Hearing Of The Capital Markets, Insurance And Government-Sponsored Enterprises Subcommittee Of The House Financial Services Committee - Approaches To Improving Credit Rating Agency Regulation

Hearing Of The Capital Markets, Insurance And Government-Sponsored Enterprises Subcommittee Of The House Financial Services Committee

Subject: Approaches To Improving Credit Rating Agency Regulation

Chaired By: Rep. Paul E. Kanjorski (D-Pa)

Witnesses: Robert Auwaerter, Principal And Head Of The Fixed Income Group, Vanguard; Robert Dobilas, President And Chief Executive Officer, Realpoint Llc; Eugene Volokh, Gary T. Schwartz Professor Of Law, Ucla School Of Law; Stephen W. Joynt, President And Chief Executive Officer, Fitch Inc.; Alex J. Pollock, Resident Fellow, American Enterprise Institute; Gregory Smith, General Counsel, Colorado Public Employees' Retirement Association

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REP. KANJORSKI: (Sounds gavel.) (Off mike) -- come to order. This hearing of the Subcommittee on Capital Markets, Insurance and Government-Sponsored Enterprises come to order. Pursuant to committee rules each side will have 15 minutes for opening statements. Without objection, all members opening statements will be made part of the record.

Today we meet to examine the operations of credit rating agencies and approaches for improving the regulation of these entities. Given the amount of scrutiny that these matters have garnered in recent months, I expect that we will have a lively and productive debate.

The role of major credit rating agencies in contributing to the current financial crisis is now well documented. At the very best, their assessments of packages of toxic securitized mortgages and overly complex structures, finance deals were outrageously optimistic. At the very worst, these ratings were grossly negligent.

In one widely reported internal e-mail exchange between two analysts at Standard & Poor's in April of '07, one of them concludes that the deals, quote, "Could be structured by cows and we would rate it." I therefore fear that in many instances the truth lies closer to the latter option rather than the former possibility.

Moreover, if we were to turn the tables today and rate the rating agencies I expect that most members of the Capital Markets Subcommittee would agree that during the height of the securitization boom the rating agencies were AA, if not AAA, failures. Clearly, they flunked the class on how to act as objective gatekeepers to our capital markets.

Along with the expressions of anger, outrage and blame that we will undoubtedly hear today, I know that we can also explore serious proposals for reform. Unless we can find a way to improve the accountability, transparency and accuracy of credit ratings, the participants in our capital markets will discount and downgrade the opinions of these agencies going forward.

One could hope that the agencies would do a better job in policing themselves, but if past is prologue, we cannot take that gamble. This time their failures were not in isolated case-by-case instances. Instead they were systemic problems across entire classes of financial products and throughout entire industries.

Stronger oversight and smarter rules are therefore needed to protect investors and the overall credibility of our markets. As a start, the rating agencies must face tougher disclosure and transparency requirements. For example, investors receive too little information on rating methodologies. The financial crisis has isolated the danger flawed methodologies posed to the system. If methodologies remain hidden, there exists no check by which to expose their weaknesses.

In addition to establishing an office dedicated to the regulation of rating agencies within the Securities and Exchange Commission, oversight must also focus more intently on surveillance of outstanding ratings. The industry has done an inadequate job of downgrading debt before a crisis manifests or a company implodes. Moreover, we must examine how we can further mitigate the inherent conflicts of interest that rating agencies face.

In this regard, among our witnesses is a subscriber-pay agency. This alternative model is worthy of our consideration. At one time, all rating agencies received their revenues from subscribers, but they evolved into an issuer-pay model in response to market developments. I look forward to understanding how a subscriber-pays agency succeeds in today's marketplace.

Additionally, the question of rating agencies' liability is of particular interest to me. The First Amendment defense that agencies rely upon to avoid accountability to investors for grossly inaccurate ratings is generally a question for the courts to determine, but Congress can also have its say on these matters, much like the other gatekeepers in our markets, namely lawyers and public accountability for rating agencies via statute. The view that agencies are mere publishers issuing opinions bears little resemblance to reality and the threat of civil liability would force the industry to issue more accurate ratings.

In sum, the foregoing financial crisis requires us to re-evaluate how rating agencies conduct their business even though we enacted the Credit Rating Agency Reform Act just three years ago. As this Congress considers a revised regulatory structure in the broader context, this segment of our markets also needs to be examined and transformed. By considering proposals aimed at better disclosure, real accountability and perhaps even civil liability, we can advance that debate today and ultimately figure out how to get the regulatory fit just right.

Now I recognize the gentleman from New Jersey for five minutes.

REP. SCOTT GARRETT (R-NJ): And I thank the chairman for holding this important hearing today.

I believe it is critical, as he says, that this subcommittee conduct proper oversight of the credit rating agencies and examine all of the issues surrounding the role that they played, if any, in the lead-up to the nation's current situation.

I'd like to thank all the witnesses on the panel attending. You know, unfortunately we don't have a representative from the SEC -- that's the government agency tasked with overseeing and regulating the NRSROs -- here with us to testify -- and so I feel it's essential that before this committee does formally consider any regulatory reforms regarding the rating agencies that we should at some point here directly from the SEC as to what, if any, additional powers or changes they see necessary.

You know, over the past decade we have seen a large increase in the role that credit rating agencies have in determining the creditworthiness of financial institutions and different types of securities. Whether it's corporate, municipal or structured finance, any entity seeking to assure investors of the quality of the debt must receive a good grade from one of these entities.

And so investors have become increasingly and too often solely reliant on the use of these ratings in determining the safety and soundness of an investment. This situation, like many of the other problems of this financial crisis, has in large part been created by government policy itself.

For literally hundreds of federal and state government statutes and regulations there are specific government requirements mandating certain grades from approved agencies. It is this formal requirement that provides an implicit stamp of approval, if you will, to the investors. Now, when an investor sees that the government has required a specific grade to make, quote, "safe investment," it basically reinforces the belief that any investment attaining such a grade is a safe investment.

But to its credit, the SEC recognizes this problem as well and they are moving to address it, so in December of last year the SEC proposed several new rules, one of which would reduce the reliance on the NRSROs ratings in the SEC's regulations. I believe it was Commissioner Casey who had it right when she said these requirements have served to elevate NRSRO ratings to a status that does not reflect their actual purpose, much less limitations of credit ratings.

So Congress really should try to follow through and re-examine all the areas where statutes mandate the ratings of NRSROs. Credit ratings are only one piece of the puzzle -- I think we'll hear that from the panel -- in determining creditworthiness. Investors must be encouraged to do their own due diligence in evaluating issuer credit quality.

Now one of the other areas that needs to be addressed is increased competition within the industry, and I hear it from the panel as well that they may be amendable to that as well. The 2006 act made a number of significant improvements to the process. Unfortunately, the law was just beginning to be implemented at the time when the financial system started to hemorrhage and the very worthwhile goals of the 2006 laws as far as fostering more competition, enhancing transparency and increasing accountability may still be achieved.

So two things I do not think Congress or the SEC should do to eliminate specific -- to eliminate specific types of pay models or prescribe exact analytics the NRSROs must use. This would go against the intent of the legislation by providing a further reduction in competition and increasing investor reliance on the ratings.

In regards to competition, a recent rule issued that also runs contrary to the goals of 2006 is from the Fed when they added the requirement that any securities used as collateral in their term asset-backed lending facility -- the TALF -- must have an A-1 rating from a major NRSRO. So this major NRSRO term is entirely new and refers to the "big three" rating agencies. While I assume that the Fed added this requirement due to the perceived better quality of the big three firms, I would remind the Fed that the big threes rated Lehman's, unfortunately, as A-1 on the day of bankruptcy.

