Instead, the bill will authorize a two-year study of the ratings agencies. After that, the Securities and Exchange Commission needs to have created a new way to assign raters to securities, or to put in place Franken’s plan. It is one of more than 25 studies mandated in the bill.

Credit ratings agencies are in the news, given Warren Buffett’s ill-received and contradictory testimony to the Financial Crisis Inquiry Commission yesterday. And Franken says that he expects the financial regulatory reform bill to emerge from the conference committee with his provision in place.

Franken wants an independent board, appointed by regulators, to choose the firms that rate investments, such as bundles of mortgage-backed securities. Historically, investment firms that created the securities have picked ratings firms. Franken says that was foolish. “Rating agencies knew that if they gave a bad rating to an instrument then they wouldn’t get the next job to do the rating,” Franken said. “So, what it did was it incentivized inflating the ratings. That’s why we have all these AAA-rated instruments that turned out to be junk.”

But Larry Summers, the head of the White House’s National Economic Council, is not on board. Ryan Grim at HuffPo reports on a meeting Summers, who acts as a proxy for the White House on economic issues, held with union leaders yesterday:

There were few surprises, attendees said, with Summers and the groups mostly in accord. The one divergence came over Minnesota Democratic Al Franken’s rating agency amendment, which would end the practice of banks choosing their own rating agencies and instead assign them by lottery, removing a colossal conflict of interest. Summers told the groups that he has yet to be persuaded that Franken’s approach is the proper one but he is willing to be convinced. He asked Public Citizen’s David Arkush and Demos’s Heather McGhee, representatives of two of the most vocal supporters of the amendment, which is part of the Senate package, for more information.

And on the Merkley-Levin amendment, the Financial Times cites unnamed sources when reporting that the stronger Volcker Rule might be swapped for Sen. Blanche Lincoln’s (D-Ark.) controversial provision forcing banks to spin out their swaps trading desks, which speculate and trade a certain type of derivative.

[A] proposal — opposed by banks — to toughen a ban on proprietary trading and stop them from betting against products they sell to customers has re-emerged during preparatory work. The provision, sponsored by Jeff Merkley and Carl Levin, two Democratic senators, would toughen the “Volcker rule,” which bans banks from trading for their own account or owning hedge funds and private equity firms, but gives regulators time to study the rule and modify it. “That is a very wishy-washy way to approach the issue,” Mr. Merkley said.

Mr. Levin said even though the Treasury would “probably…want as much power as they can get to…modify [the bill],” he thought Congress should write a strong final version. “Merkley-Levin in general is very much alive,” Mr. Levin said. “The proprietary trading provisions from a legislative perspective are very much in the mix.”

Others involved agreed with that assessment and said the proposal could be used to replace a provision by Senator Blanche Lincoln that would force banks to spin off swaps desks.

Warren Buffett (Xinhua/ZUMA Press)

Testifying before the Financial Crisis Inquiry Commission this afternoon, Warren Buffett — the legendary value investor who heads Omaha-based investment giant Berkshire Hathaway — defended the behavior of the country’s credit ratings agencies and his own role in them, while acknowledging that the model under which they operate creates a flawed system of incentives.

[Economy1] The FCIC, now notorious for its grilling of Wall Street executives, mortgage originators, government regulators and others complicit in the boom and bust, summoned Buffett to discuss the ratings agencies, which assess the chance that a financial product will default and assign it a grade that determines its price and risk. Berkshire Hathaway is a major stakeholder in Moody’s, one of the country’s two main ratings agencies — a lucrative duopoly that gave wildly inaccurate assessments of mortgage-backed securities before the crash.

As a stakeholder, one might have expected Buffett to defend the industry. And he did to a certain extent, arguing that Moody’s executives were not negligent and do not deserve to be fired, for instance. But he also undercut his own defense, noting that he “hates” the ratings agency business model and seemingly admitting that he invested in Moody’s for its profitability rather than its soundness. It made for an anemic stand for a business on the verge of major regulatory changes.

The so-called “Oracle of Omaha” largely shifted the blame from himself and Moody’s, arguing that systemically important financial firms that require government life support should have their shareholders wiped out and managers fired — but not Moody’s. And he did not acknowledge the ratings agencies’ unique role in precipitating the financial crisis, instead saying that Moody’s main mistake was to miss the trillion-dollar housing bubble along with “the rest of America.”

He actually had to be compelled to testify before the commission, declining two invitations before the FCIC subpoenaed him, saying, “YOU ARE HEREBY COMMANDED to appear and give testimony.” Still, the 79-year-old appeared unruffled and energetic, dressed in a dark suit and a red tie, seated alongside the chief executive officer of Moody’s, Raymond McDaniel.

