative spreads it requires -- the money at 30 days is not 8 available for most any spread. And it's not only the cost of 9 the money, it's the availability as well. It's an unusual 10 situation, and it's not good for the economy and the capital 11 markets. 12 MR. COLBY: Well, moving to the last topic, which 13 really is not the last topic at all because we've been 14 talking about it all day long in fits and snatches. And 15 that's the question of competition between NRSROs, regulatory 16 treatment, and barriers to entry. This is something that 17 from a regulatory standpoint started in 1975, when the 18 Commission first used the term nationally, "NRSRO." Only a 19 few people actually know what that means. It means nationally 20 recognized statistical rating organization. It's a badge of 21 honor in deciding what the haircut should be under the net 22 capital rule, and it has incrementally expanded under 23 Commission regulation to things like registration forms and 24 Rule 2a-7. It's statutory in places, it's in the '34 Act. And 25 it's spreading around the world; at the earlier session the 1 person from the British financial services agency said that 2 it's being incorporated in the Basel II capital requirements. 3 And so it becomes extremely important who gets 4 treatment under this and how it's treated. The Commission 5 hasn't ignored the fact that there's this issue; we've been 6 struggling with it for years and years. Ten years ago there 7 was serious consideration about whether we should seek more 8 regulatory authority from Congress to oversee rating 9 agencies. That never went forward. In 1994 we put out a 10 concept release that raised many of the questions we're 11 talking about today. A few years after that, we proposed 12 some amendments for a process for deciding about NRSROs that 13 has never actually been adopted. And along with this process 14 goes that question of how do we recognize them and what goes 15 with recognition, what sort of regulation, if any, is needed? 16 So I'd like to start off by saying that we're going 17 to stop when we finish discussing this or 4:45, whichever 18 comes first. So if people are tired of it, we may go 19 quickly. 20 The other thing, I think in the last session when 21 we talked about this topic, I think the consensus was that 22 this is something like Churchill's comment about democracy, 23 'the worst system except for all the rest'. And so when we 24 talk about this I think it's very important not just to point 25 out the faults, but we need to talk about what could be done 1 better -- what are the avenues for improvement. 2 I'd like to start off first by throwing open the 3 question of where there are barriers of access, to what 4 extent do they arise from the existence of largely well- 5 recognized players in the market already? To what extent 6 does it arise from the regulatory use of the rating, and to 7 what extent from a lack of desire for more sources of 8 guidance in this area? So I'm going to start -- I want to 9 start by asking Larry, you've been operating as a rating 10 agency for a very long time and only recently asked for 11 recognition. Could you talk about how you developed your 12 position and how you view these issues? 13 MR. MAYEWSKI: Well, A.M. Best I guess goes back to 14 1999, is when we started to actually expand our ratings into 15 the securities area. In fact, all of the analysis that we do 16 in the underlying insurance companies incorporates holding 17 company issues and in effect, this was just a very extension, 18 and in effect we were doing all of the work but not assigning 19 the ratings. 20 But as more and more insurance companies were 21 issuing securities and we were not in the business, they 22 asked us, you know, would you consider rating our securities? 23 And so we started to think about it, thought it was very much 24 a logical extension of what we were doing, and decided to do 25 that. 1 Clearly, the lack of an NRSRO designation has had 2 some impact. I would probably not say at this time -- or I'd 3 probably say that it's not as much the net capital rule and 4 some of the other imbedded guidelines, although those are 5 issues. But 6 overall, issuers look at it as a Good Housekeeping seal of 7 approval. And to the extent that you obtain it, you're 8 viewed as having the capabilities to do that. So from a 9 competitive standpoint, it's put us at a bit of a competitive 10 disadvantage, although, with that said, we still right now 11 rate about 115 issuers of the 400 or so that are active in 12 the marketplace. So we've had a pretty good inroad over the 13 last couple of years in that area. 14 But over the years in speaking in every panel with 15 other rating agencies, they'll always take the chance or the 16 opportunity to point out that they're an NRSRO in competition 17 with A.M. Best in terms of the insurance focus that we have. 18 But obviously, it is a barrier to entry, to a certain extent. 19 We've tried to work hard to overcome that, but there are 20 still companies that, obviously, would like to see us with an 21 NRSRO designation before they'll do business with us. 22 MR. COLBY: Mr. Harada? 23 MR. HARADA: Thank you very much. As far as R&I is 24 concerned, although the definition or criteria of the NRSRO 25 is so clearly defined, we are well-fortified as an NRSRO in 1 terms of the competition of the capital structure and quality 2 of the ratings and human resources and conflict of interest 3 point of view. 4 And also, from the point of view of the national 5 recognition, we are also -- we recognize, we think that R&I 6 is well nationally recognized, because most of the major 7 investment bank had already sent -- written some supporting 8 letter to us for our application of the NRSRO. So that in 9 this sense, we are well-qualified in NRSRO. But we haven't 10 yet been recognized as an NRSRO. This is why -- the reason 11 why such a postponement might be the ambiguity or vagueness 12 of the procedure. And especially the process of the no- 13 action process, the very much -- has not yet been clearly 14 defined. And there is no clear time limit for that 15 procedure. 16 And also, that -- of course, the definition is 17 still a little vague, so that there is some room for, what 18 shall I say, the postponement of such a procedure. 19 And so that -- but in that sense, we are well- 20 qualified as an NRSRO, but especially in the -- there is a -- 21 NRSRO is composed of the two factors. One is national 22 recognition. The second part is statistical rating agency. 23 It means that quality -- good quality of the rating, their 24 rating. 25 But the first definition -- the first -- that is, 1 national -- recognition should be less -- what should I say - 2 - stressed. It should be less important, because this -- in 3 NRSRO program, the national recognition is a kind of a 4 problem of the so-called chicken and the egg. If we are 5 recognized as a national -- as an NRSRO, we will improve the 6 situation of the national recognition. But if it is not the 7 case, then it's very difficult to be -- to recognize as a 8 national -- NRSRO. But we do -- we had been very -- 9 continuing that very effort to be recognized by the major 10 investment bank and financial institution, investment 11 management company, so that we have -- in my understanding, 12 and in our judgment, that we have well recognized as an 13 NRSRO. 14 MR. COLBY: Thank you. Jack, what are the 15 barriers to a building a business as a rating agency, not an 16 NRSRO? That's obviously a regulatory label. But what are 17 the barriers? And from where do they arise? 18 MR. MALVEY: Let me answer the question. I also 19 want to quickly add, on the overall concept here, number one, 20 I think we need to sharpen the definition of this concept, 21 for sure. Most of us in the industry don't even know what 22 this means. Two, the acronym is acronistic here. What is a 23 statistical rating organization? Are there nonstatistical 24 rating organizations? It's a qualitative art. Statistical? 