Another area in which I would like to see increased competition is the manner in which credit quality is determined. And I know that some of my friends on the committee would like to demonize credit default swaps as a horrific gambling bet made by fat cats smoking cigars and sitting in luxurious board rooms, but the fact of the matter is credit default swaps are actually additional measures of assessing the creditworthiness of different corporations or securities. And during the height of the financial panic and collapse of many major firms, credit default swaps provided a more accurate gauge of risk than some of the credit rating agencies.

So in conclusion, Mr. Chairman, I believe that the government must continue to wean investors off being solely reliant on credit ratings and encourage them to conduct their own more due diligence.

And I do greatly appreciate the chairman holding this very important hearing and looking forward to all the witnesses' testimony today. Thank you.

REP. KANJORSKI: Thank you very much, Mr. Garrett.

You've heard the bells. We have about five minutes remaining on the first vote. There are three votes. We estimate it will take us about 25 minutes, so we'll stand in recess until we complete those votes and reassemble here, immediately thereafter. (Sounds gavel.)

(Recess.)

REP. KANJORSKI: Committee will reconvene.

Now recognize the gentleman from New York, Mr. Ackerman, for three minutes.

REP. GARY L. ACKERMAN (D-NY): Thank you, Mr. Chairman.

This is not the first time that the committee has explored the role and the future of credit rating agencies in our financial system. Time and again, we've heard from the agencies that their ratings were really sound, despite the billions of dollars in losses that investors realized on so-called AAA-rated mortgage-backed securities.

I would disagree with them. From mortgage-backed securities to collateralized debt obligations and the structured finance market to bond markets, the types of products that received inaccurate ratings and the markets in which those products were traded are far too vast to support the argument that the overly favorable ratings of 2006 and '07 were just a fluke. Clearly, a systemic approach to the ratings process is needed.

Mr. Castle and I have introduced legislation that would institute such an approach. The bill, H.R. 1181, would require the SEC to promulgate rules that would determine the types of structured finance investments that are eligible to receive NRSRO ratings from credit rating agencies that have been designated as Nationally Recognized Statistical Rating Organizations. The bill also defines the criteria to which NRSRO-rated structured finance products must adhere.

You cannot accurately predict performance of newer products that have no long-term track record. That doesn't mean that you can't sell them.

To be clear, we do not want to stifle creativity. And nothing in our bill restricts the ability of originators to continue to securitize less predictable or riskier products. The legislation permits NRSROs to continue to provide ratings for securities that do not meet the proposed NRSRO criteria as long as they are not designated as NRSRO ratings.

These, you know, are the ratings upon which pension fund managers, who are collectively tasked with managing the nest eggs of millions of Americans, rely.

I'm also concerned by the assertion of many of the credit rating agencies that their ratings are mere opinions and therefore are protected by the First Amendment. Of course, I might be more inclined to support the agencies' position if their companies didn't have an implied government license, and by their financial relationships with issuers.

In my view, the often inappropriately favorable ratings that the agencies assigned to products issued by their clients amount to nothing more than paid advertisements and endorsements -- not an expression of opinion.

I hope that the subcommittee will continue to work towards restoring transparency and objectivity to the credit rating agencies, as the future of our financial markets depends on it.

I look forward from hearing from our expert witnesses and I yield back the balance of my time.

REP. KANJORSKI: Chair recognizes Mr. Bachus for three minutes.

REP. SPENCER BACHUS (R-AL): I thank the chairman.

It's not normally my tendency to be overly critical. But I'm going to make an exception in this case. (Light laughter.)

I think surely everyone now recognizes that the credit rating agencies have failed and failed spectacularly and broadly.

Inaccurate rating agency risk assessments are one of the fundamental factors, in my opinion, in the global financial crisis. And effective correction action must address these shortcomings.

As Mr. Ackerman alluded to, the rating agencies say that these assessments or ratings are opinions, predictive opinions. And I think from a legal standpoint, that's true. But in the real world, that's not reality.

The SEC special examination report of the three major credit rating agencies uncovered significant weaknesses in their rating practices for mortgage-backed securities and also called into question the impartiality of their ratings.

As the SEC report detailed, the rating agencies failed to accurately rate the creditworthiness of many structured financial products. Investors and the government both over-relied on these inaccurate ratings, which undoubtedly contributed to the dramatic collapse of the U.S. and its financial markets -- or near collapse.

In order to avoid future meltdowns, we must return to a time where the rating agencies are not deemed a valid substitute for thorough investor due diligence.

My own view is that while the SEC report did not address municipal securities, the rating agency practices were also significant factors in the problems that plagued municipal insurers -- issuers.

The federal government must also share the blame for fostering over-reliance on rating agencies. The Federal Reserve's recent designation of certain credit rating agencies as major nationally recognized statistically rating organization implies a government stamp of approval that does not exist.

What we have is what I would call -- and others have called -- a government-sanctioned duopoly. And I think that's a mistake.

As we move forward with regulatory reform proposals, the committee should consider removing from federal laws, regulations and programs all references that require reliance on ratings.

The SEC also should take action to remove similar references in its own rules as quickly as possible.

At a minimum, the committee should consider changing NRSROs from nationally recognized to nationally registered statistically rating organizations to further reduce the appearance of government support or approval.

As Mr. Garrett said, I think credit swap derivatives have -- credit default swaps have been an accurate predictor of credit risk, and more so than credit ratings. And credit ratings have become almost -- I mean -- well, I won't go into all that.

But what I would say, this should give us caution in discouraging the use of credit default swaps. And it's critical that this committee doesn't restrict the use of these CDS contracts in the marketplace as we consider broader regulatory reform.

Let me close by saying -- to say what has occurred in the marketplace since 2006 has been volatile and frightening is an understatement. Correcting the inadequacies of the credit rating process is absolutely essential to restoring investor confidence. There must be further changes in the current ratings system to respond to very serious concerns expressed by investors, market participants and policymakers alike.

I look forward to hearing from the witnesses concerning these matters.

Thank you, Mr. Chairman.

REP. KANJORSKI: Thank you, Mr. Bachus.

Next we'll hear from Mr. Castle for two minutes.

REP. MICHAEL D. CASTLE (R-DE): Thank you, Mr. Chairman.

Credit rating agencies occupy a very important place in the world of finance, as we all know. Therefore, I think this committee needs to more fully understand things about the industry and its practices.

Our present circumstance leads us to many questions. How did the agencies repeatedly miss the mark on structured finance products, only to have to lower ratings or watch a record number of these products default? What experience and history did the agencies have with some of the products they were rating? And even if their ratings were accurate, were subsequent downgrades made public fast enough?

What about the relationship the agencies have with company management, representatives of the same businesses or products they are engaged to rate? Investors, governments, broker-dealers, investment banks, and others all rely upon credit rating agencies to more precisely understand credit risks. They have to do a first rate job, Mr. Chairman. However, in some instances they are the problem or, at the very least, part of the problem; they need to become part of the solution.

I recently joined Representative Gary Ackerman -- who just spoke to this -- and reintroduced legislation that proposes reforms for the industry.

Under H.R. 1181, credit rating agencies would only be able to give an official rating to asset-backed securities that have been sufficiently tested with a proven track record or where their performance can be reasonably predicted. The SEC would have the authority to strip Nationally Recognized Statistical Rating Organizations of their NRSRO designation if the rating agency fails to comply with provisions set forth in the legislation.

We need to address this problem as part of our efforts to reform the financial system to ensure financial products are adequately examined and restore investor confidence.

Thank you, Mr. Chairman. I yield back.

REP. KANJORSKI: Gentleman from California, Mr. Royce, is recognized for two minutes.

