Back to General Resources

HFSC NRSRO Hearing

House Financial Services Subcommittee on Investor Protection, Entrepreneurship and Capital Markets

Bond Rating Agencies: Examining the “Nationally Recognized” Statistical Rating Organizations

Wednesday, July 21, 2021

Witnesses

Opening Statements
Chairman Brad Sherman (D-Calif.)
In his opening statement, Sherman said that a quarter trillion dollars of capital is allocated through the equity market, which is heavily regulated, but 20x that amount flows through debt instruments rated by the credit rating agencies. Sherman criticized the lack of transparency for ratings where estimated losses on different levels of ratings are undisclosed to the public. He also criticized the issuer-pay business model where customers pay credit rating agencies to rate their products or bonds.

Ranking Member Bill Huizenga (R-Mich.)
In his opening statement, Huizenga said that the Dodd-Frank Act significantly increased the accountability of credit rating agencies and that there is not a payment model that can omit all conflicts of interest. Huizenga quoted the Progressive Policy Institute, which stated that the issuer-pay model produces high quality and more accurate credit ratings. Huizenga concluded by urging his colleagues to stop bringing up old topics that need not be changed and focus on more recent issues.

Full Committee Chairwoman Maxine Waters (D-Calif.)
In her opening statement, Waters said that the credit rating agencies assigned high rating for worthless Mortgage-Backed Securities which led to the financial crisis in 2008. She asserted that despite knowing their importance, nationally recognized statistical ratings organizations (NRSRO) were still reluctant to remain unbiased in their credit ratings prior to 2008. Waters said that many Dodd-Frank provisions remain unfinished including reforms to minimize conflicts of interests.

Testimony
Amy Copeland McGarrity, Chief Investment Officer, Colorado Public Employees Retirement Association
In her testimony, McGarrity expressed concern with what she views as the credit rating agencies’ conflicts of interest and pointed to the high ratings credit rating agencies gave to mortgage products during the financial crisis despite the risks involved. McGarrity said that Congress needs to find out whether NRSROs are really considering crisis type events like the COVID-19 pandemic in rating the underlying bonds and structured financial instruments. McGarrity added that NRSROs still face conflicts of interest and the Securities and Exchange Commission (SEC) recently fined a large NRSRO for altering ratings for paying clients. McGarrity emphasized the failure of NRSRO reforms that were recommended by the Dodd-Frank Act resulting in poor rating qualities. McGarrity outlined that she sits on the Credit Rating Subcommittee of the Fixed Income Market Structure Advisory Committee at the SEC that proposed plans to curtail NRSROs’ problem with conflict of interest including: 1) increase NRSRO disclosure regarding models and deviations; 2) enhancing issuer disclosure for both corporate securities and securitized products; 3) establishing a mechanism for bondholders to vote on the issuer selected NRSROs.

Ian Linnell, President, Fitch Ratings
In his testimony, Linnell said that after the Dodd-Frank Act was passed, NRSROs implemented several changes: 1) establishing internal control structures governing their firms’ policies and criteria for determining credit ratings; 2) creating procedures to address and manage conflicts of interest; 3) requiring their board of directors to approve criteria to determine ratings; 4) designating a compliance officer to ensure compliance with securities laws. Linnell stressed that the Dodd-Frank Act provided tremendous guidance and regulations to ensure unbiased credit ratings from NRSROs. Linnell expressed concerns for the proposals that are under consideration for NRSRO regulations. He said that changing “who pays” NRSROs could introduce new conflicts of interest and create market confusion as to who is accountable for the rating. Linnell argued that standardizing credit rating agencies’ methodologies will not be productive since the diversity of NRSROs’ opinions can offer valuable insight to investors. Lastly, Linnell said that he agrees that equal acceptance of all credit rating agencies regardless of historical ratings performance is necessary to promote competition and for NRSROs to improve their criteria and procedures.

Jim Nadler, Chief Executive Officer, Kroll Bond Rating Agency
In his testimony, Nadler emphasized the benefit of open competition in the NRSRO space and how their firm was able to rate smaller banks while other traditional NRSROs refused to. Nadler pointed out that despite the Dodd-Frank Act trying to promote competition in the credit rating market, the three largest NRSROs still command over 95% of the market share. He said that many institutional investors still require the use of one or more of the largest NRSROs, which creates a significant barrier for entry, and he believes that all investors should permit the use of any SEC-registered NRSROs. Nadler also suggested that Congress remove any references to specific NRSROs in any regulations to allow fair competition. In addition, Nadler said that it is also important for the SEC to change their regulations on NRSRO registration to encourage entry. Nadler expressed his concerns regarding the Commercial Credit Rating Reform Act, which allows government assignment of rating agencies, highlighting that it might discourage thorough research, and prevent investors from choosing.

