LACE Financials answers to Concept Release: -Rating Agencies and the Use of Credit Ratings under Federal Securities Laws

#1 Eliminate NRSRO designation? No, but eliminate the designation from commission rules where possible.

#3 Advantages and disadvantages of allowing broker-dealers to use internally developed credit ratings to determine capital changes.

#3 (a) Brokers and dealers should have their own risk management systems with a credit risk officer. Most larger corporations in the U.S. currently already have these systems.

(a) The use of firewalls is not a good idea because of the large sums of money involved. Investors are likely to incur large losses due to abuse.
(b) Each quarter broker and dealers asset values should be determined at book and market values and adjustments to capital should be made on the difference.
(c) If brokers and dealers are allowed to issue credit ratings the SEC should consider:
(i) would this not lead to a conflict of interest?
(ii) Would brokers have a competitive advantage over other rating agencies?

#9 Possibly discontinue NRSRO designation, should another agency recognize NRSROs.

I do not believe that NRSRO designation should be discontinued. The SEC, given its' role in securities markets is the best agency to handle NRSRO designation but it needs to do a far better job. I would suggest:

(a) That the Commission make the decision on NRSRO status rather than the Division of Market Regulation;
(b) That staff handling NRSRO applications have MBA's, degrees in finance and experience in finance, rather than law degrees.

#10 Could the NRSRO designation be eliminated from some Commission rules.

(a) The use of the net capital rules should be re-evaluated by the SEC. It is a major barrier to entry for a new rating firm.
(b) The affects of NRSRO designation goes far beyond SEC Commission rules. States, municipal governments and corporations have in their by-laws restrictions on the purchase of securities, extension of credit or placement of deposits in banks that do not have investment grade ratings by NRSRO companies. Ratings issued by non-NRSRO companies, are not considered and their use prohibited. Such rules put non-NRSRO companies at a serious competitive disadvantage.

Question #12 The term "widely accepted" as an issuer of creditable and reliable ratings is very subjective-what does widely accepted mean? LACE Financial provided the SEC with over 50 letters written from national corporations in 1995, that they recognized us as a creditable rating organization. Five years later, with no mention of receiving these letters, the SEC denied our application.

Your suggestion that "recognition be conditioned on a credit rating agency documenting that it has been retained to "rate securities" issued by a broad group of well-capitalized firms"should be changed where the words "retained to rate securities issued" be changed to "as an issuer of credible and reliable ratings." These are the same words stated in the first sentence of question #12.

The SEC needs to recognize that NRSRO rating business goes far beyond that of rating new issues of stocks and bonds. Derivative contracts are in the trillions of dollars and credit ratings are used to rate the counter parties. LACE Financial provides credit ratings on the largest companies that are involved in this business for the last 19 years. Although LACE Financial is involved in rating securities we feel the SEC should also recognize that issuing credit ratings of large corporations is as important as issuing security ratings.

What is ironic about the last part of this question, because of the barriers to entry your net capital rules and your recognition criteria impose, it is not likely that new companies will be able to get to a point where they will be able to rate new issues of securities. It has taken LACE Financial 18 years before it was able to rate new securities.

#13 (a) At a minimum, should each NRSRO have rating procedures designed to ensure that a similar analysis is conducted for similar situated issuers and that current information is used in the rating agency's analysis? Yes, yes and yes.

#13 (b) Should each NRSRO use uniform rating symbols, as a means of reducing the risk of marketplace confusion? Yes, LACE Financial has adopted Standard & Poor's for new issue ratings and I believe most rating companies have adopted LACE Financial rating symbols for credit ratings.

#13 (c) At a minimum, should each NRSRO have rating procedures designed to insure that a similar analysis is conducted for similarly situated users. I believe this would be very dangerous because the differences in rating instruments, types of companies and types of issuers. Just within the banking industry you have about 30 different types of banking organizations. Would you have the same criteria to rate Citigroup, a bank with $10 million asset size banks, a credit card bank, a savings bank, a German Landesbank etc.