25 It's -- appropriate acronym. As far as -- if I were going to 1 BIS, I would say break it into GRA, Global Rating Agency, 2 Local Rating Agency, to simplify the concept. 3 The third thing is, for sure, open it up. There's 4 folks here knocking at the door who want to be rating 5 agencies. Let them come. And then let the markets decide 6 who they want to listen to here. So what are the barriers, 7 in answer to your question? They do have to, as you heard 8 from Steve earlier, they need to define or provide a 9 constituency out there. They have to have investors who are 10 willing to listen to what they have to say. That's one for 11 sure. Ultimately that's the test. Are investors going to 12 pay attention? If XYZ Corporation comes in and says, "We're 13 a rating agency," and it's rating symbol is B minus, who 14 cares if you never heard of them? So they have to go out and 15 market. I think -- the number one. 16 Number two, they have to develop a track record 17 through time. It's not an overnight process. Again, we 18 heard from Fitch. Others in the industry can well attest, 19 it's a multiyear process, really, for institutional investors 20 and the marketplace to become familiar with your 21 organization. 22 I'll stop there. I think those are the two largest 23 barriers to entry. Maybe the first one, getting back, is, 24 maybe it's the fact that some of these entities can't get 25 this official designation. That is a significant barrier. 1 MR. COLBY: I want to not let this be dominated by 2 the people seeking the rating activities, to hear from some 3 of the other folks first. 4 MR. SALTZMAN: I guess I'll chime in from the 5 perspective of the Bond Market Association. Our view is that 6 there certainly can be more transparency brought to the 7 process, and that the regulatory definition of the criteria 8 should not be a barrier to entry. I should really say, it 9 should not be an unreasonable barrier to entry, because every 10 criterion -- each and every criterion, at some level, will be 11 a barrier to entry for somebody, even if the criteria are 12 minimal in terms of the infrastructure and number of 13 employees, et cetera. 14 The one point that we've raised is this sort of 15 catch 22 associated with the national recognition criteria. 16 And picking up on some of the things that Jack said, it seems 17 to me that one can achieve a minimal level of recognition, 18 perhaps through a seasoning requirement, you have to be in 19 business for a certain minimal period of time, you have to 20 issue a certain number of ratings, without necessarily 21 imposing the end game result, because in many respects, if 22 someone is willing to put forth the capital and the 23 infrastructure, and willing to do what it takes to get 24 involved in getting regulators comfortable, even if it 25 doesn't have that national recognition, it should be afforded 1 the opportunity. 2 MR. COLBY: Amy, do you want to talk about this? 3 MS. LANCELLOTA: Well, as far as barriers of entry, 4 no, not really. I don't have any comments there, except that 5 I do think the national recognition attribute people have 6 called the chicken and egg, or whatever situation, is an 7 important one, and I do think that if there's any thought of 8 relaxing the requisite criteria for becoming designated an 9 NRSRO, that really calls for increased regulation, or at 10 least oversight by the SEC. 11 We don't have a view about the number, or whether 12 there should be greater competition. Competition is always 13 good. But I do think, though, that it would be helpful, too, 14 maybe to designate specialized NRSROs. I think Thomson 15 BankWatch was designated just with respect to rating 16 financial institutions, and that may be one way to bring in 17 additional agencies into the NRSRO designation. And I think 18 that would be helpful. But I do think if there's any thought 19 of trying to lower the barriers, or make it easier for new 20 agencies to come in, that the SEC needs to increase its 21 oversight. 22 MR. COLBY: That itself poses a set of questions. 23 We may need to come back to that topic. Steve, do you want 24 to go, and then Barron? 25 MR. JOYNT: Either way. Barron, do you want to go 1 first? 2 MR. SCHWARCZ: A few thoughts. The NRSRO 3 designation, although it's unique to the U.S., in that -- so 4 many terms -- a concept similar to NRSRO exists in virtually 5 all of the major money center nations of the world. My 6 University of Illinois Law Review article, I think -- 7 MR. COLBY: Is that for sale? 8 MR. SCHWARCZ: Absolutely. No, it goes -- I think 9 it was every country, at least, that has the data on it. And 10 it works the same way it works here. The fact that something 11 is so widespread doesn't necessarily mean it's good, but it 12 certainly is some indirect evidence of its merit. 13 In terms of the alternatives to NRSRO, there are 14 some nations, I believe India is one, that has substantive 15 regulation of the rating agencies, but I'm not sure that's -- 16 there are no major money center nations that do that, and I'm 17 not sure that that sort of -- regulation is necessary, or 18 even appropriate, under the philosophy of the securities 19 laws. 20 In terms of the anticompetitive effect, I mentioned 21 in my statement that, yes, there clearly is an 22 anticompetitive effect, and I think it needs to be remedied 23 in some way, but you have to make sure that if you remedy it, 24 you don't open up the process to so many NRSROs that you 25 basically encourage ratings shopping. That would be a very 1 unintended and perverse result. 2 And so I would disagree with those who say, "open 3 it up and let the markets decide." I'm not sure that is the 4 right answer. And as I mentioned earlier, the markets 5 themselves may try to get an NRSRO rating simply because it 6 has value, but say it translates into an NAIC rating. So you 7 want to be rather cautious about that. 8 MR. COLBY: Barron? 9 MR. PUTNAM: I'm glad I let Steve go before me. 10 NAIC is a very good client of mine, and it so happens, 11 though, they'll only use Moody's and Standard & Poors and 12 Fitch where they're issuing ratings, and then use us for the 13 rest of the financial institutions that they don't rate. 14 Because we're the only game in town other than that. 15 I think, to answer your questions on the barriers 16 to entry, I've listed some in terms of my comments earlier. 17 But I think one that was alluded to earlier, and maybe once 18 or twice, is, there's a very, very serious barrier -- and I 19 know the SEC is aware of this. I don't know if they know the 20 extent, but it's in all the -- almost all the bylaws of large 21 corporations, it's in state laws, municipalities, that they 22 must use ratings of NRSRO companies. 23 And to compete with Moody's and Standard & Poors, 24 you must -- they have tremendous name recognition, and you're 25 a new kid on the block, and you're coming in and competing 1 with them, that's tough. But when you go in and they say, 2 "Well, we can't use you, but gee, we like your service and 3 everything," and they have to change their law to do that, so 4 that they can use your service. And we've done this. We've 5 actually -- a lot of states use us, a lot of municipalities 6 use us. But that's a tough barrier to overcome. It's a 7 struggle, and we spend a lot of time and effort trying to 8 compete. We're not on a level playing field. And it's a 9 tough -- it's tough to compete with the majors. And again, 10 we're a niche player in terms of financial institutions. But 11 we've been able to stay alive for 18 years, and we've watched 12 Thomson BankWatch go down, which was our major competitor. 