12 July 2010

Al Franken and the bond rating agencies

Excerpts from a column by Dean Baker at TPMCafe:
One big piece of the financial mess was the fact the bond rating agencies blessed every piece of garbage coming out of Wall Street as investment grade. This blessing allowed packages of extremely questionable subprime mortgages to be sold all over the world at top prices.

The bond rating agencies either had no clue of what they were rating, or worse, knew that they were giving investment grade ratings to junk. The reason that they were not doing their job was that they were being paid by the issuer...

This is a problem that is painfully easy to solve. You still have the issuer (Citigroup, Goldman Sachs, etc.) pay for the rating, but you have some independent body pick the agency. This would take away the obvious conflict of interest. Giving bogus ratings will not improve your probability of being picked next time...

Finally, Senator Al Franken (a man who knows a joke when he sees one) proposed the obvious fix: have the Securities and Exchange Commission (SEC) pick the rating agency...

When the financial reform bill got to the conference committee, Barney Frank, the chairman of the House Financial Services Committee, decided that Franken's solution was too radical...

Fortunately, Franken held his ground. The conference committee agreed on a two-year long study by the SEC. Studying a proposal is usually a way to kill it in Washington. (A two-year study of the invasion of Iraq would have been a great idea.) However, the wording requires that at the end of this two-year period the SEC implement the Franken proposal unless they've come up with a better solution...

In this case, the fire department has shown up at the scene. They have discovered the source of the smoke. They have hooked up their hoses and they have decided that in two years they will start spraying the water. In Washington, that counts as success.
I don't understand why a proposal like this has to be studied for two years.  Perhaps I'm naive about some financial or regulatory aspects involved here.


  1. I think it's legislation that could have really negative unintended consequences. How would the SEC choose the ratings agency? This sounds like a recipe for corruption. Or it sounds like a way to crush any kind of competition. It also takes away incentives for the rating agencies to do good work, they are going to get business whether they are doing a good job or not.

    The solution is for the government to do nothing. If the ratings continue to be garbage, the smart investors will avoid them, therefore it will not be in the best interest of the issuing firms to pay the bad agencies for ratings. The rating agencies will be forced to improve their product or go out of business. Government involvement will only lead to unintended consequences. Solving one problem, but leaving many others in it's wake.

  2. Jacob, you are either in deep denial, or you really dont understand what has been going on. "It also takes away incentives for the rating agencies to do good work, they are going to get business whether they are doing a good job or not." - thats the problem NOW. There is no incentive to offer a bad rating when you are paid by the company issuing the paper.

    --Don in New Jersey

    "If the ratings continue to be garbage, the smart investors will avoid them"- that has never happened in the past. The ratings were garbage, and financial institutions bought the derivatives anyway.

  3. It's neither denial nor a lack of understanding. I know they don't do good work now. Clearly the system is broken, but arbitrarily assigning them business is not the way to get them to do a good job.

    How do you know it has never happened in the past. You are assuming that the investors who blindly follow the ratings are smart investors, I don't believe that. The problem is that the bail-outs prevented the companies making bad decisions based on flawed ratings from actually facing the consequences of not doing their own due dilligence.

  4. 2 years is 8 quarterly bonuses on wall street (2 yearly bonuses) and it's safely beyond the next election. What's there to understand?


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