Bill Thomas, the vice chairman of the FCIC, broke the tension in the room as he opened his questioning. “Notwithstanding the subpoena, I want to thank you for coming,” he began.

Buffett quipped back, “I want to thank you for the supboena!”

But the exchange soon became heated, with Buffett providing defensive and gruff answers to questions. Phil Angelides, the head of the FCIC, said that he had found “a lot of fingers pointing away” and “very little self-examination” at the credit ratings agencies. There were “significant failures in the product your company offered,” he said, and ratings “proved to be highly defective, not just by a small measure, but by a large amount.”

Angelides added, “If we flipped a coin, it would have been five times more accurate” than Moody’s ratings of structured products — 90 percent of which needed to be downgraded.

But Buffett said that Moody’s just made the same “mistake that 300 million Americans made” and that he did not believe its business model should change or its management should be fired. “Rising prices are a narcotic,” he said, a narcotic that intoxicated investors including himself.

Angelides pressed him on whether he should have seen the housing bubble, given that government regulators and market participants started sounding the alarm in 2004. “The Cassandras were there,” Buffett conceded. “But who was going to listen to [hedge fund investors] John Paulson in 2005 or 2006 or Michael Burry?” (Both Paulson and Burry called the bubble early and shorted the housing market, making billions as the economy collapsed.) Buffett said, “I recognized something pretty dramatic going on,” but he thought it was a “bubblette” rather than a “four star” bubble.

He also said that while he recognized real faults in the credit ratings business, he did not think that changing the model was necessary. “I hate issuer pay,” he said, describing the system by which the companies that produce financial products pay agencies like Moody’s to rate them — a conflict of interest at the heart of the business, as financial firms pressure agencies to give them better ratings and shop around for triple-A marks.

But Buffett said that he did not think anything else would work better. When asked whether the United States should adopt Sen. Al Franken’s (D-Minn.) proposal to have the government assign a rater to a financial product, he demurred. “I suppose it could happen,” Buffett said. “I’m not arguing this is the perfect model. I’m just saying it’s hard to change.

“The wisdom of somebody picking out raters — is that going to be perfect? I don’t know,” he continued, noting that the Nebraska insurance authorities tell him which ratings agencies he needs to hire to rate his products.

At another point, Angelides criticized the “very structure of credit rating agencies,” saying, “It does seem in the end, there’s lots of upside but very little downside” if Moody’s and Standard and Poor’s misrate financial products. “I think much of corporate America is tilted that way,” Buffett said, before wanly arguing, “We’ve seen significant downside” due to hits to Moody’s stock price.

Buffett also acknowledged that he personally has little investment in accurate ratings. “We hope for misrated securities, because it gives us a chance to earn a profit,” Buffett said. “I think they misrate us! [Moody's] have us a notch below Standard & Poor’s.”

Douglas Holtz-Eakin, the Republican former director of the Congressional Budget Office, repeatedly noted that Buffett’s testimony showed that ratings agencies were profitable due to their duopoly, rather than the usefulness of their ratings. Buffett did not disagree, instead noting that Moody’s and Standard and Poor’s ability to “set prices” — to somewhat arbitrarily name the fee for a rating, due to a lack of competition — made it an attractive business.

Buffett conceded that as an investor, he considered the duopoly “a wonderful economic model for the business.” And he added that Berkshire Hathaway does not rely on credit ratings agencies to analyze financial products, instead doing its own due diligence in-house.

He later said that ratings agencies might function best as a monopoly. “If there were 10 ratings agencies, all equally well-regarded [and] all acceptable to the market, they would compete on price, laxity or both,” he said. “If there were just one ratings agency, they would have no reason to compete.” He also noted that Berkshire Hathaway is reducing its stake in the company.

And, lo and behold, Buffett will testify on Wednesday on the subject of ratings agencies. Berkshire Hathaway controls a major stake in Moody’s, one of the three big credit raters.

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.

The tale comes from Barry Ritholtz at The Big Picture, who had a contract with publisher McGraw Hill, which owns the Standard & Poor’s credit rating agency, for a book on the financial crisis to be called “Bailout Nation.” Ritholtz said he was well aware his publisher owned a ratings agency, but his contract also called for him to have final editing control. Still, things didn’t work out, once McGraw Hill got a look at his chapters detailing the failings of ratings agencies. They’ve been blamed for contributing to the financial crisis by giving high ratings to risky mortgage-backed securities, as they were collecting fees from the investment banks that issuing them.

