The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
Moony's
INVESTORS SERVICE
Testimony of Raymond W. McDaniel
Chairman and Chief Executive Officer of
Moody's Corporation
before the
Financial Crisis Inquiry Commission
June 2, 2010
INTRODUCTION
Good afternoon Chairman Angelides, Vice Chairman Thomas and members of
the Commission, my name is Ray McDaniel, and I am Chairman and Chief Executive
Officer of Moody's Corporation ("MCO"), the parent of the credit rating agency,
Moody's Investors Service ("Moody's"). Moody's recognizes the importance of the
work being undertaken by this Commission and on behalf of my colleagues, I welcome
the opportunity to participate in this hearing today and contribute our views regarding the
role of credit rating agencies ("CRAs").
Over the past several years, we have witnessed events whose magnitude many of
us would have once thought unimaginable. The turmoil in the U.S. housing market that
began in the subprime residential mortgage sector subsequently led to a global liquidity
crisis and a loss in confidence in the U.S. and global financial system. The impact has
created great hardship for many Americans. Families have lost jobs, homes, and college
and retirement savings as a result of this financial crisis.
Moody's is well aware that the crisis of confidence in the market has also
impacted the confidence in the credit ratings industry. Our reputation is the single most
important asset that we have. Over the course of our 100-year history, Moody's
employees have brought their insight and integrity to rating trillions of dollars of debt and
hundreds of thousands of issuances across a broad range of sectors, asset types and
regions. Their track record for providing predictive credit opinions, which Moody's
disseminates publicly and at no cost to users, has earned Moody's a strong reputation
among capital market participants worldwide. I am proud of our history and the work of
our people.
However, the performance of our credit ratings for U.S. residential mortgagebacked securities ("RMBS") and related collateralized debt obligations ("CDOs") over
the past several years has been deeply disappointing. Moody's is certainly not satisfied
with the performance of these ratings. Indeed, over the past few years, there has been an
intense level of self evaluation within our organization.
To this end, I and members of my management team have been open to ideas,
questions and differing perspectives, from both inside and outside of the company, for
two purposes:
1) Better understanding the reasons for the poor performance in this sector.
Subprime mortgages by their nature are more risky than prime mortgages and
therefore RMBS backed by subprime pools and rated by Moody's had greater
credit protection. In addition, starting in 2003, Moody's did observe a trend of
loosening mortgage underwriting processes and escalating housing prices, and we
repeatedly highlighted that trend in our reports and incorporated it into our
analysis of the securities. However, neither we- nor most other market
participants, observers or regulators- fully anticipated the severity or speed of
deterioration that occurred in the U.S. housing market or the rapidity of credit
tightening that followed and exacerbated the situation.
2) Raising the bar in assessing credit risk in a fast changing and less predictable
market environment.
As a result of our active internal dialogue and our communications with market
participants as well as policy makers both in the United States and internationally,
we have implemented a number of new measures, some of which I will highlight
for you today, to enhance our processes. We also have been working to adapt, as
needed, our policies, systems and organization to implement rules recently
adopted by the Securities and Exchange Commission ("SEC") for nationally
recognized statistical rating organizations ("NRSROs"), and the European Union
("EU"), among other national and regional authorities.
Still, more can and should be done. In this regard, we are continuing our
communication with market participants, public sector authorities and market
commentators to better understand various concerns and recommendations. Most of the
recommendations are premised on instilling greater accountability in the CRA industry,
as well as among other market participants. We share this goal, and we welcome reform
efforts that are likely to reinforce high quality ratings and enhance accountability without
intruding into the independence of rating opinion content. We believe that many of the
changes that have been suggested- such as increasing transparency in the rating process
and reducing the use of credit ratings in regulation - likely will have a positive impact
and promote greater accountability.
We remain concerned, however, that other proposed measures are at times
contradictory in nature. This may be indicative of a broader misunderstanding about the
role and function of rating agencies in the capital markets. For example, some proposals
would promote the use of ratings by regulators, other proposals would eliminate it; some
would promote diversity of opinions, others would discourage it; still another set of
measures would increase transparency in the rating agency industry, while others could
significantly reduce it.