What would be the affects of changing LACE's criteria to new criteria?

LACE financial rates 20,000 institutions, suppose the requirements significantly change the ratings of these companies - the market reaction could have disastrous effects. For example, when LACE Financial dropped a New York bank's rating to a "D" the city of New York and the state of New York withdrew their deposits, the then Chase Manhattan Bank withdrew a 100,000 C.D., the FHLB of New York withheld its membership, and several large New York city Corporations stopped doing business with the bank.

Although I believe oversight of NRSRO companies is necessary, however the power to tell rating agencies what to do should evolve slowly as the SEC gains experience in this area. At the very least the SEC should establish a procedure that provides a means for which investors and companies being rated can register complaints. There should be some kind of review process with the rating agencies to discuss the complaints and Congress should provide the SEC with the power to penalize rating companies for serious wrong doings. Regulation must take into consideration the rating companies revenue size. Costly regulation could become a barrier to entry and high regulation costs could drive new NRSRO's out of business.

#14 should the extent of contacts with management of issuers (including access to senior level management of issuers) be used as a criterion for NRSRO status? For new issuers of securities and debt the answer should be yes. For credit ratings the answer should be no. If this criterion is established for credit ratings we will have to stop issuing credit ratings for 20,000 institutions because of the cost it will incur and since we do not charge the institutions for their ratings. The criteria are also a barrier to entry because the existing NRSRO's have such a dialog because of their market power. The large NRSRO's will say this is very important - but is it? How did this help them with Enron, WorldCom and the two Resona banks, Asahi bank $195.7 billion and Daiwa Bank $110 billion in asset size?

Question #15 To the extent a credit rating agency uses computerized statistical models, what factors should be used to review their models?

There are two parts to this question (1) what factors should be used to review the models and (2) who is the reviewer? Factors; I assume one is referring to the major determinants of financial soundness, which are the LACE variables of Liquidity for financial institutions and cash flow for most industrial companies, asset quality for financial institutions and evaluation of asset worth for industrials, capital for all institutions and earnings for all institutions. The four above variables need to be adjusted for risk. The LACE model, is based on Doctoral research ( Barron H. Putnam, "An Empirical Model of Financial Soundness: A Case Study for Bank Holding Companies", PhD dissertation, George Washington University, Washington D.C. February, 1983.) This research was used by the three Federal Bank Regulators from 1983 through 1993 and--by shifting bank examination resources from well rated banks to poorly rated banks--saved hundreds of banks from failing and millions of dollars of taxpayer money. The model has been used by LACE Financial to issue 1.2 million credit ratings over 19 ½ years. During this period LACE Financial has never had a threat of a lawsuit, nor a regulators complaint. Who is qualified to tell LACE Financial that this model should be changed?

The SEC must realize that computer models greatly aid the rating process. Computer models provide consistency to the rating process, they help expedite the rating process by compiling large amounts of information to aid the analyst and they lower the cost of rating an institution, in a "competitive industry".

Although LACE Financial may be considered a primary user of statistical models, all companies are analyzed by several financial analyses before the rating was established. (This process was shown to the SEC staff when they reviewed our rating operations in Frederick, Md.)

#16 should the size and quality of the credit rating agency's staff be considered when determined NRSRO status. I believe the staffing level is much less important than the quality of the rating staff. If a company is in business for a reasonable time period (our case 19 ½ years) and can prove to the SEC that it is a creditable rating service for large national and international companies (as we have) then size should be of little importance. I feel my qualifications to rate financial institutions far exceed any persons at any rating agency. Our staff size, that rates banks is not much different than those that specialize in this area at the other rating agencies and was certainly larger than the staffs of the three largest NRSRO's when they entered the bank rating business. What good is size if you can't get it right?