13 And that is a very serious barrier. And I've alluded to 14 others, and you're aware of those. 15 MR. JOYNT: Thomson BankWatch didn't go down, by 16 the way. They rose up with us. 17 (Laughter.) 18 MR. PUTNAM: Several of their analysts are knocking 19 on my door. 20 MR. SALTZMAN: Bob, I would just add that in some 21 respects, I think we're not actually focusing on the real 22 issue, which is, why is it the case that these substantive 23 rules embrace an NRSRO acronym and designation. Right now, 24 the NRSRO designation grew up because of its use in the 25 capital Reg M bylaws, et cetera. And as to that point, I 1 think no one has mentioned the fact that ratings continue to 2 be a very, very useful and accurate proxy for inclusion in 3 substantive regulations. You know, whether it's drawing the 4 lines in the capital rules and so forth. 5 So it seems to me -- let's not throw the baby out 6 with the bath water here. If there are problems with the 7 NRSRO designation process, don't get rid of that proxy, which 8 is very useful in substantive regulation, but bring some more 9 transparency and process to the designation process. For 10 example, Barron -- and you can understand -- why is it that 11 you're not an NRSRO? Are those reasonable. 12 Perhaps including an appeals process in that, to 13 allow you to go to some higher authority, to question whether 14 or not you've reached that level of designation. But let's 15 not go back to a situation where we completely get rid of the 16 NRSRO designation process, because I think, at that point, it 17 will truly have investor protection, and market regulatory 18 implications that I don't think anyone wants. 19 MR. COLBY: What do others think about Paul's idea? 20 It's very tempting when you look at this designation process, 21 to say that this process is just so difficult, why don't we 22 dump the use of ratings. What do others think about that? 23 Of course, you'd have to figure out what to replace it with, 24 but other views on this? Or the use of ratings in regulatory 25 provisions? 1 MS. LANCELLOTA: Bob, I personally would not scrap 2 the NRSRO designation, I think it plays a crucial role in 3 Rule 2a-7, and for that purpose, I think it's been important, 4 and it's done its job. I would not suggest, though -- the 5 SEC has gone down this road -- relying on the rating agencies 6 for regulatory purposes beyond the assessment of credit risk. 7 So I think it's important to limit their role in substantive 8 SEC regulations to an assessment of credit risk. And there, 9 I think they play a very valuable role. And Rule 2a-7, I 10 don't think -- it would just not be as successful as it is 11 today, without the use of NRSROs, and of course, Rule 2a-7 12 doesn't say your analysis stops with just looking at the 13 ratings. Mutual funds have to go beyond, and make their own 14 independent, minimal credit risk determinations, but the 15 rating agencies provide an invaluable service. 16 MR. SCHWARCZ: I agree completely with what you 17 said, and I would say that I looked at this issue 18 extensively, and I looked at nations around the world, what 19 they did, and this seems to be the way that everyone has come 20 up, and a very logical way. If you're going to -- first of 21 all, if you're going to use some sort of private ordering 22 process as part of ratings, rating agencies make sense. 23 Rating agencies look at -- only look at credit risk. 24 They don't look at investment advisability, because 25 they say nothing about the rater, you know, the suitability 1 for investment. So I mean, yes, I agree, it should only be 2 used for the credit risk, and I think that is how it's only 3 used in all the regulations I know of. 4 So I would -- the only thing I would say is -- and 5 I agree with Paul -- that if I were not an NRSRO, I would be 6 very frustrated, because I wouldn't be entirely sure what 7 criteria I could look to, to try to improve myself to get 8 there. And it would be very helpful to increase the 9 transparency of the process, just as it would be helpful for 10 the legitimacy of ratings, for the agencies themselves to 11 increase the transparency of their ratings process. And so I 12 think that would be a very desirable thing. 13 MR. COLBY: Do others want to talk about the use of 14 ratings in the regulatory process? Should I take this as 15 agreement that it's valuable? Or is everyone just tired 16 today? All right. Then there seems to be a focus, then, on 17 how do we go about choosing an NRSRO. And it has a number of 18 criteria, but one of the leading ones is this -- as Mr. 19 Harada spoke of -- national recognition. And the thinking 20 behind national recognition was actually sort of intended, 21 I'm told -- I wasn't around at the time -- to be a market 22 decision, as opposed to making it a regulatory decision. 23 Look and see, for people that are out and are being used, has 24 the market decided that they add enough value, and that their 25 ratings are good enough, that are useful enough that the 1 regulators can them use them for a similar purpose. There 2 have been a lot of thoughts expressed about that, and it's a 3 very judgmental approach, which has a transparency problem. 4 Anyone else that hasn't talked about this want to 5 speak about the use of national recognition? 6 MR. SULLIVAN: I just want to point out one thing, 7 that I believe -- and I could be wrong, but at the time that 8 the NRSRO designation came about, there weren't that many 9 regulatory sections that really depended on them, so that you 10 probably could make a national reputation without being an 11 NRSRO. Now there are so many aspects of securities law that 12 rely upon the NRSRO, that, in effect, you've created the 13 monopoly on the market. 14 I'd make the following observation. I don't think 15 that one wants to scrap the national recognition as one of 16 the criteria, because I think that it has a useful purpose. 17 And again, as to the staff, I think they do rigorously apply 18 a lot of other criteria to ensure that there's a quality 19 threshold of entrance. I think the problem becomes that, 20 under the current structure, the national recognition becomes 21 the seemingly most important determinant, the seemingly most 22 important criteria. And that, I think, is where the 23 frustration comes. So back to Paul's observation, and your 24 observation about the '97 proposal for a process, that's 25 where we should probably be focusing our efforts and our 1 attention, because it's the lack of a specific process, it's 2 the lack of timelines and the like, where I think a lot of 3 the frustration comes about. 4 And the last observation I would make is, as we 5 discussed new applicants and the like, I think that there is 6 a sense that "new" means inexperienced. And I think that 7 many of the people around the table would say that a new 8 applicant doesn't necessarily have to be an inexperienced 9 rating agency in terms of what its business line is, whether 10 it's a niche business line, or in a broader context. 11 MR. COLBY: On that topic, Mr. Kaitz, your survey 12 looked at other sources of information besides NRSROs. What 13 did you ascertain about what people were using for 14 information, and who was there, and what they were 15 contributing? 16 MR. KAITZ: Actually, almost 83 percent of the 17 people that responded to our survey, in addition to using the 18 rating agency, used other organizations, including A.M. Best, 19 Dunn & Bradstreet. And surprisingly, because all of our 20 members are corporate finance professionals, none of -- a 21 number of them use their own proprietary research, as well. 22 Again, most of our members are investors, as well as debt 23 issuers. So it was a very high percentage. But again, they 24 saw lots of value in the rating agencies, but a huge majority 25 used other sources. 