As housing and stock markets boom, has Congress learned from the last crash?
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As housing and stock markets boom, has Congress learned from the last crash?

Hopefully, lawmakers don’t need another global financial crisis to finally fix the credit rating system.

This week the Senate is set to take up a major bank reform bill that Reuters says would be “a vote on one of the biggest rewrites of financial industry rules since the Dodd-Frank Act was passed nearly eight years ago.”

The flawed Dodd-Frank bill was the legislation that arose from the 2008 financial crash and the ensuing recession. This new banking bill comes at an interesting time for Southern California’s economy. The region’s housing market is hitting record-high prices in many areas, meaning prices are back at, or near, their bubble peaks of 2006 and 2007. “The median home price – or price at the midpoint of all 2017 sales — hit $492,000 in Southern California,” the Orange County Register reported.

The state’s unemployment rate is at its lowest point in decades — 4.3 in California in December 2017, with even lower unemployment numbers in Los Angeles County, 4.2 percent, and Orange County, 2.8 percent.

And, of course, the stock market spent much of the last year booming. In this potentially bubbly economic environment, bond investors are looking to rating agencies to warn of possible trouble ahead. But the big three dominant rating agencies continue to suffer from the same conflicts of interest they had during the last financial meltdown.

Credit rating agencies still rely primarily upon an issuer-pays business model, which means banks seeking to issue debt securities pay the rating agencies to evaluate their bonds. The credit rating agencies have financial incentives to give the bond issuers whatever rating they want. The Dodd-Frank financial reforms were supposed to fix this problem but the issuer-pays model remains in place and the U.S. economy remains vulnerable to systemic credit rating errors.

Similarly, Dodd-Frank identified another problem – government agencies using credit ratings in regulations.  Taking rating assessments from private rating agencies and putting them into government regulations gives the opinions of these for-profit companies significant regulatory power that they can monetize.  Congress should insist that regulators complete, and then maintain, the full separation between ratings and regulations that were called for in Dodd-Frank.

This is also an opportunity to encourage innovation in the credit rating industry. Today it is extremely difficult for new companies to enter the ratings market. The Securities and Exchange Commission has set up rules that protect the entrenched interests of existing rating agencies and make it nearly impossible for new companies to compete in the industry. More competition could spur analytical advancements that the status quo is preventing.  The rating agencies have no need to evolve or improve their quality, but with today’s abundant and inexpensive computing power, new credit rating agencies could quickly gather data, analyze large volumes of securities, and potentially develop innovative ways of evaluating financial risks.

The federal government could further lower the cost of entering the credit rating business by updating its archaic systems and migrating financial filings from PDFs to “machine-readable” data formats. Consumers of financial disclosures, such as rating agencies, would have access to large data sets at little or no cost. This reform could be accomplished by the passage of a financial transparency bill sponsored by Rep. Darrell Issa, R-Vista.

By fully divorcing credit ratings from regulations, and then lowering the cost of entering the credit rating business, Congress could reduce the risk that bad credit ratings pose to the financial system and economy.

Adding new voices to the credit rating industry — ideally, voices freed from the conflicts inherent in the issuer-pays model — would increase the chances that investors receive accurate credit analysis, helping avoid the traps of the opaque, poorly understood, toxic debt securities that hammered the economy and home values in 2007. Hopefully, lawmakers don’t need another global financial crisis to finally fix the credit rating system.

This column first appeared in the Orange County Register