1 UNITED STATES SECURITIES AND EXCHANGE COMMISSION 2 (REVISED 01-15-03) 3 HEARINGS ON THE CURRENT ROLE AND FUNCTION OF THE 4 CREDIT RATING AGENCIES IN THE OPERATION OF THE 5 SECURITIES MARKETS 6 7 8 PAGES: 1 through 244 9 10 The above-entitled hearing commenced, pursuant to 11 notice, at 9:00 a.m. 12 13 14 15 U.S. Securities and Exchange Commission 16 Washington, D.C. 17 18 19 Friday, November 15, 2002 20 21 22 23 24 Diversified Reporting Services, Inc. 25 (202) 467-9200 1 COMMISSIONERS: 2 Chairman Harvey Pitt 3 Commissioner Roel Campos 4 Commissioner Cynthia Glassman 5 Commissioner Harvey Goldschmid 6 Commissioner Paul Atkins 7 8 OTHERS PRESENT: 9 John McCarthy 10 Michael A. Macchiaroli 11 Larry Harris 12 Annette Nazareth 13 Bob Colby 14 15 PRESENTERS: 16 H. Kent Baker, Ph.D. 17 University Professor of Finance 18 Kogod School of Business 19 American University 20 21 Deborah A. Cunningham 22 Senior Vice President and Senior Portfolio Manager 23 Federated Investors, Inc. 24 25 1 PRESENTERS: (Continued) 2 3 Sean J. Egan 4 President 5 Egan-Jones Ratings Company 6 7 Gay Huey Evans 8 Director, Markets and Exchanges Division 9 The Financial Services Authority 10 11 Frank A. Fernandez 12 Senior Vice President, Chief Economist and 13 Director of Research 14 The Securities Industry Association 15 16 Malcolm S. Macdonald 17 Vice President - Finance and Treasurer 18 Ford Motor Company 19 20 Leo C. O'Neill 21 President 22 Standard & Poor's, a division of the McGraw Hill Companies, 23 Inc. 24 25 1 PRESENTERS: (Continued) 2 3 Glenn L. Reynolds 4 Chief Executive Officer 5 CreditSights, Inc. 6 7 Greg Root 8 Executive Vice President 9 Dominion Bond Rating Service Limited 10 11 Cynthia L. Strauss 12 Director of Taxable Bond Research 13 Fidelity Investments Money Management, Inc. 14 15 16 17 18 19 20 21 22 23 24 25 1 C O N T E N T S 2 PAGE 3 Session I: The Current Role and Function of 4 Credit Rating Agencies 8 5 6 Session II: Information Flow in the Credit 7 Rating Process 71 8 9 Session III: Potential Concerns Regarding the 10 Role of Credit Rating Agencies (Conflicts 11 of Interest/Abusive Practices) 127 12 13 Session IV Potential Barriers to 14 Entry/Regulatory Treatment 184 15 16 17 18 19 20 21 22 23 24 25 1 P R O C E E D I N G S 2 CHAIRMAN PITT: As I think everybody knows, for 3 about a century, credit rating agencies have been providing 4 opinions on the creditworthiness of issues of securities and 5 other financial obligations. 6 These opinions are, obviously, of great importance 7 to investors and other market participants, and they have an 8 enormous influence on the securities markets, all of which 9 has increased significantly, particularly with the increase 10 in the number of issuers in the advent of new and complex 11 financial instruments, such as asset backed securities and 12 credit derivatives. 13 I think the globalization of our financial markets 14 also has served to expand the role of credit ratings to 15 jurisdictions beyond the United States, where the reliance on 16 credit ratings largely was confined for the first half of the 17 Twentieth Century. 18 Today, credit ratings affect securities markets in 19 a number of important and critical ways. 20 During the past 30 years, regulators, such as the 21 Securities and Exchange Commission, have increasingly used 22 credit ratings as a convenient surrogate for the measurement 23 of risk in assessing investments held by regulated entities, 24 because of the quasi public responsibilities in assessing 25 investments held by regulated entities. 1 Because of the quasi public responsibilities of 2 rating agencies, the importance given to ratings by investors 3 and other market participants and the influence of ratings on 4 the securities markets, we announced last March that we would 5 engage in a thorough examination of rating agencies to 6 ascertain facts, conditions, practices, and other matters 7 related to the role of rating agencies in the U.S. securities 8 markets. 9 Since that time, the Sarbanes-Oxley Act has been 10 enacted and it directs us to conduct a study of rating 11 agencies and their impact, as well. 12 The hearing today and the one scheduled for next 13 week represent the culmination of months of effort by the 14 staff and the Divisions of Market Regulation and Investment 15 Management, as well as in the Office of Compliance, 16 Inspections, and Examination. 17 I want to thank the staff for their tremendous 18 efforts that they have expended over the past few months. I 19 would also like to thank the members of our panel for taking 20 the time to appear before us today. 21 With that, I will turn it over to Annette Nazareth, 22 the Director of our Division of Market Regulation. 23 MS. NAZARETH: Thank you, Chairman Pitt. We have 24 assembled this broad section of distinguished and experienced 25 panelists not only to discuss the increasing importance of 1 credit ratings in today's financial markets, but, also, to 2 facilitate a number of initiatives currently underway at the 3 Commission. 4 First, the Commission has been directed by 5 Congress, as Chairman Pitt said, to conduct a study of the 6 role and function of credit rating agencies in the operation 7 of the securities markets. 8 This directive was issued in Section 702 of the 9 recently enacted Sarbanes-Oxley Act of 2002, which also 10 directs the Commission to submit a report on the study to the 11 President and Congress by January 26, 2003. 12 It is our goal and expectation that these will 13 enable us to parse in a more meaningful way the areas of 14 consideration set forth in Section 702. 15 Specifically, these areas include the role of 16 credit rating agencies in the evaluation of issuers of 17 securities; the importance of that role to investors and the 18 functioning of the securities markets; any impediments to the 19 accurate appraisal by credit rating agencies of the financial 20 resources and risks of issuers of securities; any measures 21 which may be required to improve the dissemination of 22 information concerning such resources and risks when credit 23 rating agencies announce credit ratings; any barriers to 24 entry in the business of acting as a credit rating agency and 25 any measures to remove such barriers; and, finally, any 1 conflicts of interest in the operation of credit ratings and 2 measures to prevent such conflicts or ameliorate the 3 consequences of such conflicts. 4 Another goal of these hearings is to assist the 5 Commission in determining how the Commission's regulatory 6 framework should best be applied to credit rating agencies. 7 For over 25 years, the Commission has been using 8 credit ratings from nationally recognized statistical rating 9 organizations, known as NRSROs, in Commission rules and 10 regulations. 11 During this time, the Commission has considered a 12 number of issues related to credit rating agencies, including 13 the need for direct oversight authority over credit rating 14 agencies and the appropriate role of ratings in the federal 15 securities laws. 16 Nonetheless, there remain a number of difficult 17 issues, many of which are reflected in Section 702 of the 18 Sarbanes-Oxley Act, that the Commission would like to review 19 before formally considering possible changes to the rules and 20 regulations regarding rating agencies. 21 Our agenda today reflects these issues. 22 Before I introduce today's participants, I will 23 briefly mention some details concerning our schedule today. 24 This morning there will be two sessions. We will begin our 25 opening session with brief introductory remarks from each of 1 the hearing participants. 2 We will then discuss in some detail the current 3 role and functioning of credit rating agencies. This session 4 will last approximately 90 minutes, and will be followed by a 5 15-minute break. 6 The second session this morning will explore the 7 information flow of the credit rating process; that is, how 8 rating agencies obtain and use information in the rating 9 process and how and what type of information is communicated 10 publicly and privately to issuers of credit ratings. 11 At approximately 12:15, we will break for lunch for 12 one hour and 15 minutes and we will resume our program at 13 1:30 this afternoon. 14 The first afternoon panel, which will last an hour 15 and a half, will focus on concerns regarding the role of 16 credit rating agencies, such as the potential conflicts of 17 interest and abusive practices, and our final panel, which 18 will run from 3:15 to 4:45, will address potential barriers 19 to entry in the rating business and the appropriate degree 20 and manner of regulatory oversight of rating agencies. 21 As you can see, we have a very ambitious agenda to 22 cover in a relatively short time. 23 Now, with that out of the way, I would like to 24 introduce each of the participants and then circle back for 25 any opening remarks that they would like to make. 1 First, I would like to introduce the Commission 2 today. Of course, Chairman Pitt, who we would very much like 3 to thank for calling for these hearings. 4 We also have Commissioner Atkins, Commissioner 5 Goldschmid, Commissioner Glassman, and Commissioner Campos. 6 We also have staff here today, as well, and while 7 we do have one moderator for each session, we fully expect, 8 since there is such a tremendous collective knowledge on the 9 part of the staff on this issue, that there will be a lot of 10 give and take and weighing in by the staff members who will 11 be participating, as well. 12 We have Bob Colby, Larry Harris, and Mike 13 Macchiaroli. We will be joined by John McCarthy, as well. 14 Let me introduce our panelists, as well, and we do 15 very much appreciate people taking the time to be with us 16 today. 17 We have Sean Egan, from Egan-Jones Ratings. We 18 have Malcolm Macdonald, from Ford. We will be joined, I 19 think her flight is delayed, by Deborah Cunningham, from 20 Federated Investors. 21 We have Gay Huey Evans, who very graciously came 22 all the way from London to be with us today. She is with the 23 FSA. We have Frank Fernandez, who is with the SIA and Leo 24 O'Neill, from S&P. 25 We have Greg Root, from Dominion Bond Ratings; 1 Glenn Reynolds, from CreditSights; and H. Kent Baker, from 2 American University. And that's our panel. 3 So I'd like -- oh, I'm sorry. What did I do. 4 Cynthia Strauss, from Fidelity. You know, I got tricked. I 5 said that was going to be a problem. They put two Cynthias 6 next to each other. So I've merged you into one Cynthia. 7 That's very bad, since I have a sister named 8 Cynthia. I will never live that down. 9 So I would like to give each of you an opportunity 10 to make a brief opening statement. Please be mindful that we 11 have a comprehensive and ambitious agenda, so I would ask 12 that, if you could, that you limit your statements to 13 approximately three minutes. 14 Shall we start with you, Sean? 15 MR. EGAN: Thank you. I have passed out and, 16 hopefully, everybody has a letter that we prepared. If you 17 don't have it, feel free. We have additional ones. 18 But it explains our position on the whole rating 19 field. In the first paragraph, the SEC portrays itself as an 20 investor advocate. That's their number one mission, investor 21 advocate. However, in that process, it extends that mission 22 to the rating agencies that it's recognized. Unfortunately, 23 the rating agencies that are currently recognized by the SEC 24 have had some major failures. It includes Enron, the 25 California utilities, Worldcom, Global Crossing, AT&T, AB&B. 1 There's probably a number more that we could list, but these 2 are the big ones. 3 Paragraph three, there is a study that was done by 4 Professor Baker that refers to only 29 percent of investors 5 thought that rating agencies issue timely, accurate ratings. 6 We think there are two problems associated with 7 this. One is that there's a conflict of interest, and I will 8 elaborate on that more this morning. 