Written Statement of Raymond W. McDaniel
President, Moody's Investors Service
Before the United States Securities and Exchange Commission
November 21, 2002
The following statement is submitted by Moody's Investors Service ("Moody's") to the Securities and Exchange Commission (the "Commission") in connection with the Commission's hearings scheduled for November 15 and November 21, 2002 on issues relating to credit rating agencies and their role and function in the operation of the securities markets. Moody's commends the Commission for its in-depth examination of the parts played by various market participants at this juncture in the development of the U.S. capital market. We appreciate this opportunity to contribute our views to the discussion that is currently under way at the Commission regarding credit rating agencies.
Over the past two years we have witnessed several high profile corporate scandals and bankruptcies that have reduced confidence in the U.S. capital market. In hindsight, failures can be observed at multiple levels. Some market participants initiated market destabilizing acts, some were complicit in allowing them to occur, and some - notably market watchdogs, including rating agencies - either did not identify or did not judge the severity of certain actions in ways that would have maximized investor protection.
At Moody's, we are committed to providing the best quality credit assessments available in the global markets. For 100 years our culture has been based on a commitment to continuous learning, both from our successes and our mistakes. In this spirit, and in line with our statement before the United States Senate Committee on Governmental Affairs,1 we have undertaken substantial internal initiatives that have already begun, and will continue, to enhance the quality of our analysis and the reliability of our credit ratings.
Moody's believes that the examination of our industry is appropriate and that it will encourage best practices and support the integrity and legitimacy of our service. However, we note that public and private commentary about rating agencies reveals fundamental differences in the perspectives of commentators. We suggest that these differences stem from disparate views as to the proper role and function of rating agencies and ratings. As a result, we ask that in considering an oversight framework that would enhance rating agency services, the Commission remain mindful of three critical dynamics:
1. The basic attributes and limitations of our product:
Moody's ratings provide predictive opinions on one characteristic of a corporate entity's financial enterprise - its likelihood to repay debt in a timely manner. Among other factors, our ratings are primarily based on analysis of companies' financial statements, as well as on assessments of management strategies and industry position. Because of the nature of our analysis, it heavily relies on the quality, completeness and veracity of information available to us, whether such information is disclosed publicly or provided confidentially to Moody's analysts. Moody's role is not now, nor has it ever been, to search for and expose fraud.
It is crucial that our ratings be reliable in their aggregate probability assessments of credit risk. But however desirable, it is impossible for any single opinion to be "correct" or "incorrect" on a case-by-case basis.2 To judge the quality of any opinion about the future, including rating opinions, on such a basis is to place an inordinate burden on the fundamental nature of opinions. We strongly suggest that oversight measures look to promote the trustworthiness of rating opinions in the aggregate rather than on an individual basis.
2. Oversight should bolster the intended role and use of ratings:
In Moody's view, the main and proper role of credit ratings is to enhance transparency and efficiency in debt capital markets by reducing the information asymmetry between borrowers and lenders. We believe this function to be beneficial for the market as it enhances investor confidence and allows borrowers to have broader access to funds.
However, our ratings have a number of specific characteristics3 that have incrementally and over time encouraged their adoption across a wide range of functions. They have become tools employed by issuers, intermediaries, counterparties to financial and commercial contracts, large institutional investors and global regulators, among others. Each group has a different intended objective in using ratings. Thus the rating, which in essence simply rank orders debt instruments, has taken on multiple and sometimes conflicting roles and functions within the capital market. Further, the performance or "quality" of ratings has been subjected to multiple interpretations, in some cases incompatible with the stated purpose of ratings.