The proper role of CRAs in the debt market is to be an unbiased commentator and
to provide predictive opinions on just one characteristic of an entity or obligation- its
likelihood to repay debt in a timely manner. In pursuing reforms to the industry and
market, we believe it is important to understand that:
•
Credit rating agencies are not gatekeepers.
Rating agencies are credit market commentators. They cannot stop a particular
security from being issued, nor can they stop securities from being purchased. Indeed,
markets can and do grow without ratings. Perhaps the most striking example of this
reality is the credit default swap market, which was wholly unrated but actively
traded. The capacity of individual credit rating firms to act as gatekeepers is even
more attenuated. For example, Moody's has declined to rate various market sectors
because of credit concerns and our actions have not served to "gate-keep" those
markets. To deem CRAs as gatekeepers who regulate the flow and characteristics of
securities issued is to assign CRAs a role that they are neither intended, nor equipped,
to fulfill.
-2-
•
Credit ratings are not investment advice.
Moody's credit ratings provide probability forecasts on only one characteristic of a
debt issuer's financial enterprise- the relative likelihood to repay debt in a timely
manner. In considering purchasing or selling securities, investors generally look to a
host of other characteristics, which can include price, volatility, liquidity and currency
risk of the security. Credit risk is but one factor in making an investment decision,
and sometimes not the most important factor.
•
Rating analysts do not structure or underwrite securities.
The role of the rating agency is to provide a neutral opinion on future credit risk of
debt securities and issuers. As a direct consequence, our analysts' role is "reactive"
in nature. While Moody's analysts do and should have opinions about various
aspects of issuances and transactions, they do not structure, advise on, create, design
or otherwise decide the terms of debt securities. Rather, the role of our analysts is to
understand the particular facts of the transaction as proposed by the issuer and clarify
to the issuer the rating implications of our methodologies for that transaction. 1
•
Investors should not rely on ratings to buy, sell or hold securities.
Institutional investors (who are the primary purchasers of structured products) have
their own obligations to their clients and therefore must perform their own analysis
when purchasing, selling or holding a security. The claim that such investors rely on
credit ratings when purchasing a security contradicts the responsibilities these
investors have to the individuals whose money they manage. Brokers and investment
professionals advising retail investors have similar responsibilities and obligations.
Credit ratings are a tool in the process, not a buy, sell or hold recommendation.
•
Every business model has conflicts of interest that need to be managed.
Issuers, investors and governments (which are also major issuers ofbonds) all have
economic interests in what ratings are assigned to securities. Some now argue that
replacing the issuer-pays model with an investor-pays or deal-pays model will
remove potential conflicts of interest and create better quality ratings. Such proposals
ignore the fact that conflicts are inherent and must be properly managed for any
model in which those paying rating fees are interested in the outcomes. It also
ignores the fact that our ratings in other sectors, which also have operated under the
issuer-pays model for over four decades, have performed well during the extremely
challenging market conditions of the past several years (and have performed better
during the issuer-pays period of our history than the five decades during which
Moody's operated under an investor-pays model).
Similar discussions take place in the corporate and government debt sectors; for example, when a corporation
is contemplating changes in financial structure or business strategy (e.g., the potential rating implication of a
share buy-back program on a corporate issuer's senior unsecured debt obligations), or with new corporate
issuers to whom Moody's has not previously assigned a rating.
-3-
•
Concerns about rating shopping do not stem from the business model.
Many market participants have expressed concerns with the practice of rating
shopping. Moody's has publicly shared such concerns for years. Rating shopping,
however, is the result of insufficient disclosure of relevant information for purposes
of assessing a security - whether as a credit rating agency or an investor- rather than
the choice ofbusiness model. In the absence ofpublic disclosure of information
reasonably necessary to analyze debt securities, rating shopping equally hinders firms
regardless of business model. In the U.S., this is perhaps the most striking difference
between the markets for corporate versus structured debt.