9 Two is the lack of competition. 10 Let me just, first, touch on the conflict of 11 interest. Moody's, and that's the only one where we can get 12 public information, Moody's obtains 87 percent of their 13 revenue base from issuers. 14 You have a similar problem, and that is the problem 15 with the equity analysts. They are serving the issuers' 16 interests. 17 Now, they can claim that any one issuer is 18 relatively a small portion of their overall revenue base. 19 However, the same argument could be made for the equity 20 analysts, Blodget -- and who is the other big one that is in 21 the news? Grubman, Jack Grubman, the equity analyst. So we 22 don't think that argument that they are a relatively small 23 portion of the revenue base holds much water. 24 The second fact, and that is a lack of competition, 25 is really picked up by the Justice Department's phrase, 1 "partner monopoly." 2 Now, this is not an oligopoly. If you remember 3 from your economics, oligopoly is when you have a couple 4 firms competing for the same revenues. Here, if Moody's 5 gains some revenues, it's not going to take away from S&P's 6 revenues. 7 You need two ratings to have an issue and some 8 people refer to this as a two and a half firm industry. 9 Fitch shows up in less than ten percent of the corporate 10 ratings that we look at. 11 I'm on to page two. In the package, you have a 12 letter and it's rare to get letters like this, but it's a 13 letter from First Albany. Basically, a First Albany broker 14 had clients that had some securities. Those securities were 15 ultimately -- the company was acquired by Allied Signal. 16 Allied Signal asked the rating agencies not to 17 issue a rating, to withdraw their ratings, so that Allied 18 Signal could buy back those securities at a lower price. 19 And the rating agencies said, "I'm sorry. That's 20 what the issuer requested." And they came to us asking for a 21 rating. 22 We thought this was inappropriate, and you have 23 some material. It's very rare to get something in writing 24 with that and it's a couple years old, but it's still there. 25 We have a couple recommendations and they're at the 1 bottom of page two. One is to recognize some non-conflicted 2 rating firms that have succeeded in warning investors. I 3 mean, that's why we're all here is because of these huge 4 losses. 5 Two is to prohibit issuer compensation. If there 6 are problems in the equity analyst field, there are also 7 problems in the ratings field. You're dealing with basically 8 the flip-side of the same coin. 9 Three is prohibit involvement with rated firms and 10 dealers. Moody's Chairman, Clifford Alexander, was on the 11 board of Worldcom up until last year. The biggest bankruptcy 12 in U.S. history and the Chairman of Moody's was on the board. 13 This is crazy. There's no way that should happen. 14 You should also shoot down the board of the National 15 Association of Security Dealers. They're supposed to be 16 independent. 17 Four is remove the exclusion from Regulation FD. 18 Why in the world should these private firms be given an 19 exclusion from Regulation FD, when all their competitors 20 aren't given that? It doesn't make any sense. They're 21 private firms. Why not let them compete on the same business 22 as everybody else. 23 Five is separate ratings from consulting. The same 24 issue with the accounting firms. 25 Six, prohibit the use of rating triggers. One of 1 the problems with Enron is that S&P and Moody's didn't want 2 to downgrade them because these rating triggers would have 3 thrown them into bankruptcy. 4 Get rid of your triggers. Just say forget it, you 5 can't use it in any security documents. 6 Seven is don't hold yourself out as independent if 7 you're not independent. They list in their web site, they 8 describe themselves as independent. They're not. 9 Eight is police monopolistic practices. There are 10 two aspects to it. One is right now in the structured 11 finance area, there are a number of press releases that Fitch 12 has made whereby Moody's is cutting their ratings by up to 13 six notches in the structured finance, which basically makes 14 it very difficult for Fitch to compete. 15 Moody's has no basis for doing that. They haven't 16 done a study. In fact, you could probably argue that in some 17 cases, Moody's ratings should be cut much more, especially 18 right before offering. 19 Nine is prohibit a collar to investors as basically 20 inside information. 21 Ten, if this is too much, get rid of this whole 22 NRSRO designation. If the SEC doesn't feel comfortable in 23 making adjustments to protect investors' interests, and that 24 has to be the guiding light, we think, in this whole process, 25 we agree with the SEC's mission, get rid of it. Get rid of 1 the whole NRSRO designation. The market will sort it out and 2 they will be much better off. 3 We have, afterwards, some additional charts. 4 MS. NAZARETH: Sean, could I cut you a little short 5 now. 6 MR. EGAN: Yes. Thank you. 7 MS. NAZARETH: We have lots of additional time. 8 Thank you. Mr. Macdonald? 9 MR. MACDONALD: Thank you. I'm delighted to be 10 here on behalf of Ford Motor Company. Certainly, we hope to 11 provide our insights into a very important subject to our 12 company and to many other companies in the United States. 13 In our view, the rating agencies provide a very 14 valuable service to the capital markets. At best, they have 15 a very difficult job, with multiple objectives and serving 16 multiple constituencies. 17 Ford has extensive experience with the rating 18 agencies. For many years, we lived in the rarified air of 19 AAA. Unfortunately, that's a thing of the past and, in more 20 recent times, our ratings have varied quite considerably with 21 the economy and the health of the domestic auto industry. 22 The principal issues that we would hope will be 23 raised today include these significant concentration of power 24 in a shrinking number of rating agencies. 25 The potential for conflict with differing forms of 1 communication to differing constituencies which they serve. 2 Finally, the potential lack of transparency in the 3 rating process and the seeming inconsistencies in the rating 4 process over time. 5 Thank you. 6 MS. NAZARETH: Thank you. Gay Huey Evans? 7 MS. EVANS: Thank you. On behalf of the Financial 8 Services Authority, we thank the Commission for inviting us 9 here today. So thanks. 10 Clearly, much can be said about rating agencies, 11 and I know this is to be brief comment, but from the UK, we 12 do believe there is information asymmetry in the securities 13 markets. 14 Issuers do know more about their own 15 creditworthiness than do investors. It may be both feasible 16 and cost-effective for major investors to undertake their own 17 credit analysis, but this is not the case for small 18 investors. So there is a demand for information and to meet 19 this demand, we need a supply of information, reliability, 20 and, firstly comes along the supply of information in the 21 form of rating agencies. 22 So we have demand and supply in the market for 23 information, just as in the markets for any other commodity. 24 Second, investors cannot easily monitor credit 25 rating agencies for the same reasons they cannot easily 1 monitor issuers. 2 Thirdly, the final trick is to find a way of 3 charging for the information provided by credit rating 4 agencies, since, once this information is revealed publicly, 5 it is no longer of value to the credit rating agency. 6 Over time, we have seen, which has been good, a 7 general switch from charging for subscriptions to charging 8 the issuer for a rating. The issuer is prepared to pay 9 because the impact on its cost of funding, access to a 10 broader pool of investors, and by signal of relative quality. 11 So credit rating agencies appear to have solved the 12 equivalent public good problem of how to pay for the what 13 lighthouse. In fact, they spread the costs across investors. 14 Now, the paradox is, is this for the best, in the 15 best of all possible worlds. There has been explosive growth 16 in the use of credit ratings since the 1970s, but at the same 17 time, the informational value of credit ratings appears to 18 have declined. 19 Maybe a lot has been published on the web, but the 20 length and complexity of methodologies is probably not so 21 comprehensible to many, particularly the retail. 22 There also remains a broad correlation between 23 ratings and default experience, but there has also been a 24 lack of predicted power in individual cases that were 25 mentioned earlier. 1 And how much of the broad correlation is due to 2 changes in ratings immediately ahead of defaults? 3 Almost no empirical studies find no added value of 4 credit ratings over and above other indicators of default, 5 and particularly what we watch are credit spreads, despite 6 the access of credit ratings agencies to non-public 7 information. 8 Indeed, some studies find that credit spreads are 9 superior to credit ratings in predicting defaults, although, 10 equally, it must be recognized that credit spreads perform 11 just as badly as credit ratings in the individual cases that 12 we've already mentioned earlier. 13 Now, on the regulatory side, why have credit rating 14 agencies prospered in recent decades? Now, some have 15 attributed this to regulation. 16 Now, this is not the place for a UK regulator, even 17 though I have a non-English accent, to explain the history of 18 this regulation, and I think Chairman Pitt did a little bit 19 of this earlier. 20 But it is substantial and it is noteworthy. 21 However, these regulatory licenses should not be portrayed in 22 black and white. First, investors also impose rating caps 23 for purely market related reasons; for example, to resolve 24 the principal agent problem in monitoring fund managers, 25 insurance companies, et cetera. 1 Second, the use of ratings by the market is much 2 more refined than the use by regulators who tend simply, in 3 Europe, to divide securities into investment grade and sub- 4 investment grade. 5 Third, part of the explanation for the growth in 6 the use of ratings since the '70s must be because of the 7 growth of tradings in securities and, indeed, credit. 8 Nevertheless, we must remain alert to the 9 possibility that the use of credit ratings by regulators may 10 distort the market for ratings information. 11 A new area that has come out, if anybody is 12 watching, as a banking regulator, the new Basel Accord. It 13 is designed to include a reasonably simple standardized 14 approach, but nevertheless, for this term risk sensitive, to 15 including what we call risk buckets, than currently exists 16 today, and credit ratings are to provide a reasonably simple 17 and straightforward means of populating these risk buckets. 18 The use of credit ratings reflects the universal 19 availability and because, as a more risk sensitive approach 20 demands, the ratings are reasonably well correlated with 21 probabilities of default. 22 So, for example, in the standardized approach that 23 the banks have today for putting capital aside and if they 24 used any of the ratings, let's say S&P, sorry, but whereby 25 all corporate exposures are currently included with the 100 1 percent risk bucket, in the Basel II new approach, a AAA to a 2 AA-minus rated corporate can be included at 20 percent, an A- 3 plus to an A-minus at 50 percent, and a BBB-plus to BB-minus 4 at a 100 percent, and then below the BB-minus, at a 150 5 percent. 6 So the ratings are extremely important, at least 7 for the future, if Basel II goes forward, and, similarly, for 8 collateral and guarantees, and it goes on. 9 But the recognition in the Basel Accord II has to 10 be a public processes, and basing off six criteria. 