A bill to address accountability and transparency in this crucial industry.
The origins of last year's financial meltdown are precisely captured in e-mails uncovered by the Securities and Exchange Commission (SEC) while investigating the credit-rating industry that is entrusted with evaluating investment risks.
In one e-mail, an analyst says that a particular deal "could be structured by cows" and still get a good rating. In another, a manager confesses, "Let's hope we are all retired and wealthy before this house of cards falters."
Not surprisingly, the SEC concluded that the conduct of these credit-rating firms was a "principal underlying cause" of the financial crisis.
It's now been one year since our nation's financial system came close to total collapse, with huge, long-established financial institutions toppling left and right, including Lehman Brothers, Merrill Lynch and Bear Stearns.
The financial system has improved since then, and many on Wall Street would like to return to business as usual. But short-term recovery should not deter us from the job of necessary long-term reform.
The financial crisis was preceded by a housing bubble as institutional investors kept pumping more money into mortgage-backed securities and other complex financial products that were rated as sound investments.
As it turned out, many of these investments were not what they appeared to be. What once looked like gold was suddenly exposed as toxic waste.
Also exposed were the deeply flawed, overly optimistic ratings that had been issued by credit-rating firms, such as Fitch, Moody's and Standard & Poor's, which dominate that industry.
These companies unfortunately have been quasi-official judges of investment risk in the financial markets. They are supposed to keep the markets honest by offering investors reliable judgments about the potential risks of different investments.
All of this might sound like something far away in the upper altitudes of high finance. But when financial markets malfunction, it becomes more difficult and expensive to borrow money for home mortgages, college loans and small-business loans. And, if you have a pension or mutual fund, the institution that manages your money relies on credit ratings to make sound investments for you.
In recent years, the credit-rating industry failed to do its job on a colossal scale, misleading investors by giving favorable ratings to thousands of investments that didn't deserve them.
While there are many underlying issues that combined to cause the financial failures, and while numerous regulatory and legislative changes are needed to address them, credit-rating industry reforms are essential.
The root of the problem is simple. The credit-rating firms are actually paid by the very people whose financial products they rate. It's a prescription for "grade inflation." Financial institutions even learned to play the rating firms against one another, "shopping around" to see who would give the best rating.
In some cases, the rating firms were also getting paid to help put deals together, so they were in effect rating themselves. In this ratings game, there were just too many opportunities for greed to trump objectivity.
We need much stronger safeguards to protect the integrity of our financial markets. That's why I was the first to join with Sen. Jack Reed of Rhode Island to cosponsor a bill to reform the credit-rating industry by improving its accountability and transparency.
Our Rating Accountability and Transparency Enhancement (RATE) Act will do several things:
First, it will give the SEC new, stronger authority to oversee credit-rating firms and hold them accountable so their ratings are more accurate and not unduly influenced by conflicts of interest.
Second, it will require the firms to have independent compliance officers to manage conflicts of interest in accordance with SEC rules.
Third, it will require the firms to be more transparent by disclosing information about their methods and conflicts of interest so investors can better gauge the accuracy and performance of the ratings.
Finally, the legislation will change existing federal law that has effectively given these firms immunity. Instead, investors will be allowed to sue a firm that "knowingly or recklessly" fails to review key information in developing its ratings.
The sooner we reform the financial system, the sooner we can restore the health of the American economy.
Amy Klobuchar, a Democrat, represents Minnesota in the U.S. Senate.
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