#19 Should the Commission consider a credit rating agency's financial resources as a factor in determining NRSRO status. What is more important: how much money a company has or whether it has been able to stay in business when three NRSRO companies could not. The SEC should recognize that rating certain instruments can be very specialized and in many cases there are only a few individuals that may have the knowledge to provide these services. For example, LACE Financial has a Commercial Capacity Rating Service that rates the largest amount of Commercial insurance that a Title Insurance company can issue and stay in business if there is 100 percent claim. As far as we know, this is the only service of its kind in the world and basically one Senior Financial Analyst (MBA) in finance at LACE oversees the service. Should this service be eliminated because of size? Should we add more analysts to do the job that requires only one analyst?

#20 should a rating agency that confines its activity to a limited sector of a debt market be considered for NRSRO recognition. Yes, as long as those who use its services feel it is issuing creditable ratings and has a verifiable track record. This is how new rating services get started.

#21 Should the Commission consider a provisional NRSRO status for rating agencies that comply with NRSRO recognition criteria but lack national recognition. No. New entrants need all the help they can get to go against the established market power of the large existing NRSRO's.

#22 Should the Commission develop supplemental criteria to evaluate ratings quality that would be applicable to both rating agencies performing traditional fundamental credit analysis and those primarily reliant on statistical models?

No. I do not believe that this can be done; please see answers to question #21.

#23 I believe it is more important to apply these criteria to existing NRSRO's than as a condition for NRSRO status.

#24 Yes. The SEC should be very careful in setting standards for they could kill industry objectivity and innovation.

# 25 Should recognition of NRSRO's occur through Commission action Yes. The staff of the Division of Market Regulation has made the past decisions that have resulted in the current condition of the rating industry. The decision for NRSRO status is far too important to be made at the staff level. This staff held up LACE Financial's application for NRSRO status for eight years and then denied it with out clear reason. We feel they never fully understood the use or importance of credit ratings and took an adversary position towards our company. It is our opinion, that the staff of the Division of Market Regulation has a negative opinion towards creditable companies trying to obtain NRSRO status and has a definite bias towards the status quo.

# 26 should the Commission publicize applications for NRSRO and seek public comments on the credibility and reliability of the applicants ratings. LACE Financial, as an applicant would not have a problem if this were done. If public comment is asked about new entrants then it should also be asked concerning existing NRSROs. It is very likely that existing large NRSROs would receive on the average more negative comments than positive ones. What would the SEC do about this?

#27 should the Commission establish a time period to serve as a goal for action on application for NRSRO recognition. Yes. A 90-day time period would seem reasonable possibly and extending it 90 days if there were problems with application.

I believe that the SEC must first decide whether new creditable entrants are good for the industry. If so, then there should be a mindset change or staff changes within the Division of Market Regulation and a proactive policy of working with applicants to meet SEC requirements. No U.S. Government Agency should be allowed to hold an application for eight years and never provide them with written information on the status of the application.

# 28 Examination oversight of NRSROs

The approach to regulation by the SEC should be well thought out. Involvement by the SEC should be based on the amount and seriousness of complaints. Over regulation will certainly hurt the industry and particularly the smaller companies and force consolidations.

Creditability is everything in the rating business - if you are not creditable, no one will use your services unless there are no alternatives.

# 30 It is difficult to answer this question without knowing what the NRSRO criteria are. Filing annual certifications seems very bureaucratic.

# 31 Should the Commission solicit public comment on the performance of each NRSRO, including whether the NRSROs ratings continue to viewed as credible and reliable.

I believe that soliciting public comment on the performance of NRSROs could lead "too much to do about nothing" and possibly lead to the creation of an unneeded bureaucracy at the SEC. Why not allow for complaints to be registered on the SEC website concerning NRSRO ratings and the rating agencies could be called upon to address the complaints by the SEC. Violation of laws could be forwarded to the Justice Department. If the SEC plans to revoke NRSRO status, they should be prepared to apply the punishment equally to both large and small NRSRO companies.

# 32 No.

# 33 If NRSRO's are subjected to the "Advisers Act", it should be amended to be relevant to the business of NRSRO's.

# 34 Yes

# 35 (a) Are there minimum standards or best practices to which NRSROs should adhere. No. I say no only because this does not seem practical and could be a waste of a lot of resources.