11 The first criteria is objective, objectivity, and 12 the other five are independence, international access and 13 transparency, disclosure of methods, actual default rates, 14 and a likelihood of ratings transitions, sufficient resources 15 and credibility. 16 The least of the eligible rating agencies is made 17 available by national regulators under Basel II. Banks are 18 not allowed to cherry-pick across credit rating agencies and 19 they must use agencies consistently and disclose which ones 20 they use. 21 Banks also have to disclose the amount of exposures 22 they have in each risk rated basket. 23 So Basel II, designed to be more risk sensitive 24 than Basel I, will actually depend on rating agencies more 25 than they do so today. 1 So in conclusion, we can say a whole lot more, but 2 much can be said with regard to the usage of credit ratings 3 for other market purposes, either whether it's rated 4 structures, finance, SPVs and synthetics, and other aspects 5 of rating agencies which we are bound to discuss. 6 But I would like to close on a major problem with 7 ratings, that adjustment is delayed for far too long before 8 the ratings fall to the trigger level, again, the problem of 9 too much reliance being placed on ratings, and I hope that 10 gets covered today. 11 MS. NAZARETH: Thank you, Gay. Frank? 12 MR. FERNANDEZ: Thank you, Annette. I promise to 13 be brief and respect the two minute rule. 14 Since you have my written introductory remarks, I 15 would just like to say my thanks to the staff and the 16 Commission for this opportunity to appear here at these 17 hearings. 18 I applaud you for both the timeliness of this issue 19 and bringing it forward and recognizing the critical role 20 played by the credit rating agencies in providing valuations 21 and risk assessments to financial markets, and for providing 22 this forum to evaluate and assess these functions which are 23 key to securities markets operations, as well as the 24 performance of the credit rating agencies who provide them. 25 Given the breadth and depth of the market expertise 1 around this panel, I'm going to try and confine myself to 2 something I do disproportionately, which is assessing the 3 costs and benefits of supervision and regulation, and looking 4 at the business model that is being applied here. 5 I think it is important to consider some of the 6 broader issues of the provision and the business of 7 information, particularly economic and financial assessments 8 of that business, particularly and specifically looking at 9 them both in the whole and for the segments of both the 10 provision of data analysis and valuation, because I think 11 they are distinct functions with distinct implications. 12 Beyond that, I will address them when we get to 13 specific points. 14 MS. NAZARETH: Thank you. Leo? 15 MR. O'NEILL: Thank you. Well, on behalf of 16 Standard & Poor's, I would like to thank the SEC for the 17 invitation to discuss the role of rating agencies in the 18 United States capital markets. 19 Standard & Poor's has been rating debt securities 20 since 1916 and in view of this long history in the capital 21 markets, we fully recognize the importance that our ratings 22 have played and will continue to play in the assessment of 23 credit risk in this country and abroad. 24 I believe the fundamental reason that Standard & 25 Poor's and other ratings have grown in importance in our 1 capital markets is our long track record of providing 2 independent, objective, and reliable opinions on 3 creditworthiness. 4 Indeed, ratings have found their way into various 5 regulations far back as 1931, when the Comptroller of the 6 Currency sanctioned ratings as a tool for banks to haircut 7 their capital for bonds held in inventory. We are heartened 8 that Basel II, they're seeing the same need. 9 In 1975, when the SEC coined the phrase "nationally 10 recognized statistical rating organization," and in 1976, 11 when the SEC designated Standard & Poor's as an NRSRO, I 12 believe they were simply stating a market reality that 13 Standard & Poor's had earned over 60 years and they were not 14 conferring a newly won status on us. 15 Now, more than 25 years later, the U.S. capital 16 markets, which have experienced enormous growth, continue to 17 be extremely well served by Standard & Poor's ratings. 18 Our ratings are subject to intense market scrutiny 19 every day, but they remain globally accepted benchmarks that 20 are respected for their independence and their integrity. 21 In continuing our important role and extending the 22 benefits of independent, credible rating services, both here 23 and abroad, depends on a framework that continues to preserve 24 the independence of credit rating agencies and recognizes the 25 market, the market is the best judge of a credit rating 1 agency's quality, objectivity, and independence. 2 Standard & Poor's also has a long history of 3 constructive dialogue with the SEC and other government 4 agencies about important issues affecting the capital 5 markets. We are frequently asked our views on key analytical 6 issues and we openly share our rating methodologies and 7 practices with the SEC and other government entities. 8 Today will be no exception. 9 Let me close by stating the obvious. We fully 10 recognize the value that we add to the markets and we 11 understand that it rests on a platform of integrity, 12 objectivity, and independence. 13 We also recognize that in the absence of such 14 qualities, our value in the marketplace diminishes, if not 15 disappears entirely. Hence, all of our processes, all of our 16 standards, all of our methodologies are geared to meeting the 17 objectives of integrity, quality, independence, and the 18 record will show, as it has in the past, that the valued 19 reputation that Standard & Poor's has earned is well-deserved 20 because of that deep commitment and our every intention is to 21 keep it. 22 Thank you. 23 MS. NAZARETH: Thank you. Greg? 24 MR. ROOT: I want to thank the Commission very much 25 for giving us this opportunity to address such an important 1 issue that affects the capital markets. 2 I'd just like to give you a little bit of 3 background about Dominion Bond Rating and summarize what we 4 think is the most critical issue that the rating industry 5 faces at this point in time or that the Commission faces 6 regarding rating agencies. 7 Dominion Bond Rating is a Canadian-based rating 8 agency. We have been in business now for 26 years, so we 9 don't have quite the longevity of Standard & Poor's, but we 10 are one of the early participants in the rating agency 11 business. So we have quite a long experience level in that 12 respect. 13 We are a privately held company. We have no other 14 activity. So we are totally independent in our activities. 15 Just by way of background, the Canadian market, 16 there are no actual formal rules and regulations as there may 17 be here, that exist here in the states in terms of mandating 18 that issuers be rated. 19 So the success of DBRS and our activities are very 20 much driven by market acceptance, and that's the acceptance 21 of the issuers, as well as the investors, as we think that's 22 a very important aspect that drives the rating business 23 overall, not just in Canada, but here as well. 24 DBRS rates and tracks about a thousand different 25 issuers, but because of the nature of the Canadian market, 1 with all the cross-border activity between the U.S. and 2 Canada, a substantial amount of our activity is here in the 3 United States. 4 So, obviously, what affects the rating business 5 here in the U.S. is very much important to Dominion Bond 6 Rating. 7 Overall, having been in the industry for quite some 8 time, I would concur with Leo. I think the rating business 9 has been very effective and has been very supportive of the 10 development of the capital markets overall. 11 I wouldn't say it's been totally flawless. But if 12 you look at the overall track record, I think it stands on 13 its own. 14 The key issue that we see that we think needs to be 15 addressed is with the NRSRO being such an important part of 16 many of the activities in the capital markets, we feel NRSRO 17 should be clearly defined. I think that is the most 18 important issue, is to define what an NRSRO is, have very 19 clear rules and regulations and guidelines for what it takes 20 to become an NRSRO, with an appropriate time frame, and, that 21 way, let the market judge very much who is the NRSRO and who 22 can be and who should not be. 23 So I think if that were to be accomplished, 24 overall, I very much believe that the system works well and I 25 think that today's session is important to continue to 1 discuss it, see if there are areas that could benefit from 2 some adjustment or improvement, but I think we will hopefully 3 find that it's not broken. 4 Thank you very much. 5 MS. NAZARETH: Thank you. Glenn? 6 MR. REYNOLDS: Thank you for inviting me to be part 7 of this very important hearing. 8 I come to this topic from the angle of an 9 independent credit research firm. We are not a rating agency 10 and we are not looking to become a rating agency. 11 Our primary product is market-based research on 12 issuers, industries, and segments of the marketplace. We are 13 not involved with managing assets or with underwriting 14 activity. 15 But like many analysts, I have been spending a fair 16 share of my 20-year career trying to predict the rating 17 agency behavior patterns. It's a significant input into the 18 performance of securities in the market and is a critical 19 portfolio management variable that we all need to watch 20 closely. 21 The last year has been as challenging as any in my 22 career and it's easier to sympathize with the demands placed 23 on the rating agency. That said, they have one of the most 24 important roles in the capital markets. 25 In my prepared written comments, which will be 1 posted to the SEC website, I focused on three areas that I 2 find most pressing and look forward to discussing today. 3 First, the quality of information flows and the 4 transparency of the ratings process has proven very uneven 5 over the past year and the post-Enron response has left many 6 institutional investors alarmed that there is an attempt to 7 over-compensate. 8 Together with some other dislocations in the 9 market, coming off a year of record investment grade 10 issuance, in particular, in 2001, it has inflamed market 11 volatility and created a serious crisis of confidence among 12 bond-holders. 13 If there is anything that is the case, it's that 14 there has never been a time where clarity and specific 15 descriptions and details of the ratings parameters have been 16 more important than they are today and the process has left 17 much to be desired. 18 Investors are intermediaries in the business of 19 taking risks, but they do need to understand fully the rules 20 of engagement. 21 Second, we believe that changes in the market over the 22 past year could bring some new competition to the NRSRO peer 23 group. We don't believe it is appropriate to attempt to burn 24 the NRSRO framework to the ground. We just think it needs to 25 be upgraded and the bar raised. 1 Third, we believe there are some working conflicts 2 of interest that are at least worth exploring, which we will 3 discuss later. 4 I will repeat one point that we made in our written 5 comments, and that is I think it would be worthwhile to more 6 intensively survey the institutional investor base and the 7 processionals in the brokerage and banking sector on the 8 performance of the agencies and the pros and cons of the 9 approaches. 10 We suspect that the power of the agencies and what 11 they wield in the marketplace and the relationships that need 12 to be maintained with the rating agencies may discourage a 13 full public airing and confidentiality could encourage more 14 candor. 15 I look forward to the proceedings. Thank you. 16 MS. NAZARETH: Thank you. Kent? 17 MR. BAKER: Thank you very much. I appreciate the 18 opportunity of being asked to participate in the panel. 