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, eithe