Reckoning day for the raters

But now it’s June, and the financial-reform spotlight has turned elsewhere. As a House-Senate conference committee prepares to take up the ratings issue (perhaps as soon as tomorrow), industry lobbyists have been working frenetically behind the scenes to get the White House and congressional leaders to put the Franken amendment to a quiet death.

That amendment tackles the built-in conflict of interest that one outside observer after another has identified as a key problem. “We’ve got to deal with the conflicts,” Sen. Richard Shelby (R-AL), the ranking minority member of the Senate Banking Committee, declared in a January 2009 exchange with Mary Schapiro, the Obama administration’s choice to head the Securities and Exchange Commission.

“That’s right,” Schapiro agreed. “I think the compensation model… where the issuer pays for the rating is really at the heart of the conflict problem…”

The conflict-of-interest theme came up again in a hearing conducted by the Financial Crisis Inquiry Commission just two weeks ago, although much of the media was too busy parsing the comments of Moody’s largest shareholder, Warren Buffett, to notice anything else. “It was very clear to me that my future at the company and my compensation would be based on the market share that we brought in,” Eric Kolchinsky, the Moody’s alum-turned-whistleblower, testified.

Why did the duopoly of Moody’s and Standard & Poors slap so many Triple AAA ratings on bonds that cried out to be labeled as junk? Because that was the way to get more business from the bankers who paid them and picked them, and often had their help engineering securities to achieve the desired rating.

Under the Franken amendment, investors considering the purchase of asset-backed bonds will be guaranteed at least one risk evaluation by a firm that has been independently chosen. (A new ratings board, with investors in the majority, will act as a clearinghouse for initial ratings.) “Analysts’ chief motivation will be getting it right, instead of making bankers happy,” the former investment banker (now Atlantic magazine blogger) Daniel Indiviglio observed, describing the provision as “one of the most substantial amendments to the reform effort to date.”

One thing the rating agencies have going for them in the final deliberations, besides public inattenton, is the legitimate and widespread desire to wean investors off the habit of relying on credit ratings. It is tempting to many in Washington to think they can settle the question simply by telling investors, “Do your own damn homework!”

Reduced reliance cannot be the be-all and end-all of ratings reform, however. To begin with, Congress has no jurisdiction over the many state and local agencies that have woven credit ratings into their rules. And regardless of what the law says about ratings, small institutional investors will continue to need outside help in the complex task of tracing asset-backed bonds and other structured, multi-tiered debt securities to their underlying assets.

“At this point in time there are no organizations ready to take the agencies’ role in the capital markets,” Kolchinsky noted. “Furthermore, the perverse incentives [of the rating agencies] will apply to any private organizations charged with the same task.”

To make a real difference, then, Congress has to take steps to make the rating agencies more honest and less powerful. Progressives should be calling on negotiators to be serious about both problems, rather than using one as en excuse to evade the other.