1 COMMISSIONER ATKINS: I have a question, to follow 2 up on Mr. Malvey's discussion there. Is there any merit to a 3 two-tier type of thing, like minor leagues and major leagues, 4 and then have people graduate up through the steps? And 5 then, obviously, change other regulations that are 6 bootstrapped on this NRSRO concept. But I don't know if 7 anyone had any thoughts on that to follow up on this point. 8 MR. MALVEY: Let me respond. To be determined, to 9 be thought about. I'm not sure that sort of an apprentice 10 rating agency would have much ability in the marketplace. I 11 don't know exactly the test that the Commission goes through 12 to examine nationally recognized. But there are certainly 13 many ways you could -- looking at it objectively, if you look 14 at the amount of assets out there in the market, and if 15 you've had some threshold level whereby you had institutional 16 investors certify a certain level, is it 5 percent, is it 10 17 percent of the market, and write a letter, almost like a 18 politician filing and saying that we have enough signatures 19 here to file for candidacy in a particular jurisdiction. 20 Can't you do that? Get $50 billion? Is it $100 billion? Or 21 do you already do that? All you have to do is get -- to say 22 yes, and you're in. 23 (Laughter.) 24 MR. COLBY: The Justice Department, I think, 25 Steven, you and maybe others suggested some sort of a 1 provisional registration. 2 MR. SCHWARCZ: Right. They basically say -- they 3 suggested that the designation be given to -- and I'm sort of 4 taking my own summary of it, with my changes, but it's in the 5 article. Foreign recognized rating agencies, and also 6 subsidiaries of high-reputation U.S. firms, active in 7 evaluating the business and securities of companies. And 8 then they suggested -- and I think it makes a lot of sense -- 9 that there be a provisional time period, perhaps a year, to 10 make sure that it works out okay. 11 MR. COLBY: Anyone have any reaction to this? 12 MR. JOYNT: I'm patiently waiting to speak, but 13 I'll wait until you're ready to go for rating agencies. 14 MR. COLBY: Are you speaking about this topic? 15 MR. JOYNT: Yes. 16 MR. COLBY: Okay, go ahead. 17 MR. JOYNT: Maybe I'll give you some background on 18 the development of big rating agencies and little minor 19 league, or major league kind of approach. If you go back to 20 1989 when there were six or seven rating agencies, there 21 really was two tiers. There was Moody's and Standard & 22 Poors, the two large dominant ones. And for smaller rating 23 agencies, two of which were only recognized in a limited way, 24 IBCA and Thomson BankWatch, and then Duff & Phelps and Fitch 25 were broadly recognized. 1 So you have a test case for what we're thinking 2 about here for the future, and how it might unfold. So I 3 would point out, or maybe ask the rhetorical question, which 4 we asked ourselves in 1989. If you have two very dominant 5 rating agencies that do competent ratings, which we think 6 everyone agrees that the ratings -- do a good job of rating 7 risk. Why does anyone need any of the rating agencies? Why 8 is anyone going to pick Fitch? 9 And it turned out that people found tremendous 10 value in another rating agency. Not an NRSRO, necessarily, 11 for regulations and rules, although it could be helpful for 12 that. But instead, for -- at the time, if we go back, rating 13 agencies -- the two larger ones were accused of being black 14 boxes, and people wanted more transparency from the rating 15 agencies. There was a lot of turnover at the rating agencies 16 of analysts. People were looking for more experienced 17 analysts to talk to on the investor side. And the issuer 18 side, as well. At least there were newspaper articles 19 written about this at the time. 20 Securitization was beginning. And investors and 21 issuers wanted new model developments, new thinking to be 22 happening faster and quicker, and more resources for that. 23 And all of those are -- and also surveillance information. 24 Also they wanted more surveillance information, more 25 research. So at the time, the ratings were the key. 1 Ratings. And the research wasn't as readily available, or 2 widespread, or there wasn't as much of it. Especially 3 original research. 4 So Fitch actually stepped in with that in mind. 5 How can we compete on that basis? And I would argue that 6 those were the advantages that Fitch brought. And in the 7 first four or five years, Fitch was almost always added as 8 third rating agency, never in replacement of one of the other 9 two larger ones. So I do see -- we are pro competition, and 10 I do see a role for other rating agencies. Thomson BankWatch 11 was used for bank ratings, as it was mentioned. And maybe in 12 a limited way. So I do see more usefulness. I do think you 13 need to set standards and guide them, and think about them, 14 but there is a useful purpose. 15 We decided at Fitch to move on from that, because 16 we wanted to compete at the other level, as a global rating 17 agency. And the reason for that is, in addition to our 18 business interests of expanding and growing, is that 19 investors and issuers wanted another choice. They wanted a 20 choice actually of two ratings out of any three, not two 21 ratings out of any two. And what you would describe as the 22 big three. 23 So the result of our mergers with Duff & Phelps, 24 where they had stronger corporate and insurance expertise 25 than Fitch had, IBCA, which had an international network and 1 a strong banking practice, and Thomson BankWatch, which, 2 interestingly, we didn't go acquire -- it was being sold by 3 Thomson Financial, a major player with significant resources, 4 deciding they didn't want to compete in the business. It was 5 very difficult to compete as a small, niche rating agency 6 against the two larger rating agencies. So we bought them, 7 and they merged and joined with us. 8 So we weren't buying NRSROs, either. We were 9 buying experienced analysts and the capability to compete on 10 a global scale. So I think we're now operating on that 11 level. We do see some competitive issues out there in that 12 way, and I think they're important for this group I've 13 mentioned to think about. Because if you think you're 14 opening competition by naming some new rating agencies for 15 niche areas, or for international securities, then they will 16 only be named in a limited way. Their effectiveness in the 17 marketplace will be used in a limited way. And they won't be 18 broad-based rating agencies, readily accepted quickly. 19 And also, there's a large development outside of 20 these regulations we're talking about. The largest new class 21 of investors in the last two years has been CEOs, 22 collateralized debt pools created. Hundreds of billions have 23 been created within the last 18 months. And those aren't 24 regulated, other than by the ratings they get from, 25 predominantly, the two large rating agencies. 1 And in those instances, they don't acknowledge 2 ratings of all NRSRO. They only acknowledge ratings of the 3 other rating agencies. So for instance, both Moody's and 4 Standard & Poors require that they buy securities, 80 percent 5 of their portfolio must be rated only by Moody's or Standard 6 & Poors. So there isn't an open -- they're not allowed to 7 choose the Fitch Ratings because we're an NRSRO. They're 8 proscribed not to. If they use Fitch as a rating, then they 9 receive penalties in the analysis done by the two larger 10 organizations. So that is a large investor pool. 11 And actually, they've had great effect on our 12 market share, and we've built over 10 years' great expertise 13 in commercial mortgage securitization. In the first quarter 14 of this year, our market share went from 60 percent, about 15 equal to the other two larger players, to 19 percent within 16 one quarter. So it has actually, since, rebounded, because 17 the CEOs have not raised as much new money. 