Robert J. Rhee, Professor, University of Florida Law School
In his testimony, Rhee said that credit reporting agencies need to be meaningfully regulated.  Rhee warned that opening the NRSRO market for competition could create a “race to the bottom” exacerbating the “rate-shopping” phenomenon that partly caused the 2008 financial crisis. Rhee said that the Commercial Credit Rating Reform Act would improve the credit rating agency by reducing the poor incentives of the issuer-pay model. Rhee said that the Uniform Treatment of NRSROs Act, which allows the Federal Reserve to make the ultimate determination of whether a credit rating agency is unreliable, would be appropriate. Rhee also said that the Transparency and Accountability of NRSROs Act, which requires the SEC to produce reports on NRSROs to disclose the agency’s name, would help increase accountability for deficient and noncompliant rating agencies. He added that this would also impose no additional regulatory cost on the industry. Rhee outlined that he views the Restoring NRSRO Accountability Act as helpful in increasing costs for the credit rating industry but also producing greater care in the production of credit ratings. Lastly, Rhee commented on the Accurate Climate Risk Information Act that would try to incorporate climate risks into credit ratings. He said that doing so poses the question of whether Congress or the SEC has the expertise or whether they should mandate a specific analysis of credit risk for private firms. Rhee concluded by saying that, despite Dodd-Frank Act reforms, structural problems like conflicts of interest remained within the credit rating industry.

Michael Bright, Chief Executive Office, Structured Finance Association
In his testimony, Bright said that there was substantive regulatory change since 2008 welcomed by credit rating agencies. Bright emphasized that other proposed types of payment systems still have risks for conflicts of interest and that they present even greater risks to the existing system. Bright added that there are two recommendations that investors came up with: 1) additional disclosure that issuers can provide on the selection process for the NRSROs they engaged to rate their deal; and 2) disclosure from rating agencies if there are any changes to their standard criteria. Bright expressed concern for a quasi-government agency that will select credit rating agencies and the SEC’s involvement in credit rating. He stated his view that a government-controlled assignment system will reduce the incentive to compete on the quality of ratings. Bright concluded by saying that transparency is always the most important for credit rating agencies and that their members are committed to creating a healthier capital market moving forward.

Question & Answer
Ratings Manipulation
Sherman mentioned his proposed legislation to apply liability only if there was a showing of gross negligence and asked Nadler if he were to do business and had to accept liability of gross negligence would he stay in business or go on strike. Nadler said he has to look at this more carefully, but the main point to agree upon is the need for bad behavior to be reprimanded.

Huizenga asked what the “price” someone can pay to get a good rating. Linnell said clearly there is no price. Huizenga said if it was the case, it should be punished.

Rep. Trey Hollingsworth (R-Ind.) said he keeps hearing that these agencies have no incentives to be “right” and asked witnesses to describe the reputational risk to credit rating agencies and the broader market implications of intentionally distorting those ratings. Linnell said firms would be out of business if they just inflated their ratings to get business. Nadler said investors would lose interest very quickly because they would be able to tell if agencies were inflating ratings.

Standardization Concerns
Sherman asked Linnell what harm he sees in simplifying the ratings to be A+, A, A-, B+, etc. Linnell said credit ratings are meant for professional investors not retail investors, and that the professional investor understands the ratings. Sherman said if an investor is paying for the ratings, it should be in terms he or she understands.

Rep. Bill Foster (D-Ill.) asked what the downside would be of standardizing the ratings. Nadler said standardization itself would not change anything and added that rating agencies already do a good job putting descriptions around each of their ratings.

Rep. Van Taylor (R-Texas) said his concerns are with analytics being affected by groupthink and subordination levels declining. Nadler said rating agencies post crisis competition had created rating inflation, and that before the crisis with three agencies compared to six agencies post crisis. Linnell said there is always a danger with groupthink and thinks efforts to harmonize too much could increase risk.

Liability
Foster asked about other possibilities for putting “skin in the game”, like requiring rating agencies to carry insurance against the risk of ratings turning out to be bad. Linnell said the ultimate sanction on poor performance of ratings is that the rating agency would be out of business quickly.

Rep. Emanuel Cleaver (D-Mo.) asked what is wrong with requiring the firms to insure their ratings. Linnell said they are a prediction of the future and that insurance companies insuring those predictions with one hundred percent accuracy would be very expensive.

