January 14, 2020
Tim Geithner might have left his job as Treasury Secretary seven years ago, but his legacy lives on. The Wall Street Journal reported that the financial firm Morningstar had reached a settlement with the SEC over marketing it had done for firms whose bonds it had rated.
SEC rules prohibit rating agencies from doing promotional work for firms whose bonds it rates. This is done to prevent the obvious conflict of interest, that it may give better ratings as part of a promotional effort.
This conflict of interest is inherent in the rating process as it is now designed. Rating agencies have an incentive to give high ratings as a way to attract business.
This was one of the problems that led to the run-up in the housing bubble, the collapse of which caused the Great Recession. Rating agencies gave investment grade ratings to mortgage backed securities that they knew were filled with bad mortgages because they did not want to lose the business.
There is a very simple solution to this problem which was addressed in an amendment to the Dodd-Frank financial reform bill inserted by Senator Al Franken. (I worked with Senator Franken’s staff on this amendment.) The amendment would require issuers to contact the SEC, who would then select the rating agency. This would eliminate the incentive to give good ratings to attract more business. The Franken amendment passed with bipartisan support, getting 65 votes in the Senate.
Unfortunately, as he discusses in his autobiography, Tim Geithner arranged to have the amendment killed in the conference committee. Ensuring that the corrupt system we had in the housing bubble years was left in place.