18 Actually, on the high-yield side, they've performed 19 poorly, so they're not raising much new money. And 20 traditional buyers, like insurance companies, that do use 21 NRSRO regulations, and are familiar with using Fitch, have 22 started requesting and using Fitch again. So actually, our 23 market share has moved back up. But still, there's an -- I 24 believe there's an artificial impediment in the external 25 nonregulated market usage of rating agencies. 1 Now, I will tell you -- and I'm almost finished -- 2 that that slips over to this group, because, in fact, money 3 market funds also -- 35 percent of prime money market funds 4 have ratings, and the expectation -- from Standard & Poors 5 and Moody's, and the expectation there is that they use their 6 ratings, not our ratings either, in doing their analysis of 7 those money market funds. 8 And in fact, one of the money market funds that's 9 here has a very large holding in a structured investment 10 vehicle, which has that same kind of requirement. We've met 11 with the vehicle, and it has ratings from Moody's and S&P, as 12 required to use their ratings. And so by transfer, all the 13 way through the process, what you think is choice, freedom of 14 choice by designating any NRSRO, including, today, Moody's, 15 S&P, and Fitch, and maybe if you'll designate further ones, 16 they will not be able to be used by the market power that's 17 happening outside of your regulations. 18 But we've suggested that you think about that 19 issue, look into it. I think there is a remedy I would 20 offer, which is, if you're designated NRSRO, then you should 21 expect them to not operate in anticompetitive ways, because 22 we think they are doing that, for competitive reasons, not 23 for analytical reasons. So there is some merit for an 24 analytical argument. But I'd ask the economists whether 80 25 percent is a requirement for a random selection. I think 1 it's much lower than that. 2 And also, you could force NRSROs to accept the 3 ratings of other NRSROs, given that you've vetted them. And 4 if there's a limited acceptance of the NRSRO for bank 5 analysis only, then obviously you think they're capable. The 6 market must think they're capable. And the net result of 7 that would only be to give freedom of choice to all the 8 investors. So every investor I've met, and investment banker 9 on this topic, would like to be able to choose us. They 10 might not choose us. 11 And in fact, I would argue they would probably 12 continue to move through Moody's and S&P a lot, because they 13 have very strong name recognition, and good reputations. But 14 I certainly would like to be freely chosen, and so I think 15 there's something you can do about it, and you should 16 consider that. Thank you. 17 MR. MCDANIEL: I'll just respond to a couple of 18 comments from Steve, partly in agreement and partly in 19 disagreement. But I guess I should start by saying that 20 Moody's absolutely believes its competitive practices are 21 fair and proper. I think a number of Steve's early comments 22 I would agree with. We are pro competition, and we are, 23 being pro competition, really pro diversity of opinion. 24 That's really, in our view, what's critical. It's not the 25 number of rating agencies, but it's the number of credible 1 opinions that are available in the marketplace. 2 And I think, because of that orientation or 3 framework, is perhaps where Steve and I part ways a bit, 4 because I think the assertion that all NRSRO ratings should 5 be treated similarly assumes that the opinions should be 6 treated as fungible, and that assumes that the opinions are, 7 in fact, fungible. And we very strongly believe they are 8 not. We have quite a bit of statistical information that 9 indicates they are not. 10 And we think that, when the market is using the 11 Moody's rating, it should have a Moody's independent 12 assessment of that rating. I would also add, just as a 13 technical matter, that we do not require 80 percent Moody's 14 rated assets in the -- there are other ways have assets 15 contributed into -- other than having Moody's ratings. 16 MR. COLBY: Anyone else want to discuss this topic? 17 Two things arose in my mind. One is the question of -- if I 18 understood you, Steve, you said that maybe this should be a 19 topic addressed by regulation, that would go with being an 20 NRSRO. Steve earlier said that you didn't think 21 adding regulation to the NRSRO process was valuable. 22 The legal situation we're in now is that NRSRO is 23 not a statutory category. And our authority over it arises 24 from some limited authority, based on recognition, which 25 we've never truly exercised very much, and the fact that 1 NRSROs to date have consented to be registered as investment 2 advisors, and yet much of the investment advisor regulation 3 is inapposite to what they do. 4 And so my question is, do any participants think 5 that there should be some additional form of oversight or 6 regulation of NRSROs as they are now? If we should design a 7 means to speed and extend the recognition process? Whether 8 there would need to be greater oversight in some way, shape, 9 or form? 10 MR. SCHWARCZ: I will briefly respond. The 11 concerns that Steve raises, I don't think, have anything to 12 do with the NRSRO designation. And in fact, the more -- I 13 mean, they're completely independent of it, because in fact, 14 the more NRSROs there are, then marginally, the less 15 concerned -- the less the concern would be. The concerns 16 that Steve raises have to do with antitrust law, and in fact, 17 if Moody's or Standard & Poors are violating the antitrust 18 law, then that's something that they should be punished for 19 if that's happening. But they say it's not happening, and so 20 that's an issues that has nothing to do with this hearing, I 21 think. 22 MS. LANCELLOTA: Well, I can't read it in my 23 article, because I haven't written an article. The -- has 24 weighed in on this issue, starting in 1994, when you issued 25 the -- and in 1998 when you issued the specific proposal. 1 MR. COLBY: The trade association equivalent to an 2 article. 3 MS. LANCELLOTA: That's right. And we do think 4 that, given the significant role they play in the 5 marketplace, and the significant reliance, that there should 6 be greater oversight. And I think it can be done fairly 7 easily. I know you stretch resources, but there needs to be 8 some more oversight than I think what's currently being done. 9 While they may not be investment advisors in the traditional 10 sense, they are providing investment advice and receiving 11 compensation for it. The SEC does have broad inspection 12 authority of their books and records under the Advisors Act. 13 I think it's appropriate to continue to somewhat regulate 14 them under the Advisors Act, but putting aside the specific 15 regulatory structure, I do think that your inspection staff 16 can get out a little bit more, and do a more vigorous 17 examination of whether they continue to meet the criteria. 18 You were talking earlier about the national 19 recognition attribute, and how difficult that is, because it 20 is subjective. But one way to test it may be to solicit 21 public comments on a periodic basis, as to whether or not the 22 market really does see them as issuing credible, reliable 23 rating agencies. And I said earlier in my opening remarks, 24 it's my understanding that the FCC does something like this, 25 where they have a broadcast license renewal process, where 1 they do go and solicit public comment from those that are 2 actually the end users of the product. 