REP. EDWARD ROYCE (R-CA): Well, thank you, Mr. Chairman.

You know, the extent to which our entire financial system was and continues to be dependent upon the grades issued by NRSROs is really remarkable. Rating agency grades are incorporated into hundreds of rules, laws and private contracts. And that affects banking, insurance, mutual funds. It affects pension funds.

By making the agencies' opinions count toward determining whether banks had an adequate amount of capital, in essence gave their opinions a quasi-official status, basically, from the government. And considering how badly the rating agencies misjudged the risks in recent months, the quasi-official treatment of their opinions should be re-evaluated.

The federal government's over-reliance on the rating agencies compound the marketwide perception that these ratings are in some way more than just opinions and are in fact the best indicators of risk. This signal to the market lessens the perceived need for counterparty due diligence that a well-functioning market requires. Both our over- reliance on the major rating agencies and the poor performance of these entities during the recent market downturn has led me to believe that major reforms to the industry are needed.

I believe Congress should focus on encouraging alternative tools to assess potential gains or losses, which would enable consumers and institutions to better comprehend investment risk.

Further, federal regulators should re-evaluate their dependence on these ratings before the federal government has asked once again to dedicate another $13 trillion due to the economic consequences of this lack of foresight.

And Mr. Chairman, again, I thank you for this important hearing and yield back the balance of my time.

REP. KANJORSKI: Thank you very much, Mr. Royce.

Mr. Capuano for three minutes.

REP. MICHAEL CAPUANO (D-MA): Thank you, Mr. Chairman.

Mr. Chairman, first of all, thank you for having this hearing. And I'm looking forward to both this testimony and actually moving some legislation further in the year.

I haven't been able to go through all the testimony here before me, but I know there's been a lot of talk by some that somehow the freedom of speech amendment allows people to say and do anything they want. And I would respectfully disagree. I consider myself a major defender of the First Amendment, and I would do whatever I can to maintain the freedom of speech.

However, the freedom of speech I don't think applies when you're getting paid. When you're getting paid, you should be held to a higher standard. And if you want freedom of speech, stop getting paid, write an op-ed in the paper -- not a problem. Say whatever you want. People can listen to you, not listen to you. That's all well and good.

But when your words can and does, number one, ask people to rely on you and, number two, move markets, I do think you should be held to -- I think it's unequivocal that you should be held to a certain standard.

What that standard is -- I think that's fair. I don't think it's fair to say that people can't be wrong. Everybody can and is wrong on a regular basis. And it is a hard thing to distinguish between what is simply an appropriate and fair and reasonable error of judgment versus some other action that might require some reaction.

So anyway, I'm looking forward to this hearing, Mr. Chairman. I thank you very much for doing this.

And I actually look forward to being able to improve the market for investors and to make it so that people can actually rely on the opinions of the credit rating agencies.

REP. KANJORSKI: Thank you very much, Mr. Capuano.

The gentleman from Texas, Mr. Hensarling, is recognized for two minutes.

REP. JEB HENSARLING (R-TX): Thank you, Mr. Chairman.

We know there are a number of causes to our nation's economic turmoil; most have their genesis in flawed public policy.

To state the obvious, the three major credit rating agencies missed the national housing bubble. This doesn't necessarily make them duplicitous, doesn't necessarily make them incompetent, but it does make them wrong -- very, very wrong.

Unfortunately, many investors due to legal imperatives or practical necessity relied exclusively on ratings from the three largest CRAs without performing their own comprehensive due diligence.

We now know that the NRSRO term has been embedded in our law, approximately 10 federal statues, approximately 100 federal regulations, roughly 200 state laws and around 50 state rules.

I believe the failure of the credit rating agencies would not have generated the disastrous consequences that it did had the failure not been compounded by further misguided government policies which effectively allowed the credit rating agencies to operate as a cartel.

By adopting the NRSRO system, the SEC has established an insurmountable barrier to entry into the rating business, eliminating market competition among the rating agencies. People assumed wrongly the government stamp of approval meant accurate ratings.

Now, we took a step in the right direction with the Credit Rating Agency Reform Act of 2006, but it was too little, too late. There's a vitally important lesson we must all learn regarding implied government backing. We have seen the results from the government stamp of approval on Fannie and Freddie. We now see the results of the impact of denying a competitive market for credit rating agencies. We must certainly consider this in the development of a potential systemic risk regulator designating specific institutions as too big to fail, creating a self-fulfilling prophecy.

Outcomes in the market cannot and should not be guaranteed by the government. It causes people to become reliant, dependent and engaged in riskier behavior than they otherwise would.

When people believe that the government will perform their due diligence for them on the front end or will bail them out on the tail end, this is very dangerous for the investor and disastrous for the nation.

And I yield back the balance of my time.

REP. KANJORSKI: The Gentleman from Georgia for two minutes.

REP. DAVID SCOTT (D-GA): Thank you very much, Mr. Chairman. This is a very important and timely hearing.

As we continue to monitor the current economic climate we're in and look toward solutions and improvements that can be made, I believe that this hearing is very, very timely, as the credit rating agencies did in fact play a considerable role in what has transpired, what will also impact what transpires in the near future.

Once our financial institutions achieve the desired quality grade on a product, it pays the agency for the rating. This process, as some claim, is rife with conflict, as they believe the agencies are acting as the market regulators, the investment bankers and as a sales force all the while claiming to be providing independent opinions. That's it, the problem in a nutshell.

As these organizations are extremely important to the financial world, we should realize they did have a role to play in where we are now. But I also want to more intently focus on finding some consensus on how to move forward.

These organizations determine corporate and government lending risk and are in an integral part of our financial services sector. And as such, I want to ensure we take all issues into account, including conflicts of interest as well as the international finance world and reforming just how we rate financial products.

More examination of these agencies is indeed in order to evaluate the need for improvement, as many have complained that the rating agencies did not adequately assess the risky nature of mortgage-backed securities.

The credit rating agencies have grown more powerful over the years, maybe more powerful than anyone had really intended. However, I do look forward to the witnesses' testimony and how their review of and opinions on this subject will shape the committee's further review of this issue.

Thank you, Mr. Chairman.

REP. KANJORSKI: Thank you very much, Mr. Scott.

And I hear from the gentleman from Georgia, Mr. Jenkins.

REP. LYNN JENKINS (R-KS): Thank you for holding this hearing today --

REP. KANJORSKI: Oh.

REP. JENKINS: -- Mr. Chairman.

I am by no means an expert on the topic of credit rating agencies. So I'm certainly glad that we have this opportunity to learn more about this issue.

The credit rating agencies' role in the economy is a straightforward one. They're to provide independent analysis to the quality of various financial assets.

These agencies, led by Standard & Poor's and Moody's, for quite some time, have been relied on by the capital markets to provide independent, meaningful analysis.

Investors relied on the supposedly independent ratings, giving these agencies for investment decisions where a AAA rating had become the stamp of approval, ensuring that the investment was a safe one.

Over time, the original business model where agencies were paid by the investors was replaced with a model where the agencies were paid by the issuers themselves. Some would say this led to an inherent conflict of interest but led to the financial collapse that we've been witness to.

Others have said that over time the agencies became little more than a mirror of the market's assessment of risk of a particular bond, providing minimal additional value.

The question can also be asked whether ratings replaced investor due diligence.

Thank you, Mr. Chairman.

I yield back the remainder of my time.

REP. KANJORSKI: Thank you very much.

And now we'll hear from the gentleman from California, Mr. Sherman, for two minutes.

REP. BRAD SHERMAN (D-CA): Thank you.

Most entities will eventually work in their own interest. Patriotic speeches and appeals to patriotism only go so far.

