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.