3 And finally, they said this morning, I think the 4 NRSROs should be accountable for their ratings. I just don't 5 under how they can be exempt from expert liability, given the 6 minimal level of regulations imposed on them, and the 7 significant role that they do play in the marketplace, and 8 the significant reliance on them. I just don't really 9 understand how -- I don't understand, I guess, the rational 10 for the exemption. 11 MR. MCDANIEL: From Moody's perspective, in terms 12 of expert liability standards, what we're dealing with is 13 probabilistic assessment -- these are not -- ratings are not 14 performance guarantees. And obviously, ratings will perform 15 in a binary manner. And in fact, they will either pay or 16 they will not. But nobody knows that today. And so what we 17 are doing is putting ratings into -- using ratings -- credit 18 -- risk factors. It may be helpful to think of it the way an 19 insurance company might put 25-year-olds with 40-year-olds 20 for risk factors in actuarial. But you have the risk 21 process, and the 25-year-olds are going to die. Some 40- 22 year-olds are going to live. 23 MR. COLBY: Hopefully. 24 MR. MCDANIEL: On the whole, there would be more 25 mortality among the 40-year-olds than the 25-year-olds. So 1 therein is the risk. And so what we have are opinions about 2 the future with degrees of uncertainty to those opinions. 3 And we are also, I would add, publishing those opinions. And 4 there is very strong history as to how opinion publishers are 5 treated. 6 MR. COLBY: Paul, did you want to respond? 7 MS. LANCELLOTA: Can I respond real fast? I don't 8 think anyone expects the rating agencies to be correct 100 9 percent of the time. That would be impossible. But you're 10 rendering a professional opinion. You're exercising 11 professional judgment. And given the reliance on it, I think 12 you should be willing to stand behind it. I mean, there are 13 other opinions that appear in registration statements, and 14 the process is -- or the law is that you get their consent, 15 the issuer gets the expert's consent, and the expert is 16 liable to investors for negligently misleading opinions. 17 So there are opinions that are included in 18 registration statements. They're not statements of 100 19 percent accuracy, or no one's holding them up to that 20 standard. That would be an impossible standard. But it 21 seems to me that the rating agencies should be willing to 22 stand behind your professional -- your exercise of 23 professional judgment, and your rendering of the opinions 24 that you render. 25 MR. MCDANIEL: As far as following professional 1 standards and procedures, I think that that is a fair 2 expectation from the marketplace. 3 MR. COLBY: Paul? 4 MR. SALTZMAN: Yes. Just to sort of throw the Bond 5 Market Association into the picture here, I think part of the 6 problem is that any regulatory framework that involves the 7 federal government into the assessment of subjective rating 8 quality is a real serious problem, on multiple levels. To 9 have the office of compliance and examination, or the NASDR, 10 or whomever else one would appoint as the inspectors, go in 11 and second-guess the opinions of rating agencies, obviously, 12 with all the benefit of hindsight, is truly problematic on 13 multiple levels. That is not to say, however, that the 14 Securities and Exchange Commission couldn't perform more of 15 an ongoing monitoring role, once the NRSRO designation 16 process, or if the NRSRO designation process becomes a little 17 bit more objective and transparent. 18 Perhaps, you suggested, certifications whereby the 19 rating agencies can, on an ongoing basis, certify to their 20 compliance with the procedural aspect of the NRSRO 21 designation process. But to the point of accountability, I 22 guess, again, I would remind everyone that the opinions 23 expressed by the rating agencies are just simply not 24 recommendations, in the traditional sense that securities 25 analysts or other opinion makers provide. They're one tool, 1 they're one factor. You've heard from multiple sources. 2 In a wholesale market, there are many different 3 aspects of the information spectrum, and ratings are simply 4 one aspect of it. So the accountability point, I think, is 5 sort of nice to talk about, but rating agencies are not 6 guarantors of performance, any more than mutual funds are. 7 MR. COLBY: With the Commissioner's lead, let's 8 just say that you all are now Commissioners. You take a pay 9 cut, and you get attacked in the press. It gets worse. And 10 you're beginning to think that there is a rating agency out 11 there that's an NRSRO, whose ratings are inflated, and 12 they're being used in a variety of contexts to satisfy 13 regulatory requirements. Now what do you do? What's the 14 approach? 15 MS. PETERSEN: Actually, I think that this goes 16 back to an issue that's been floated previously, which is, 17 since we don't know exactly what it takes to become an NRSRO, 18 and I don't think that the average investor knows what that 19 designating really means, other than the fact that if you 20 confer it on someone, then it must really mean something, 21 because you're the SEC, and you're supposed to be protecting 22 investors, and therefore, NRSRO must mean something. 23 So at the end of the day, what is it that it's 24 supposed to do, and are you "in a position" to be able to 25 walk into a rating agency, and determine whether or not the 1 quality of the analysis that is being placed on the ratings 2 in the marketplace is good, bad, or indifferent? You can go 3 in, and you can ask them, "What are your processes? What kind 4 of people do you have on staff? How often do you issue 5 ratings?" 6 But I don't know that a lot of that objective 7 criteria is necessarily going to spell the difference between 8 whether or not the ratings that the agency is generating are 9 good, bad, or indifferent. And that's the reason why I have 10 mentioned the issue of competition. Because from an 11 investor's point of view, especially if we are going to be 12 held to some regulatory standards, it would be helpful for us 13 if we could choose to go out and use the ratings generated by 14 folks whose opinions we value. And that's not to say that we 15 don't value a lot of the opinions that are being expressed by 16 the three agencies now. 17 But if indeed there are other people out there who 18 have established a reputation for themselves in something 19 that we feel would be beneficial in our overall process, we'd 20 like to have the opportunity to be able to say we are meeting 21 our regulatory requirements by having the requisite NRSRO. 22 It just so happens that maybe in one case, it's Moody's and 23 LACE, or in another case it's A.M. Best and Fitch. So that's 24 the issue. What is the NRSRO's status? Why should we be 25 held to a standard that we're not absolutely certain that 1 you're giving us? 2 MR. COLBY: I don't want to foreclose any other 3 Commissioner from speaking, but it sounds like you're really 4 taking issue with the use of NRSRO in a regulatory context. 5 Because it sounds like what you're saying -- and maybe I'm 6 misunderstanding -- is that we should have more people to 7 choose from, so that we can find a way of compliance with 8 Rule 2a-7 that accords better with our view of what the real 9 credit risks are. 10 MS. PETERSEN: Well, it just opens up the 11 opportunity for us to remain in compliance, without 12 necessarily being perceived as trying to cook the books, or 13 to go rating shopping. At the end of the day, the issue 14 becomes, did you make a reasonable investment decision? What 15 did you do, as a result of change in circumstances, to 16 protect the investor? 