This is an industry that gave AAA to Alt-A and is as responsible for where we are now as anyone else playing on Wall Street.

Two things create the self-interest. The industry is picked by the issuer and believes it cannot be sued by the investor. One of those two things needs to change.

Now, the public accounting firms are picked by the issuer, but they're subject to lawsuits. The auditing firm that audited WorldCom doesn't exist anymore. And in the old days they were general partners -- general partnerships, so 100 percent of all the partners' personal equity would be gone. That provided even more incentive to provide for a good audit.

If that -- if we're not going to force the firms to renounce any first amendment arguments as a condition for doing business on Wall Street, then we need to end the system where they're picked by the issuer. Otherwise there will be a race to satisfy the issuer by providing the highest ratings to the issuer. And we'll get triple-A on Alt-A. It won't be mortgages next time. It'll be some other kind of bond. And we'll be back here in another economic crisis.

We don't allow the pitchers to pick the umpires. If we did, the strike zone would go from the ground to well above the head. We cannot allow the issuers to pick the bond rating agencies or the credit rating agencies, unless we're then going to bring in trial lawyers with instant replay cameras. That would assure that the umpires wouldn't cater to the pitchers if they were subject to lawsuits and instant replay. But one of those two things needs to change. Or the fear of God will prevent us from being in this situation for -- with mortgages for a few years, but we'll be back here in another semi-depression with some other kind of credit instrument.

I yield back.

REP. KANJORSKI: Thank you very much, Mr. Sherman.

I'll now introduce the panel.

And I want to thank you all for appearing before the subcommittee today.

Without objection, your written statements will be made part of the record. You will each be recognized for a five-minute summary of your testimony.

First, we have Mr. Robert Auwaerter, principal and head of the Fixed Income Group, Vanguard.

Mr. Auwaerter.

MR. AUWAERTER: Mr. Chairman and members of the subcommittee today, thank you for the opportunity to testify at this important hearing.

I'm the head of the Fixed Income Group at Vanguard, which is the world's largest mutual fund company.

Credit ratings provide a useful purpose in the financial markets. For the small investor, they act as a way to provide standardized way for investors to do an initial screen of potential investment choices.

For institutional investors they provide instructions to their managers on how to limit risk.

They also serve as a constructive purpose in government regulations, the most prominent being SEC Rule 2a-7 governing money market funds. There, NRSRO ratings protect investors by limiting the fund's ability to chase higher yields through riskier securities based on the fund's own subjective assessment. While NRSRO ratings serve as an objective and necessary qualification for buying a security, on their own they are not sufficient to warrant an investment.

Importantly, credit ratings are a starting point. Investors must do their own analysis when determining the appropriateness of an investment. Investors choose Vanguard to invest on their behalf in part because of our ability to employ significant resources toward assessing credit risk in our bond portfolios.

In total, Vanguard has 25 senior credit analysts with over 400 years of cumulative industry experience.

It's important to recognize that in order to avoid the mistakes of the past, 100 percent perfection and accuracy in ratings cannot be the goal.

However, we believe there is need for further regulation of credit rating agencies. The focus of these efforts should be on improving transparency, reliability of credit ratings, while at the same time controlling and disclosing the conflicts of interest exist in all credit rating agency business models.

For example, the ratings process for corporate borrowers must address the need to protect material nonpublic information from being disseminated. Currently, issuer-pay credit rating agencies will take material nonpublic information such as management forecasts into account in the ratings assessment process.

We're concerned that proposals that force full disclosure of all credit rating material from corporate issuers, including nonpublic information, to all potential credit rating agencies will in the end end up limiting disclosure to all credit rating agencies. Under this scenario, we would expect credit ratings to become less reliable, not more reliable.

However, on the other hand, we're in favor of greater and more frequent disclosure by issuers of municipal and structured finance securities. Structured finance and, for that matter, municipal ratings are impaired by a lack of transparency of key credit rating determinants by the issuer of the security. We'd like to see greater transparency and disclosure from the issuers to the investors as a feature of improved regulations.

Regardless of the business model, the ratings product must be subject to very high standards of independence, diligence and accountability. For that reason, Vanguard supports an increase in the authority of the SEC to provide appropriate oversight of the NRSROs.

Improved regulations and oversight should focus on transparency and reliability of the ratings process. The NRSROs should be subject to regular audits that test compliance to internal procedures, the independence of rating actions, and the diligence of the ratings process.

The goal of these audits should not be to regulate the actual ratings but, rather, the process by which the rating agencies derived these ratings.

These NRSRO designations should be limited to CRAs that are in compliance with strict regulatory requirements.

There is opinion out there that by inducing greater competition into the CRA marketplace, ratings quality will automatically improve. While competition itself can be constructive, it may come at a significant cost. By artificially leveling the playing field, inducing many new participants, the market will be littered with a wide dispersion of credit ratings for issuers and structured finance transactions.

It is very important that in designating a credit rating agency as NRSRO that the SEC determines there is sufficient analytical and operational resources to perform at appropriate level of independent credit analysis.

By definition, NRSROs should have a wide market appeal, should not be niche rating agencies focusing on narrowly defined segments of the market.

Importantly, under these new rules, with the ability to pull an NRSRO designation would provide a powerful incentive for compliance.

Regulators should finally consider the creation of a standing advisory board comprised of the key rating agency constituents. It could serve an important role in providing feedback on new product types, ratings performance, and regulatory proposals to both to the credit rating agencies and the appropriate regulators.

In summary, we think that credit ratings serve a useful purpose in the market and in government regulations. And we support the increase in the authority of the SEC to provide oversight to ensure that credit rating agencies have the appropriate resources and procedures to deliver a ratings product that meets very high standards of independence, diligence and accountability.

Thank you.

REP. KANJORSKI: Thank you very much, Mr. Auwaerter.

Next we'll here from Mr. Robert Dobilas, president and chief executive officer of Realpoint, LLC.

Mr. Dobilas.

MR. DOBILAS: Yes. Thank you for the opportunity to participate in this hearing.

The rating agency legislation passed by the Congress in 2006 was an important step forward. It greatly improved the regulatory process by which a rating agency can receive a national designation from the SEC. And it has in fact increased the number of competitors.

But given the worldwide collapse of the credit markets and the loss of trillions of dollars by individuals, companies and governmental entities, it is now clear that Congress needs to take further action addressing the conflicts of interest which have arisen in the context of having rating agencies paid by the corporations whose debts they are evaluating.

As the Congressional Oversight Panel has stated, the "major credit rating agencies played an important and perhaps decisive role in enabling and validating much of the behavior and decision making that now appears to have put the broader financial statements at risk."

Realpoint uses a different business model than S&P, Moody's and Fitch. We are an independent, investor-paid business, which means our revenues come from investors, portfolio managers, analysts, broker/dealers and other market participants who typically buy a subscription pay to our services.

We produce in-depth monthly ratings reports on all current commercial mortgage backed securities. Moody's, S&P and Fitch, on the other hand, are paid by the issuers of the security. They are paid substantial up-front fees on a pre-sale basis by the corporations selling securities or investment banks which are underwriting the sales.

The fees can exceed $1 million in a single transaction.

In a word, the results of the issuer-paid business model have been miserable.

The SEC recently published data showing that Moody's has had to downgrade 94.2 percent of all the subprime residential mortgage-backed securities it rated in 2006. This is the equivalent of a Major League Baseball player striking out in 19 of 20 times at bat.

We see a similar trend developing now in the CMBS market.

