Last week, I wondered if anyone in Congress would get their act together and try to deal with the problem of the credit rating agencies as part of the Wall Street reform bill. These raters essentially sold their power to high-rate crap securities to the highest bidder among the banks, because they are hired and paid by the companies whose securities they rate. Jeff Merkley told me that “there hasn’t been enough work done on it yet to come up with a solution.”
Sen. Al Franken has quietly done the work, and come up with an amendment that would change the way the rating agencies and their issuers do business. His amendment, co-sponsored by Bill Nelson and Chuck Schumer, would set up an office inside the SEC that would assign initial rating requests to the accredited rating agencies, rather than have the issuer hire the raters. “Our amendment brings the most fundamental change to the rating agency system,” said a staff member for Senator Franken who walked me through the amendment today.
The reform, modeled after a proposal by NYU law professors Matthew Richardson and Lawrence White, plugs a hole in the Wall Street reform bill by removing the conflict of interest among the rating agencies, according to Franken. He told ABC News yesterday that “If a failing student paid their teacher to turn their F into an A, everyone would agree that what the teacher had done was unethical … But right now, investors are being sold a phony bill of goods. We need to protect consumers from the pay-to-play system that rewards Wall Street players at the expense of Main Street.”
Here’s what the amendment would do. It would allow the SEC to set up a self-regulatory organization (that is, one not created by Congress) called the Credit Rating Agency Board. The CRAB, made up of investors as well as independent regulators, would then create a roster of qualified rating agencies, and select a method of assigning initial ratings on securities to those agencies. The amendment would encourage randomization but not mandate it. Staffers explained to me that a literal randomization would swamp the smaller rating agencies, who wouldn’t be able to handle the workload, relative to the big three of Moody’s, Fitch and Standard & Poor’s. The rating issuance would have to account for the performance of the rating agencies, and the board would not know which agency the issuer preferred.
Issuers could then go out and get a secondary rating after this initial rating, but the initial rating would stay on the record of the security. Franken staffers believed this would prevent deals where the issuing bank haggles with a rating agency for a better rating, and would lead to more accurate results, even in the secondary ratings, since a variance between that and the initial rating would raise eyebrows.
The amendment does not tie the statutory rulings that certain investors can only buy bonds rated AAA, like public pension funds, to that initial rating, which would seem to be the best way to prevent gaming of the system. Otherwise, the bank could go get a secondary rating to meet that statutory requirement. But Franken’s staff hoped that the initial rating would tend to deflate the lesser ones.
After the fact, the board would have to evaluate the performance of the rating agencies in their roster. And they would be encouraged to provide more business to those agencies which performed more accurately in their ratings assessment. Bill Nelson has a similar amendment on post-ratings surveillance that would assess the products after the initial rating.
“The smaller rating agencies think this could help them get into the market, because the big three raters block out competition,” said a staffer. The smaller agencies could compete without having to essentially bribe the issuers. They would be guaranteed initial business if they became a qualified rating agency, and would compete on quality rather than price or influence. Essentially, this could end the practice of “too big to fail” rating agencies, where a bad rater gets cycled through and rewarded by the system.
It’s unclear when we’re going to get amendments voted on in the Senate, but when we do, the Franken amendment could be one of the more critical.
UPDATE: Dean Baker, the partial inspiration for the Franken amendment, blesses the proposal, calling it “very good” in a statement to FDL News. Baker also talks me off the ledge about the prospect of having secondary ratings used to qualify bad securities for statutory arrangements. “In terms of the later ratings, if they had to identify them as ones they have solicited, I think they would have little value. So, I wouldn’t worry about that part.”