Today, the House Financial Services Committee's Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises held a hearing entitled "Approaches to Improving Credit Rating Agency Regulation." The purpose of the hearing was to "reevaluate how rating agencies conduct their business" and to examine the need for further regulation. The Committee hearing follows a Securities and Exchange Commission roundtable held just last month discussing a number of topics including the performance of the rating agencies leading up to the current market crisis, the lack of competition in the industry, conflicts of interest and possible regulatory and statutory changes in the business and oversight of the ratings agencies.
Testifying before the Committee were the following witnesses:
- Robert Auwaerter, Principal & Head of the Fixed Income Group, Vanguard
- Robert Dobilas, President and Chief Executive Officer, Realpoint LLC
- Eugene Volokh, Gary T. Schwartz Professor of Law, UCLA School of Law
- Stephen W. Joynt, President and Chief Executive Officer, Fitch, Inc.
- Alex J. Pollock, Resident Fellow, American Enterprise Institute
- Gregory Smith, General Counsel, Colorado Public Employees’ Retirement Association
Subcommittee Chairman Paul E. Kanjorski (D-PA) opened the hearing on credit rating agencies by stating that "At the very best, their assessments of packages of toxic securitized mortgages and overly complex structured finance deals were outrageously optimistic," and that the Subcommittee seeks to "explore serious proposals for reform."
Much of the witness's testimony focused on the differences between the "subscriber-paid" and "issuer-paid" business models of issuing credit ratings. Mr. Dobilas praised the Credit Rating Agency Reform Act of 2006, however he stressed that "[b]oth Congress and the financial regulatory agencies need to step in once again to address the glaring failures by the major credit rating agencies which are at the heart of the current credit crisis," and that "[l]ack of confidence in credit ratings continues to eviscerate the financial markets." He went on to describe the independent "subscriber-paid" business model of issuing credit ratings, and the conflicts associated with the "issuer-paid" business model, in particular that the "issuer-paid" model invokes "shopping" for preliminary ratings. Under the "issuer-paid" model, the issuer or arranger of debt offerings "[h]as the ability to control the ratings process of a new issue by awarding the rating contracts and its very substantial fees to rating agencies that provide favorable preliminary ratings." Mr. Pollock went so far as to classify the "issuer-paid" model often used by the dominant rating agencies as a "cartel" by "restricting supply," however, he does not necessarily believe the "issuer-paid" model should be restricted, rather there should be "prominent disclosure" of whether a rating was paid for by investors or issuers, to "[e]ncourage meaningful competition between the two models.
In contrast to Mr. Dobilas and Mr. Pollock's concerns with the "issuer-paid" model, Mr. Joynt outlined several of Fitch's policies and procedures which he believes "effectively" manages any potential conflicts of interest associated with the "issuer-paid" model, such as, among others, separating the company's business development from credit analysis, no direct compensation to analysts based on the revenues associated with their ratings, and "an independent internal review function review all ratings criteria." Moreover, Mr. Joynt stressed that a move to a complete “investor pays” model, could also remove ratings from the public domain in light of the fact that it would require market participants to actively subscribe for the ratings product. Instead he supports "fair and balanced oversight and registration of credit rating agencies" expanding on recent SEC rulemaking and the recently adopted European Union regulatory framework for credit rating agencies, in order "foster transparency, disclosure of ratings and methodologies and management of conflicts of interest."
While not addressing the two business models directly, Mr. Smith instead argued that despite the passage and implementation of the Credit Rating Agency Reform Act of 2006 "[r]ecent practices demonstrate that additional reform is necessary," such as requiring Nationally Recognized Statistical Rating Organizations (NRSROs) to:
- Publicly disclose complete historical records for all outstanding credit ratings in order to provide investors and the market with the ability to "assess and compare ratings and rating agencies";
- Provide the SEC with the ability to "(1) mandate disclosure of potential conflicts of interest; 2) police conflicts of interest; 3) freely investigate business relationships; and 4) adopt further rules to ensure the independence of NRSROs and to promote high quality ratings." This may include adopting regulations which require disclosure of business relationships, waiting periods for NRSRO employees seeking employment with a client of the rating agency and strengthening the responsibilities and requirements of each NRSRO's compliance officers;
- SEC regulation over NRSRO compensation, including amortizing fees over the life of the instrument, tying total compensation to the accuracy of the rating, and requiring public disclosure of fee schedules and the amount of compensation received for individual ratings; and
- SEC oversight of the disclosure of rating methodologies and any reasons why an NRSRO would "veer from its stated methodology."