Franken's Aggressive Rating Agency Reform Passes

Until today, the rating agencies were holding their breath, hoping they might escape Congress' financial reform effort virtually unscathed -- until Sen. Al Franken (D-MN) made them gasp. His aggressive reform measure, which targets the ratings industry, passed today in the Senate by a vote of 64 to 35. One of the most substantial amendments to the reform effort to date, it will change the financial industry's process for obtaining ratings on asset-backed securities (ABS).

The new legislation calls for every new ABS bond issue to have a rating by one agency assigned by a new board, instead of being chosen by the investment bank creating the security. The board will consist of mostly investors along with a few other industry participants. Although the underwriter can solicit additional ratings, it cannot escape the verdict of the assigned agency, so it cannot shop around for whichever agency has the most favorable view.

This amendment will also help to solve the conflict-of-interest problem where rating agencies may feel the need to rate bonds more leniently, since the banks are their sources of income. Now, the bank must pay the assigned rater, whether it likes its conclusion or not. And the rules the board must follow dictate that the better an agency does, the more future business it will get. Analysts' chief motivation will be getting it right, instead of making bankers happy. More objective ratings are expected to result.

Competition within the ratings industry will also be enhanced through the legislation. Right now, the three big rating agencies essentially control the market. This legislation would provide a voice for the smaller firms to begin rating more bonds and to gain the credibility to compete for investors' praise and trust. It should also enhance the diversity of market views reflected by ratings.

Of course, the bill on a whole hasn't passed the Senate yet. And even when it does, this amendment is still subject to the conference process, where the Senate bill will have to be reconciled with what the House passed in December before heading to the President's desk. The House bill doesn't includes a provision nearly as aggressive in dealing with the rating agency problem as Franken's amendment. So there is some question of whether this measure will make it into the final version of financial reform. It probably doesn't bode well that Banking Committee Chairman Chris Dodd (D-CT) was one of the handful of Democrats that voted against the amendment. But since more than one-quarter of Republican Senators voted in favor, it may find bipartisan support in the House.

For more information on this amendment, check out this post from last week.