Senate Hears Testimony on Credit Rating Agencies

By W. Bernard Mason

On August 5, 2009 the Senate Committee on Banking, Housing and Urban Affairs held a hearing entitled “Examining Proposals to Enhance the Regulation of Credit Rating Agencies”. The Committee heard from two witness panels. The sole witness on the first panel was Michael Barr, Assistant Treasury Secretary for Financial Institutions. The second panel consisted of: John Coffee, Professor of Law, Columbia University; Lawrence White, Professor of Economics, New York University; Stephen Joynt, President and CEO, Fitch Ratings; James Gellert, President and CEO, Rapid Ratings; and, Mark Froeba, Principal, PF2 Securities Evaluations, Inc.

Committee Chairman Christopher Dodd (D – CT) opened the hearing by pointing out two areas that he felt were primary problems causing the current crisis: the first was the marketing of unacceptable loan products that mortgage originators knew would never be repaid at fully indexed rates and the subsequent securitization and sale of these products and the receipt of substantial compensation for doing so; and, the failure of the credit rating agencies to properly evaluate and rate these products for the use and benefit of investors. He said instead of helping investors understand risk, these organizations were “hiding” risks. He wondered if the credit rating agencies were even needed in today’s environment.

Ranking Member Shelby pointed out The Credit Rating Reform Act, passed in 2006, was intended to address the perceived weaknesses in the credit rating agency system and in the Nationally Recognized Statistical Rating Organization (NRSRO) process administered by the SEC. He said this legislation was not enacted until 2007, too late to deal with the problems already existing in the system. He remarked that in considering new measures, “every option should be on the table”. He stated that he believes the rating agencies played a “pivotal role” in the collapse of our financial markets.

Senator Dodd began his questioning of Secretary Barr by stating his amazement to discover that the rating agencies, in many cases, do not verify the underlying information presented to them before assigning ratings and asked if it would not be appropriate to require such verification. Mr. Barr said he believed it would be inappropriate for the government to design a particular methodology; he said the primary issue is disclosure and transparency so that, if no independent verification has been performed, potential investors clearly understand that situation.

Senator Shelby asked what could be done to bring back investor confidence, since the NRSROs have failed so badly. He said the SEC had given considerable confidence to these rating agency firms, so what should be done now that that confidence was misplaced? Secretary Barr said there should be greater competition, with more entrants into this activity and more diversity of approach. Mr. Barr said the Administration wants to reduce regulatory agency reliance on these agencies by removing regulatory requirements that require NRSRO ratings.

Senator Bob Corker (R – TN) observed that we have just witnessed the worst regulatory failure in 30-40 years and regulators outsourced oversight of the securitization market. He marveled that the Administration wants to specifically dictate consumer financial products but only seeks transparency with respect to credit rating agencies. Mr. Barr first clarified that the Administration was not proposing that the government dictate specific products, only that a standard, easily understood product be part of a financial institution’s array of product offerings. He said in dealing with these consumer issues, we are assuming unsophisticated customers who need more specific protection. With respect to the securitization market, investors are more sophisticated and this market would benefit more from clear and complete disclosure. Senator Corker then asked where the Administration stands with respect to the question of who pays for the services of the NRSROs. Mr. Barr said he believes it makes sense to have different payment models. He said the goal is to reduce reliance on these credit ratings, but it will take time to develop alternatives. Senator Corker then asked if it would be wise to require the NRSROs to have “skin in the game” with respect to the performance of the securities they rate. Secretary Barr said he believes that would be beneficial.

Senator Mark Warner (D – VA) asked if it would not be important to translate the NRSRO ratings into something more meaningful that would provide a sense of the actual chance of default and of the magnitude of loss given default. Secretary Barr said such a system would be very beneficial. Senator Dodd took specific note of this issue and said it was deserving of further attention.

Senator Mike Johanns (R – NE) asked if the “little guy” wouldn’t end up paying the costs of any plan implemented to improve the current system. Secretary Barr said that everyone is now paying for the effects of a broken system and we need to get these problems under control. He said “the trade-offs are not even close”.

Senator Jeff Merkley (D – OR) observed that the Administration’s proposal to ban credit agency consulting fees and introduce better disclosure of payments still may not eliminate the perception of a conflict of interest on the part of the NRSROs. He asked if other approaches had been considered. Secretary Barr said that banning consulting fees, requiring better disclosures, closing the personnel “revolving door”, and creating a strong SEC compliance office would go a long way in addressing these concerns. He said the Administration had looked at different pay models (issuer, user, etc.) and all had particular deficiencies. Senator Merkley then asked if some security instruments simply weren’t too complicated to understand and properly rate, and if the better approach wouldn’t be to simply ban them. Secretary Barr said that was an option, but he believed there were ways to deal with these problems without an outright ban.