19 The role that I perceive for myself is really that 20 on the academic role, because that's my environment. One of 21 the things that I hope to be able to contribute to these 22 hearings involves some empirical research that a colleague 23 Sattar Mansi, and myself have conducted involving credit 24 rating agencies. 25 These publications, one appeared earlier in the 1 year in the Journal of Investing, and the second publication 2 Mr. Egan referred to earlier, at least one of the comments or 3 findings from that particular study will appear in the next 4 issue of the Journal of the Business Finance Accounting, and 5 the title of that paper is "Assessing Credit Rating Agencies 6 by Bond Issuers and Institutional Investors." 7 In those studies, we took, hopefully, a 8 dispassionate view of credit agencies and trying to get input 9 from users of those particular services, specifically looking 10 at the bond issuers, focusing upon industrial issuers, and, 11 also, from institutional investors, primarily looking at the 12 segment relating to mutual fund investors, which, of course, 13 are large purchasers of these bonds. 14 There were four key issues or key research 15 questions that we focused upon in these studies, and I just 16 want to mention those topics, without going into the findings 17 at this particular time, which I can share, where that is 18 appropriate, during these hearings. 19 The first research question focused upon does the 20 number of rating agencies hired by issuers to rate bonds 21 differ from the number that are required by institutional 22 investors of these corporate bonds, given the different 23 perspectives. 24 We'll talk about the importance of having that type 25 of competition within the industry. 1 The second issue involved do the issuers and 2 institutional investors perceive any differences in the 3 accuracy among the various key rating agencies within the 4 U.S., and I'm sure our folks at S&P would like the results of 5 that, since they tend to be more favorable for S&P than the 6 other agencies. But I'd just make that as a quick comment. 7 The last two questions, I think, perhaps are more 8 germane to these hearings. The third question basically 9 focuses upon do issuers and institutional investors believe 10 that agencies maintain corporate bond ratings on a timely 11 basis, and Mr. Egan referred to part of the results that we 12 had, and being able to maintain timely ratings certainly is 13 critical in the marketplace today as opposed to having 14 excessive lags or at least lags that may be viewed as 15 excessive by market participants. 16 The final issue that we investigated involved do 17 issuers and institutional investors believe published ratings 18 of corporate bonds accurately reflect their issuers' 19 creditworthiness, and, of course, that is the key purpose 20 underlying bond ratings in the first place. 21 So we'll try to share some of those results during 22 the course of the hearings today. 23 Thank you very much. 24 MS. NAZARETH: Thank you. Cynthia? 25 MS. STRAUSS: I'm Cynthia Strauss, from Fidelity 1 Investments. I thought in these few minutes I would just 2 give a little background on who we are and how the rating 3 agencies really affect us, as well as a general comment on 4 our views. 5 At Fidelity, we manage about $360 billion of 6 investment grade U.S. dollar fixed income funds, and that's 7 spread about $240 billion in money market funds and about 8 $120 billion in bond funds. 9 We play a fiduciary role for millions of 10 shareholders. Our funds are principally distributed through 11 retail investors and they are in mutual funds, and Fidelity's 12 role is one of a fiduciary. 13 We do our own research for these funds. 14 The rating agencies are incredibly important to us 15 because they have tremendous influence on the markets in 16 which we participate. They are supportive tools, as we've 17 all said, for individual investors in the marketplace, small 18 and large. 19 They are the very structure of the marketplace, 20 just I said, investment grade references their ratings. They 21 are the risk language that we all speak and rely on. 22 They are important, too, because they are embedded, 23 appropriate to the SEC, in many of our regulations, very 24 important to money markets. Again, the cash for many, many 25 individuals in the marketplace. 1 They are also embedded in various state and federal 2 regulations that really we pay a tremendous amount of 3 attention to as fiduciaries. 4 And last, but not least, I think often goes 5 unnoticed is that the rating agencies drive industry 6 standards. They, in essence, are the voice for the 7 marketplace. They may set, for example, the level of 8 liquidity that a corporation should have to be a strong 9 issuer. 10 They actually are at the front line in designing 11 the structure of the ever-growing asset backed market. 12 So with that background, we have tremendous respect 13 for the agencies. We think, in many ways, they do an 14 excellent job with an ever increasing challenge. 15 When you think about it, there are only three. 16 Their business model is a for profit model, and yet they 17 serve a public, a greater public interest, and things really 18 haven't gone too wrong. 19 However, all is not well. I do think I agree it's 20 very timely that we're here. The examples that brought us 21 here were Worldcom and Enron, but as I hope to be able to get 22 into later today, there are many other examples, perhaps more 23 subtle today, of problems that could be facing this model 24 with only few rating agencies in the future. 25 That being the case, I think Fidelity's view is 1 that the NRSROs do need greater oversight to make them more 2 directly accountable to the markets that they serve. 3 Our specific issues are going to be more in the 4 area of the inconsistency and lack of transparency, which you 5 have already heard from a few, as well as their role as 6 driving industry standards, as I already mentioned, and I 7 look forward to getting into those in the examples later on. 8 Thank you. 9 MS. NAZARETH: Thank you. I want to welcome 10 Deborah Cunningham, who has had an arduous trip to get here. 11 We haven't given you time to sort of get settled in. 12 We can offer you a chance to make a statement now 13 or give you a little time to get your bearings and speak up 14 later. 15 MS. CUNNINGHAM: I'm fine. 16 MS. NAZARETH: Great. Wonderful. 17 MS. CUNNINGHAM: I'm Debbie Cunningham. I'm Senior 18 Portfolio Manager and Senior Vice President with Federated 19 Investors. Federators is an asset management firm that is 20 based in Pittsburgh, Pennsylvania. 21 Currently, we have about 200 billion in assets 22 under management. 23 My particular group that I'm in charge of at 24 Federated deals with our stable net value asset taxable 25 funds, and that includes about a $130 billion of those $200 1 billion in assets. 2 It includes our government money market funds and 3 our stable net asset value GIC products. 4 So my intention today is to address the group more 5 as a buy side, particularly with emphasis with regard to 6 money market funds and Rule 2a-7, as a Rule 2a-7 buy side 7 investor. 8 My use of the rating agencies and the NRSROs is 9 basically through the portion of our assets that we invest in 10 what we call our prime money market funds, and those are the 11 ones that can take credit risks. 12 Rule 2a-7, which is part of the Investment Company 13 Act of 1940, is the precedent that we use and that is the 14 NRSROs are required to be utilized within management of funds 15 that are holding themselves out as being 2a-7 funds. 16 Currently, about $70 billion of the assets that we 17 manage are subject to this particular regulation requiring 18 the use of NRSROs. So we've been using them since they've 19 been in business, since we've been in business, and, 20 essentially, when the NRSRO information was added into Rule 21 2a-7, there were seven different rating agencies at that 22 time. 23 We are now down to, through consolidation, through 24 the consolidation process, to three of them. 25 And although I don't really have a problem with the 1 three that exist, our preference is definitely to have more 2 rather than fewer, and this is basically because we like the 3 input that is available from the reputable sources. 4 This would assume that these would be qualified 5 NRSROs and that they would meet some minimum standard that 6 was set in the marketplace. 7 On the other hand, if there were any type of 8 legislative changes that would require us to always follow 9 all NRSROs and always purchase all NRSRO ratings, we would 10 have problems with more than the three or four or five or six 11 that have been in place in the marketplace on a recent 12 historical basis. 13 Currently, Rule 2a-7 is such that it requires 14 what's called a second opinion rule and the ratings 15 information is derived from a second opinion rule. 16 If there is only one rating on the particular 17 issuer that we're looking at, then that rating is the one 18 that counts. 19 If there is more than one rating, then, 20 effectively, you need two, a second opinion, in order for an 21 issuer to be considered first here, topped here. 22 So even if you had seven different rating agencies, 23 really the two that you need, there are two that you would 24 need as confirmation that this issuer would be first tier. 25 This is all utilized within our analytical basis at 1 Federated from an independent credit analysis standpoint of 2 taking inputs directly from the research that's done by the 3 rating agencies and utilizing that in determining minimal 4 credit risk for the securities that we purchase within the 5 portfolios that we use. 6 We would definitely advocate more NRSROs, as I had 7 indicated, and we would absolutely hope that any additional, 8 as well as the current NRSROs would be subject to oversight 9 and accountability, some of which exists today, but a lot of 10 which does not exist today. 11 And we know that the assessment of financial health 12 is not an easy thing to predict going into the future, 13 whether it's short-term or long-term, and our analysts are 14 faced with that on a day-to-day basis. 15 We know there is never going to be a 100 percent 16 certainty in that type of a business, but we feel that with 17 additional oversight, with additional accountability, and 18 with additional competition in that marketplace, definitely 19 the usefulness of these assessments, I think, will be better 20 served and would be better used by the investor base. 21 We also think that if you merge the due diligence 22 process that is typical by analysts to assess analysis or to 23 assess the financial health of a company with what is 24 currently the rating agencies' credit assessment, we, again, 25 think that with more oversight, you could produce better 1 results for investors. 2 Lastly, the last thing I would like to encourage 3 rating agencies to do is really to recognize each others' 4 ratings. There are published sources of information that 5 detail what makes up a AAA rating or what makes up an A1-plus 6 or a P1 or an F1-plus rating across the three NRSROs that 7 exist today, yet, in many instances, the rating agencies will 8 only look to their own internal ratings when viewing 9 information and trying to rate it. 10 So I would promote some sort of an acknowledgment 11 and recognition across the NRSRO base so that we would be 12 able to more fully enjoy the ratings benefits of the three 13 that exist today and hopefully more that exist in the near 14 future. 15 I think that's about it. I can address other 16 things as the questions come forth. 17 MS. NAZARETH: I was going to start with a question 18 that I think Cynthia actually touched on quite directly in 19 her opening statement, which was the relative importance of 20 credit ratings for use for credit analysis. 