The Franken Amendment
Franken's proposal specifically targets the conflict-of-interest. He proposes to create a board that would assign one rating agency to evaluate each new issue asset-backed security. The board would be made up of a majority of investors (at least four), at least one issuer representative, at least one rating agency representative, and at least one independent member. The issuer can hire additional agencies for more ratings if it desires to do so.
All Nationally Recognized Statistical Rating Organizations (NRSROs), i.e. rating agencies, could apply to become "qualified" organizations to rate various types of asset-backed securities. Once they are approved, they would be pseudo-randomly assigned deals. The bill says that the selection should take into account track records. So the better the rating agency's past performance, the more deals it will get in the future.
How It Fixes the Problem
By putting a board in place to assign a rating agency, you no longer have an environment where an issuer has full discretion to choose rating agencies. As a result, even if an issuer doesn't like an initial rating, it can't drop the analyst and choose a different company to provide a final rating for a new bond. The conflict-of-interest then disappears, because the rating agencies derive their business based on the new board's discretion, which will take into account their past performance.
The amendment also indirectly helps the competition problem. There are actually 10 NRSROs, though you would never know it by looking at the market share of the big-three. Up to now, it's been hard for the little guys to break into the industry, since the big-three had strong relationships with the issuers and were more trusted by investors, since the smaller agencies had so little exposure. The new system would help the markets to better gauge how the smaller rating firms do, while allowing issuers to still utilize the big-three on their own to comfort wary investors.
"The market -- not government mandates -- should decide the value of our work," says S&P spokesman Edward Sweeney. But that's sort of exactly what the amendment would do. The board wouldn't consist of bureaucrats; it would be mostly investors, with a few other financial industry players thrown in. And past performance -- the value of an agency's work -- would be a specific criteria used to determine how much business it gets.
The possibility that rating agencies lose the incentive to invest in and hone their businesses also concerns S&P, since a board would choose the agencies instead of the market. Again, if the bill mandated that every agency gets a certain amount of business no matter what, then this would be a problem. But the process will remain competitive, so continuing to develop expertise still matters. If one agency performs poorly enough, it could be taken out of the mix entirely.