A sensible, bipartisan solution to the conflicts of interest that too often arise between credit ratings agencies and the firms that hire them to judge their products should be adopted by the Securities and Exchange Commission.
The reform, championed by Sen. Al Franken, D-Minn., and Sen. Roger Wicker, R-Miss., is the result of an amendment to the 2010 Dodd-Frank financial-reform legislation. The amendment triggered a two-year study that requires the SEC to act if it determines that it is “necessary or appropriate in the public interest or for the protection of investors.”
This was the issue at hand at a May 14 Credit Ratings Roundtable convened by the SEC. Franken appealed directly for a plan that would create an independent, SEC-appointed board that would assign which ratings agency would calculate the risk of financial products.
Currently, sellers of financial products hire their own ratings agencies. This can create a conflict of interest, because agencies have an incentive to signal that they will assign a high rating to win the business.
“The analogy I like to use is if a figure skater paid the judges to give her a ‘10’ every time,” Franken told an editorial writer.
At the roundtable, Franken used a regional example that connected Wall Street to Main Street. “A pension manager making investments for the pension funds of volunteer firefighters in Kandiyohi County in central Minnesota simply doesn’t have the resources to do his or her own credit risk analysis,” he told commissioners.
Those agencies with the resources — like Standard & Poor’s, Moody’s, and Fitch, the three firms that dominate the market — are resisting changing a system that has brought them benefits.
“The [Franken] proposed system could create new conflicts, be costly, slow to implement and cause uncertainty to the marketplace,” Douglas Peterson, president of Standard & Poor’s, said at the roundtable. “We believe that a government-run assignment system is not the best way forward.”
The Franken-Wicker proposal is imperfect, but it would improve on the status quo. And in doing so it would not jettison the financial industry’s infrastructure. Rather, it would create a mechanism to avoid so-called “ratings shopping” that can result in high ratings for substandard investments — in some cases, “junk,” according to Franken.
There are other proposals, including having ratings users pay for the analysis. But that might mean that small investors would have less information than major players. Others suggest a system of shoring up ratings with unsolicited analyses. But it is unclear how often competitors would take on the complex and costly process of creating unsolicited ratings if they were not directly compensated by the issuer.
The house of cards created by AAA evaluations for subprime mortgage-backed securities finally imploded during the 2008 financial crisis. Those harrowing days became the much longer era now known as the Great Recession. Most Minnesotans, including Franken, don’t need to be reminded of the impact. Many saw their lives upended due to collapsed portfolios or sudden recession-related joblessness. Some are still struggling to put their financial, professional and personal lives back together.
The individual setbacks became collective. Busted budgets on the federal, state and local levels led to deeper deficits or reduced services. Or, in many cases, both.
Memories seem conveniently shorter on Wall Street. But the recent run-up in equities markets should not preclude the systemic reforms needed to avoid the mistakes of the past.