Demos Report Called for Clearinghouse to End Incentives for Inflated Ratings
Washington — The Senate voted Thursday to distance the companies that rate the riskiness of debt instruments from the banks that structure the debt. By a bipartisan vote of 64 to 35, Senators approved an amendment by Sen. Al Franken (D-MN) to the financial reform bill to establish a self-regulatory body that will administer the assignment of credit ratings to the private credit rating agencies. Under current law, rating agencies are selected—and paid—by the issuers of the securities being rated.
In the December 2009 report, Reforming the Rating Agencies, Demos senior fellow James Lardner highlighted the inherent conflict of interest in the issuer-pays business model, in which intense pressure to gain market share drove rating agencies to lower standards, ignore risk factors and stamp Triple-A grades on thousands of mortgage-backed securities that would ultimately prove to be junk. Those inflated ratings created huge markets for these toxic products, the eventual failure of which would strip trillions of dollars from American investment and retirement accounts. The report called for the creation of an independent clearinghouse that would receive rating applications from securities issuers and assign each job to a rating agency. "The clearest and most important virtue of the clearinghouse proposal," Lardner wrote, "is in bringing the incentives of the rating agencies into alignment with their mission."
Demos applauded the Senate's action and urged all Members of Congress to maintain this important fix as the bill moves through the final stages. "Nowhere was the breakdown of our financial system more stark than in the failure of the credit rating agencies to uphold their fundamental mission of assessing creditworthiness," said Caleb A. Gibson, Federal Affairs Manager at Demos. "The Franken amendment will eliminate the banks' ability to shop for the most favorable rating and promote competition based on accurate, reliable ratings. Democrats and Republicans have identified a straightforward way to achieve the kind of decisive change that is needed."