November 12, 2002
BY ELECTRONIC MAIL
Mr. Jonathan G. Katz
Re: File No. 4-467
We set forth below Fitch's views on the role and function of rating agencies in the operation of securities markets provided in anticipation of the hearings on credit rating agencies scheduled for November 15 and 21, 2002.
Fitch Ratings traces it roots to the Fitch Publishing Company established in 1913. In the 1920s, Fitch introduced the now familiar "AAA" to "D" rating scale. Fitch was one of the three rating agencies (together with Standard & Poor's ("S&P") and Moody's Investors Service ("Moody's")) first recognized as a nationally recognized statistical rating organization (a so-called "NRSRO") by the Securities and Exchanges Commission ("SEC") in 1975.
Since 1989 when Fitch was recapitalized by a new management team, Fitch has experienced dramatic growth. Throughout the 1990's, Fitch especially grew in the new area of structured finance, by providing investors original research, clear explanations of complex credits, and more rigorous surveillance than the other rating agencies.
In 1997, Fitch merged with IBCA Limited, another NRSRO headquartered in London, significantly increasing Fitch's worldwide presence and coverage in banking, financial institutions and sovereigns. Through the merger with IBCA, Fitch became owned by the French holding company, Fimalac S.A., which acquired IBCA in 1992. The merger of Fitch and IBCA represented the first step in our plan to respond to investors' need for an alternative global, full service rating agency capable of successfully competing with Moody's and S&P across all products and market segments.
Our next step in building Fitch into a global competitor was our acquisition of Duff & Phelps Credit Rating Co., an NRSRO headquartered in Chicago, in April, 2000 followed by the acquisition later that year of the rating business of Thomson BankWatch. These acquisitions strengthened our coverage in the corporate, financial institution, insurance and structured finance sectors, as well as adding a significant number of international offices and affiliates.
As a result of Fitch's growth and acquisitions, it today has approximately 1,200 employees, including over 700 analysts, in over 40 offices and affiliates worldwide. Fitch currently covers 2,300 banks and financial institutions, 1,000 corporations, 70 sovereigns and 26,000 municipal offerings in the United States. In addition, we cover over 7,000 issues in structured finance, which remains our traditional strength.
The Role of Rating Agencies
Fitch is in the business of publishing research and independent ratings and credit analysis of securities issued around the world. A rating is our published opinion as to the creditworthiness of a security distilled in a simple, easy to use grading system ("AAA" to "DDD"). Explanatory information is typically provided with each rating.
Rating agencies gather and analyze a variety of financial, industry, market and economic information, synthesize that information and publish independent, credible assessments of the creditworthiness of securities and issuers thereby providing a convenient way for investors to judge the credit quality of various alternative investment options. Rating agencies also publish considerable independent research on credit markets, industry trends and economic issues of general interest to the investing public.
By focusing on credit analysis and research, rating agencies provide independent, credible and professional analysis for investors more efficiently than the investors could perform that analysis themselves.
Currently, we have over 3,200 institutional investors, financial institutions and government entities subscribing to our research and ratings and thousands of investors and other interested parties that access our research and ratings through our free website and other published sources and wire services such as Bloomberg, Business Wire, Dow Jones, Reuters and The Wall Street Journal.
Ratings are used by a diverse mix of both short-term and long-term investors as a common benchmark to grade the credit risk of various securities.
In addition to their ease of use, efficiency and wide availability, we believe that credit ratings are most useful to investors because they allow for reliable comparisons of credit risk across diverse investment opportunities.
Credit ratings accurately assess credit risk in the overwhelming majority of cases. Credit ratings have proven to be a reliable indicator for assessing the likelihood that a security will default. Fitch's most recent corporate bond and structured finance default studies are summarized below.
The performance of ratings by the three NRSROs is quite similar. We believe this similarity results from the reliance on fundamental credit analysis by the NRSROs and the similar methodology and criteria of all of the NRSROs.
Through the years, NRSRO ratings also have been increasingly used in safety and soundness and eligible investment regulations for banks, insurance companies and other financial institutions. While the use of ratings in regulations has not been without controversy, we believe that regulators rely on NRSRO ratings for the same reason that investors do: ease of use, wide spread availability and proven performance over time.
Although other methods can be used to assess the creditworthiness of a security, such as the use of yield spreads and price volatility, we believe that such methods, while valuable, lack the simplicity, stability and track record of performance to supplant ratings as the preferred method used by investors to assess creditworthiness.
However, we also believe that the market is the best judge of the value of ratings. We believe that if ratings begin to disappoint investors they will stop using them as a tool to assess credit risk and the ensuing market demand for a better way to access credit risk will rapidly facilitate the development of new tools to replace ratings and rating agencies.
The Credit Rating Process
We believe that for the most part credit rating agencies have adequate access to the information they need to form an independent and objective opinion about the creditworthiness of an issuer. While the rating agency exemption under Regulation FD helps to promote an uninhibited response to requests for information, the nature and level of nonpublic information provided to Fitch varies widely by company, industry and country. Nonpublic information frequently includes budgets and forecasts, as well as advance notification of major corporate events such as a merger. Nonpublic information may also include more detailed financial reporting.
