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Home Publications Blogs Beat the Press Credit Rating Agencies Likely to Evade Dodd-Frank Provision to End Conflict of Interest

Credit Rating Agencies Likely to Evade Dodd-Frank Provision to End Conflict of Interest

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Tuesday, 14 May 2013 04:47

One of the key issues in the financial crisis was the fact that mortgage backed securities (MBS), filled with subprime mortgages of questionable quality, managed to get Aaa ratings from the bond-rating agencies. While ignorance and stupidity may explain much of what happens on Wall Street, there were people at the rating agencies who did raise questions about the quality of these securities. In one e-mail at S&P an analyst complained that it would rate an MBS as investment grade if it were "structured by cows." The analyst's complaint was ignored for a simple reason, S&P was making lots of money rating MBS.

Senator Al Franken proposed a simple way to eliminate this obvious conflict of interest. He proposed having the issuer use the Securities and Exchange Commission (SEC) as an intermediary in the hiring process. Essentially, this means that the issuer would have to call the SEC when they wanted to have an issue rated and the SEC would then pick the rating agency. This would eliminate the incentive for the rating agency to issue an investment grade rating to get more business. The Franken Amendment passed the senate by a huge 65-34 majority, winning bi-partisan support. (Disclosure: I had written about this sort of reform and discussed it with Franken's staff.)

While this might have seemed like a victory for simple common sense, the amendment was largely eviscerated in a conference committee, apparently at the urging of then House Finance Committee Chair Barney Frank. Instead of implementing the amendment, the conference bill called for the SEC to study the issue and make a decision by the end of July, 2012.

The SEC is now almost a year late in this process, but apparently is prepared to ignore the rule, with an assist from the Washington Post. In an article discussing the SEC's plans, the Post dutifully repeated statements from the industry groups that were almost complete nonsense, without consulting any of the many experts who could have spoken in support of the Franken proposal.

 

The meat of the article told readers:

"'There just doesn’t seem to be enough support in Washington to blow up the business model,' said Jaret Seiberg, an analyst with Guggenheim Partners.

"Some analysts say the appetite for creating a new bureaucracy is waning at a time when emphasis has been placed on shrinking the government. In addition, the structured finance industry and its Washington supporters are worried about having a board, instead of the ratings firms, determine rating criteria, said Tom Deutsch, executive director of the American Securitization Forum.

"'The plan would eliminate independent judgment of the rating agencies and replace it with a government-mandated, government-endorsed ratings assignment board,' Deutsch said."

If the Post was interested in running a news story rather than an ad for the bond-rating agencies they would have found an expert who would have explained that the SEC would essentially be selecting from a very small number of qualified rating agencies almost at random. The "new bureaucracy" needed for this task could fit into the closet of a typical Wall Street CEO.

As far as the American Securitization Forum spokesperson's complaint that the plan would "eliminate independent judgment of the rating agencies and replace it with a government-mandated, government-endorsed ratings assignment board," this is a complete lie. The government already determines which credit rating firms provide an acceptable basis for assessing credit risk.

The SEC would presumably apply the same sort of standards in allowing credit rating agencies to rate MBS as it already does in determining that they are qualified to rate issues more generally. The Washington Post did the bond-rating agencies a great service by implying that the Franken Amendment would involve some major departure from current practices.

This process provides a great example of how a simple good government reform with wide bipartisan support could be derailed by the actions of a relatively liberal member of Congress with the complicity of the major media.

The Wall Street Journal piece was somewhat better. Unlike the Post piece, the body of the article was not filled with unchallenged assertions from the industry. It also pointed out that the SEC had missed the deadlines specified in the law.

 

Note: Typos corrected from an earlier version, thanks to Robert Salzberg.

Comments (15)Add Comment
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written by Chris Engel, May 14, 2013 7:26
While this might have seemed llike a victory for simple common sense, the amendment was largely eviscerated in a conference committee, apparently at the urging of then House Finance Committee Chair Barney Frank.


Dean,

My understanding was that Barnie Frank was an ally. Why did he urge it to get gutted? Because he wanted a more comprehensive reform or because he was shilling?