Senator Jim Bunning (R – KY) said everyone agrees the current system has failed. He said we must break the hold of the top three NRSROs and asked if all regulatory requirements for the use of these ratings shouldn’t be eliminated. Secretary Barr said this should be pursued, but he felt each requirement needed to be analyzed individually. Senator Bunning obtained agreement from Secretary Barr that there are basic conflicts existing in the current system.

Senator Charles Schumer (D – NY) said he had hoped with the passage of the 2006 legislation that the ratings agencies would be one of the cornerstones of a sound credit market; instead the credit rating agencies turned out to be one of the weakest links and this needs to be fixed. One of the weaknesses was that issuers “went shopping for ratings just like they were shopping for used cars”. He said because the revenues of the NRSROs increased with the increase in the securitization market, the agencies had every incentive to help issuers structure the products to get the ratings they wanted. The result was that ratings agencies rubber-stamped as” investment-grade” complex products they didn’t understand, and their flawed models didn’t factor in such adverse assumptions as escalating mortgage defaults. He wondered if the message was getting through to the NRSROs that change was necessary. He then cited a recent example of a questionable issuance that had just been highly rated by Moody’s. He put forth a suggestion that the SEC randomly select particular security issuances (he suggested one out of every ten rated products) for a secondary review by another rating agency as a means of encouraging proper conduct by the primary NRSRO on the selected issuance. Secretary Barr said he shared the conceptual goal to have more than one NRSRO rate particular issues, particularly in the case of structured finance products. Mr. Barr said the Administration suggests having the selected agency provide all information on their particular issuance to all the other rating agencies so that they can do their own analysis and “demonstrate their prowess” in assigning ratings as a means of competitive control over ratings quality.

In commencing questioning of the second panel, Senator Shelby asked Professor White if the government wasn’t sending a confusing message to regulated entities by instructing them to invest only in products possessing an acceptable NRSRO rating, while the NRSRO’s rating disclosure informs that no investment reliance should be placed on the assigned ratings. Professor White said he didn’t know “whether to laugh or cry” over this situation, and said this was one reason he advocated removing such reliance on the NRSROs. He said the burden should be on the investment manager to justify the investment, and that could be done through independent research either directly or by an independent third party (who could be an NRSRO or some other expert). Professor White said we should recognize that these complex products are not being purchased by unsophisticated investors, and investment managers should have the responsibility to either research the product or find someone to do it for them.

Senator Shelby then asked how we can bring confidence and trust back to the securitization market. Professor Coffee said we had a very good securitization market In the 1990s, but it got corrupted through the creation of more complex products that no one could completely understand. He said a good rule would be – if a product is too opaque to explain and understand, it should not be issued. He foresees simpler forms of asset-backed securities in the future, because the market will insist upon it.

Senator Corker said it was obvious that Committee Members were shocked to discover that no due diligence had been performed by the NRSROs as part of their process for assigning ratings. He asked Mr. Joynt what value the credit rating agencies were providing the public, given this lack of due diligence. Mr. Joynt said he believed there was enough public information available such that independent due diligence reviews were unnecessary. He viewed the NRSRO’s service to be the analysis of that public information and the projection of future performance based upon that public information. Senator Corker said he understood this concept as it relates to corporate issuances, but he fails to see what real assurance an NRSRO rating provides when considering an asset-back product, not backed by a corporate issuer but by mortgages, and the rating agency does not actually research and analyze the underlying mortgages. He said he failed to see any value being offered in this situation. Mr. Joynt said the NRSROs look to the issuing entity, the servicer, the accounting firm that signed off on the financial statements and then make a determination.

Senator Bunning stated that, during the housing boom, the rating agencies issued ratings without reviewing any information regarding the underlying mortgages. If they had, perhaps they would have detected some of the fraud and bad underwriting practices. Professor Coffee agreed with the assessment and pointed to information indicating that the percentage of “liar loans” expanded from approximately 28 percent in 2001 to 51 percent in 2006. Senator Bunning then asked if information on existing “toxic” securities should be shared with all the rating agencies so a better picture could be developed regarding the true condition of these products. Mr. Gellert said he believed this was the most important first step in getting the securities market moving again. Senator Bunning then asked if rating agencies should be subject to suit for errors in their ratings. Professor Coffee said he did not think there should be a cause of action simply for negligence. Misjudgments should not produce litigation; instead, it should be in instances where there is recklessness. In his view, giving ratings with no facts is “reckless”.

The hearing was adjourned with the understanding that this subject will be further explored following the August recess.