Yesterday, the House Committee on Oversight and Government Reform held a five-hour hearing on the role of credit rating agencies in the recent financial crisis. Six witnesses, appearing on two panels, testified during the hearing and submitted written testimony. The first panel included former managing directors of Moody’s and S&P and a founding principal of Egan-Jones Rating Co., whose application for designation as a nationally recognized statistical rating organization (NRSRO) was approved by the SEC in December 2007. The second panel consisted of the chief executive officers of Moody’s, S&P and Fitch, the long-dominant U.S.-based NRSROs.

First panel:

Jerome Fons, Former Managing Director, Moody’s Investor Services.

Frank Raiter, Former Managing Director of Residential Mortgage-Backed Securities, Standard & Poor’s

Sean Egan, Managing Director, Egan-Jones Ratings

Second panel:

Deven Sharma, President, Standard and Poor’s

Raymond W. McDaniel, Chairman and CEO, Moody’s Corporation

Stephen W. Joynt, President and CEO, Fitch, Inc

The opening remarks of Committee Chairman Waxman (D-CA) set a confrontational tone for the hearing. Throughout the hearing, Committee members referred to internal communications at the firms suggesting that their responsibility to provide a realistic evaluation of the securities being rated had been compromised.

Sean Egan of Egan-James Rating Co. joined a former executive at Moody’s in faulting the existing “issuer pays” system, in which issuers of securities pay for credit ratings from the agencies, and which, in his view, creates a potential conflict of interest on the part of the rating agencies. Members questioned the soundness of the issuer pays system and the “ratings shopping” that allegedly accompanied it.

The CEOs of the three large NRSROs steadfastly denied that conflicts of interest had affected their agencies’ ratings judgments, while also describing various measures that they had taken since the market meltdown to “enhance the integrity” (in the words of S&P’s Sharma) of their ratings processes.

Committee members engaged in plenty of finger-pointing, but there was little discussion about possible alternative solutions. When asked, Mr. Egan opined that the only solution to the problem is for institutional investors to stop basing decisions on ratings from conflicted agencies.

In June, the SEC proposed to amend 38 existing rules that reference the use of NRSRO ratings in the context of bond issuances and structured products, including eliminating references to NRSRO ratings in 11 of those rules. The SEC proposal is reflected in three separate releases that address rules under the Securities Act , the Exchange Act and the Investment Company Act. The comment period for each proposal ended on September 5, 2008, but the SEC has not scheduled an open meeting to approve file rule amendments.