Today, with the benefit of hindsight, many observers have suggested that the
events that ultimately have come to pass were inevitable and easily predictable. As the
events were unfolding, however, multiple potential outcomes were considered
possible. Numerous market experts, including economists, financial institutions,
prominent opinion providers in the media, and the federal government had differing and
at times contradicting views regarding the ultimate performance of the U.S. housing
sector and its potential knock-on effect on the broader economy. Moreover, once the
sector began to experience shock, these same entities and individuals had differing views
on the duration and severity of the downturn and the shape of the recovery. No one could
tell with certainty whether the downturn would last a few months, or a few years.
Similarly, predictions varied widely about whether the market would quickly rebound,
climb in a more gradual but steady manner, or experience a "double dip." These
questions persist today, and a range of views continue to exist.
In my testimony, I will discuss briefly the prospective nature of credit ratings; the
role and use of ratings in the capital markets; ratings performance; the issuer pays model;
measures we have in place to mitigate the potential conflicts of interest arising from that
model; and Moody's efforts to advance the quality, transparency and independence of our
credit ratings.
I.
BACKGROUND ON MOODY'S
Credit rating agencies occupy an important but narrow niche in the information
industry. Our roots are in the American tradition of the marketplace of ideas and our role
is to publish opinions about the relative future creditworthiness of, among other things,
bonds issued by corporations, banks and governmental entities, as well as pools of assets
collected in securitized or "structured finance" obligations. By making these opinions
broadly and publicly available, rating agencies help to reduce information asymmetry
between borrowers (debt issuers) and lenders (debt investors). We sift through vast
amounts of available information, analyze the relative credit risks associated with debt
securities and debt issuers, and offer our opinion.
Moody's is the oldest bond rating agency. In 1909, American entrepreneur John
Moody published a manual, Analyses of Railroad Instruments, which introduced a
system of opinions about the creditworthiness of railroad bonds. Today, we have more
than 1,000 analysts in some 20 countries around the world. Our products include our
-4-
credit rating opinions, which are publicly disseminated via press release and made
available on our website at no cost, as well as research and special reports about debt
issuers and their industries. Since 2007, Moody's has registered with the SEC as an
NRSRO. Nine other firms are registered with the SEC as NRSROs, and the SEC has
estimated that approximately another 20 CRAs will become registered as NRSROs in the
future. 2
The growth of the industry has been primarily spurred by three important factors.
1) Disintermediation of debt markets: Rather than borrowing exclusively from
banks, companies began to borrow funds in the public debt markets which in
tum resulted in growth of those markets. The public markets use the free flow
of information and opinion. Ratings are part of that flow.
2) Internationalization of finance: Rather than being limited to their domestic
markets, investors and issuers began to seek out one another in the crossborder markets. As the flow of capital across national borders rose, the need
for a common language for credit became increasingly more important.
3) Growth of structured finance: Because of a number of regulatory and
accounting rules, structured finance became an important means of
diversifYing funding sources and managing risk on balance sheets.
II.
MOODY'S RATINGS ARE PREDICTIVE OPINIONS ABOUT FUTURE
OUTCOMES
Moody's ratings provide predictive opinions on just one characteristic of an entity
- its likelihood to repay debt in a timely manner. Our ratings of corporate issuers
(including financial institutions) are based primarily on analysis of financial statements,
as well as assessments of management strategies, industry positions and other relevant
information. Our ratings of structured finance bonds 3 are based primarily on analysis of
the transaction's legal structure, the cash flows associated with the assets on which the
transaction is based and other risks that may affect the bonds' cash flows. In both
corporate and structured analysis, we also take into consideration publicly available
factors that may be relevant to the credit analysis, such as market dynamics, pricing
information on the securities and other prevailing or contradictory views. Our analysis
necessarily depends on the quality, completeness and veracity of information available to
us, whether such information is disclosed publicly or provided confidentially to Moody's
analysts.