17 And therefore, if we feel that some entity that's 18 relatively new -- or let's say, a law firm who decided they 19 want to go out on their own, and perhaps the skill and 20 expertise that they take out into the marketplace to 21 establish their own partnership is something that you want to 22 continue participating in, but now you're being told that you 23 can't use that expertise any longer, because it's newsletter 24 part of Baker & McKenzie. They've gone off to the Adams & 25 Jones partnership. 1 And that's pretty much what you're imposing upon us 2 with this NRSRO status. It's that we don't have, 3 necessarily, the ability to use LACE or A.M. Best to reach 4 the regulatory requirement that's being imposed on us, even 5 though, perhaps, those entities have the expertise to bring 6 to bear on that sector of the market that would be beneficial 7 to us and to our investors. 8 MS. NAZARETH: Where would you draw the line? How 9 would you determine, if you were a Commissioner, from a 10 regulatory standpoint that the buy side was not out, 11 basically, shopping for ratings that they wanted, as opposed 12 to ensuring that they were credible ratings? 13 MS. PETERSEN: Well, I'd have to throw that back 14 and ask, is the criterion that you use for an NRSRO 15 designation one that clearly identifies and appreciates the 16 relative skill set -- the absolute skill set among the 17 analysts in the agencies that have achieved that status? 18 MS. NAZARETH: I think what's happened, and it goes 19 back to what Paul said, is that I'm not sure you would want 20 government employees making those determinations, and so what 21 it does is this very, obviously, imperfect proxy for that, 22 and this is the chicken and egg problem -- what does the 23 marketplace think? 24 COMMISSIONER GOLDSCHMID: You're saying that, as 25 part of the marketplace, if she had more choice, she could 1 think more. That that would give her the ability to select 2 the good ones, in a way that right now she's trapped in. 3 MR. COLBY: But you used good ones for regulatory 4 purposes. Because she's always free to use these people for 5 analysis. 6 COMMISSIONER GOLDSCHMID: But she's saying she's 7 trapped into it, if I understand you, because the NRSRO 8 designation is just too powerful a designation for all kinds 9 of regulatory reasons. 10 MS. PETERSEN: And it's even more problematic for 11 us on the public finance side than it is on the corporate 12 side, because on the corporate side, there has been, 13 historically, an understanding that market access is going to 14 be more real if you have two ratings. And therefore, most of 15 the issues out there tend to have two ratings. On the public 16 finance side, however, it's not unusual, in many 17 circumstances, to only have one rating. 18 And when Rule 2a-7 says that you have to comply 19 with this regulatory mandate that says you need to have most 20 of your portfolio in tier one rated securities, yet a lot of 21 the issuers, and your ability to remain invested means that 22 you're going to end up with a lot of securities that only 23 have one rating on it. I'm kind of backed into a corner. 24 And what Jerry said earlier about this cliff. Their access 25 to -- short-term marketplace is being, potentially, stymied 1 by the fact that they're the only ones doing it. 2 I can't -- even if I disagreed, let's say I think 3 that Moody's had too high a rating on that security. The 4 only way I can vote now is by not buying. And therefore, 5 you're not giving me the opportunity to say, "Well, I don't 6 think that it's quite tier one, I think it's a tier two 7 security, and therefore, I'm going to go with the lesser of a 8 million dollars or 1 percent for issuer under Rule 2a-7." 9 So it's one of those situations where it's well 10 intentioned, because Rule 2a-7 is trying to make sure that a 11 dollar in is a dollar out. But it has this unintended 12 consequence of saying that we who do have true liability, in 13 the event that we blow it, and we -- that we, even though we 14 have that requirement, are still forced to look to only three 15 agencies currently to get that kind of information. 16 And the thing that I would throw out, too, we don't 17 have any of our money funds rated by Moody's or S&P. But if 18 an entity were to get one of those money fund ratings, I 19 think that a perception -- and this is my personal opinion -- 20 as an investor, if I placed my money into something that had 21 a specific designation, it's got a triple A money fund rating 22 from Moody's, I'm expecting that the people at Moody's really 23 know what they're doing, and have the capacity to let me know 24 if there's something wrong, because I'm expecting that, if I 25 put something in a triple A, that's really good, because I, 1 the investor, know that triple A is really good. And I don't 2 know that there are double A-rated money funds. I don't know 3 if there would be a single A-rated money fund. 4 So I think as far as what the investor expects, 5 based on what the Commission has established as the gold 6 standard, with the three NRSROs, is really important, and 7 just something that needs to be considered when thinking 8 about either increasing or decreasing regulation, or however 9 you choose to handle it. 10 MR. COLBY: In true Commissioner form, she took a 11 question and revealed its complexity. Neal, I think, is 12 next. 13 MR. SULLIVAN: I think if I were the Commissioner, 14 I'd say to the staff, you've brought this issue to me, and 15 you've asked me to take some sort of action. Yet there are 16 no underlying criteria against which I can judge a retraction 17 of the status. And I would be -- I would ask you, are you 18 asking me to refer this, because there has been some 19 violation of a securities law? Are you asking me that 20 there's been some sort of qualitative or quantitative erosion 21 or concern that you think has risen to the point where I can 22 take that designation away, yet you don't have any objective 23 criteria against which I can measure that, and then support 24 my decision. So I think, as a Commissioner, I would say to 25 the staff, "Would you please promulgate -- would you please 1 propose some criteria against which I can measure the 2 performance of these designated rating agencies, so I can, if 3 these issues arise, take action. But in the absence of that 4 criteria, in the absence of that process, I'd be hesitant to 5 do so. 6 MR. COLBY: So you're saying that, unless you have 7 objective criteria, there will not be a way to take an 8 outlier that's inflating the rating criteria out of the 9 NRSRO? 10 MR. SULLIVAN: I'm hesitant to use words like "any" 11 ever, but I think it is more problematic, yes, and I think 12 that the entire process is strengthened when you take various 13 criteria, both objective and subjective, and publish that, 14 and utilize it, and apply it to different applicants, and to 15 different existing NRSROs in the marketplace. And I think it 16 would strengthen the Commission's hand, rather than weaken 17 it. 18 MR. COLBY: Jack? 19 MR. MALVEY: I just wanted to point out the very 20 good news that there really are criteria, and we can measure 21 the efficacy of the rating agencies through time. In the 22 asset management industry, over the last three decades, has a 23 very large and healthy consulting industry, which does 24 measure the performance of assets managers. There are all 25 sorts of statistical techniques which are regularly applied. 