21 So I thought I would turn to the other two 22 participants who may have some interesting insights into 23 this, which would be Glenn and Deborah. 24 You spoke, Deborah, about how you make use of these 25 credit ratings, partly because they are regulatorily 1 mandated. But could you speak a little bit more about how 2 much they are actually used, even on the buy side, in a 3 sophisticated shop like your own in terms of how you 4 determine what you are going to purchase for various 5 portfolios and how much you do rely on the ratings? 6 MS. CUNNINGHAM: Certainly. We utilize the ratings 7 as an input to our own internal credit assessment. We, in 8 many ways, attempt to duplicate the process that the rating 9 agencies provide for investors that don't have the means of 10 duplicating that internal mechanism themselves, and we 11 essentially utilize, in that process, the rating agencies' 12 information. 13 We utilize other sources of information, as well, 14 from various street firms research, to information from the 15 companies themselves, to basically public information that is 16 available via internet type sources. 17 But the rating agencies' input is absolutely of 18 importance and it's also important, I think, from a 19 regulatory standpoint, that before we can start the process 20 with our own internal analysis, we have to meet the hurdles 21 of having the NRSRO ratings that we're looking for from a 22 regulatory standpoint. 23 MS. NAZARETH: Okay. Glenn? 24 MR. REYNOLDS: If people want to get a sense of how 25 all pervasive the NRSRO designation is, just go to Google and 1 type in those letters and you'll read page one of one 2 thousand pages. So you get the idea, it's everywhere out 3 there. 4 The first line of using the ratings designation is 5 just the explicit parameters that many mutual funds, pension 6 funds, and insurance companies may have put some of its 7 discretionary and in-house and some of its shareholder-driven 8 based on a prospectus which has been delivered to investors. 9 So very often it's hard and fast, but then as you 10 drove down a little bit more, it can very dramatically impact 11 the price behavior of securities, which is a performance 12 issue for these portfolios, which directly affects policy- 13 holders, mom-and-pop retail investors, mutual funds, savings 14 plans, pensions. 15 One of the things in the past that has been a real 16 problem is the minimum rating threshold in some portfolios 17 creates what we used to call a forced seller. 18 Once it drops below a ratings tier, they have to 19 kick the security out. Wall Street traders are in the 20 business of looking to chop trading for those opportunities, 21 because they immediately drop the bid down because they smell 22 a forced seller in the market. 23 That inflames the volatility and heightens the 24 loss. After some difficult experiences with that, people 25 have eased those types of restrictions, where they're even 1 more discretionary in the timing of the sale, but a ratings 2 move goes far beyond just a lower average quality. It can 3 inflame the magnitude of a loss for a given institutional 4 investor. 5 And when we talk about institutional investors, 6 behind every institutional investor is a whole array of 7 retail investors. 8 But then it keeps going from there, as we'll talk 9 about later, ratings triggers in other areas. That security 10 that you may own, whether it be a BB or a BBB rated security, 11 will have follow-on effects from that ratings change that 12 effects the quality of the credit collateral posting 13 requirements on OTC derivative trades, bank line repricing; 14 in some cases, explicit puts, ratings indexed. 15 So it gets very complicated, and we'll spare you 16 all the arcane credit mumbo jumbo, but it goes well beyond 17 the fact that the spread widens. It can have follow-on 18 effects that are concentrated on some investors and some 19 types of portfolios more than others. 20 MS. NAZARETH: Did you have something to say? 21 MR. BAKER: I just had an observation on the uses 22 of those ratings. Part of our study did focus on, from the 23 issuer's perspective, on the number of ratings that they 24 generally used and we found that, from our study, again, 25 relating to the industrial sector, that approximately 20 1 percent of those companies did use a third credit rating 2 agency, and the primary reason that that was done was because 3 there were essential conflicts that existed, that is, a split 4 rating between basically S&P and Moody's. 5 In order to try to clarify that, they went for a 6 third rating, in many respects, to try to provide additional 7 information to the marketplace with that third rating. 8 MS. NAZARETH: Thank you. 9 MR. COLBY: Could I just follow-up? Glenn, I 10 understood you to say that you have to watch the rating 11 because of the impact of the rating itself on the market 12 price. But could I just go back and follow up with Cynthia 13 and Debbie? 14 To what extent are you using the rating because of 15 the clarity of the insights and the analysis of the rating 16 agency itself as opposed to the effect it might have on 17 price? 18 MS. STRAUSS: As Debbie said, as well, we use it in 19 two ways. One is the rating agencies are some of the best, 20 we consider, peer analysts out there, in many cases. So we 21 use their research as an input to our research. 22 But since we do independent research, it's a 23 compliment. It's input. 24 But what really is critical, I think, in some of 25 the issues looking forward is the point that Glenn made, that 1 the direction of the ratings can really impact many things 2 about that company, and I'm sure Mac will have comments about 3 that, as well, and it can really impact that company's access 4 to capital markets, what's going to happen in the 5 marketplace, which is something that we, as market 6 participants, look at. 7 And we'll talk about later that we argue greatly 8 that the rating agencies are trying to figure out how their 9 ratings impact market prices, and we'll get back to that 10 later. It's a very worrisome area. 11 We're looking at market prices, what could happen 12 if the rating goes down, what could happen to that company's 13 fundamental liquidity if they are shut out of the investment 14 grade market. 15 MS. CUNNINGHAM: I echo all the things that Cynthia 16 said. I would just add that we have found, in the past, that 17 the written input that we get on the rating agencies, what is 18 available in written form or what is available in printed 19 form on their web sites, is oftentimes not as useful as the 20 global input that we get from talking to their analysts. 21 It's oftentimes less timely, from a date specific 22 standpoint. So the printed material may be dated, to some 23 degree. It's hard to keep exactly with current times on 24 that, in that regard, yet we are able to, from a verbal 25 standpoint, get very good input, typically, up-to-date input 1 by speaking with their analysts. 2 So I would note that it's not just on a written 3 basis that we utilize their information, but even more 4 important, probably on a speaking basis. 5 MS. NAZARETH: Thank you. Mac? 6 MR. MACDONALD: While I recognize that from an 7 investor perspective, the input, other than the written input 8 from the agencies may be important. 9 It does, I think, give me a great deal of cause for 10 concern that that data, which, in many cases, is data that is 11 being released free of the oversight of Reg FD, is being 12 potentially used to provide information to one individual 13 alone. 14 I have to say up front that the agencies with whom 15 we deal have been absolutely superb in their handling of 16 confidential information. In the 20 or so years that I've 17 had personal experience, we have never come across a 18 situation where confidences have been abused. 19 But having said that, we do find that we receive 20 reports that personnel from the rating agencies have made 21 comments to analysts, investors, and others that they will 22 not make publicly and they will not make to us, and I believe 23 and I am concerned that that can lead to serious distortions 24 in the markets. 25 MS. STRAUSS: Can I just make one comment on that? 1 We may get a chance to -- I know we have FD later on, but I 2 just want to make the linkage, which is very worrisome to 3 Fidelity and I think others in the marketplace. 4 We just mentioned the power of a moving of a rating 5 in impacting market prices, and yet the fact that the rating 6 agencies have access to information that investors can't have 7 creates great concern for us. 8 Our position has always been that we encourage 9 greater disclosure to the marketplace and to investors, 10 because this creates a difficult situation for all parties. 11 MS. NAZARETH: I think this does raise a very 12 interesting issue for the Commission. It is something that 13 has come up in other discussions that we have had with market 14 participants and has been high on Chairman Pitt's list of 15 issues. 16 If the key information that is so important for the 17 buy side is information that, in fact, is not in the public 18 domain, then perhaps there is something with what we are 19 requiring to be in the public domain, and I certainly think 20 that is a significant point that is being made there. 21 MR. O'NEILL: Ms. Nazareth, I feel like -- I'm 22 trying to behave myself here. I can respond to all of these 23 here at one time or another, but I will take your lead on 24 that. 25 On the information that we get, the confidential 1 information we get, we've actually -- this is not something 2 that came out of Reg FD, as you know. Rating agencies, for 3 many, many, many years prior to Reg FD, were the recipients 4 of information that issuers provided to us on the condition 5 that we would not make that public and, also, on the 6 condition, and what we are, is we do not trade securities, we 7 do not buy, hold, sell securities in that regard. 8 That information is there solely for the purpose of 9 providing a credit rating. 10 The disclosure obligation, obviously, is not on the 11 rating agencies. The disclosure obligation is on the 12 corporations that file with the Securities and Exchange 13 Commission. 14 MR. COLBY: Mr. O'Neill, could you address the 15 issue that has been raised about verbal contacts with the 16 analysts at the rating agencies and what sort of information 17 is made available in that context? 18 MR. O'NEILL: Sure. I'll take Deborah and Cynthia, 19 who have direct contact with our analysts and they hear what 20 they hear. 21 I suspect, like I believe, that what we put out on 22 our web site, what we put in our publications is intended to 23 provide a broad audience with the reasons for maintaining our 24 rating or changing our rating or what have you. 25 Certainly, an analyst from outside our organization 1 calls up with a specific question or specific concern, 2 assuming it does not breach, it cannot breach the 3 confidentiality seal that we have put on this information, we 4 will, obviously, respond to those analysts with specifics. 5 I think that's important that we do that and, in 6 fact, we pride ourselves on being available to the analytical 7 community that way. 8 I would encourage our people to continue to do that 9 and I think it would be a bad practice for the rating 10 agencies to put a cloak or a seal over their rating opinions 11 in any way. 12 So, again, we will respect the confidentiality. We 13 will not disclose the confidentiality of that information. 14 MS. NAZARETH: Could I ask the other two rating 15 agency representatives to address the issue, as well? 16 MR. ROOT: First of all, I very much agree with 17 Leo. I think the important thing is transparency and I think 18 if you take a look at the type of information that Dominion 19 Bond Rating publishes and puts out there, we are very clear 20 and open in terms of what is incorporated into our ratings, 21 what the key issues are, and we think that's important. I 22 think that is one of the issues here, is to what extent the 23 rating agencies are communicating, what is behind the 24 ratings, basically. 