While access to nonpublic information and senior levels of management at an issuer is beneficial, an objective opinion about the creditworthiness of an issuer can be formed based solely on public information in many jurisdictions. Typically, it is not the value of any particular piece of nonpublic information that is important to the rating process, but that access to such information and senior management can assist us in forming a qualitative judgment about a company's management and prospects.
It is also important that rating agencies not be inhibited in requesting information and thereafter subjecting that information to vigorous internal analysis and discussion. In that connection it is critical that the courts afford shield law and journalist privilege protection to rating agencies so that rating agencies are not unduly burdened by third-party discovery and the confidentiality of their deliberative processes are respected.
Another factor critical to the adequate flow of information to the rating agencies is the understanding that information can be provided to a rating agency without necessitating an intrusive and expensive verification process that would largely if not entirely duplicate the work of other professionals in the issuance of securities. Thus rating agencies do not perform due diligence and assume the accuracy of the information that is provided to them by issuers and their advisors. Since rating agencies are part of the financial media, we believe that our ability to operate on this assumption, and to exercise discretion in deciding how to respond to informational concerns, is protected by the First Amendment.
Conflicts of Interest
Fees. We do not believe that the fact that the issuer pays a fee to Fitch creates an actual conflict of interest, i.e., a conflict that impairs the objectivity of Fitch's judgment about creditworthiness reflected in Fitch ratings. Rather, for the reasons stated below and based on our experience, it is more appropriately classified as a potential conflict of interest, i.e., something that should be disclosed and managed to assure that it does not become an actual conflict.
By way of context, our revenue comes from two principal sources: the sale of subscriptions for our research and fees paid by issuers for the analysis we conduct with respect to ratings. In this we are similar to other members of the media which derive revenue from subscribers and advertisers that include companies that they cover. Like other journalists, we emphasize independence and objectivity because our independent, unbiased coverage of the companies and securities we rate is important to our research subscribers and the marketplace in general.
Fitch goes to great efforts to assure that our receipt of fees from issuers does not affect our editorial independence. We have a separate sales and marketing team that works independently of the analysts that cover the issuers. In corporate finance ratings, analysts generally are not involved in fee discussions. Although structured finance analysts may be involved in fee discussions, they are typically senior analysts who understand the need to manage the potential conflict of interest.
We also manage the potential conflict through our compensation philosophy. The revenue Fitch receives from issuers covered by an analyst is not a factor in that analyst's compensation. Instead, an analyst's performance, such as the quality and timeliness of research, and Fitch's overall financial performance determine an analyst's compensation. Similarly, an analyst's performance relative to his or her peers and the overall profitability of Fitch determine an analyst's bonus. The financial performance of analysts' sectors or groups do not factor into their bonuses.
Fitch does not have an advisory relationship with the companies it rates. It always maintains full independence. Unlike an investment bank, our fees are not based on the success of a bond issue or tied to the level of the rating issued. The fee charged an issuer does not go up or down depending on the ratings assigned or the successful completion of a bond offering.
Our fee is determined in advance of the determination of the rating and we do not charge a fee for a rating unless the issuer agrees in advance to pay the fee. While we do assign ratings on an unsolicited basis, we do not send bills for them. Any issuer may terminate its fee arrangement with Fitch without fear that its rating will be lowered, although we do reserve the right to withdraw a rating for which we are not paid if there is insufficient investor interest in the rating to justify continuing effort to maintain it.
Why Issuers Request Our Ratings. In the case of Fitch's corporate finance ratings, over 95% of the companies and financial institutions that we rate requested our rating (or the rating was requested by the company's financial advisors or investors) and agreed to pay our fee even though the entity is almost always already rated by both Moody's and S&P.
In structured finance, which accounts for over 50% of our revenue, we are frequently one of two rating agencies rating a security chosen by the issuer from among the three agencies.
In structured finance, issuers select us to rate securities because of the excellent reputation we have built for transparent, high-quality analysis, extensive research and comprehensive and timely surveillance. In the case of corporate finance ratings, we believe that companies, financial advisors and investors request a Fitch rating, and issuers agree to pay us to conduct our analysis, because of the equally strong reputation of our corporate and financial institutions research.
Issuers chose to use and pay for a Fitch rating because our independent research improves investor awareness, increases the liquidity of the issuer's securities and reduces the cost of funds. In corporate finance ratings, academic research also supports the value of a third rating showing that companies rated by a third rating agency improve their cost of funding.1
Disclosure. Charging a fee to the issuer for the analysis done in connection with a rating dates back to the late 1960s. It is widely known by investors. Fitch firmly believes that the disclosure of the arrangement by which an issuer pay fees to Fitch in connection with Fitch's ratings of the issuer is appropriate. Accordingly, Fitch currently discloses that it receives fees from issuers in connection with our ratings as well as the range of fees paid. This has been our practice for many years. We do not believe, however, that it is necessary or appropriate to provide disclosure of the specific fees or any more extensive financial disclosure. We believe that the specific fees we charge and the revenue we derive from other sources are proprietary and if known by our competitors, both of whom possess dominant market power in certain markets, would cause us competitive injury. We believe that the far more important disclosure is that the fee arrangement exists and the range of those fees.
