Washington — Senator Al Franken (D-MN) has introduced a financial-reform amendment that finally addresses the root problem of the credit rating agencies—their built-in conflict of interest. The "Restore Integrity to Credit Ratings" amendment, co-sponsored by Senators Charles Schumer (D-NY) and Bill Nelson (D-FL), substantially embraces a remedy set forth in a recent Demos policy paper on this subject.
The Franken-Schumer-Nelson amendment calls for the creation of a Credit Rating Agency Board, with investors in the majority, to oversee the ratings agencies and to develop and administer a new method of making initial rating assignments. Until now, securities issuers have been permitted to choose their own raters, giving them a continual incentive to give out higher ratings in order to gain market share. Under the so-called "issuer-pays" system, the Big Three rating agencies —Moody's, Standard & Poors, and Fitch — bestowed Treasury-bond-style AAA ratings on the great majority of roughly $3.2 trillion in mortgage-backed securities issued between 2002 and 2007. These were the bonds that, along with related CDO's and side-bets, eventually propelled the entire financial sector to the edge of collapse.
"Why did the rating agencies ignore the glaring risks of these housing-bubble-inflated securities?" asked James Lardner, Demos' Senior Policy Analyst. "Because that was the way to get more business from the bond issuers who paid them, picked them, and, in many cases, had their separate (and separately paid) help figuring out how to achieve the desired rating."
In 2004 and '05, Standard & Poors and Moody's lowered their standards again and again, as each sought to avoid the perception that it might be even marginally less accommodating. "I knew it was wrong at the time," Standard & Poors director Richard Gugliada testified later, adding that "it was either that or skip the business."
In a Demos report, Reforming the Rating Agencies: A Solution that Fits the Problem, Lardner outlined a plan to randomly assign bond offerings to ratings agencies. The Franken-Schumer-Nelson amendment calls on the new Credit Rating Agency Board, operating under the oversight of the Securities and Exchange Commission, to study the random-assignment idea, among others, before developing a system that ensures rating agency independence. The board would also be charged with evaluating ratings accuracy on the basis of simple, transparent criteria, such as the number of times that investment-grade bonds defaulted or lost significant value. The most accurate ratings agencies could be rewarded with additional assignments. Those with the poorest records could, in extreme cases, be suspended or removed from the pool.
The Senate began debating financial reform this week. Over the next two weeks, the Senate is expected to consider scores of amendments to an omnibus measure voted out of the Committee on Banking, Housing, and Urban Affairs with the support of its chairman, Democrat Christopher Dodd of Connecticut.
"The first imperative of rating-agency reform is to align the incentives of these badly corrupted entities with their mission," Demos' James Lardner said. "The Franken amendment would be a game-changer: the rating agencies would go back to being the cool observers of the bond market that we need instead of the high-flying Wall Street players that, in the era of deregulation, they were tragically allowed to become."
"Demos applauds Sen. Franken and his colleagues for moving to fill a crucial gap in the bill's otherwise strong set of measures to strengthen oversight of credit rating agencies."