Models are tools sometimes used in the process of assigning ratings. But the
credit rating process always involves much more, including the exercise of independent
judgment by the rating committee. Ultimately, ratings are subjective opinions that reflect
the majority view of the rating committee's members.
SEC, "Final Rules: Oversight of Credit Rating Agencies Registered as Nationally Recognized Statistical
Rating Organizations," Release No. 34-55857 at 33607.
In using the tenn "bonds," I am referring to the various types of debt instruments issued by structured vehicles.
-5-
The heart of our service is expressing opinions on the relative credit risk of longterm, fixed-income debt instruments, expressed on a 21-category rating scale, ranging
from Aaa to C. 4 In the most basic sense, all bonds perform in a binary manner: they
either pay on time, or they default. If the future could be known with certainty, we would
need only two ratings for bonds: "Default' or "Won't Default." However, because the
future cannot be known, credit analysis necessarily resides in the realm of opinion.
Therefore, rather than simple "default I won't default" statements, our ratings are
opinions about the risk of outcomes in the future with degrees of uncertainty.
Moreover, our opinions are about the relative credit risk of one Moody's-rated
bond versus other Moody' s-rated bonds. In other words, Moody's ratings provide a
perspective on the rank ordering of credit risk, with the likelihood of loss increasing with
each downward step on the rating scale. The lowest expected loss is at the Aaa level,
with higher expected losses at the Aa level, yet higher expected losses at the single-A
level, and so on.
Ill.
ROLE AND USE OF RATINGS
Moody's ratings are one means of disseminating information about a bond to the
broader market. They are not the only means of disseminating information. 5 The most
important source of information about securities is the issuer itself- from whom the
original investor is purchasing the security.
As part of our responsibility to the market, we believe it is essential for investors
and others to understand the role of rating agencies and what credit ratings can and
cannot measure. In particular, we have made it clear that our ratings are not designed to
address any risk other than credit risk and should not be used for any purpose other than
as a gauge of default probability and expected credit loss. On our website, in our press
releases and in a variety of publications we consistently discourage market participants
from using our ratings as indicators of price, as measures of liquidity, or as
recommendations to buy, sell or hold securities- all of which are regularly influenced by
factors unrelated to credit. Moody's has also continuously advocated for the elimination
of regulatory use of ratings.
Our ratings are not, and should not be treated as, statements of fact about past
occurrences, guarantees of future performance or investment recommendations. The
likelihood that debt will be repaid is just one element, and in many cases, not the most
material element, in an investor's decision-making process for buying credit-sensitive
securities. Credit ratings do not address many other factors in the investment decision
process, including the price, term, likelihood of prepayment, liquidity risk or relative
4
Moody's also assigns short-term ratings~ primarily to issuers of commercial paper- on a different rating
scale that ranks obligations Prime- I, Prime-2, Prime-3 or Not Prime.
For example, in the corporate sector, debt issuers provide registered filings with the SEC, buy side and sell
side analysts provide their perspective on the securities and the financial media provides their perspective on
the various offerings.
-6-
valuation of particular securities.
IV.
RATINGS PERFORMANCE
Moody's success depends on our reputation for issuing neutral and predictive
ratings - and the strong performance of our ratings is demonstrated over many credit
cycles on the hundreds of thousands of securities we have rated. As a means of selfevaluation and in the interest of market transparency, Moody's conducts and publishes
annual default studies and periodic ratings performance reports, which we post on our
website, www.moodys.com. These default studies, which we have been publishing since
the 1980s, show that both our corporate and our structured finance ratings have been
reliable predictors of default over many years and across many economic cycles. There
will always be unanticipated developments in the markets that affect the credit risk of
securities - and we have seen this starkly over the past several years. Indeed, because of
events that occur at different times in different sectors, which will never be perfectly
predictable, default rates by rating category vary widely from year to year across regions
and industries within the corporate sector, as well as within various structured finance
sectors.