Oversight that bolsters the "quality" of the rating would necessarily differ depending on the role or function the rating is intended to fulfill. We respectfully submit that the primary role of rating agencies and ratings is to enhance the efficiency and transparency of debt capital markets and to protect investors, and ask that the Commission remain mindful of the differing approaches within the market as to:
3. The divergent needs and objectives of the various users of ratings:
"[S]ince the days of John Moody, the uses of credit ratings have evolved."4 While rating agencies have rightly been the subject of market critique and discussion, the various groups of market participants expressing views have different and potentially rivaling needs and goals, some of which are not primarily aligned with market efficiency or transparency or investor protection. For example, issuers use our ratings because many investors demand that they do so to access the capital markets. Not surprisingly, issuers would like higher ratings and greater control over the rating process. Large institutional investors often use our ratings in their portfolio composition and governance guidelines. Generally, these investors prefer stability in the ratings on securities that they own and disfavor rating actions that are subsequently reversed.5 Finally, governmental entities have incorporated ratings into banking, insurance, securities and other regulations to limit risk in financial institutions for the dual purposes of promoting investor protection and financial market stability.
These multiple uses of ratings result in the following conflicting opinions from the diverse users of our ratings:
- rating agencies act too slowly to lower ratings on deteriorating credits;
- rating agencies act too quickly to lower ratings, restricting companies' access to capital and causing credits to deteriorate;
- rating agencies are compromised by revenue derived from issuers and thus rate issuers too highly; and,
- rating agencies are overly conservative and rate issuers too lowly.
Given the contradictory implications of these critiques, it would appear that some commentators may be influenced by objectives other than market efficiency and transparency and investor protection. It is also possible that some commentators believe ratings should be able to serve market efficiency, transparency and investor protection while simultaneously serving a growing body of other uses and objectives.
In the remainder of our written statement we discuss those issues which the Commission has identified as meriting further examination: 1) the role and function of our ratings; 2) the information flow in our credit process; 3) conflicts of interests and abusive practices; and, 4) barriers to entry.
I. Moody's and Our Rating System
Moody's is a leading global credit rating and research firm with more than 800 analysts and offices in 17 countries around the world. Moody's products include in-depth research on major issuers, industry studies, special reports, and credit opinions that reach subscribers globally. Our credit research covers a broad range of debt totaling over $30 trillion, and our analysts publish research on approximately 85,000 corporate and government securities, 73,000 public finance obligations, 4,300 corporate relationships, and 100 sovereign nations.
Moody's has nine primary long-term debt rating categories.6 Investment-grade ratings range from a high of Aaa, down to a low of Baa. Ratings below Baa are considered speculative-grade. Moody's applies this long-term scale to ratings on other types of financial obligations and to companies. Moody's also assigns short-term ratings--primarily to issuers of commercial paper--on an independent rating scale that ranks obligations Prime-1, Prime-2, Prime-3 or Not Prime. In all, Moody's ratings are designed to provide a relative measure of risk, with the likelihood of default increasing with lower ratings.7 Moody's ratings reliably group bonds into similar classes of risk.
Investors are primarily concerned with relative value based on their investment horizon, the particular term and conditions of the debt, creditworthiness, pricing and the options that may be included in the bond.8 Accordingly, our credit ratings have traditionally provided one element in support of the investment decision-making process. As such, they help lower the aggregate costs of borrowing and lending and increase overall market transparency and efficiency for both issuers and investors. However, certain attributes of ratings have, over time, encouraged proliferation in the types of users and uses of ratings:
- Public dissemination. Because ratings are publicly available, information about issuers can easily and quickly be disseminated to broad and varying groups of users.
- Simplicity. Rating symbols distill much information into an easy to use symbol.
- Breadth of coverage. Moody's ratings exist on a large and diverse group of entities and debt instruments. Our service allows investors to assign an individual issuer or debt instrument into a credit risk class vis-à-vis the overall universe of debt issuers and instruments.
- Objectivity and independence. Moody's internal policies and procedures have mitigated the latent conflict of interest that is inherent in the rating agency business model. As such, our rating opinions are the product of analysis that is unbiased and trustworthy.
- Predictive content. The predictive content of our ratings has been consistently mapped and measured. Moody's and unrelated academics have published studies on the relationship between our ratings and credit defaults. Research has shown a strong relationship between Moody's ratings and actual default experience. Put simply, corporate bonds that have received higher ratings from Moody's default less frequently on average than lower rated bonds.
