Senate Fails Government-Sponsored Rating Agency Reform

The Franken amendment to the Senate banking bill will make the rating agency problem worse.

Al Franken’s famed Saturday Night Live character Stuart Smalley was fond of the phrase “trace it, face it, erase it!” In the recurring sketch, Franken’s Smalley would inadvertently mock the self-help industry by comically exhorting his talk show guests to find the true cause of their pain by tracing the root of their problems, facing them head on, and erasing them from existence. In real life this isn’t a bad approach to fixing a problem. Unfortunately, this is not the approach Senator Al Franken (D-MN) and his colleagues in the Senate have been taking while piecing together a banking regulatory reform bill to address the financial crisis.

From too-big-to-fail policy to derivatives regulation, the Senate is failing to deal with underlying causes. And last week another reform mistake was added to the banking bill when comedian-turned-lawmaker Franken offered an amendment to the financial reform bill that would increase government control over the credit rating agencies-critical players in creating housing bubble and financial crisis. Tracing the causes of the financial crisis reveals that excessive trust in the credit rating agencies was fostered by their government sponsorship, not a lack of federal oversight. The Franken amendment has exacerbated, rather than erased, the rating agency problem.

Since the 1970s, the Securities and Exchange Commission (SEC) has authorized certain credit rating agencies to be used as measurements for capital requirements and guides for pension funds, among other things. In effect, the SEC has created “government-sponsored rating agencies,” that distort the market in ways that are similar to their siblings Fannie Mae and Freddie Mac.

Investors and the market saw ratings from approved organizations as carrying a federal seal of approval. The market regularly trusted the agencies’ assessments with little outside due diligence. That doesn’t excuse the agencies for getting it wrong or investors for failing to do their due diligence, but it helps explain how the economic system got into this mess.

The rise of super complex mortgage-backed securities and other similar products tested the sanity of such a system. As Sen. Franken and most other senators appear to understand, the ratings agencies skewed investor understanding of complex products by labeling bundles of BBB-rated securities as AAA-rated, when packaged in the right way. Nothing had changed in the risk and the models were flawed.

But what the 65 senators who voted for the Franken amendment are seemingly ignoring is that the government seal of approval on certain rating agencies created an incentive structure that destroyed real competition and made the organizations lazy. But since the government-sponsorship label applied equally to the various rating agencies, the issuers of products could simply shop for the best rating at the lowest price from any of the organizations, instead of actually forcing the firms to compete on measures of accuracy.

The result was a failure by Standard & Poor’s, Moody’s, Fitch, and the others to make all necessary calculations in their ratings as the market changed, leaving investors holding the AAA tranches of high risk “crappy” securities made up of BBB-rated loans.

The Franken amendment would attempt to remedy this situation by allowing the SEC to assign rating agencies to certain securities. But this completely misses the point of why the current rating agency regime is failing and so convoluted: government sponsorship distorts market signals. The Franken amendment will take the current distortion and expand it, meaning credit rating agencies will carry an even stronger stamp of approval.

During the crisis, banks took advantage of the high ratings given to repackaged, high risk securities to increase their leverage, based on false assumptions about the accuracy of the credit ratings. They didn’t believe they had a reason to question the accuracy of the ratings, and many believed the government support for the economy-both through housing policy and monetary policy-would keep the market growing forever. The structure of government-sponsored rating agencies unequivocally increased risk taking.

Changing the current regulatory structure of government-sponsored rating agencies to government-distributed ratings will not encourage investors to take on fewer risks, and will not prevent the rating agencies from making more errors in the future. In contrast, ending government-sponsorship for rating agencies will force organizations to have more competitive rating models, will force firms to earn and keep a reputation for excellence rather than depend on a government support system, and will provide incentives for firms to spend more time digging into a trade or investment on their own.

Anthony Randazzo is director of economic research at Reason Foundation. See here for more information on rating agencies and the financial crisis.