1 And the rating agencies themselves -- and some of the date is 2 submitted here -- measure things like what is the default 3 rate on various rating categories. That data goes back 4 decades. We can look and see. As an illustration today, we 5 can fit credit quality term structure vis-a-vis ratings, to 6 see who is the most accurate, who is the market closest to in 7 terms of ratings. And I'll throw out the notion -- it should 8 not be the notion that an agency which has the highest 9 ratings possibly would be suspect, and off the mark. You 10 should also be careful, an agency could also ingratiate 11 itself to some entities on the buy side, by saying, "We have 12 the lowest ratings." And you can check that, so we can look 13 at those things today. So it's not a problem, really, to 14 create a test to evaluate this. 15 MR. SALTZMAN: Very quickly, I would embrace that 16 concept that Jack identified, but more in the nature of 17 disclosure. It would seem to me entirely appropriate that, 18 perhaps as part of the NRSRO designation prepaid 19 subscriptions, to standardize and to require some sort of 20 performance-based disclosure. But I think when you move 21 beyond the mere disclosures to some form of merit regulation, 22 that some form of subjective judgment about inflation or 23 deflation of a particular rating, that's where I think you 24 get into a slippery slope of not only First Amendment issues, 25 but all sorts of other problems. 1 MR. COLBY: Let me see if I understand what you're 2 saying. It would be all right to tell a rating agency that 3 was always two grades higher than everyone else that they had 4 to disclose that, but we shouldn't pull -- or stop those 5 ratings from being used for regulatory purposes? 6 MR. SALTZMAN: That's correct. Because ultimately, 7 I would -- this is a market where ratings, for the most part, 8 are not the exclusive tool. And the fact of the matter is 9 that that marketplace itself, whether through credit spreads, 10 whether through reputation, will effectively put that rating 11 agency out of business. So as long as you have -- and I 12 wouldn't -- I would even argue perhaps to, as a precondition, 13 regularized disclosure. You know, standardized, regularized 14 disclosure, so that, on an ongoing basis, the market can 15 assess the quality and the performance other rating agencies, 16 but not to have substantive invasive regulation where someone 17 is making the judgment as to what's good or bad. 18 COMMISSIONER GOLDSCHMID: Well, there's one more 19 possibility I just want to throw in, which is to look not at 20 the merits. No one wants someone sitting over your shoulder 21 on merits. But what about judging professional conduct 22 or all of the rating agencies explain how they've built in 23 various checks and safeguards? Is there any reason why we 24 shouldn't look to see whether they're serious about that, in 25 terms of practice? 1 MR. MCDANIEL: From the Moody's perspective, I 2 don't think we would have a problem with that. In fact, I 3 think it would be beneficial to the industry, because to the 4 extent that our practices are as good as we believe they are 5 -- and that's confirmed by the Commission -- that's, I think, 6 going to help our reputation. 7 MR. COLBY: I would just add that, as a practical 8 matter, that is one of the areas that the Commission staff 9 looks at. So that exists today, as is, yet it is not a 10 published or noticed criterion. 11 COMMISSIONER GOLDSCHMID: I think we could do more 12 in the way of publication, and some have argued we ought to 13 be doing more -- although our resources are limited. 14 MR. COLBY: Any other Commissioners want to speak? 15 MR. SCHWARCZ: Michael already said what I was 16 going to say, so I don't want to repeat it. But just a few 17 brief thoughts. And that is, in answer to the, I guess, 18 Stephanie's concern. Of course, if you designate more 19 NRSROs, then you at least try to ameliorate your problem. 20 I'm not sure I would agree with Paul that -- you made a 21 statement, you said that the market would take care of a 22 rating agency that is not doing its job. If you take that to 23 its logical limit, you should designate any rating agency 24 that wanted to be an NRSRO. And I'm not sure you would mean 25 that. And I'm not sure that would have a good impact. 1 So I think you still need to be a little cautious. 2 And so what I would suggest is, just as I had -- or really, 3 the Department of Justice had proposed, taking rating 4 agencies and putting them initially on a provisional NRSRO 5 status. One could, in answer to the question you originally 6 raised, Bob, about what happens if the SEC suspects the 7 ratings are much too high? One could go to the rating agency 8 and say, "Look, we're going to put you on a provisional 9 downgrade status." Sort of like a credit watch, so to speak, 10 what rating agencies now do with bonds. And that would 11 certainly get their attention, and make them -- give them a 12 very strong incentive to try to remedy any problematic 13 actions without really -- without sort of forcing them right 14 over the cliff. 15 But to do that, I also agree with Paul that you 16 really -- it would really help politically for you to have 17 more transparent standards as to how you designate an NRSRO. 18 Because let's assume that S&P was thought to be issuing too 19 high ratings, it would be very hard politically to say, 20 "We're going to take you off of NRSRO status," without having 21 -- or even put you on a provisional downgrade, without having 22 criteria. 23 COMMISSIONER GLASSMAN: What would be the basis for 24 our deciding that somebody's ratings are too high, or too low, 25 or just right? Unless we had the time period, especially for 1 the long ratings, the 15 years or so to determine whether 2 they actually are correct, how can we make that decision at 3 the Commission? 4 MR. SCHWARCZ: Well, I think there are two answers 5 to that. One, in terms of the -- the best way to do that is 6 rating stability, I would argue. See a rating, once 7 designated, you know, how long that rating really keeps up, 8 and whether the defaults of investment-grade debt issues. 9 You know, as everyone agrees, there to be defaults, and the 10 analogy to the insurance categories makes a lot of sense. 11 But I think if one rating agency, one NRSRO had a history of 12 defaults that was much higher than the history of the others, 13 and if the stability of their ratings was much weaker than 14 those of the others, that would be a highly bad factor. 15 Now, of course, as you've correctly stated, that's 16 something that you wouldn't know until substantial time had 17 gone by, unless there are really some pretty lousy ratings. 18 And therefore, the concept is, well, what happens if you 19 provisionally say we're going to give, I guess, R&I a 20 provisional rating, and a year goes by, and there are no 21 defaults, and then two years later you find out there are 22 many -- there are really problems. Well, that's where the 23 concept of putting them back onto a provisional footing would 24 come into play. So you can sort of downgrade the agency, as 25 well. 1 But the other thing, of course, you can do during 2 the year period, is, you can perhaps see how they're 3 performing their business, seeing there are no conflicts. 4 I'm not -- I'm probably not the best person to say as to how 5 you would go about it, but I imagine there's at least a 6 people process of going about it, like Commissioner 7 Goldschmid said, and you look at the standards of conduct. 8 COMMISSIONER GLASSMAN: Yes. The latter kind of 9 inspection is something that we do, and that's not difficult 10 in context. But what you're suggesting in terms of our 11 flagging high ratings and low ratings, without history, seems 12 more difficult. 13 MR. SCHWARCZ: Well, that hypothetical, of course, 14 was not one I had raised. I was only responding to it. I 15 would go more to the rating stability and the defaults of 16 investment-grade. 17 MR. COLBY: At this point we're coming close to the 18 end of our time. Are there any people that wanted to add 19 comments that they're just waiting to make? 20 Well, in that case, I thank you very much for 21 coming in. We ended on time and under budget. And we very 22 much appreciate the assistance you've provided us. 23 (Whereupon, at 4:45 p.m., the hearing was 24 concluded.) 25 * * * * *