In contrast Realpoint's ratings were lower from the outset and have proven to be more stable than those of the issuer-paid agencies. Even during these unprecedented times, downgrades at Realpoint are less than 30 percent on all current CMBS transactions and have generally taken place six to 12 months sooner than the corresponding rating actions taken by other rating agencies.

The core problem with the issuer-paid system and the most important message that I would like to leave with the subcommittee today is that the integrity of the rating process is undermined by the pervasive practice of rating shopping.

When issuers decide to bring a new security to market, it generally begins the process by providing data to the three rating agencies. Three rating agencies are more than willing to provide preliminary levels on ratings, knowing that the issuer will tend to hire the agency the provided the highest ratings.

We hear a lot about the complexities of modern finance. But the rating process is hardly complex.

The solution is equally simple and it only takes one step: Let all the designated rating companies have the same information and prepare their own pre-sale ratings regardless of whether or not they are ultimately paid by the issuers or by investors.

In our view there is simply no better or more straightforward way to enhance the integrity of the ratings process than to share the information with all agencies which the SEC has deemed of as being a nationally recognized agency.

In fact, the SEC has already proposed precisely such a rule through an amendment to its fair disclosure rules. The public benefits of having the simple step are immediate and manifestly obvious.

Last year, the Federal Reserve began implementing the Term Asset- Backed Securities Lending Facility, or TALF, program.

Initially, the ratings component of TALF was limited to Moody's, S&P and Fitch. We are pleased that the Federal Reserve is now taking the steps to increase the number of rating agencies eligible to participate in this program.

As a matter of fact, we just learned that Realpoint and DBRS are part of the TALF program.

We believe that this will increase competition and lead to more accurate ratings behind the taxpayer guarantees, which stand behind these programs.

TALF and other comparable programs utilize the standard industry practice of requiring two ratings in order for securities to be deemed suitable collateral. There is likewise no valid public policy reason for not insisting that at least one of these ratings be an independent, investor-based rating.

In this manner, the TALF program serves not only as a catalyst for restarting the securitization market but is a vanguard to reform the credit rating industry.

A mandate to have TALF and other government-assistance programs utilize the ratings of at least one independent rating agency would enhance investor confidence in those programs and set the stage for ultimately resurrecting reliable ratings in the private sector.

In short, the American taxpayer should not be subject to the same failed ratings shopping syndrome I describe earlier.

In conclusion, the integrity of the ratings process is deeply flawed. But this is not a complex problem. And in fact, it is not that different from when we were all in high school and everyone sought out the teachers who were known as easy graders. We simply need to put an end to the ratings shopping process that encourages issuer-paid rating agencies to inflate their ratings.

Thank you very much for your time.

REP. KANJORSKI: Thank you very much, Mr. Dobilas.

We'll now -- next hear from Mr. Eugene Volokh, Gary T. Schwartz professor of law at UCLA School of Law.

Mr. Volokh?

MR. VOLOKH: Mr. Chairman, members of the committee, thanks so much for having me out here.

I was asked to provide an objective First Amendment analysis of the free speech issues raised by the regulations and liability for speech of ratings agencies. I'm a scholar of the First Amendment, I'm not a scholar of commercial law, and I will try to stick to what I think the First Amendment law sets forth without opining on what I think is sound financial policy here.

So my first point is that the ratings issued by rating agencies are, generally speaking, speech of the sort that is presumptively protected by the First Amendment. They are predictive opinions based on factual investigation and based on some degree of expertise.

In that respect they're quite similar to the work product investment newsletters or, for that matter, of commercial -- the financial pages of well-respected newspapers.

Those, too, offer predictive opinions based on factual investigation with some degree of expertise on the part of the author.

Now, those, too, are for-profit entities, or at least try to be for profit entities. That does not strip them of First Amendment protection. First Amendment protection has long been understood as being offered to for-profit entities, otherwise newspapers, magazines, movie studios, all of them, would be constitutionally unprotected.

To be sure, rating agencies are particularly, or at least were particularly respected and their speech was found to be particularly valuable. But the fact that speech is especially valuable does not diminish the scope of First Amendment protection that's offered. And the fact that people rely on that speech, generally speaking, does not diminish that scope of First Amendment protection.

So generally speaking, the First Amendment is presumptively in play here. That's not just my view, that is the view of the federal circuit courts that have considered this issue in the related context of libel lawsuits -- so by the "ratees" against the rating agencies. The 6th and the 10th circuits have spoken to this very issue and have said this is First Amendment -- the heartland of First Amendment protection.

Now, to be sure, not all speech ends up being protected by the First Amendment. So for example, if an agency is actually paid to issue a favorable report -- not just issue a report but issue a favorable report -- that would probably make it commercial advertising, which is much less protected under the First Amendment.

Much as if a newspaper were paid to write favorable article about a company, which I believe is considered quite unethical in newspapers, I'm told that it's not uncommon in sort of fluff entertainment magazines and the like. But that would presumably be commercial advertising.

The fact, though, that there is a payment being made, not for the positive review, but a payment being made by a company to the subject of the review does not make the review commercial advertising. And we can see that in part because newspapers routinely take advertising from the very same companies whose products they review.

And there is some degree of possible pressure to bias the reviews in this respect. If you want to keep getting advertising from Ford you may want to write positive reviews of Ford -- counteracted by the desire to maintain the value of the newspaper's own brand.

But generally -- while that lead some papers to be very careful about that -- generally, that does not strip speech of full protection.

Likewise, there are certain situations in which a company may be hired specifically to give personalized advice to an investor, much like an accountant or a lawyer or a psychotherapist or what have you could be hired to give personalized advice to their client. That would presumably sit the speech in the category of professional client speech, which is much less protected.

And that might in fact describe what some rating agencies do in certain circumstances. There are some cases in which rating agencies have been found to do just that.

But generally speaking, the fact that they are professionals who offer expert commentary does not make them subject to this kind of restriction -- that so long as they're speaking to the world at large and they're not kind of addressing their advice to the personalized circumstances of a particular person whom they're counseling, that -- their speech generally remains fully constitutionally protected.

Finally, that speech might be protected categorically to the extent it's treated as a matter of opinion, or might be protected under The New York Times actual malice standard to the extent that it implies specific, verifiable facts, which means that it wouldn't be judged by a negligence standard, but rather by a question of whether they knew the statements were false or likely to be false.

Again, there is lower court case law on this very point.

So those, I think, are the constraints and direct regulation or litigation against rating agencies.

However, to the extent that the government chooses to say we will give some special status to certain agencies on condition that, for example, they don't take money from the companies that they rate -- so whether they only take money from subscribers. And if they don't want to be subject to those conditions they're free to express their opinions; however, they do not special government-provided status. That kind of restriction on agencies that are given this specialized status as a condition of getting that status would probably be constitutionally permissible.

Thank you.

REP. KANJORSKI: Thank you very much.

We'll now hear from Mr. Stephen W. Joynt, president and chief executive officer of Fitch Incorporated.

Mr. Joynt.

MR. JOYNT: Thank you, Chairman Kanjorski, Ranking Member Garrett and members of the committee. I'd like to spend just a few minutes summarizing my prepared statement.

Nearly two years has passed since the onset of the credit crisis. What began as stress focused on the global debt capital markets has evolved into a more severe economic slowdown. An array of factors has contributed to this, and these have been broadly analyzed by market participants, the media, and within the policymaking and regulatory communities.

During this time, the focus of Fitch Ratings has been on implementing initiatives that enhance the reliability and transparency of our ratings.

More specifically we are vigorously reviewing our analytical approaches and changing ratings to reflect the current risk profile of securities we rate.

In parallel, we've been introducing new policies and procedures and updating existing ones to reflect the evolving regulatory frameworks within which credit rating agencies operate globally.

