Hearing of the Senate Banking, Housing and Urban Affairs Committee - Turmoil in U.S. Credit Markets: The Role of the Credit Rating Agencies

Interview

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SEN. REED: Well, Mr. Chairman, thank you very much. And I have a statement that I would like to include in the record, but make some comments. First, welcome to Chairman Cox.

And we've been down this road before. In the wake of Enron we saw flaws in the credit rating system. We've tried to address those faults. I want to commend Senator Shelby for his efforts as chair last year in at least giving the SEC some authority and some traction in this regard. But I think what we've seen in the last 12 months has been another indication that we have to take more directed action.

Twelve months ago when, at your request, I chaired a hearing, the subprime crisis was seen as a $19 billion worldwide phenomenon that was already self-correcting. That's not the case and so I think we have to do much more.

We have to ensure that the commission has the authority to adequately supervise or regulate or direct credit rating agencies. We have to ensure, I think, that the new rules that they're promulgating really do the job. As I said, we've been down this road before and we're still going down it. I think we want to reach an appropriate conclusion.

We have to, I think, ensure that we have the appropriate balance between a market discipline and goods rules and regulations. That's something I think that is out of balance at this moment.

I'll conclude by the comments of Lew Ranieri, who created the mortgage-backed security years ago when he said, "The mortgage-backed security sector was unfettered in its enthusiasm and unchecked by today's regulatory framework. We have a quasi gatekeeper in the rating services, and in the end, the SEC is a regulator of the capital market. It is the one who can touch this stuff and make a difference." And I think we have to touch this stuff and make a difference now, since we haven't done it in the past.

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SEN. REED: Well, thank you, Mr. Chairman.

Borrowing an analogy from another field, do you think that any of these rating agencies were guilty of malpractice, not meeting the standard that you would expect, as the chairman of the Securities and Exchange Commission, in the execution of their responsibilities to rate some of these securities?

MR. COX: That is one of the questions that we are asking and, in part, coming to answers on in our ongoing examination of the three largest firms.

As you know, we have some 40 people on that project right now, and we expect to report fully to you by early summer.

SEN. REED: Your typical remedy, again, in -- using this rough analogy is -- for malpractice of some type of action against the individual institutions in restitution or something, or, at least to correct the behavior. And I'm trying to sort of connect the dots here between at least the possibility of not operating appropriately and any type of sanction under -- they claim and the claim's been, I think, affirmed that they're protected under the First Amendment in terms of any type of legal liability. How do we get them to behave differently if, in fact, there's a serious question of misperformance?

MR. COX: Well I think that from the fourth quarter of 2007, forward, we're in a different world, because now we have regulated industry with legal standards of conduct as we were just discussing. They can be censured, they can be hit with targeted sanctions, they can get the death penalty -- there are all sorts of regulatory norms that they will now have to comply with.

In addition, we'll have a marketplace that's now much more competitive, not so oligopholistic. We already have additional credit rating agencies that have been able to enter the business as NRSROs as a result of the new legislation, and the disclosure and transparency that the new regime should provide will force -- I think it is the legislative intent, and we expect it as well, some quality as a result.

SEN. REED: You said, Mr. Chairman, that you've got 40 individuals working on this analysis. When you implement the regulations, will you have the dedicated staff of roughly that size with the expertise to continue to evaluate the performance under the new regulations?

MR. COX: It's not necessary to have the current examination staff on a permanent basis as part of the CRA program, but we do have budgeted approximately in the range of 10 to 20 people over the long haul for this purpose.

SEN. REED: It just seems to me that everything we read about these products, they are inherently complicated and complex -- in fact, many people won't buy them. I mean, Jamie Diamond (sp) has been quoted several times saying they're too complicated, I don't understand them, I won't buy them. And yet you'll have about 20 people who are going to overlook the credit ratings.

Do you think that's adequate resources to ensure that they're -- unless this is simply procedural -- they check the blocks -- you know, we did this, we did this, we did this -- but with no substantive regulation?

MR. COX: For purposes of managing the registration and inspection regime -- and remember, we can use the resources, as we are using now, of our Office of Compliance, Inspections and Examinations for this purpose in the future as well. But for the ongoing purposes of managing the registration and compliance regime, I think that's about the right number. On the other hand, the reason that I am inviting the views of this Committee on the size and scope of this program, is so that we can be sure that within the context of the overall SEC, we have, in fact, right-sized this function. It's a brand new function, and we want to get it right.

SEN. REED: In that regard, how thoroughly will you anticipate this staff looking down through? I mean, maybe this is not exactly correct, but a simple security model for mortgage-backed security where there's actually mortgages and that pool of mortgages, you sell securities. And then there's the CDOs which are basically -- gets more complicated CDO squares, et cetera. Do you anticipate that your staff would be looking all the way through the -- independently to the collateral of these securities or at least on a spot-checking basis?