Very strange, I know Dodd-Frank has holes everywhere, but I thought in general that he was one of the few who look out for the public interest.
Credit Rating Agencies are Economic Predators on Behalf of Other Predators
written by Last Mover, May 14, 2013 7:37
Meanwhile in the predatory economy that America has become, credit rating agencies on the demand side certainly have no problem giving "accurate" ratings to ordinary individuals no matter how small or bogus the amount involved.

For example, a common practice of companies with millions of customers is to ding them with an array of bogus charges usually too small to be worth challenging but large enough to be highly profitable given the take from millions of customers.

Those who do challenge the constant stream of petty fraud that endlessly invades the most menial of consumption spending can easily end up with a reduced credit rating for a ridiculous small amount, and challenging the credit rating agency itself starts the whole insane procedure over again.

And this doesn't even get to the fundamental question of why Americans don't have complete control over their own credit records. Why do they have to pay for their own credit data?(the required "free" access is farcically made difficult to the point of being impossible).

If anything credit rating agencies should be paying Americans for access to their private financial property and anyone who wants out of the credit rating system altogether should be allowed to withdraw by requiring all credit data be removed from the agencies.

Of course that won't happen because it looks too much like a working free market where consumer sovereignty reigns from the demand side through the power of free choice.
...
written by liberal, May 14, 2013 8:39
Chris Engel wrote,
My understanding was that Barnie Frank was an ally.


That's not my understanding. While this stuff was unfolding my distinct impression was that Frank's actions were most simply explained by assuming his was acting in the interests of the FIRE sector.

Sure, they passed the reform bill, but the bill does very little. (There might be some bright spots like the CFPB, but...)

Take the part that mandates that things be set up so that large institutions can be unwound in an orderly fashion if they go under, so the government won't have to bail them out if there's a crisis. There's no real structural reform there. Because there's no true structural reform, these firms still won't be easy to unwind, and the government will bail them out again (meaning, their counterparties and their bond holders).
...
written by liberal, May 14, 2013 8:43
Last Mover,

What I don't understand (I haven't been able to find anything on the web) is why people aren't able to launch defamation suits when their credit is unfairly dinged (be it against the credit reporting agency or against the entity that sent the bad report to them).
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written by Last Mover, May 14, 2013 9:11
@liberal

Because in the case of nickel and dime stuff, say mostly below $100 per incident yet numerous, it would have to be a class action lawsuit and they outlawed those too.

They have nothing to lose. For example locking in customers who try to cancel service with fees made up with no basis is common. If it's not paid they simply sell it to a collection agency for pennies on the dollar and lose nothing, which gives the debt collectors huge incentive to hound the customer for years along with threats to reduce the credit score.
Bogus
written by Jim, May 14, 2013 9:28
That's epic bs! I dont get why the bond insurers didn't sue the ratings agencies along with the banks. There must be something in the rep and warranty that indemnified the ratings agencies.
The ratings agencies argued they only offered an opinion protected by free speech
written by John Wright, May 14, 2013 10:10
As I remember, some short sellers believed the ratings agencies would be successfully sued for the "optimistic" AAA ratings they gave to MBS.

The purest play was to short Moody's (S&P is inside McGraw-Hill), as the shorts believed Moody's would be left with zero equity after court judgments were paid, making it a great short.

If you look at the stock chart for Moody's, it is at 65.68 now, not far from its peak of 75 in 2007.

I believe Moody's and S&P's defense was that they only offer opinions, which are protected by free speech.

And apparently those bad opinions, that caused many people financial harm, didn't damage the Moody's brand.

Another booster shot for middle class American cynicism.



Barney Frank...ally?
written by pete, May 14, 2013 12:11
While he was trying to rope in the Fed with Ron Paul, a good thing, his other major work was in the early 2000s to insulate Fannie and Freddie from increased regulation, such as having their securities be registered with the SEC. In particular, some in congress wanted increased scrutiny over their massive purchases of low quality loans. Fannie and Freddie managed to rope in support from inner city congresspeople to prevent the scrutiny. Even in the spring of 2008 Barney said F&F were in great shape. This is a great disservice to the country, simply rolling over for lobby money.