I've provided details in my written statement, so I'd like now to move on to the primary focus of today's hearing, where do we go from here?

As this committee considers this important topic we'd like to offer our perspective on a number of important issues.

Transparency is a recurring theme in these discussions, and at Fitch we are committed to being as transparent as possible in everything we do. But transparency also touches on issues beyond the strict control of rating agencies.

All of Fitch's ratings, supporting rationale and assumptions and related methodologies and a good portion of our research are freely available to the market in real-time -- by definition, transparent.

We do not believe that everyone should agree with all of our opinions. But we are committed to ensuring that the market has the opportunity to discuss them

Some market participants have noted that limits on the amount of information that is disclosed to the market by issuers and underwriters has made the market over-reliant on rating agencies, particularly for analysis and evaluation of structured securities.

The argument follows that the market would benefit if additional information on structured securities were more broadly and readily available to investors, thereby enabling them to have access to the same information that mandated rating agencies have in developing and maintaining our rating opinions.

Fitch fully supports the concept of greater disclosure of such information. We also believe that responsibility for disclosing such information should rest fully with the issuers and the underwriters and not just with the rating agencies.

Quite simply, it's their information and their deals, so they should disclose that information.

A related benefit of additional issuer disclosure is that it addresses the issue of ratings shopping. Greater disclosure would enable non-mandated NRSROs to issue ratings on structured securities if they so choose, thus providing the market with greater variety of opinion and an important check on perceived ratings inflation.

The disclosure of additional information, however, is of questionable value if the accuracy and reliability of the information is suspect. That goes to the issue of due diligence.

While rating agencies have taken a number of steps to increase our assessments of the quality of the information we are provided in assigning ratings, including adopting policies that we will not rate issues if we deem the quality of the information to be insufficient.

Due diligence is a specific and defined legal concept. The burden of due diligence belongs with issuers and underwriters. Congress ought not to hold rating agencies responsible for such due diligence or requiring it from others. Rather, Congress should mandate that the SEC enact rules to require issuers and underwriters to perform such due diligence, make public the findings, and enforce the rules they enact.

In terms of regulation more broadly, Fitch supports fair and balanced oversight and registration of credit rating agencies and believes the market will benefit from globally consistent rules for credit rating agencies that foster transparency, disclosure of ratings and methodologies, and management of conflicts of interest. We also believe that all oversight requirements should be applied consistently and equally to all NRSROs.

One theme in the discussion of additional regulation is the desire to impose some more accountability on rating agencies. Ultimately the market imposes accountability for the reliability and performance of our ratings and research; that is, if the market no longer has sufficient confidence in the quality of our work, the value of Fitch's franchise will be diminished and our ability to continue to compete in the market will be impeded.

While we understand and agree with the notion that we should be accountable for what we do, we disagree with the idea that the imposition of greater liability will achieve that. Some of the discussion on liability is based on misperceptions, and while those points are covered in my written statement, it's worth highlighting that the view -- that the rating agencies have no liability today is unfounded.

Rating agencies, just like accountants, officers, directors and securities analysts, may be held liable for securities fraud to the extent a rating agency intentionally or recklessly made a material misstatement or omission in connection with the purchase or sale of a security. Beyond the standard of existing securities law that applies to all, fundamentally we struggle with the notion of what it is that we should be held liable for. Specifically, a credit rating is an opinion about future events -- the likelihood of an issue or issuer that they will meet their credit obligations as they come due. Imposing a specific liability standard for failing to accurately predict the future in every case strikes us as an unwise approach.

Congress also should consider the practical consequences of imposing additional liability. Expanded competition may be inhibited for smaller rating agencies by withdrawing from the NRO (sic) system to avoid specialized liability. All rating agencies may be motivated to provide low security ratings just to mitigate liability.

In closing, Fitch has been and will continue to be constructively engaged with policymakers and regulators as they and you consider ideas and questions about the oversight of credit rating agencies. We remain committed to enhancing the reliability and transparency of our ratings and welcome all worthwhile ideas that aim to help us achieve that.

Thank you.

REP. KANJORSKI: Thank you very much, Mr. Joynt.

We will now hear from Mr. Alex Pollock, resident fellow, American Enterprise Institute.

Mr. Pollock?

MR. POLLOCK: Thank you, Mr. Chairman, Ranking Member Garrett, members of the subcommittee.

As many of the members said in their opening statements, in the housing and mortgage bubble of our 21st century the government- sponsored credit rating agency cartel turned out to be a notable weakness. The regulatory NRSRO system made the dominant rating agencies into a concentrated point of possible failure which then failed.

Considering this history, Deven Sharma, the president of S&P, has rightly said that we need to, in his words, "avoid inadvertently encouraging investors to depend excessively on ratings." Let me add we certainly need to avoid intentionally encouraging investors to depend excessively on ratings and to treat them as one of many inputs.

As Congress made clear in the 2006 Credit Rating Agency Reform Act, greater competition in the credit rating agency sector was a key objective and indeed this is the right strategy. At the beginning of 2005 I published an essay entitled "End the Government-Sponsored Cartel in Credit Ratings," and that still summarizes my view.

I do think there's been significant progress in the right direction by the SEC since the 2006 act -- for example, registering Realpoint as an NRSRO -- but we can go further. In the ideal case, as Congressman Bachus said, we'd get rid of all statutory and regulatory references to NRSRO. I don't know if that's doable.

I'd also strongly support his suggestion of replacing the meaning of "R" as "recognized" with "registered," so that we had only national registered rating agencies. That would be a step in the right direction.

As I remember, we talked about that in 2005, 2006, maybe even had it in bills at one point but it didn't make it into the final act.

Now what everybody in financial markets wants to know is the one thing that nobody can know, namely the future, so Wall Street continually invents ways to make people confident enough to buy securities in spite of the fact they can't know the future, and these assurances, as has been said, are of course opinions and the credit rating agency ratings are an extremely important form of such opinions. In the course of financial events, some such opinions will inevitably prove to be mistaken -- some disastrously mistaken -- as has been evident in the 21 months since the beginning of the financial panic in August 2007. We'd all like to have this infallible knowledge of the future.

Can't we somehow, quote, "assure" credit ratings which are, quote, "accurate," to borrow terms from a current bill in the Senate? Can't we guarantee having models which are right? The answer is no. No rating agency, no regulatory agency, no modeler with however many computers can make universally correct predictions of future events.

In the worst case, the worst case would be to turn the SEC, through the regulation of ratings process, which could easily turn into regulating ratings, into a monopoly rater, which would also suffer from the same lack of ability to predict the future as would any, to touch on a separate topic, any so-called systemic risk regulator, should we make what I believe to be the mistake of creating one.

But having more credit rating competitors, especially those paid by investors in my view increases the chances that new insights into credit risks and how to conceptualize, analyze, predict and measure them, will be discovered. It'll also reduce the economic rents to the present dominant rating agencies. And should we create this more competition, we should expect and welcome greater dispersion of ratings -- that will tell us we're getting different points of view -- and whether ratings are concentrated around a mean or dispersed would be very important information for investors.

A particularly desirable form of increased competition, as others have said, is from rating agencies paid by investors, which do have a superior alignment of incentives. A frequent objection to competition in credit ratings is that there would be a so-called race to the bottom, but this does not apply at all to the logic of investor-paid ratings.

In my view, all regulatory bodies -- not just the SEC, all regulatory bodies -- whose ratings supported over reliance on the government-sponsored ratings cartel should develop and implement ways to promote the pro-competitive objective of the 2006 act, and all regulatory rules concerning rating agencies from all regulators, not just the SEC, should be consistent with encouraging competition from the investor-paid model.