MR. COX: Most certainly on a sampling basis, and probably across the board, just in terms of the different genres of products that are being rated.

SEN. REED: You had raised in your opening statement the possibility of less reliance under the SEC rules on ratings. Can you amplify that?

MR. COX: One of the concerns that's been expressed in several of the multi-national fora, including the financial stability forum and IOSCO, is that there was insufficient attention paid to what these ratings were and what they were not, and that there was, in some cases, nearly mindless reliance on the fact that it said Triple A. In order to make sure that the ratings are understood for what they are and what they are not, we're going to have a lot of new disclosure.

At the same time, we want to make sure there's not a "check the box" mentality, and if the rule says you can do X if you have a Triple A rating, that might induce that kind of behavior. So we won't be able to purge, by any means, our rules of references to ratings, but there may be some fine tuning that we can do in order to make sure that we don't create that moral hazard.

SEN. REED: Well, it would seem to me that as you -- theoretically, as you diminish purposely the role of the ratings, not that, you know, Good Housekeeping Seal of Approval, you put the onus, I think, either directly by rule, for publicly registered companies to independently evaluate the ratings that they're either buying or they're arranging to obtain, that might be appropriate for some larger institutions, but for small investors, for municipalities, for people who are looking -- don't have the infrastructure, how fair would that be -- how effective would that be?

MR. COX: Well I think that if the only consequence of change were to increase the investor burden, then we would not have accomplished the objective. We've got to be very, very sensitive to that.

The opportunity, I think, that we have is to state very clearly in our rules, what is the point that we are trying to establish -- what's the objective test that we're asking people to meet. And if a rating --

SEN. REED: What is that test?

MR. COX: Well, it depends entirely on the circumstances. The ratings themselves are mentioned in rules and in statute, I should add, in many different contexts. But if we can simply clearly state, and in plain English, what it is that the law and the rules are trying to accomplish by referencing these ratings, we can add a little more context to it, so it's not just a mindless act of "I got the rating" even if the use of a rating for that purpose would not be appropriate.

SEN. REED: Thank you.

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

Professor Coffee, one of the things that is constant in Chairman Cox's comments and the questions of my colleagues is accountability. Today before this new regulation was proposed, other than shareholders, who are the rating agencies accountable to in a material sense?

MR. COFFEE: (Off mike.)

SEN. REED: You've got to --

MR. COFFEE: It's easier to say ways in which they're not accountable. They don't have private liability. There's no regulatory agency like the NASD or PCAOB for accountants that has jurisdiction over them. It's only now that the SEC is proposing rules.

Sure, they have a reputation, but in a world in which for the past there have only been three agencies, it's not where -- not a world where reputation counts as much. And reputation means less when you're also selling a regulatory license. So even if the market doesn't trust you, they will still pay you a fee to get that regulatory license.

They are left in a position where they are only very weakly accountable and less accountable than the other major financial gatekeepers.

SEN. REED: Chairman Cox suggested that when these new rules are rolled out there will be a new world, a world in which the presumptive immunity from even a suit for negligence would be overturned. Can you comment on that? What's your sense of this new world that emerges?

MR. COFFEE: I have a great respect for Chairman Cox, but the devil is always in the details and I don't know what these new rules will say. I think that there are areas in which we need some strong rules, and while I thought he gave us a strong statement, much of it was a little opaque on exactly what the rules are going to look like, and I can't evaluate rules until I see them. But I don't think, absent some kind of either liability risk or possibility of suspension or forfeiture, that we're going to have the same governmental oversight powers over the rating agencies that we have over the accounting profession or the securities analysts.

SEN. REED: Final question because you've all been very patient. I'm not picking on Professor Coffee or ignoring anyone else. Thank you all, ladies and gentlemen, for your testimony.

But it would seem -- I mean, I think the system you described is -- there's absolutely no incentive for an investment bank that's putting together an issuance and going to a credit agency to then come back and say, "You gave us a lousy rating," because what they're trying to buy is the best rating, and when they get it, they've got what they paid for. So there's no -- there's nothing in the system today for anyone individual to come back and say, "You didn't do the job." And that I think goes back to the same point about it's easier to list the lack of accountability than the points of accountabilities.

MR. COFFEE: And as a result, this market has collapsed. No longer are there any real estate mortgage-backed securitizations. There are also very few commercial mortgage securitizations. Thus I think the industry does have a common interest with the regulators. This market is not going to come back and there are not going to be fees for ratings securitizations that don't happen unless we can make the rating agency credible again. So I want to focus respectively, and I think the industry as well as regulators have to find a way to create confidence because without it, there aren't going to be fees.

SEN. REED: Thank you very much.

Thank you, Mr. Chairman.

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