25 I'm not going to speak for our competitors, but, 1 certainly, if you look at Dominion Bond Rating, this is 2 something that we put very much as a top priority, is making 3 sure that -- the rating itself is one thing. 4 It's what is behind the rating, what you are 5 assuming, because, again, we can sit down and discuss ratings 6 between us and we're going to agree to disagree. 7 So I think what's important for us is that you know 8 what's behind our thinking and you may say that we may be too 9 optimistic about the economy or whatever it is and, 10 therefore, you can adjust our ratings accordingly, but it's 11 important, as long as we are quite open in terms of what 12 we're looking at, then we think that is as important as the 13 rating itself, and that is something that we very much 14 emphasize at Dominion Bond Rating. 15 COMMISSIONER GOLDSCHMID: Just to pin that down a 16 drop. But do you have a confidentiality policy on material 17 information you have been given? 18 MR. ROOT: Absolutely. Again, I'll go back to Leo. 19 Prior to joining Dominion Bond Rating, I was with one of the 20 NRSROs, Thomson BankWatch. I have never come across a 21 situation where having confidential information has been 22 breached, certainly by any of the organizations currently or 23 prior, and I assume Leo will support that at Standard & 24 Poor's and I suspect the other agency. 25 So while it's something that needs to be continued 1 to be looked at and considered, I think if you look at the 2 history, it has never been an issue that has been violated 3 and I think that is very important to communicate in this 4 forum. 5 CHAIRMAN PITT: Mr. Macdonald, do you find that you 6 are asked for the same information from each credit rating 7 agency? 8 MR. MACDONALD: To a great extent, Mr. Chairman, we 9 are. But the nuances and the depth to which the questioning 10 is subjected can be quite different over time. 11 I would give you a current example. The issue of 12 under-funded pensions is of great concern to one rating 13 agency, far less a concern to others. 14 All three have asked about it, but in one case, in 15 great depth, in the other cases, a few questions, an 16 understanding, and move on. 17 MS. NAZARETH: Sean? 18 MR. EGAN: Thank you. Our position at Egan-Jones 19 is that the exclusion of NRSROs from Regulation FD provides 20 the opportunity for abuse, and those opportunities haven't 21 fully been explored 22 In fact, if it is not corrected, we think, over the 23 next couple years, you will see some huge abuses. 24 There is no reason why these private firms should 25 be given information ahead of other participants in the 1 market. If it's relevant, produce a press release to 2 everybody. 3 Gathering information such as on the rating 4 triggers which is done by the two rating firms and then 5 providing that to private clients is inappropriate. It 6 should be sent out to everybody at the same time to even the 7 playing field. 8 CHAIRMAN PITT: There is a general exclusion, 9 though, in FD, if you have a confidentiality agreement, which 10 would seem to me to achieve exactly the same purpose. How 11 would you differentiate that? 12 MR. EGAN: The other market participants aren't 13 going to get that confidentiality. In fact, as a practical 14 matter, what would happen is that if the name S&P or Moody's 15 is on the letterhead, they will be given that confidential 16 information. If it's not, they won't be given it. 17 CHAIRMAN PITT: Maybe I haven't made myself clear. 18 Let's assume you got your wish and there were no specific 19 exemption for NRSROs in the process. There is still an 20 exemption for anybody who receives information based on 21 giving a confidentiality agreement. 22 So what is the difference? 23 MR. EGAN: Our position is exclude that. If it's 24 part of an underwriting, that's fine, but if it's part of an 25 ongoing rating assessment process, why hold these other firms 1 in some superior position? 2 COMMISSIONER GOLDSCHMID: But one thing ought to be 3 clear to everybody. If you've signed a confidentiality 4 agreement or you have such a policy that is understood, if 5 there is then misuse of that information, there are far more 6 serious consequences than FD. That becomes insider trading, 7 with all of that criminal and civil and treble damage 8 penalties potentially available. 9 So this would be a very serious violation, if it 10 occurred. 11 CHAIRMAN PITT: But there is also a shifting of 12 responsibility. It shifts the information away from the 13 originator of the information, the issuer, to the recipient 14 of the information, where it would belong once you've gotten 15 a confidentiality agreement. 16 I don't want to belabor the point, I just don't 17 understand how getting rid of the specific exemption would 18 necessarily change anything if companies complied with the 19 policy of FD to require a confidentiality agreement from any 20 rating agency to whom they gave information. 21 MR. MACDONALD: Following up on the Chairman's 22 point. I would merely say that in terms of if we were 23 required to observe FD with the ratings, the quality of the 24 rating for the investors would undoubtedly go down, because 25 there is no way that we would release confidential product 1 plans for future years and data of that type, which could be 2 used by our competitors. 3 So applying the exemption from FD, I think, 4 improves the rating process. 5 Now, let me change subjects a little bit. One of 6 my concerns about this, shall we call it, informal contact 7 between people from the agencies and individual investors is 8 that the general form of rating comes out of a committee, as 9 I understand it, at most of the agencies. 10 That committee is made up of a group of 11 individuals, clearly, not all of whom share the same opinion 12 on an individual company. 13 To the extent that one individual perhaps has a 14 more positive or a more negative outlook and that individual 15 is talking with an investor, the nuances and phrasing of his 16 or her comments may not necessarily reflect the opinion of 17 the rating committee. 18 For that reason, I would strongly support the data 19 from the rating agencies only be published and, therefore, 20 subject to full oversight of the internal committees. 21 COMMISSIONER GLASSMAN: Can I just ask a follow-up 22 question? I just want to make sure I understand. 23 Are you saying that the exemption from FD does 24 improve the quality of the ratings? 25 MR. MACDONALD: Absolutely. 1 COMMISSIONER GLASSMAN: So for the non-designated, 2 the rating agencies that are not designated NRSROs, who are 3 not exempt from Reg FD, are missing whatever it is that is 4 improving the ratings by this exemption. 5 Is that a correct interpretation? 6 MR. MACDONALD: Basically, I was taking the point 7 that to require us to observe FD with respect to the rating 8 agencies that we choose to use, we do have a choice, gives us 9 the ability to give them better information, which, in turn, 10 benefits investors. 11 CHAIRMAN PITT: The question that I was originally 12 getting at when I posed it to you, which relates to FD, is if 13 you see different rating agencies focusing on different 14 information, do you assume any responsibility to make sure 15 that every rating agency that comes in to talk to you winds 16 up receiving effectively the same information irrespective of 17 how they may use it in their rating? 18 MR. MACDONALD: I think the answer to that is 19 certainly with respect to written information, for example, 20 in the past month, we have met with the three nationally 21 recognized agencies and each one of them received an 22 identical 76 page book of data. 23 Now, the questions that followed from meetings, 24 that were extensive, clearly provided more follow-up and, in 25 fact, subsequent telephone conversations would probably mean 1 that in certain areas, one agency asked more questions and 2 received more information than others. 3 CHAIRMAN PITT: That's what I would assume, simply 4 because different people are going to be focused on different 5 issues. 6 But if you apply what the underlying philosophy of 7 FD is, so the company gives out information that may be 8 significant, it is supposed to provide it to everyone. 9 Now, in the rating agency context, where there is 10 no application of FD, the question still remains if, in the 11 course of doing this, you discover that information that has 12 been ferreted out by questioning may be relevant to a rating 13 or may take on more significance than you would have thought, 14 the question is should there be some obligation to provide 15 the same information to every rating agency that might be 16 interested in covering Ford, for example? 17 MR. O'NEILL: Having done this sort of thing, I 18 think that puts a burden on the issuers to get into the minds 19 of the analysts and try to determine what it is that's truly 20 important to the analysts. 21 I don't think our analysts come in and say to 22 Malcolm, "Malcolm, here's a real big one, you got to get this 23 one right." No. They would ask dozens and dozens and dozens 24 of questions, I'm sure, over periods of days, many times. 25 CHAIRMAN PITT: Thousands and thousands. 1 MR. O'NEILL: It would be wonderful if that could 2 happen. I think, in reality, it's difficult. 3 CHAIRMAN PITT: That is the way FD operates outside 4 that context. If a corporate official says something to an 5 analyst who happens to ask the right question, putting aside 6 the rating agency context, there is an obligation on that 7 official to then consider whether that information is 8 material and should be disclosed to the marketplace as a 9 whole. 10 MR. MACDONALD: I would have -- in fact, it would 11 be a major efficiency if I could see all three rating 12 agencies in the same room on the same day for four hours. 13 I do not believe the agencies necessarily, and I 14 look to Leo as to whether they would support that. 15 MR. O'NEILL: No. No. We think that the value 16 inherent in our ratings is the key value, is the independence 17 of our process from the other rating agencies. So we would 18 definitely not want to participate in a process which 19 creates, in the final analysis, a homogenized singular view 20 to the marketplace. 21 Some comments have been made about rating agencies 22 and transparency and understanding why our ratings are what 23 they are. I think part of the issue is that we all have our 24 own criteria, our own emphasis. Yes, there is a strong 25 correlation between the rating agencies, but there are 1 nuances to our approaches, changes in our approaches, 2 differences in our approaches. 3 It sometimes makes it difficult to understand what 4 the total picture is. You may understand exactly what DBRS 5 does or even Egan Ratings and S&P, but then when you put it 6 all together in one situation, it becomes difficult to 7 understand what is driving the total mix. 8 I think that's appropriate. This is a market that 9 is based upon the independence of opinion and investors' 10 ability to ferret that out and make it ultimately their own 11 decision. 12 MS. STRAUSS: I'd like to just have another voice 13 in this, which is, again, we are here talking about advocacy 14 for the marketplace. 