I've previously proposed that a group of major institutional investors, maybe Vanguard, should set up their own rating agency capitalized and paid for by these investors working from their point of view, and it continues to seem to me likely the market would demonstrate a preference for the ratings of such agencies. And a successful competitor would find ways to distinguish itself by creating more valuable ratings, perhaps as suggested by our colleague Rob in his testimony by superior ongoing surveillance.

In sum, Mr. Chairman, competition in the rating agency sector has made some progress since the 2006 act, and greater competition remains, in my opinion, not only an essential but also an achievable objective. And thanks again for the opportunity to be here.

REP. KANJORSKI: Thank you very much, Mr. Pollock.

I now recognize the gentleman from Colorado, Mr. Perlmutter, to introduce our final witness.

REP. ED PERLMUTTER (D-CO): Thank you, Mr. Chair.

It gives me great pleasure to introduce my friend Greg Smith, who is the general counsel of the Colorado Public Employees' Retirement Association, of which I was a member.

Greg is the co-chairman of the Council of Institutional Investors. He is also the chair of the subcommittee which deals with the credit rating agencies. He has a background in business and commercial matters having represented pension plans as well as a variety of business interests over the years.

He holds a Bachelor of Science from the University of Colorado and a law degree from the University of Denver, and we look forward to his testimony. Thank you.

MR. SMITH: Thank you very much, Chairman.

Thank you, Chairman Kanjorski, Ranking Member Garrett, Congressman Perlmutter. I appreciate the kind words.

I am here to speak on behalf of the Colorado Public Employees' Retirement Association, a pension fund with more than $29 billion in assets and responsible for the retirement security of over 430,000 plan members and beneficiaries. I greatly appreciate the opportunity to be heard and talk about what I believe is the right direction for credit rating agency reform.

My brief remarks will include an overview of how Colorado PERA uses credit ratings, suggestions on how the Securities and Exchange Commission can provide better oversight of the ratings industry, and views on the need to strengthen NRSROs' accountability for their ratings.

Credit ratings are an important and sometimes mandated tool for many market participants, including pension funds. Most institutional investors do not rely exclusively on ratings. This holds true for Colorado PERA as well as most of our peers. Ratings are a part of the mosaic of information that we consider during the investment process.

Initially, we define our risk tolerance and we determine what type of allocation is necessary to stay within that range. Ratings serve as a first cut to identify securities for further consideration and analysis. Without such a tool, we and many other investors would have no initial way to screen the tens of thousands of new instruments available for investment each year.

Because of their significance in the capital market and their status as financial gatekeepers, we believe NRSROs must be held to a high standard of quality, transparency and independence. Congress and the SEC must work to strengthen and extend oversight in several areas ranging from disclosure to policies to methodologies. My written testimony provides more detail, but I would like to highlight a few suggestions for action here.

Like many institutional investors, we encourage the SEC to expand its proposal regarding the delayed disclosure of credit rating actions and credit rating histories to include all outstanding credit ratings regardless of whether or from whom the NRSRO received its compensation. Similar to the provisions governing auditors, NRSROs should be required to disclose business relationships and should be prohibited from providing ancillary services. They should also publicly disclose fee schedules and the amount of compensation received for individual ratings and from individual clients.

A mandatory one-year waiting period should be in place for any NRSRO employee seeking a position with a client, and the SEC should strengthen the current responsibilities and requirements pertaining to NRSRO compliance officers -- that's their internal compliance officers. At a bare minimum, more detailed information regarding the NRSROs' rating methodologies should be made available publicly and in a user-friendly model.

Providing the SEC with the additional authority and resources, however, will not itself create an adequate system of checks and balances. The market must have a path of recourse. Where these financial gatekeepers fail to adhere to their reasonable industry standards, they should be held accountable for those failures.

Expressions of concern regarding the business viability of NRSROs in the event of private right of action where recognized by legislation are premised on the contention that NRSROs would become guarantors of the performance of the instruments that they rate or would somehow become liable in the event a particular rating is changed and the value of the instrument is negatively impacted.

While this premise serves the interest of those desiring to maintain a lack of accountability, the reality is that no market participant is seeking that form of accountability. Rather, we are seeking to have these officially sanctioned gatekeepers held to a reasonable industry standard for the process and methodology that is employed, including the adequacy of the due diligence and the unbiased nature of the conclusion.

The threat presented to NRSROs by a private right of action is in essence no different than that presented to other participants in the marketplace, including institutional fiduciaries like my organization. We, like others, are responsible for the process we adhere to. Our honesty and our lack of conflicts or appearances of conflicts of interest in the discharge of our responsibilities is imperative to our success. We protect our organization from liability by creating a robust process and strictly monitoring our adherence thereto. We see no legitimate barriers to such a risk-management approach by the NRSROs.

Thank you for the opportunity to be here. I look forward to your questions.

REP. KANJORSKI: Thank you very much, Mr. Smith. Let me start off with my first question to you.

When you buy security, how "depthful" do you look at the security? Do you do due diligence on your part to go back all the way to see how the security was supported and what the pool was made up of and who the participants are in the mortgages?

MR. SMITH: Absolutely. We look -- we drill as far as we can drill. We look at how the issuers are, obviously, what their creditworthiness is.

REP. KANJORSKI: Issuers being the underwriters or the individuals who have mortgages?

MR. SMITH: Well, it depends on what kind of instrument we're talking about, but if we're talking about mortgage-backed securities --

REP. KANJORSKI: Mortgage-backed securities.

MR. SMITH: Mortgage-backed securities: We would attempt to go back to where the mortgages are but that's a difficult thing for us to do. There's some reliance --

REP. KANJORSKI: Well, if you can't do that then where do you get the information whether or not you should buy that type of security except that it's rated AAA?

MR. SMITH: Well, what we do as a large institution is we go out and buy the research from the very people that are issuing the ratings. So we try and drill into it by buying that research from the rating agencies themselves.

REP. KANJORSKI: So they not only rate the security, they get paid to sell you the materials they use to rate the particular security?

MR. SMITH: There are certainly research relationships where we purchase research from the very institutions that issue ratings, yes, sir.

REP. KANJORSKI: Okay, very good.

Mr. Fitch (sic), how many people would your organization employ? I'm sorry, Mr. Joynt. (Laughter.) That's a Freudian slip, sir.

MR. JOYNT: I think our present employee count globally is about 1,900.

REP. KANJORSKI: Nineteen hundred. And you're one of the three largest in the world, is that correct?

MR. JOYNT: Yes.

REP. KANJORSKI: And how many employees would you have had, you'd say, in 2002?

MR. JOYNT: I would be guessing. We had --

REP. KANJORSKI: About the same amount?

MR. JOYNT: No, it would have been much less in -- Fitch Group is both growing on its own and merging with other smaller rating agencies, so we've made some acquisitions -- of a bank watch rating agency, Duff & Phelps rating agency, IBCA -- so it's very hard to answer the question, but I would say we may have been half that size.

REP. KANJORSKI: Half that size. Okay, how many of those people are involved as analysts in mortgage-backed securities?

MR. JOYNT: In mortgage-backed securities, I can get you that answer. I don't have that answer off the top of my head globally how many employees that --

REP. KANJORSKI: Would you be much different than one of the other three major rating agencies that showed a profit or an income in 2002 of $3 billion and then in 2006 $6 billion? Has your revenue changed as much as that over that three-, four-year period?

MR. JOYNT: Well, our revenues have grown both through combining with these other rating agencies and growth on our own. The size of our company is much -- is smaller than the other rating agencies. Our revenue base would be less than $1 billion.

REP. KANJORSKI: One billion dollars?

