How The Ratings Agencies Were Tamed

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A few weeks ago, as Congress raked various Goldman suits over the coals for peddling financial products they had later bet against, some observers complained lawmakers’ ire was being directed at the wrong culprits. It was the ratings agencies, the critics argued, that had made these doomed-to-fail packages of debt glimmer and shine. (Our colleague Barbara Kiviat described it as “slapping AAA lipstick on collateralized debt pigs.”)

The problem is a matter of incentives. Financial institutions pay ratings agencies to grade their products. The banks have all the leverage: if they don’t like a rating, they can walk and take their money with them. Compounding the problem is the fact that these firms are turning around and selling these instruments to someone else, so their motivation is to shop around for a favorable rating rather than an accurate one. The result, of course, is a bunch of securities that look very, very good but that can go very, very bad.

So while Senators chewed out Wall Street execs for hawking gilded garbage, an underlying systemic problem remained. Making matters worse was that the fact that the financial reform legislation being debated in Congress did little to address the problem. The Senate bill fell back on that easiest of deferrals — a commissioned study to examine the problem [punting noise].

Today, the Senate passed an amendment 64-35 that takes a legitimate crack at addressing the issue. Under the new measure introduced by Minnesota Democrat Al Franken, the SEC would form a panel to pick which ratings agency gets to grade each financial instrument, using either a lottery or rotating assignment system. But here’s the crucial twist: The chance any given agency has of being assigned to provide a rating would be weighted. The more accurate ratings an agency gives over time, the more business gets steered its way. Functioning properly, the system would undo the shop-around culture while incentivizing more precise ratings.

The amendment’s passage was far from a certainty. It represents a significant shift in the way the financial sector does business and even Chris Dodd, the Democratic architect of financial reform, ended up voting against the measure.  The ratings agencies, for their part, are unhappy. “Credit rating firms would have less incentive to compete with one another, pursue innovation and improve their models, criteria and methodologies,” S&P spokesman Ed Sweeney said. This could lead to more homogenized rating opinions and, ultimately, deprive investors of valuable, differentiated opinions on credit risk.” While almost any industry will buck under the yoke of tighter regulation, the measure could have some serious unintended consequences.

American companies are not the only customers of American rating agencies. Foreign governments get their national debt rated here and there are troubling political implications if other countries perceive U.S. influence in that process. Assignment of international debt does not appear to be directly addressed in this amendment, but it does include a nod to the problem:

(6) DISCLAIMER REQUIRED.–Each initial credit rating issued under this subsection shall include, in writing, the following disclaimer: `This initial rating has not been evaluated, approved, or certified by the Government of the United States or by a Federal agency.’

In addition, some U.S. government programs rely on ratings agency assessments when determining regulations or recommending investments. An amendment from Republican Senator George LeMieux that changes a bunch of statutory language to disentangle government organizations from the ratings agencies passed on a 61-38 vote Thursday. (Mike Konczal explains the measure in further detail here.)

When legislation spends a lot of time wriggling its way through Congress, it runs the risk of being defanged. In the case of financial reform, the bill seem to be sprouting teeth left and right.