15 Two points. One, Mr. Macdonald, you may feel that 16 the confidential conversations you're allowed to have with 17 the rating agencies makes a better rating process, but we 18 would disagree. From the rating process to the marketplace 19 is really what is important here. 20 Again, I'm not sure that that is always the case. 21 It may feel better that you don't have to give information in 22 a more public forum and, therefore, you think that the 23 outcome of the rating is better, but I don't know that that 24 is the case. 25 I can see many situations where that is not 1 necessarily the case. What makes the rating good is how well 2 the agency analyzes the company, makes an assessment, and 3 clearly articulates that to the marketplace, so the 4 marketplace can make its best assessment of that. 5 I also want to remind you that many investors, such 6 as ourselves and Federated, we're fiduciaries, and the SEC 7 specifically asks us to make independent assessments of these 8 companies. 9 In addition, with just very specifically saying you 10 should not rely on the ratings, with your regulations 11 requiring us to do this, and yet you are also saying the 12 agencies can have access to things that we don't, it puts us 13 in a very -- we think that is where the conflict is. 14 We like the process the rating agencies do. We 15 think they have vigorous discussions that are healthy. But 16 we also, in the marketplace, have responsibilities that are 17 separate from that, which are fiduciary duties, which we take 18 very seriously and we think are appropriately put into Rule 19 2a-7. 20 Different perspective. 21 CHAIRMAN PITT: Mr. Egan, could I just ask you one 22 question? Do you find that there are circumstances where you 23 do not get information you request? 24 MR. EGAN: Yes. In fact, it's rather frustrating 25 that the information is provided to the other NRSROs and it 1 is not disclosed to the market shortly after it is provided 2 to them. 3 So, yes, but we manage. In fact, we tend to think 4 that this whole Regulation FD issue is outweighed by the lack 5 of competition and the conflict of interest. 6 We have been getting ratings right and by measuring 7 of whether or not the other agencies come in to our ratings. 8 So it's very important. We think that Regulation 9 FD should address this issue. Obviously, some other people 10 share our opinion. 11 But it ties into some other things, too, that have 12 -- that are more important. Otherwise, we wouldn't be able 13 to -- we wouldn't be in business. We wouldn't be able to get 14 the ratings early and right. 15 COMMISSIONER CAMPOS: I have a question, Cynthia. 16 We have two perspectives. Mr. Macdonald says he needs 17 confidentiality. You're saying, yes, but from the buy side, 18 I don't get information that the ratings agencies get. 19 How would you square that? What, in your mind, 20 creates the right balance to satisfy the marketplace and 21 satisfy the need of companies to keep things confidential, if 22 you acknowledge that there is such a need? 23 MS. STRAUSS: I guess it's pretty simple. I think 24 we would encourage companies to disclose, if it's that 25 important to a rating, that it should be disclosed publicly. 1 There are finer points to things. 2 COMMISSIONER CAMPOS: What about the future 3 products and if that's going to mess up my competition with 4 GM or something, what would you do about that? 5 MS. STRAUSS: Quite frankly, I personally, and 6 others in our group have been long-time analysts of the auto 7 companies and I don't think the ability for the debt holders 8 -- we're talking about the debt markets here, which are 9 looking at future earnings streams with a particular weight 10 on liquidity, cash flow, sustainability. 11 I don't think you need to know what the latest new 12 design on the auto -- for a new auto is to assess their 13 financial capabilities. 14 Again, I don't know whether all that is released to 15 the ratings agencies, but I haven't felt that we -- with the 16 auto companies, to be fair, I don't think that we feel like 17 we're going without important information. We get, I think, 18 pretty good disclosure. 19 We always want it to be better, but -- so the idea, 20 what is worrisome is that there -- I just don't think it's a 21 good area to be in where there is this confidential 22 information. 23 We don't have it and then we're reliant, we the 24 marketplace, on the rating agencies doing the right thing 25 with it. I just think it creates an uncomfortable imbalance, 1 which can also add volatility. 2 One of the issues I'm very concerned about now is 3 the increased volatility in the debt markets, and there are 4 many factors for that. But one of them is if a rating agency 5 moves its rating in a way that we can't understand, because 6 it may not be transparent and clear, the marketplace right 7 now, one of the things they wonder is why are they doing 8 that, what is it that they know that is not disclosed to us, 9 and I don't think that favors companies. 10 It certainly adds to volatility and I just don't 11 see the benefit for investors or issuers. 12 MR. O'NEILL: I think we try to. We try to go to 13 great, great lengths to explain why we lower our ratings. 14 I think we're in kind of a unique period. I mean, 15 hopefully, it's unique, and the sensitivity about 16 creditworthiness I think is probably at a pretty all time 17 high, maybe going back to the mid '70s or early '70s, when 18 people woke up to credit risk. 19 So, obviously, there is great sensitivity. Credit 20 spreads are very, very wide here. A lot of uncertainty, 21 trust, we've all heard all of these things in the 22 marketplace. 23 There have been periods of time, and not too long 24 ago, when rating agencies lowered ratings and did those sorts 25 of things and the market didn't -- you know, it made 1 absolutely no difference whatsoever in any respect. 2 So our view is stay level, stay consistent, and 3 make sure that we are responsive to the information 4 requirements of the markets, and also stay independent. We 5 can't be adjusting our ratings because other rating agencies 6 do certain things. 7 So that's our mantra. 8 MR. HARRIS: I wanted to follow up on a question 9 for Ms. Strauss, because you all are in the same position, 10 theoretically, as any other stockholder out there. In fact, 11 Reg FD was pretty much aimed at you all, because in the past, 12 companies would share information on road shows with 13 institutional investors rather than with individual 14 investors. 15 So it seems to me that if there is a 16 confidentiality agreement with a credit agency, that that 17 acts as sort of a safety valve, a pressure valve to get 18 information out into the marketplace in more of a rational 19 way. 20 So I was wondering if you all had any opinion about 21 that. 22 MS. STRAUSS: I would just like to -- we did, 23 actually, both Debbie Cunningham and ourselves actually 24 addressed this issue at the time of Reg FD. Reg FD was 25 addressing concerns about companies, I think, in large part, 1 companies giving equity investors information that wasn't 2 broadly available, a concern, a serious concern for all of 3 us. 4 But particularly in this market, we're talking 5 about the debt holders and so we don't particularly have 6 people running to us trying to give us a lot of extra 7 information about their future earnings or try to influence 8 us in that part. 9 MR. HARRIS: But it did in road shows. I mean, 10 that was what FD was aimed at. 11 MS. STRAUSS: I understand that, but I can't -- 12 Fidelity did not feel that they were abusing that, getting 13 tips on that. 14 But let me just get over to the debt markets. One 15 of our concerns at that time, and is always the case, is, 16 again, the position of us. We are fiduciaries and under Rule 17 2a-7, we are specifically required to make an independent 18 assessment of a company's debt metrics, which includes 19 liquidity. 20 Disclosure does not focus on the debt markets. It 21 typically focuses on the equity markets. So we, for years, 22 relied on conversations with companies about their backstop 23 facilities, their liquidity profiles, how they are planning, 24 if the markets throw them -- if they're throwing out of the 25 markets, to manage their short-term debt positions and so 1 forth, and our great concern about Reg FD is that it is not 2 typically disclosed in financial statements because they tend 3 to aim at the stock market, which isn't typically -- maybe a 4 little more recently, but is not typically interested in the 5 liquidity. They are interested in earnings growth. 6 I don't know if that really answers it, but we're 7 not looking -- we don't want non-public information. We're 8 not seeking to get extra information people are not -- our 9 business is taking what information is available and making 10 the best possible decision with it. 11 So that's why I say this whole issue of the rating 12 agencies, potential or theoretical, I mean, I don't know how 13 much they get, just seems to me to create an imbalance. 14 It's not a big thing we worry about, but I think it 15 does add concern in the marketplace when an agency may act in 16 a way that we don't understand. 17 We sit there and one of the first things we wonder 18 is what is it that they know, and I think that that adds 19 unnecessary volatility and uncertainty to the marketplace. 20 That's it. 21 MR. O'NEILL: We would strongly advocate that there 22 be more disclosure, more communication between debt issuers 23 and buy side or sell side analysts. We think there is a 24 great need for it. 25 The debt markets have grown huge in the last 25 1 years and have a huge impact on the future of how retirees 2 are going to finance their future. 3 We need a robust, independent buy side fixed income 4 community. They need to have the right information. They 5 need to have good ratings and good transparency. 6 The debt markets have gotten very complex with 7 securitization and how do you figure all of this out. 8 So clearly there is a need for more open 9 communication between the buy side and the issuer community, 10 and we would advocate that. We encourage that. 11 I don't know what it creates for Malcolm in his 12 work day, but maybe a lot more. 13 MS. NAZARETH: Frank has been very patiently 14 sitting here. He's ready to make a point. 15 MR. FERNANDEZ: First, Cynthia, I'm not 16 unsympathetic. It sounds like you're arguing a lot of points 17 that I argued from our standpoint when it was an equity issue 18 on Reg FD, and I think it would probably be a shock to 19 anybody at the staff of the Commission to find I would agree 20 with you on a Reg FD issue, particularly Commissioner 21 Goldschmid. But I do have to agree with you on this. 22 COMMISSIONER GOLDSCHMID: Goldschmid will note that 23 one basic distinction between the rating agencies and 24 everyone else in terms of analysts is they're not doing it 25 for selfish interest. 1 Everyone else can trade and trade ahead to the 2 public and tip clients, and that is a very serious market 3 problem. 4 MS. NAZARETH: Could I interject, also? I think 5 there has been some confusion on what the exception is for 6 FD, and you know it far better than I do. 7 But it's not limited to NRSROs. It's for people 8 involved in the credit rating business. So whether a firm 9 has that designation or not is not, at least by the words of 10 the exception -- 11 MR. EGAN: The reality in the marketplace, the 12 reality is that companies will only give that confidential 13 information to the currently recognized NRSROs. 14 I think it is quite ironic that Fidelity, one of 15 the biggest investors, is arguing that Regulation FD be 16 adjusted for the rating agencies. What about the middle tier 17 firms or the small firms? 18 There is no reason why a couple of private firms 19 should be given market information ahead of everybody else. 20 It's crazy. I mean, how is the investor being benefitted by 21 that? They're not. 22 MR. FERNANDEZ: I think this is the point -- if I 23 could finish. 24 MS. NAZARETH: Go ahead, Frank. 