Franken Amendment Would Bring Real Rating Agency Reform

Senator Al Franken (D-MN) has no sense of humor when it comes to the rating agencies. He has proposed the toughest new reform to date to eliminate the conflicts-of-interest that many blame for their bad ratings of mortgage securities. The Senate's bill is otherwise very weak on rating agency reform and does not offer a fix for this problem. While it's unclear if the amendment (.pdf) is the best way to fix the rating agency problem, it would improve the current system.

The Rating Agency Problem

The rating agency problem is a structural one. Right now the agencies are paid for their ratings by the very parties that will make money from selling the bonds -- the issuers and investment banks. Clearly, those creating the bonds have a distinct bias to want those ratings to be as high as possible: then they'll be more attractive to investors and more lucrative to sell. And the rating agencies want to keep getting the issuers and banks' business. As a result, they feel pressured to provide high ratings instead of solid analysis. Rating agencies are plagued by a conflict-of-interest.

Additionally, some have complained that there isn't enough competition in the ratings market. Right now, three companies -- Moodys, S&P, and Fitch -- account for virtually all ratings. With so little competition, there's not much diversity in the assumptions they have about the market.

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.

Some Concerns

"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.

Some in the industry also worry about a provision in the larger Dodd bill which hold the agencies liable if it's determined that they did not perform reasonably well. The term "reasonable," is quite vague, however. So another complaint might be that agencies would now be assigned to perform ratings through the Franken amendment, but they would be held to a seemingly vague standard of liability if paired with the Dodd bill. This isn't quite right. An agency can choose not to rate a type of security or even a specific transaction. There would be no coercion to rate anything.

Finally, the amendment does appear to improve the current framework for rating agencies, but it could be argued that the entire framework should be thrown out: why not eliminate the agencies altogether? Investors should be less reliant on rating agencies and perform their own analysis. That's clearly a more drastic alternative. Rather than reform the ratings system, you would be eliminating it. But if you want to reform the current environment, rather than get rid of it altogether, then this amendment appears to be a very good start.