Tuesday, May 11, 2010

Al Franken's plan to end the credit rating conflicts

Posted in the Washington Post by Senator Al Franken:

I was heartened to read the May 5 editorial "A standard and poor remedy," highlighting the disturbing conflicts of interest in Wall Street's credit rating system. For the past two weeks, I've been working with Professor Matthew Richardson of New York University's Stern School of Business, mentioned in the editorial, to craft an amendment that would fundamentally change the incentives driving the rating industry.

As the editorial pointed out, the market is plagued by conflicts of interest and doesn't reward ratings for their accuracy: The current system allows investment banks to shop around to get the most favorable bond rating.

My amendment would create an independent board to assign a rating agency to each newly issued bond, taking into consideration the capacity and expertise of each agency. It would monitor their performance over time and reward the best actors with more assignments. This would eliminate conflicts of interest and make the system more accurate, fair and transparent. It would increase competition by giving smaller rating agencies an opportunity to compete against the largest three agencies, which have abused the current model.

We must take action that would change the way the system works by putting accuracy ahead of profits.

And here's a Q&A from Ezra Klein's blog on the Washington Post:

Why did you decide to focus on the rating agencies?

The agencies were an enormous part of the problem. They were giving AAA ratings to products that didn't deserve them. There's this inherent conflict of interest where the issuers of these financial products were shopping for raters. It's become very clear that what's going on was they had an incentive to inflate the ratings to get more business. In some cases the agencies were just stupid, but there was also a reason to be stupid. They had motive.

How does your amendment fix the problem?

Instead of the issuer shopping for ratings, we'd form a board under the SEC that would decide which rating agency rates each instrument. I don't mandate how they do it. But it wouldn't have to be totally random. The board would be comprised mainly of investors and people who manage pensions and university endowments. One of the advantages of this is that it'd inject more competitions into the business. Right now, we have Moody's and Standard & Poor's and Fitch doing 94 percent of the ratings. This board could give business to smaller agencies. You'd be rewarded on accuracy and so the incentive would be to be more accurate.

And that, you hope, takes care of the problem wherein the rating agencies actually do a worse job because they're now guaranteed to get business?

Right. Depending on the nature of the product, you'd be able to judge the accuracy over some period of time. Developing a track record of accuracy would be in your interest as opposed to rewarding the exact thing we don't want, which is inflating ratings on behalf of the banks.

Another criticism people have raised about this approach is that giving the government more power over the agencies will leave them more beholden to the government. Right now, the agencies have been criticized for downgrading Greece, and in the future, with our deficit, you could imagine them downgrading America. But not if they rely on the federal government for work.

Well, maybe there'd be part of this where they're not rating government securities. I'm not sure how that would work. But this is about the securities that got us into trouble. So it might not be how we'd do a Treasury bond.

Rather than bringing them further into the government's embrace, why not just kick the rating agencies out altogether? Right now, the government credentials them, uses their "AAA" rating in certain laws and generally makes sure they're central to the system. Why not let them rise or fall on their own?

I think that would be a problem. You could say let's just not have any rating agencies. But we'd have a problem if we didn't have rating agencies at all. I think what you want are rating agencies that do a good job.

To press you on that, though, you'd still have rating agencies. It just wouldn't be the government saying you have to listen to them. And that seems like a good thing to me. Even if you get rid of the conflict-of-interest problem, it still seems to me that these players exist to tell Wall Street that it doesn't really need to know what it's doing. You can be an English literature major who's only been on Wall Street for five months and as long as you know it's "AAA" or "BBB," you're good to go.

I think the government sanction in this amendment would incentivize accuracy and mean that these agencies would do their due diligence and compete and be a bit smarter than the ones in Michael Lewis's book, who seemed particularly easy to fool.

It has occasionally seemed to me that the best reform would be to tax the banks and use the money to make the people at the rating agencies the highest-paid folks on Wall Street.

Well, there might be something to that. I don't prescribe how much they'll get paid but if you are rewarded by your track record, people who do a better job will be paid more.

Do you know if your amendment will get a vote?

I'm not certain. But probably next week sometime. We've been talking to the banking committee staff and I hope that it does come up next week, either as is or in some form. We're very prescriptive in this for how the board will look and there are other ways to skin this cat.

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