To put this concept in perspective, prior to the recent crisis, investment-grade
structured finance securities had somewhat lower credit losses on average than
investment-grade corporate securities. This strong overall performance of structured
securities led many market participants increasingly to perceive the sector to be "safer"
than the corporate sector.
V.
ISSUER-PAYS BUSINESS MODEL
For the past four decades, Moody's has been paid primarily by issuers of the
securities we rate. Some observers argue that an investor-pays business model would
have fewer potential conflicts than an issuer-pays model. We believe this presumption
ignores the sources and drivers of potential conflicts of interest in the ratings business as
well as the significant public policy benefit associated with the issuer-pays model.
•
First, investors can be just as motivated as issuers to influence ratings. In practice,
the term "investor" is a short-hand description for any subscriber to a rating service
and describes a variety of parties with vested interests in the credit ratings of
securities, including:
Short Sellers (for example, hedge funds that take a significant short position
on a particular company): as subscribers under an investor-pays model, they
may be highly motivated to encourage a negative rating action- and the more
negative and unexpected the action, the better for their financial interests.
Long Investors: similar to their short counterparts, long investors are
understandably interested in the outcome of rating actions. Before they
purchase a security they may prefer lower ratings to obtain higher yields;
following a purchase (especially for those who trade actively) they are likely
-7-
to prefer to have ratings maintained or raised rather than lowered to avoid, for
example, valuation mark-downs or forced sales.
-
Governments: governments, often faced with competing financial market and
social policy objectives, may seek to have ratings "protect" nationally,
systemically or politically important issuers such as large industrial employers,
banks or governments themselves. This is particularly an issue in instances
where governments have stepped in to provide systemic support to such
institutions, i.e., when the prudential regulator also becomes an investor.
•
Second. there is ofien no clear distinction between investors and issuers. Investors
frequently are entities that also are issuers, such as banks, insurance companies and
governments.
•
Third, shifiing "who pays" will not prevent issuers (rom using other financial means
to try to influence ratings. Entities seeking to influence rating actions can and have
attempted to do so by challenging rating agencies through commercial mechanisms
unrelated to fees, such as litigation to coerce higher ratings.
Put simply, numerous parties- including investors, issuers and governments- may want
ratings assigned and maintained in a manner that is most beneficial to their interests, and
those interests may often conflict with the goal of the CRA to issue an independent rating.
If Moody's provides a rating and is paid by an entity- regardless of which type of
entity- that has an interest in that rating, then we must protect against influence by that
entity on our rating actions. Currently, the market broadly understands the potential
conflicts of interest in the issuer-pays model, and Moody's makes plain the steps we take
to manage those conflicts. Transparency itself is a protection. If the industry were to
adopt an alternative business model, it would not eliminate the perceived conflict, but
merely shift it.
Given that potential conflicts are embedded in all feasible business models, we
believe that offsetting public policy benefits need to be considered. The issuer-pays
model of the rating business serves the public policy objective ofbroad,
contemporaneous dissemination of credit rating opinions to the public without charge.
We recognize that this business model entails potential conflicts of interest that could
impact the independence and neutrality of our rating process. However, we have a four
decade track record of effectively managing these conflicts. We also recognize that
potential conflicts of interest arising from other sources, such as securities ownership and
business and personal relationships, could similarly impact the rating process. 6
To maintain our independence, and to protect the integrity of our credit ratings
and rating process, we have adopted wide-ranging policies and procedures. Some of our
policies and procedures to manage conflicts include:
•
Determining rating opinions through a "rating committee" process. Our opinions
For a detailed discussion of the various policies and mechanisms we have in place that manage and mitigate
the potential conflicts in our business model, please see the 2006, 2007 and 2008 updates to the "Moody's
Investors Service Report on the Code of Professional Conduct," ("Moody's Report"), available at
www.moodys.com.
-8-
are not the decision of any individual analyst but are determined by a majority
vote of the members of a rating committee, with the most senior members voting
last so as not to influence the votes of the junior members.