- Judicious rating process. Our ratings are arrived at through a rigorous and judicious process that tends not to react to transitory conditions in favor of longer-term considerations and ratings stability.
These attributes, however, must be weighed against the inherent limitation of ratings. While Moody's credit ratings have proven to be good predictors of creditworthiness, Moody's cannot represent our ratings to be -- nor should investors or other observers expect them to be -- performance guarantees. Ratings are expressions of opinions about the risk of outcomes in the future, not statements of historical facts. In the most basic sense, all bonds perform in a binary manner: they either pay on time, or default. If the future could be known, there would only be two ratings for bonds: good or bad. Because the future cannot be known, credit analysis resides in the realm of opinion. Thus ratings are, by nature, opinions about the future with degrees of uncertainty.
II. Information Flow In the Credit Process
In conducting our analysis prior to formulating a rating opinion, Moody's analysts will review publicly available information - for example, SEC filings - and will typically obtain additional information from numerous other sources9 and the issuer.10 Most issuers operate in good faith and provide reliable information to the securities markets, and to us. Yet there are instances where we may not believe that the numbers provided or the representations made by issuers provide a full and accurate story. As we neither have nor seek formal investigative authority,11 in such circumstances our analysts are encouraged to maintain a healthy degree of skepticism in considering the information gleaned from issuers, and we endeavor to use our judgement to produce the best ratings. Our only alternatives are to: build conservatism into the rating; refuse to assign a rating; or, in rare cases, withdraw an outstanding rating. We strive to avoid the two latter alternatives because we do not believe they usually best serve the objectives of market efficiency, transparency and market protection.
Although issuers are not obliged to provide information to us, in most instances they have proven to be an important source of input for our rating opinions. Our ability to consider sensitive information judiciously, and not to unnecessarily reverse ratings over short periods of time because we are "surprised" by new information, is highly valued by most market participants, including many regulatory bodies. Consequently, it is important that issuers be given the opportunity to discuss their business with us in an unfettered manner. For example, if issuers feel that they are prohibited from having confidential or hypothetical "what if" discussions with Moody's, we will be less informed, we will provide less timely market evaluations, and we will inevitably be more reactive and less considered in our rating analysis. Such reactiveness in ratings would increase volatility and decrease transparency in the capital market.
Issuers have historically been able to provide non-public information to rating agencies for the purposes of assigning or maintaining a rating. Recently, Regulation Fair Disclosure (Reg FD) expressly permitted issuers to continue to discuss confidential information with us.12 As a result, our ratings at times incorporate information that is not public. In such circumstances, we do not disclose the actual non-public information itself. Rather, if in our opinion the non-public information impacts the risk profile of an issuer or a debt instrument, it will be reflected only in our public rating. Our underlying motivation is to strike an appropriate balance between receipt and preservation of confidential information (allowing judicious rating decisions), with serving market efficiency, transparency and investor protection by providing an independent and up-to-date risk assessment.
When Moody's takes a rating decision, the issuer is contacted and informed of Moody's imminent intent to publish that rating decision. As part of the process, Moody's provides the issuer with a copy of the draft press release announcing the rating decision. The draft press release will include the rating action and our reasoning for the rating action. The issuer then has a brief opportunity to review the draft press release to verify that it does not contain any inaccurate or non-public information. The issuer may be dissatisfied with the rating outcome but the decision will be made public unless the issuer provides us with new material information.13 The press release, detailing any rating action, is available on our web-site for the following three days. After that, the ratings as well as the rating history can easily be accessed through our web-site.
III. Potential Concerns Regarding the Role of Credit Rating Agencies: Conflicts of Interest / Abusive Practices
Moody's generates a substantial majority of our revenue from rated issuers. As such, the system embeds latent conflicts of interest, as exist, for example, with financial news publications that solicit advertising business from companies about which they report. We strongly believe, however, that the issuer-fee based structure of the ratings business is supported by fundamental market mechanics and is critical to the operation of ratings. Regardless, Moody's acknowledges that such conflicts deserve examination and must be effectively managed.
