So far, I've been pretty positive about the Senate's version of systemic risk regulation (.pdf). In a proposal that otherwise calls for sweeping changes to the current regulatory framework, I was extremely disappointed to see the meager reforms the plan has in mind for rating agencies. It essentially seeks to have the ratings industry work as before, but with some minor changes. That's kind of like giving a new coat of paint and oil change to a rusty 1973 Ford Pinto with an engine that once exploded: even if you get it running once more, it might just blow up again under certain conditions.
For starters, the Senate wants better controls in place during the rating process. Although that makes a lot of sense on paper, here's the thing: the process is already pretty well-controlled.
In my experience, there are several analysts working on a deal who specialize in the type of security a bank wants rated. Those analysts then decide the assumptions that should be in place, given the specific characteristics of the bond. They then bring their assumptions and decisions to a sort of broader credit committee at the rating agency who needs to sign off on those final ratings.
As you can see, this isn't a situation where a rogue rating analyst can just slap AAA ratings on whatever he feels like. Controls weren't the problem.
Another idea that sounds great would be if rating agencies established methodologies around the ratings they give. Here's the problem: they already do this too. For example, click here (.pdf -- yes, you have to register, but it's free) for Moody's Approach to Rating U.S. Residential Mortgage-Backed Securities. You can find such methodologies for everything the agencies rate.
The Senate also hopes to make these methodologies more transparent. Well, isn't the fact that you can search and access any of these methodologies on their websites for free pretty good transparency already? Again, establishing transparent methodologies wasn't the problem.
This is perhaps my favorite part. The Senate wants to ensure each rating analyst:
(1) meets standards of training, experience, and competence necessary to produce accurate ratings; and
(2) is tested for knowledge of the credit rating process.
Let's try to imagine a test question that could have shown up on a periodic exam that might have helped to show a mortgage-backed securities (MBS) rating analyst was ill-equip to handle his job prior to the mortgage market's collapse:
Question #23: Can real estate prices decrease?
A. They did once, but that won't happen again.
B. Maybe, but the bankers who send us MBS deals swear they won't.
C. Yes, but we don't think they will, especially not dramatically.
D. Yes, and consequently, we should rarely provide AAA ratings to subprime MBS without truly dramatic credit enhancement.