•
Prohibiting all analysts from holding fee discussions with or owning securities in
the institutions in whose rating process they participate. 7 Moody's has established
a new commercial unit that is solely responsible for commercial interactions with
issuers, and analysts continue to be completely excluded from such conversations.
•
Not evaluating or compensating analysts on the basis of the revenue associated
with the entities in whose rating process they participate.
•
Providing that credit ratings will not be affected by the existence of, or potential
for, a business relationship between Moody's (or any of its affiliates) and the
issuer (or its affiliates) or any other party, or the non-existence of such a
relationship. Rather, credit ratings are to be determined solely on the basis of
factors relevant to the credit assessment. Ratings committees are not to refrain
from taking rating actions based on the potential effect of the action on Moody's,
an issuer, an investor or any other market participant.
•
Not creating investment products or providing buy I sell I hold recommendations.
The SEC is also continuing its rule-making activities with regard to NRSROs.
Some of the new rules address potential conflicts of interests, and we are adopting
whatever additional policies and procedures may be necessary to implement these rules
as they are finalized.
VI.
MOODY'S EFFORTS TO ADVANCE THE QUALITY, TRANSPARENCY
AND INDEPENDENCE OF CREDIT RATINGS
The economic downturn has exposed vulnerabilities in the infrastructure of the
global financial system, and important lessons for market participants have emerged from
the rapid and dramatic market changes of the past two years. For Moody's part, we have
responded to concerns expressed by both the private and public sectors by undertaking
initiatives to improve the credibility of our ratings and strengthen their quality,
transparency and independence. We have taken steps to:
•
Strengthen the analytical integrity of ratings;
•
Enhance consistency across rating groups;
•
Improve transparency of ratings and the ratings process;
•
Increase resources in key areas;
•
Bolster measures to avoid conflicts of interest; and
•
Pursue industry and market-wide initiatives.
Except through holdings in diversified mutual fimds.
-9-
The individual actions and initiatives that we have pursued in each of these areas
are important but numerous. We catalog and discuss them in Moody's Special Comment,
Strengthening Analytical Quality and Transparency, which was first published in August
2008 and updated subsequently. The updated Special Comments are available on
Moody's website. 8
One initiative that I wish to highlight is especially important to addressing issues
of confidence in structured fmance: our introduction of additional measures to help the
market better understand the characteristics and performance attributes of securitized
instruments. These added metrics, known as V Scores and Parameter Sensitivities,
seek to address two distinct questions asked by investors: (i) what is the degree of
uncertainty around the assumptions that underlie our structured ratings; and (ii) how
sensitive are Moody's ratings to changes in our key assumptions? We believe that
supplementing our traditional ratings with answers to these questions will improve
market understanding, a key ingredient to confidence. Moreover, these additional metrics
are intended to respond to the interests of various oversight authorities, which have asked
that rating agencies more clearly distinguish the performance expectations of securitized
instruments versus corporate and public finance obligations.
We believe that we have made good progress in improving the analytical quality
and transparency of our ratings. We also recognize that our practices must evolve along
with changes in market dynamics. We expect to continue developing and modifYing our
approach in step with market needs, as well as with regulatory expectations.
CONCLUSION
Moody's has always believed that critical examination of the CRA industry and
its role in the broader market is a healthy process that can encourage best practices,
support the integrity of our products and services, and allow our industry to adapt to the
evolving expectations of market participants.
Many actions can and have been taken by Moody's and at the industry level, and
policymakers at the domestic and international levels have proposed a host of reform
measures for our industry and credit markets generally. Moody's wholeheartedly
supports constructive reform measures and we are firmly committed to meeting the
highest standards of integrity in our rating practices, quality in our rating methodologies
and analysis, and transparency in our rating actions and rating performance metrics.
Thank you. I am happy to respond to any questions.
"Strengthening Analytical Quality and Transparency," August 2008. Updates of the document were
published in December 2008 and November 2009.
-10-
@FedFRASER