The market in which Moody's and other credit rating agencies operate is different from most markets because the purchasers of ratings are not the primary consumers of ratings. Issuers purchase our credit ratings, but they do so because investors use and therefore need ratings. Yet investors are less motivated to purchase individual ratings than are issuers. Because ratings are made publicly available, investors have free, unfettered access to all ratings. Investors also have a broad choice in the selection of investments, and so are most interested in the general application of ratings, rather than in a rating on any single bond. They simply lack the incentive--and in the case of small investors, the capacity--to finance the operations of credit rating agencies on an issuer-by-issuer basis.14 Issuers, on the other hand, do have the incentive to pay for credit ratings because they do not have the same flexibility in obtaining capital that investors have in deploying capital. An issuer must sell its security to investors, and issuers know that investors demand credit ratings. Thus, the rating agency business model based on issuer-fees is determined by basic market mechanics specifying the entity willing to pay for a rating,15 and the requisite human cost of fundamental credit analysis.
To maximize market confidence and properly fulfill their role, rating agencies must effectively mitigate the latent conflicts in the business model. Among the elements of Moody's management of the rating system that foster and demonstrate objectivity are:
- Fundamental principles of Moody's ratings. Moody's has adopted and publicly disclosed certain fundamental rating principles:
- The level of ratings is not affected by a commercial relationship with an issuer;
- Moody's will not forebear or refrain from taking a rating action based on the potential effect of the action on Moody's or an issuer;
- Rating actions will reflect judicious consideration of all circumstances influencing an issuer's creditworthiness; and
- Rating decisions are taken by a rating committee and not an individual rating analyst.
- Little customer concentration. No issuer family represents more than one and one-half percent of Moody's annual revenue, and the vast majority represent less than one quarter of one percent each.
- Annual "report card." The predictive content and performance history of Moody's ratings is measurable, measured, and published each year-both in the form of Moody's Default Studies, and through third-party academic analysis and commentary.
- Rating changes. Despite the issuer-fee based business model, actual global performance over the last 18 years shows that, on average, 15% of issuers experienced downgrades annually versus only 9% of issuers that experienced upgrades.
- Market discipline. The market reviews the work of rating agencies on a daily basis.
- Fixed fee schedules. In general, Moody's charges fees according to written schedules; fees are disclosed in writing as part of the rating application.
- Industry structure. The small number of rating agencies serves to ameliorate the risk of threats by issuers to "rating shop." Rating shopping describes instances where an issuer refuses to engage in discussions with an agency that gives a less favorable perspective on an issuer's creditworthiness and instead "takes its business" to agencies that provide the highest ratings. Because the current industry structure minimizes rating shopping, rating agencies can conduct their activities to preserve the integrity of their ratings and long-term reputations and effectively resist short-term issuer demands.
- Separation of the analyst from the business relationship. The analyst is discouraged from being a party to discussions regarding payment or prices. A separate group within Moody's handles such matters. That group involves the Team Managing Directors ("TMDs"), who are involved in the rating process, as necessary.
- No relationship between analyst compensation and revenues from rated issuers. Analysts are not compensated based on the revenues associated with the companies that they rate.16
- No analyst-specific conflicts of interest. As a matter of policy, rating analysts are not permitted to hold or trade in the securities of issuers that they analyze, apart from holdings in diversified mutual funds.
- Protection of the credit process regardless of issuer payment status. Unpaid published ratings are subject to the same standard of analysis and rating committee process as paid ratings.
- Disclosure prohibition. Analysts are required not to disclose any confidential information to any third party and to sign a confidentiality agreement, ensuring that they are aware of this requirement. In addition, analysts are required not to trade securities based on non-public information and each analyst is required to submit a securities compliance form on a quarterly basis. The completion and content of such forms is monitored internally. Violation of these policies is subject to disciplinary action, including termination of employment.