The SEC should drop the requirement of ratings agencies. FOB Buffet says he pays no attention to ratings agencies, they do their own credit analysis.
...
written by liberal, May 14, 2013 2:19
pete wrote,
...his other major work was in the early 2000s to insulate Fannie and Freddie from increased regulation...


While I would agree that there was a lot of bad policy surrounding the GSEs, they weren't the proximate or ultimate cause of the bubble, and they're almost certainly not among the biggest problems that "reform" didn't fix. (Main one IMHO was not so much "too big to fail" but rather "too complex to fail"---within and between financial firms.)
...
written by watermelonpunch, May 14, 2013 2:23
The SEC should drop the requirement of ratings agencies.


Well... why do they not just have someone else pay for it? Someone who's money isn't going to be spent to make something look better than it is?

I think anyone would have to be daft to trust a quality rating by the maker of something - whatever it is. It should be a no-brainer that if someone's trying to sell something they're going to talk it up, or pay someone else to talk it up. This is not some new phenomenon, it's as old as human history (& pre-history no doubt).
liberal...I did not say that at all...
written by pete, May 14, 2013 3:38
I was merely pointing out that Fannie and Freddie went kaput. And agreed, Frankendodd actually raised the fixed costs of banking, meaning more integration, fewer banks bigger banks.

Back to the bubble...though, certainly F&F were huge lobbiers in defense of relaxed lending. They were under direct orders to increase their lending to lower incomes. That much is indisputable. They merely wanted to avoid scrutiny so they could keep the risk unknown. So they lobbied congressfolks from the poorer districts to keep the congress off their back. And it worked like a charm. In 2004 they were like 40% of securitized lending to poorer folks. I guess that doesn't make them part of the problem, since Dean Baker knew it was a bubble in 2002. But those last two years were doozies!
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written by liberal, May 14, 2013 4:35
pete,

All I meant was that they weren't central to the bubble. But yes, they weren't making anything any better in terms of the overall picture.
...
written by liberal, May 14, 2013 4:41
watermelonpunch,

It's actually a difficult problem. If the issuing entity pays for the rating, then there's a conflict of interest, as we're discussing. If someone does their own credit analysis and it leaks, or if people observe what they're doing and just follow their buying decisions, they can free ride on the person who did the analysis.
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written by watermelonpunch, May 14, 2013 7:32
If someone does their own credit analysis and it leaks, or if people observe what they're doing and just follow their buying decisions, they can free ride on the person who did the analysis.


Well then the solution is a no brainer, that it has to be the solution proposed, that the choice of rating agencies should be done by an independent entity... as proposed that the SEC assign it randomly.

Though I think even then, there would probably be shenanigans. I can't think of a scenario... but there has to be a flaw someone will wind up exploiting. Because that's what the financial sector does - exploits things to make money.
Somehow it would wind up eventually that someone would wind up getting incentives somehow to do something that screws over regular folks.

I just think if you're not the one paying someone, they have no true & enforceable obligation to do right by you instead of doing right by themselves or someone else who is paying them.

The only thing that can engineer that to work another way is enforceable laws & enforceable regulations.
And doesn't that come right back to why the financial services industry doesn't want such laws... because those laws interfere with their bread & butter, which is exploiting flaws or weaknesses.

I wonder if we just have to accept that if we want a financial sector, it's going to be dog eat dog... and it's just going to implode & bust on a regular basis.

I would prefer heavy regulation and a tiny purely practical financial sector.
But that's not going to happen. There's too many people who are making money hand over fist in the financial sector. And it seems they'll go to any lengths to protect their jobs. (Even if it means depriving others of not only jobs, but lives.)
...
written by liberal, May 15, 2013 11:28
watermelonpunch wrote,
Though I think even then, there would probably be shenanigans. I can't think of a scenario... but there has to be a flaw someone will wind up exploiting.


I completely agree.

I would prefer heavy regulation and a tiny purely practical financial sector.
But that's not going to happen. There's too many people who are making money hand over fist in the financial sector. And it seems they'll go to any lengths to protect their jobs. (Even if it means depriving others of not only jobs, but lives.)


Agree, again (sadly).

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.

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