25 MR. FERNANDEZ: You hit on one of the points here. 1 I think you have to distinguish between the exemption 2 provided for someone who is providing a quasi public function 3 here. 4 You are not trading in the market if you are an 5 NRSRO. You are not acting on this for portfolio adjustments 6 or any other purpose. We hope. 7 But I think that's a point that we should address, 8 because I don't believe that this is a Reg FD issue and I 9 think there are more important issues that need to be 10 considered today than this one. 11 But there is another flaw, I think, in here, is the 12 failure to distinguish, and you alluded to it, between 13 information and analysis. At a certain point, you have to 14 draw the line there in terms of what is disclosed and then 15 the mosaic that may be created by the analysts with that 16 information or conclusions he may draw or his competitive 17 ability to ferret and drive from a piece of information that 18 he is provided. 19 That's different than the disclosure of a piece of 20 material information. So I think that distinction has to be 21 drawn, as well. 22 The second is the inference that is being made here 23 that there is some evidence that there has been misuse of 24 this privilege, this safe harbor, this exemption that has 25 been provided, and I would like to hear what that is, because 1 I've looked at this and we not only look at the application 2 of this for just the NRSROs, but let's remember there's like 3 37 different credit rating agencies, CRAs, globally. 4 Then there is, in addition to the surveys we do of 5 our own risk management functions, the particularly the very 6 sophisticated large institutions and their risk management 7 systems that also have some regulatory obligations in terms 8 of providing oversight. 9 I hear and see nothing either on an anecdotal or a 10 secondhand nature that there has been any abuse of this at 11 all. So I think in conclusion on this generalized point, I 12 hate to agree on a Reg FD issue with you, but I think that 13 this is not the issue that we are treating here. 14 You can argue a lot that there are impediments to 15 accurate appraisal, and if there is a problem, if you have a 16 problem, do what we have had to do. If you think they know 17 something you don't, go to the person who has the obligation 18 to disclose what that material piece of information is and 19 ask the company themselves for an explanation. 20 MS. STRAUSS: We actually have not had a specific 21 concern -- I don't have a specific example with the rating 22 agencies on this. So I was just clarifying the various 23 points here. 24 Also, as you can see by the fact that I don't know 25 what they get that we don't, if they do, they're keeping it 1 very confidentially. We don't get tipped, we don't get -- 2 MR. FERNANDEZ: Quite honestly, on the sell side, 3 when you're doing this, you discreetly or explicitly 4 incorporate all the publicly available credit rating 5 assessments out there as part of a reflection of market 6 sentiment, and that tends to be actually a numerical input 7 into your evaluation process. 8 And it's a two-way flow, in a lot of senses. So 9 when there is a deviation even between your assessment and 10 those of the three rating agencies, you do want to know what 11 the basis of that deviation is. 12 I'm not a lawyer, but if I understand FD correctly, 13 the obligation then for that disclosure is on the part of the 14 issuer and you have a right to certainly go ask the issuer is 15 there something that I am missing here. 16 MS. NAZARETH: Right. Commissioner Goldschmid? 17 COMMISSIONER GOLDSCHMID: How good are these 18 ratings? How good are they over time in terms of correcting? 19 MS. NAZARETH: I think that's a very important 20 question. I think we should start with that. Why don't we 21 take a 15-minute break and come back with that very important 22 question. 23 Thank you. 24 (A brief recess was taken.) 25 MR. HARRIS: Welcome to this session on information 1 flow in the credit rating process. 2 Access to current reliable information is an 3 essential ingredient in making a timely and credible credit 4 assessment. This holds true for credit rating agencies, 5 which need a continuous flow of accurate information to 6 assess the creditworthiness of a specific issuer or issue. 7 It also holds true for many issuers of credit 8 ratings who need explanatory information to understand the 9 rationale upon which a credit rating is based. 10 During the past few years, a rapidly changing 11 credit environment and a number of high profile bankruptcies 12 have highlighted the need for the communication of reliable 13 and timely credit information to credit rating agencies and 14 to the users of credit ratings. 15 To better understand how information flows in the 16 credit rating process to and from credit rating agencies, we 17 will focus this session on issues related to the flow of 18 information in the credit rating process. 19 We will begin the session by discussing a number of 20 issues concerning the flow of information from issuers to 21 rating agencies. We will consider the types of information 22 made available by issuers and deemed significant by rating 23 agencies when issuing credit ratings, the access credit 24 rating analysts have to senior level management of an issuer, 25 the extent to which rating agencies independently verify 1 information obtained from issuers, and steps taken by rating 2 agencies when they are unable to obtain complete or reliable 3 information. 4 Of course, you recognize I am reading from set text 5 here. We have already done much of this and we will adjust 6 ourselves a little bit accordingly. 7 We will then focus on the flow of information from 8 rating agencies to the users of ratings. We will consider 9 the method by which credit agencies disseminate their ratings 10 and notices that ratings are under review to subscribers and 11 the public; whether sufficient information is publicly 12 available regarding credit ratings, the rating process, and 13 the information on which a rating is based; and the extent to 14 which information concerning the rating is available to 15 subscribers that is not available or not publicly as readily 16 or as soon to the public. 17 Two specific areas that we would like to discuss, 18 actually, we have already discussed one of these, are the so- 19 called rating triggers and Regulation FD. I suspect we'll 20 skip much of FD, since we've done a good job of it already. 21 Rating triggers are provisions in financing or 22 operating agreements that require a company to retire its 23 financing or post new collateral with counterparts in the 24 event of creating a credit rating for the firm or if its 25 outstanding obligations decline below a certain level. 1 We would like to discuss the extent to which rating 2 agencies are aware of credit triggers and whether rating 3 agencies are hesitant to issue a downgrade that would 4 activate a credit trigger. 5 We can talk a little further about Regulation FD, 6 but I suspect we've done a pretty good job. 7 There are also, in addition, a few topics that we 8 didn't have a chance to get to from the last session that I 9 would also like to address, and I'm going to start with a 10 very fundamental issue that I think we need to explore 11 further as we consider the flow of information in the credit 12 rating process. 13 What exactly is a credit rating? All of us are 14 familiar with it, but we need to understand exactly what a 15 credit rating is to understand many of the issues that we are 16 discussing today. 17 So let me start by asking Leo, with a blank piece 18 of paper, what is a credit rating? What purpose does it 19 serve? 20 MR. O'NEILL: Actually, I hope I can answer this. 21 COMMISSIONER GOLDSCHMID: And, Leo, I'm going to 22 push you to go on and say how good are they and how good are 23 they over time. 24 MR. O'NEILL: The credit rating is a relative sense 25 of the creditworthiness of an obligor, what is the 1 likelihood, relative likelihood that the obligor will be able 2 to make its debt repayments in a timely fashion over a period 3 of time. 4 A rating is assigned at a point in time. 5 Consequently, if events change or circumstances change, 6 ratings will change accordingly, and that's why we maintain 7 surveillance and that's such an important part of what we do 8 on ratings. 9 In terms of the quality of ratings, how well do 10 they work, clearly, as I think was pointed out and all the 11 statistical evidence will show, there is a very, very strong 12 correlation between the ratings and ultimate default. And 13 I'm proud to say it's a positive correlation. The higher the 14 rating, the less likely that an issuer will default. 15 A rating is not predicted in the sense that I can 16 tell you today which issuers are going to default at some 17 point in the future. 18 What I can tell you is that AAAs, for example, one- 19 half of one percent, roughly, of AAA will, in all likelihood, 20 default sometime over the next 15 years. I can also tell you 21 that if you are rated single B, that likelihood of default 22 rises to about 50 percent over that period of time. 23 Interestingly enough, and I think this supports the 24 earlier discussion, obviously, there is great need for 25 investors to have their own analytical expertise to identify 1 which of those 50 percent don't default and they may disagree 2 about percentages, even. 3 So I think that sometimes people believe because we 4 rate something single A, that that guarantees that this issue 5 is not going to default. No, it doesn't. It just creates a 6 relative likelihood. 7 Finally, the whole quality issue of ratings, I 8 think that you cannot accept the rating just solely on its 9 symbol. That symbol is usually accompanied with something 10 that's called an outlook or credit watch or a rationale that 11 decrease the dependency, the dependency of that rating on 12 certain conditions that might take place in the future. 13 So to just take the number, the letter grade and 14 say that's it, no. You have to look at it in the total 15 context of the opinion that we give. 16 The final comment I will make, the quality of that 17 rating ultimately depends upon the accuracy and the 18 timeliness, and the disclosure that is provided to the rating 19 agencies. 20 I would clearly say that when that disclosure is 21 flawed, as it was in many of the situations we have 22 unfortunately had in the last couple of years, I'm sorry to 23 say that the basic premise of that rating is suspect, because 24 it cannot accurately reflect credit conditions at a point in 25 time without that accurate disclosure. 1 COMMISSIONER GLASSMAN: Can I ask a question on 2 those statistics? What is the time frame that you're talking 3 about in terms of if you have a AAA? 4 MR. O'NEILL: Generally, what we've said, we 5 generally like to take a view that goes out two to three 6 years in terms of what we think we can understand today about 7 current conditions in the future. 8 I think what we've seen in the past several years, 9 and other periods in history, is that the volatility tends to 10 accelerate in periods of economic decline and economic 11 recession. 12 So what happens is the events change. They change 13 quickly. Conditions worsen much more so than what we 14 foresaw, perhaps others foresaw, and hence the ratings tend 15 to change with more volatility during periods of high 16 economic stress. 17 MR. HARRIS: Can you describe more completely the 18 process by which ratings are reissued? 19 MR. O'NEILL: A rating is -- first of all, the 20 process, very simply stated, is we assign two analysts to 21 every rating that we do, a senior analyst or a lead analyst 22 and a junior analyst. 23 We will meet with issuers. We will gather all the 24 information. We will then do all the analysis and assign a 25 rating. We then begin a continuous review process on that 1 rating. We don't just put it on the shelf and bring it out a 2 year later, dust it off, and take a look at it. It's a 3 continuous review process. 4 To the extent, from the earlier discussion on 5 conversations with third party institutional analysts and 6 everything, we control that very, very precisely.