IV. Potential Barriers to Entry / Regulatory Treatment
Throughout its examination, the Commission has expressed an interest in evaluating whether the appropriate level of competition exists among credit rating agencies. Moody's appreciates the Commission's concern for an appropriate industry structure and an appropriate level of competition within the industry to promote the objectives of market efficiency, transparency and investor protection. We believe that vigorous competition has advantages and disadvantages in promoting these primary objectives.
In considering competition issues, Moody's asks that the Commission view them in the context of the unique dynamics of the credit rating agency industry. As explained above, Moody's and the other credit rating agencies operate within a framework wherein our ratings are used by entities with opposing goals and desires. Investors associate "quality" with the most reliable ratings, while issuers associate "quality" with the highest (plausible) rating possible.17 Furthermore, most market participants, and issuers in particular, express no desire to invest in many ratings on a single instrument. Currently, there are important costs of executive time to obtain a rating. What issuers desire is greater ability to select among ratings providers for purposes of having greater control over the rating outcome, which they perceive will positively influence the marketability of their debt. Therefore, only a limited number of agencies will attain an issuer's business, regardless of the aggregate number of ratings competitors.18
Considering the unique dynamics of our market, historically new market entrants and marginal participants have sought to make their products more attractive to issuers by offering higher ratings than do more established market participants.19 Some new entrants might be inclined to try to compete in this manner because of the ease with which such a strategy could be implemented and the short-term benefits that might accrue to the entrant as a result. Therefore, Moody's believes that the usefulness of credit ratings in the aggregate for market efficiency, transparency and investor protection would decline in the event that more Nationally Recognized Statistical Rating Organizations ("NRSROs") are established and rating levels become a more important element of competition within the industry. The effectiveness of some uses of ratings in regulation, particularly those that depend upon absolute levels of ratings, such as investment grade and non-investment grade, would also decline.
Professor Steven L. Schwarcz of Duke University in a recent law review article20 has described rating agencies as private providers of a public good, the assessment of creditworthiness in public debt capital markets. We are not aware of examples of beneficial competition among privatized regulators and urge the Commission to carefully consider the appropriate basis of competition. We believe that the current industry practice where most securities receive ratings from at least the majority of the currently authorized NRSROs preserves high professional standards and discourages inappropriate competition among rating agencies, as has effected other market "watchdogs."
This is not to suggest that Moody's ratings would deteriorate if the Commission designates more NRSROs and competition within the industry is more based on rating level-- in fact, we would do everything possible, consistent with continuing business viability, to maintain ratings quality. In addition, over the long-term, it may well be unlikely that a strategy of ratings inflation would be successful due to the importance of the credibility of ratings with investors. Accordingly, Moody's does not view this prospect as a significant threat to our business. We raise the issue only to highlight the potential harm to investors, and the market as a whole, if the structure of our industry and the nature of competition within the industry are not considered without specific attention to the inherent tensions among users of credit ratings.
* * * * *
As the Staff of the Senate Governmental Affairs Committee said in a recent report, "[i]f history is a guide, credit rating agencies generally get it right."21 Moody's long history as a leader in the credit ratings business demonstrates the success of the methodology employed by our analysts. In making our rating decisions, we apply accounting, economic, financial, and industry-specific knowledge in evaluating publicly available information, including SEC filings and audited financial statements, and financial and other information voluntarily disclosed by issuers.
Our approach to ratings is consistent but it is also flexible enough to meet the demands of the constantly evolving markets that we cover. We ask that the Commission consider this flexibility in deciding whether and in what manner to increase oversight of our business. Any regulation that requires application of a specific methodology in arriving at ratings may make rating agencies less able to react to future credit events. The issues that have led to the current crisis in the markets--corporate governance, accounting fraud, ratings triggers, etc.--have been identified, and Moody's continues to adopt reforms to better address these issues. It is likely that the difficult issues that will confront credit rating agencies in the future will be different from those in the public eye today, and it is imperative that credit rating agencies retain the flexibility necessary to meet these future demands.