  (b) Would it, or would it not, be a productive use of Commission resources to develop the expertise to, e.g. issuers related to the quality and diligence of the rating analysis. The SEC certainly needs greater expertise in understanding the rating industry which may lead to a mindset change shifting from protection of the status to that of bringing about more competition, better ratings and most importantly lower prices.

#36 If a currently recognized NRSRO gave up its NRSRO recognition because of concerns regarding the regulator and liability environment, what effect, if any, would that have on the market.

If one of the two largest companies gave up NRSRO status the other large one would likely follow and it would be business as usual because of their market power. These companies are entrenched and I believe act as a duopoly. If Fitch were to drop its NRSRO status, much of the business would go to the other two largest companies. New entrants would be hurt considerably and their business would go to existing NRSRO companies. High cost of regulation may dissuade new entrants from accepting NRSRO status and they will remain niche players and not grow to compete with the larger raters. LACE Financial cannot accept NRSRO status if regulatory costs take away a significant amount of the profits that are needed for the development of services.

# 37- 41 Conflicts of Interest LACE Financial, as an applicant for NRSRO status, feels comfortable if the SEC sets up rules to prevent conflict of interest. However, conflict of interest should apply to existing NRSROs as well as new entrants. What concerns us most is a high cost of record keeping since we rate 20,000 institutions. The SEC has to be careful, such that it does not create another barrier of entry to the industry in the form of regulatory costs.

# 42 should NRSRO recognition be conditioned on a rating agency having adequate financial resources (e.g. net assets of at least $100,000 or annual gross revenues of at least $1,000,000 to reduce dependence on individual issuers or subscribers.

The SEC needs to consider that new entrants are likely to be small and specialized. One million in revenues means nothing if you have large losses. Having $100,000 in net assets I believe is fair. Because of the market power of existing NRSROs and existing barriers to entry, it will be difficult for new entrants to reach $1 million in revenues.

# 43 When a new rating agency begins its business, it is likely to exceed the 3% level since it only has a few clients.. this limitation would be more appropriate for larger NRSROs. Again, there is a concern that this could become a regulatory burden.

# 45- # 48 Anti- Competitive Practices

An economist who specializes in industrial organization can tell you that anti-competitive practices can only occur with significant market power. Such concerns should be addressed to the two largest NRSROs and not to new entrants.

Using unsolicited ratings and indicating that payment of a fee will result in a higher rating is extortion and illegal and this should be the concern of the Justice Department.

Information Flow

# 49 Yes, in the form of guidelines to existing NRSRO's and new entrants.

# 50 No, for regulatory burden reasons.

# 51 No, for regulatory burden reasons.

# 52 Should NRSRO recognition be conditioned on a rating agency disclosing whether or not an issuer participated in the rating process.

This I believe is standard procedure in the industry for new issue ratings. To prohibit new NRSRO's from this practice, would prohibit them from issuing ratings on new issues. This could become a new barrier to entry by the SEC that would be 100% effective concerning new issue ratings.

# 53 No. Should NRSRO recognition be conditioned on a rating agency's agreeing to public dissemination of its ratings on a widespread basis at no costs, as is currently the case.

The phrase "as is currently the case" is not true. The three large NRSRO companies do not release all their ratings and sell them as service as does LACE Financial. The three large NRSRO's make the majority of their revenues by exchanging money for rating an institution. If the SEC is concerned about a conflict of interest in the rating industry this is where they should be focusing. Investors and creditors pay LACE Financial for their rating services. Although LACE does not provide these free to the public it issues a service, (used primarily by libraries), that contains ratings for 20,000 institutions. The service is sent out four times a year for $370. If someone wants a rating on a domestic institution the rating cost $85 and $100 for a foreign institution. If any institution that we rate calls for their rating is given to them free of charge.

# 54 Yes, for new issue ratings - notification could be put on their website. No for credit ratings because of the large amount of institutions we rate. Since LACE Financial does not charge for credit ratings, we have always reserved the right either to rate or not rate an institution.