Two Credit Rating Agency Reforms Amended Into Dodd Bill

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Thursday, May 13, 2010 at 5:15 pm

This afternoon, the Senate passed two amendments enhancing the regulation of credit rating agencies, which assess financial products and assign them ratings based on their likelihood of default.

The credit rating business has a conflict of interest at its heart, in that the companies hire the ratings agencies — the biggest of which are Fitch, Moody’s and Standard and Poor’s — to assess their products. (Today, New York Attorney General Andrew Cuomo announced an investigation into whether eight banks, including Goldman Sachs, gave the agencies false information about their financial products to get better ratings.)

Assigning an incorrect rating both obscures a financial product’s risk and leads to its mispricing in the marketplace. Routinely in the run-up to the financial crisis, for instance, the agencies assigned AAA ratings, meant to imply a risk of default no higher than that of U.S. Treasury bonds, to frankly dodgy assets, such as subprime mortgage-backed securities. Many of those assets, vetted by the agencies as solid as oak, ended up more like particleboard.

Two amendments — a primary amendment by Sen. Al Franken (D-Minn.) and an amendment to the amendment by Sens. Maria Cantwell (D-Wash.) and George LeMieux (R-Fla.) — help to reform the credit ratings business.

Franken’s amendment creates a new organization within the Securities and Exchange Commission to assign an agency to a financial product. This means that banks cannot shop around for a better rating. It also awards the most accurate ratings agencies with more business.

“This conflict of interest has cost American investors and pensioners billions and billions of dollars because supposedly risk-free investments have failed or been downgraded to junk status,” Franken said on the Senate floor this afternoon, also noting that agencies compete to have more accurate ratings, not to please the big banks. “Imagine that!”

The Cantwell-LeMieux amendment eliminates the government’s practice of stamping certain ratings agencies (currently 10 of them) as a “nationally recognized statistical rating organizations.” It strikes the term NRSRO from all government documents, instead saying the government should rely on some other vetting institution or system.

The NRSRO designation shows up in hundreds of laws and regulations, and props the NRSROs’ business from competition from other agencies. For instance, currently the SEC says that certain mutual funds can only invest in securities with A ratings from NRSROs. If the Dodd bill passes, the SEC will need to rewrite that rule without reference to those certain ratings agencies.

“The damage in the financial markets was due in large part because of our reliance on these rating agencies,” LeMieux said in a statement.  “Let’s make sure that these rating agencies do not get rewarded for bad behavior. The federal government has allowed these few ordained agencies to have such a large pull in the market place. That needs to be changed to allow a more diverse and accurate approach to proving credit worthiness and further prevent future economic crisis.”

The two amendments seem to clash, as Franken’s amendment perpetuates the NRSRO designation. Democrats say the two amendments will be reconciled before the final vote. Sen. Chris Dodd (D-Conn.), the architect of the regulatory reform bill, opposed both amendments on the grounds that the issue needs more study.

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