MR. JOYNT: Less than that, 600 or 700 million dollars. That would be at its peak. So we're smaller than the other two.

REP. KANJORSKI: Right.

Now, in your testimony it seemed to say that you're really only giving an opinion here and you shouldn't be held for doing the due diligence that would support that opinion. Is that correct substantially?

MR. JOYNT: In the technical way or legal way that due diligence is described, yes, that's correct.

We do a lot of thoughtful research and analysis.

REP. KANJORSKI: Do you do a professional analysis and is it a professional study that you make or what? I think I saw in your written testimony that it's nonprofessional. Is that correct?

MR. JOYNT: I'm not sure I know the -- I believe that we're highly educated and do thoughtful analysis. How do you describe professional? I think we act very professionally. If that's a legal sort of characterization, I'm not sure.

REP. KANJORSKI: Okay. Well, do you think it's the responsibility of a rating agency to practice due diligence?

MR. JOYNT: No.

REP. KANJORSKI: It's not?

MR. JOYNT: No.

REP. KANJORSKI: Categorically not. So what would --

MR. JOYNT: Due diligence the way I understand it --

REP. KANJORSKI: Under the law.

MR. JOYNT: -- is a legal term, yes. I'm not a lawyer, so.

REP. KANJORSKI: Right.

Well, what would you say just off the cuff, not based on studies, that if the first payment of a mortgage wasn't made and if there were no records or support documents of income level, what likelihood would that reflect on the likelihood of default or failure of that type of a mortgage?

MR. JOYNT: Yeah, I would think that would be pretty poor.

REP. KANJORSKI: That would be a poor operation, right?

MR. JOYNT: I would think so.

REP. KANJORSKI: Would you be surprised that I'm in possession of a study with major insurance companies that bought mortgage securities that were AAA-rated by the three major agencies -- not all rating but in various amounts -- where in 1998 only 3 percent had a failure as a result of a defaulting on payments, particularly the first payment, and then in 2000, 4 percent failed to make and defaulted on the first payment, but that in 2007 15.6 percent of the mortgage holders failed to make the first payment on the mortgage? Would you find that remarkable if those figures came to your attention?

MR. JOYNT: Yes. Similar to -- I'm not an expert, of course, on mortgage finance, but having said that, I think we all recognize that the origination of riskier and lower-quality mortgages accelerated during the period of the mid-2005, (200)6 and (200)7. I think we all now see that more clearly.

We also have gone back and studied mortgages in securities that we've rated and feel like there was a significant incidence of poor originations and maybe significant fraud in the originations.

REP. KANJORSKI: Yeah. My time's run out. I just want to get this last question in, if I may.

Those facts, assuming those facts that I've related to you are correct, what would you recommend that -- the system that you would recommend that that kind of information could be made available and brought to the attention of Mr. Smith and his pension fund when he's making a purchase of securities?

MR. JOYNT: Very clearly we've stated that we think all the disclosure that can be made by anybody in the market that helps educate all investors -- and not just rating agencies but all investors -- should be supported. So I would be in support.

REP. KANJORSKI: Well, who's the agent or the person that should be responsible to make that report? Not you because you're not responsible for due diligence.

MR. JOYNT: I would think the issuer of the securities and/or their underwriter should be presenting the information that supports --

REP. KANJORSKI: And nobody is to check the authenticity or what material has been presented to anyone? In other words, liars get to keep their lies and get to benefit from their lies. Is that correct? We have no check and balance for that system?

MR. JOYNT: No, I would not suggest that. There are checks and balances.

REP. KANJORSKI: What is the check and balance?

If I'm the guy that's issuing the pool and 15 percent of the mortgages in my pool have failed to pay the first payment on their mortgage, who's supposed to tell Mr. Smith about that problem?

MR. JOYNT: There should be some kind of check in the system, some kind of expert --

REP. KANJORSKI: Well, knowing the system, is there?

MR. JOYNT: -- that can underwrite or re-underwrite those securities, those individual loans. It has not been our expertise. We've not developed expertise to underwrite individual loans in these securities.

REP. KANJORSKI: Sort of it's not my fault, it's Mr. Garrett's fault, is that what you're saying?

MR. JOYNT: That's not what I'm --

REP. KANJORSKI: Mr. Garrett, you're recognized for five --

REP. GARRETT: I missed that point. What was my fault? (Laughter.)

REP. KANJORSKI: He just blamed it on you.

REP. GARRETT: I know. I was blamed in the last election for a lot, so -- for this debacle. (Laughter.)

I thank the panel for your testimony.

Mr. Pollock, in your testimony you said an astounding thing. You said we would all like to have infallible knowledge of the future, but so we can how some -- assure credit ratings are accurate can't we guarantee having models that are right?

Well, apparently you haven't been coming to these hearings because we already are coming up with a model. It's called a systemic-risk regulator. And that individual or individuals is going to be able to do what the credit rating agencies and investors and everybody else have not been able to do and that is predict the future for all these -- for the future.

Do you have any comment?

MR. POLLOCK: I think your point is absolutely right, Congressman.

REP. GARRETT: There we go.

Let me just throw this out to the panel; Mr. Pollock and somebody else mentioned this earlier: As far as the regulator right now and we had a discussion earlier today on this matter with regard to who regulates the -- not who regulates the regulator -- who regulates the rating agencies, the SEC, and that they're out there doing the audits and what have you.

Does anyone on the panel have any comments on the SEC and their -- my opening comment was should we would have them here, maybe in a future hearing having them here, as them being the arbiter or the regulator of the industry?

You can say something nice about the SEC if you're worried that they're, you know --

MR. AUWAERTER: No, I think with the SEC they are the proper regulator. I question whether they have the resources to do it right now, to go out to the agencies and determine that the processes are working right.

MR. SMITH: I think also that in the '96 act -- or, I'm sorry, the 2006 act -- there were some restrictions put on the SEC that I think they're committed to doing a better job of regulating credit rating agencies if they're given the full range of powers to do so.

REP. GARRETT: And I'll just throw out the one idea: Is there anyone else out there -- I mean, banks have to deal with credit issues all the time so should we switch this over to bank creditors (sic) -- the banking regulators who look at this? Does anybody suggest that?

Sure, Mr. Pollock.

MR. POLLOCK: I just have a comment, if I may, on the banking regulators.

Of course, what's happened historically is increasingly the banking regulators have outsourced the credit judgment to the credit rating agencies.

Notably, as I think someone mentioned in an opening statement, due to the so-called Basel II capital requirements, which not only outsourced the credit decision but also the capital requirement decision to the ratings, I think you have to say on behalf of the rating agencies a lot of them commented that that was a bad idea, and it was a bad idea.

REP. GARRETT: Well, just very quickly sort of -- and it goes Mr. Dobilas on this, if I'm pronouncing it correctly -- Mr. Pollock, since we can't get an all-seeing all-knowing person out there and my question for the panel, if we have enough time, will be what do we really need -- what does the -- sort of this is along your line of questioning -- what do the agencies really need to be looking at in order to make the proper determinations? (Inaudible) -- even if we do away with the regulations, it really comes down to whether you have someone out there, whether they're regulator or not regulator, coming up with a methodology to try to do the best they possibly can to predict the future.

And then my question to follow on that, Mr. Dobilas, will be: How come according to your testimony you said that -- you alluded to the fact that even in the midst of this Realpoint has been able to issue accurate credit downgrades six to 12 months sooner than your largest competitors. How are you able to evaluate it better?

MR. POLLOCK: One important point is who is making a decision to hire the credit rating agency. An investor-paid rating agency has to convince investors that its ratings are worthwhile buying.

REP. GARRETT: Okay.

MR. POLLOCK: That's a really good check and balance right there.

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