Probabilities of Default (PD)
Foster asked about returning to assigning default probabilities under industry standard stress scenarios. Linnell said ratings agencies publish comprehensive default data but do not define those ratings according to PDs because the rates change across economic cycles. Foster said he was unaware one can predict what the default rating is going to be during an economic downturn and said the real answer may be to publish the models. 

Changes since 2008 Financial Crisis
Huizenga asked what has changed between 2008 and today. Bright said the understanding that the underlying asset prices can go down, noting that this was the number one mistake made by everyone prior to 2008. Huizenga asked if he believes investors have an adequate voice in these discussions and what members who buy bonds daily say. Bright said members would say they have a good dialogue with both the issuers and rating agencies.

Rep. Ann Wagner (R-Mo.) said more regulation does not solve everything and mentioned her and Congressman Foster’s Risk-Based Credit Examinations Act to make the required reported material only risk-based. She asked witnesses to describe changes in the rating industry environment since 2008. Linnell said the environment is more competitive today. Wagner asked what has changed in terms of the performance of credit ratings since 2011, to which Bright said volatility has substantially increased and quality has improved.

Rep. Bryan Steil (R-Wisc.) asked Linnell what changes had the biggest impact on his company’s performance through 2020. Linnell said post-Dodd-Frank, the changes made them more heavily regulated and subjected to yearly inspections, they were required to invest more in their controls and procedures and managing conflicts of interest, and they have had to invest a lot of time and effort in explaining to investors the key driving risk factors behind credit ratings. Steil asked how market participants account for the potential bias arising from possible conflicts of interest. Bright said investors have a dialogue with the rating agencies and will gladly point out when they think something is wrong.

Cleaver asked what Congress need to do on credit rating agencies. Rhee said the fundamental structure has not changed much since 2008, noting that general dominance and compensation models are the same. Rhee said he would like to see a link between compensation and performance. McGarrity said the issuer pay models are a problem, and she also supports a pay-for-performance model.

Proposed Legislation Comments
Rep. French Hill (R-Ark.) asked Bright to explain limitations in legislation that makes use of a rotational model to try to assign credit ratings. Bright said they want a dynamic with healthy tension and issuers having to sell their bonds to an investor with a particular rating and the agency needing to explain their methodology, arguing it is an appreciated and important dialogue. Bright said if it were simply a check box criteria that throws you into a rotation system, he worries it would eliminate the incentive for rating agencies to work with them to improve the quality of their ratings. Linnell said the proposed legislation would negatively impact market competition and harm investors if it only requires one rating rather than two.

Rep. Anthony Gonzalez (R-Ohio) asked Bright about recommendations to enhance issuer disclosures as well as requiring NRSROs to disclose more information on their models and methodologies. Bright said there are many disclosures with more information than stakeholders are looking for. For the methodology recommendation, Bright said models are never one hundred percent right, and that the important thing is to just have a conversation about what assumptions are involved and what empirical data is being used and why. Gonzalez asked about the alternative compensation schemes, Bright said both the assignment and investor-pay-models present many conflicts of interest.

Steil noted that some NRSROs specialize in analyzing certain asset classes or industries and asked if an assignment model would ignore these specializations. Bright said he strongly believes it would lead to a less reliable credit rating.

ESG
Rep. Alexander Mooney (R-W.V.) asked Linnell if credit ratings were less reliable due to political interference and how that would impact the broader financial sector. Linnell said any impediment to the independence and integrity of credit ratings would reduce their value and contribution to the financial sector. Mooney reemphasized that he is concerned with efforts to politicize the credit rating process.

Rep. Sean Casten (D-Ill.) asked about climate risk and to what degree the private sector is doing calculations we do not need to repeat and where there may be gaps. Nadler said they evaluate anything, including climate risk, that impacts the credit rating and are also working to begin to include disclosure around ESG risk that may not impact the credit today but could impact the market liquidity of the bonds in the future. Casten asked if credit rating agencies differentiate between transition and physical climate change risks. Nadler said they do. Linnell said the focus of their analysis is do ESG factors affect default behavior of the company in the future and said they assign ESG relevance scores.

Rep. Juan Vargas (D-Calif.) continued Casten’s point and asked witnesses if they are downgrading any parts of the country with respect to transition or physical risks. Nadler and Linnell said no, but Vargas mentioned that in March 2021, they downgraded PG&E (located in the Bay Area) because of wildfires. Linnell said they assess ESG factors as they reflect and affect credit risk in companies and said they have changed many ratings from companies who were initially given a highly relevant rating on environmental issues, adding that social and governance issues often get more urgent relevance ratings than environmental ones.

For more information on this hearing, please click here.