In closing, Moody's would like to thank the Commission for the opportunity to participate in these important proceedings. Moody's welcomes this opportunity to work with the Commission in its examination of credit rating agencies and their role and function in the securities markets and we are eager to assist the Commission in any way possible going forward.
|1|| See Rating the Raters: Enron and the Credit Rating Agencies, Hearing Before the Senate Governmental Affairs Committee, 107th Cong., S. Hrg. 107-471 (March 20, 2002).
|2|| For example, while the vast majority of Baa securities pay off certain Baa securities default. Neither result is "wrong" per se. But an issuer with a Baa rating whose bonds do in fact pay off will argue that their securities were rated too low, just as an investor holding the rare defaulted Baa security would argue that the rating was too high.
|3|| As we will discuss in greater detail below, these attributes include: predictive content; expression as easy to use symbols; and public and wide, free dissemination.
|4|| See Financial Oversight of Enron: The SEC and the Private Sector Watchdogs, Report of the Staff to the Senate Committee on Governmental Affairs, at 100 (Oct. 8, 2002) (emphasis added).
|5|| Portfolio guidelines as adopted by many institutions can cause investors to sell securities, sometimes into unfavorable market conditions. As a result, portfolio managers desire stability in ratings to avoid potential trading losses from rule-based trading actions.
|6|| Our rating categories were originated in 1909.
|7|| The lowest expected probability of default is at the Aaa level, with a higher expected default rate at the Aa level, a yet higher expected default rate at the single-A level, and so on down through the rating scale.
|8|| The most common option is the right of the issuer to call the bond, which, if exercised, transfers value from the investor to the issuer.
|9|| Such as: macroeconomic analysis, industry-specific knowledge, and legal and regulatory environment.
|10|| Including site visits and reviews of management projections and strategy.
|11|| Other entities are better equipped for the job of policing the accuracy and honesty of the financial and other information that companies provide to the public.
|12|| See 17 C.F.R. § 243.100(b)(2)(iii). Reg FD was intended to correct a specific perceived market abuse by equity analysts, that is: selective disclosure. The exemption granted to rating agencies and journalists merely preserved the status quo ante. The Commission in essence granted the exemption: i) to avoid First Amendment challenges; ii) because neither rating agencies nor journalists were selectively disseminating information; and, iii) absent the exemption, investors would receive lower quality opinion from both the rating agencies and the media.
|13|| If the issuer informs Moody's that there is new material information available, Moody's will temporarily refrain from releasing the rating decision and assess the materiality of the new information. Such "appeals" are rare and only occur when questions of fact are outstanding or in dispute.
|14|| Economists call this a "collective action" problem.
|15|| That is to say, the public availability of ratings for investors combined with the relative indifference of investors versus issuers to the absence of a rating on any single bond.
|16|| Analyst compensation consists of: base salary, annual bonus and Moody's Corporation stock options. The annual bonus is based on: (i) assessment of analyst individual performance; (ii) the distribution of relative performance assessments; and (iii) Moody's Investors Service performance relative to annual budget.
|17|| It is possible that a higher rating will provide lower cost funding options for the issuer. It is also possible that a low rating will potentially increase the cost of funding for the issuer, or in certain cases deny the issuer access to certain markets.
|18|| This is especially true if assignment of unsolicited ratings is discouraged in the marketplace.
|19|| See Richard Cantor & Frank Packer, The Credit Rating Industry, Federal Reserve Bank of New York Quarterly Review (Summer/Fall 1994). We note that Richard Cantor is presently an employee of Moody's.
|20|| See Steven L. Schwarcz, Private Ordering of Public Markets: The Rating Agency Paradox, 2002 U. Ill. L. Rev. 1 (2002).
|21|| See Financial Oversight of Enron: The SEC and the Private Sector Watchdogs, Report of the Staff to the Senate Committee on Governmental Affairs, at 99 (Oct. 8, 2002) (emphasis added).