Rating Advisory Services. We also understand that concerns have been expressed that additional conflict of interest issues are posed by rating agencies providing consulting or ratings advisory services.
By way of background, Fitch only recently introduced our Ratings Assessment Service. Since the introduction of this service in May of this year, we have performed only two assessments.
Traditionally, Fitch received inquiries from time to time from issuers and their financial advisors about the impact potential major corporate events such as acquisitions, recapitalizations and major asset sales might have on the issuer's rating. As with all reasonable questions raised by an issuer, the Fitch analyst receiving the inquiry would discuss the matter internally and attempt to provide the issuer with an indication of the likely effect the event would have on the rating. We considered this type of feedback to be a routine part of the rating process. The feedback was informal and uncompensated.
Over the past few years, issuers and their financial advisors frequently asked Fitch to provide them with a more definitive response to inquiries regarding the rating effect of major corporate events. Frequently, they also would request our views on multiple scenarios relating to these major events. These inquiries began to become more demanding in terms of the time commitment required to address the inquiries.
Both of our competitors (S&P and Moody's) have for sometime been offering a similar paid service to issuers. Several issuers and major financial advisors also told us that we were at a competitive disadvantage because we did not offer a ratings assessment service. After significant internal discussion, we launched our new service in reaction to issuer demand for more certainty in the process of assessing the rating impact of a major corporate event.
Fitch does not tell issuers what they have to do to get a specific rating. The engagement letter used for this service also asks the issuer to acknowledge that Fitch is not acting as its advisor in this process and that a material change in the information provided, transaction structure, economic environment or business conditions of the issuer may affect the final rating.
Based upon these procedures and the clear understanding of the issuer that the final rating can change if circumstances change, Fitch believes that it will be at complete liberty to issue a different final rating if circumstances change between the issuance of the conditional rating and the final rating.
We are, however, mindful of the need to assure the independence of our ratings and we welcome any suggestions as to how we might improve the rating assessment service to avoid or mitigate any potential conflicts of interest.
Competition and Barriers to Entry
Fitch believes that our emergence as a global, full service rating agency capable of competing against Moody's and S&P across all products and market segments has created meaningful competition in the ratings market for the first time in years. Fitch's challenge to the Moody's/S&P monopoly has enhanced innovation, forced transparency in the rating process, improved service to investors and created much needed price competition.
Academic research confirms our belief that innovations in the ratings industry have often "been initiated by the smaller rating firms [Fitch and its legacy firms], with the larger two [Moody's and S&P] then following."2 At Fitch, we are particularly proud of the work that we have done in the development of innovative methodologies to analyze new structured finance securities. These innovations in the securities markets have had substantial economic benefits. For instance, academic research has found that securitization has had a positive impact on both the availability and cost of credit to households and businesses.3
Fitch firmly believes in the power of competition. We also believe that there is always a demand for insightful, independent credit research. The NRSRO system is designed, appropriately in our view, to assure that recognized organizations possess the competence to develop accurate and reliable ratings and protect against the establishment of rating organizations that would haphazardly issue investment grade ratings to low quality securities at any time. Without a system to recognize rating organizations for their competence, many important capital adequacy and eligible investment rules used in financial institution regulation would be ineffective.
We believe that the SEC should formalize the process by which a rating organization is recognized. The criteria for recognition should include an evaluation of the organization's capability, resources and independence, use of the organization's ratings by market participants and studies of the performance of the ratings over time. We believe these are the reasons that market participants widely use NRSRO ratings, whether or not they are subject to regulations that refer to ratings. We also believe that the SEC should consider continuing the practice of limited recognition that acknowledges the special expertise of smaller organizations in selected areas of specialty such as the recognition of IBCA and BankWatch for their expertise in rating banking and financial institutions.
While the NRSRO system is often cited as a barrier to entry for new rating organizations, we believe that the debate over the NRSRO system ignores the single most important barrier to entry in the ratings market: the Moody's/S&P monopolies.
Moody's and S&P are a dual monopoly, each possessing separate monopoly power in a market that has grown to demand two ratings. Each engages in practices designed to perpetuate its market dominance and extend it to otherwise competitive markets such as structured finance. As we have publicly stated for more than a year, through their discriminatory practice known as "notching", Moody's and S&P are successfully altering competition in the commercial and residential mortgage-backed securities market by leveraging their monopoly position in other markets.
No matter what the ultimate outcome is in the debate concerning the NRSRO system, new entrants will have limited success competing with Moody's and S&P until their anticompetitive behavior is appropriately addressed. Despite a decade of effort, multiple mergers and millions of dollars of expense devoted to our effort to become fully competitive with Moody's and S&P, Fitch may still be marginalized in formerly competitive markets because of the monopoly power Moody's and S&P wield.
If the SEC wishes to address barriers to entry in the ratings market, the Commissioners should consider enacting rules prohibiting anticompetitive conduct by NRSROs and precluding NRSROs from discriminating against the ratings by other NRSROs for the purpose of preserving market share.
Please feel free to contact me here at Fitch if you have any questions regarding Fitch or this statement.