From Ritholtz:

When it came to chapter 14 — Who is to Blame? – there were issues about the style of what I wrote about Moody’s, S&P and Fitch’s. I literally called the ratings agencies and investment bankers “Pimps and Whores;” I accused them of engaging in pay for play (buying ratings) payola, etc. Rather than describe it, I will simply post the original version here.

Ritholtz got some pushback from an editor, but still figured he could tell his story:

Now, before you assume I am an idiot for doing a book that was critical of the ratings agencies with a publisher that owns S&P, understand that I properly anticipated this. My contract gave me Final Edit. Not only that, I had previously discussed this issue months earlier with then publisher Herb Schaffner. (He was laid off in a big Q4 round of firings).

Sometime over the summer, Herb informed me that the ratings agencies discussions would have to be handled “delicately and diplomatically.”

I responded, “Sorry, Herb, but I don’t do diplomacy.” If they wanted someone who was subtle or diplomatic, boy did they have the wrong guy. I offered to return the advance check and we could all move on. He backed down, and I assumed — apparently quite wrongly — that this was the end of this issue. How can you write a book on this subject and not lambast the ratings agencies?

Well, apparently you can’t, at least not in this case. Editors wanted more changes in the ratings agency section, but Ritholtz said no way. He told them to cancel his contract, if they wanted to go that route. McGraw Hill did.

The publisher said in a statement the book was canceled because of conflicts over editing and sourcing, not because of criticism of the ratings agencies; Ritholtz denies that.

In the end, as the financial system continues to teeter on collapse, “Bailout Nation” and its story of the behavior of credit agencies during the subprime boom still awaits the light of day.

Congress doesn’t know what its next step will be in regulating Wall Street after the financial meltdown. But the House Oversight and Government Reform Committee accomplished an authoritative takedown today of the credit ratings agencies. Through documents obtained by the committee and unusually sharp questions from committee members, we learned this:

• During the housing bubble of 2002-2006, there was virtually no government regulation of the credit-rating agencies. The Securities and Exchange Commission proposed rules in 2002 to monitor them. That’s when bond issuers were securitzing subprime mortgages and collateralized debt obligations at ever increasing rates. By the time Congress finally passed a reform act, it was 2006 and the housing bubble was about to burst.

• The credit-rating agencies were even more tardy in responding to the housing market collapse than the SEC and Congress. Moody’s CEO Raymond McDaniel continually issued reassurances that the mortgage-backed securities and credit default swaps his firm was rating AAA deserved the rating.  Even privately, McDaniel only began to identify the problem in Sept. 2007.

A transcript (pdf) of a Moody’s “town hall” company meeting shows that McDaniel told his employees in September that it was time “to speak as candidly as possible about the subrpime market.” But the discussion mostly centered on “extensive outreach to the media” to disentangle the rating company from the subprime mess.

Just one month later, McDaniel wrote to his board of directors (pdf) that the company’s business model needed to have a “careful postmortem” evaluation.

• The credit rating agency industry is in tatters. Moody’s has been around for 100 years, but it wasn’t until the late 1970s that the company had to rely on the issuers of bonds for its profits. The obvious conflict of interest– will an issuer come back to a credit-rating agency if the agency unfavorably rates the bond?– finally caught up with the industry in the subprime mortage market.

None of the rating companies developed a credible model to rate mortgage instruments, and there was a race to the bottom to rate risky bundles of subprime loans as AAA.

“In my [Baltimore] district,” said Rep. Elijah Cummings (D-Md.), “students are not able to get loans, businesses are closing and seniors are going back to work. You’ve lost our trust.”

The CEOs didn’t respond to Cummings’ remarks or numerous other accusations that they have lost the public’s trust.

But it was clear that the credibility of an entire financial industry had been destroyed in just five hours.

In May 2004, a managing director at S&P,  Yu-Tsung Chang, wrote a letter to a company executive complaining that S&P lost a “huge” mortgage-backed security deal because of a “huge difference in the credit support level.” Moody’s gave the mortgage-backed security a top rating apparently because it chose to ignore interest-rate risk. The S&P executive said that, “…we need to address this now in preparation for future deals.”

The letter (availabe in PDF) shows that there was no consideration of whether S&P’s rating system was correct on the merits.

The committee has focused on how the rating agencies didn’t appear to understand the financial instruments, derived from the subprime mortgage market, it was evaluating. But, more scandalously, they never developed new models to help understand them.

In the short term, this was beneficial: the combined profits of Moody’s and S&P went from less than $300 million to more than $600 million from 2002 to 2006. Now, however, the credit rating agencies may have “lost their brand,” as Rep. Chris Shays (R-Conn.) put it– and possibly their future role in evaluating financial instruments.