Credit rating reform efforts moving in right direction

Congressional attempts to eradicate conflicts of interest from the Wall Street credit agencies’ business model are headed in the right direction, to the benefit of all investors.

There is clear evidence that the agencies did shoddy work in rating the mortgage-backed securities and collateralized debt obligations at the heart of the crisis. They relied on outdated models of the mortgage market and obsolete data on mortgage delinquencies in rating mortgage-backed securities. In addition, some ratings analysts advised investment bankers on how to structure securities to gain the coveted triple-A ratings, a clear conflict of interest.

Investment bankers packaging securities wanted triple-A ratings because many potential institutional investors were allowed to invest only in such securities. And ratings agency analysts knew that if they did not provide the desired rating, the bankers could take their business to another agency that might be more accommodating.

The Senate has approved an amendment to its financial-reform bill, sponsored by Sen. Al Franken, D-Minn., under which the Securities and Exchange Commission would establish an independent board charged with assigning which ratings agency would evaluate each new structured financial security.

The issuer would not choose the ratings agency.

No longer would issuers be able to shop for favorable ratings on their securities, playing one ratings agency against another. Credit ratings analysts would have no incentive to tailor their ratings to the wishes of issuers, rather than the needs of investors.

A majority of the members of the board would represent investors, but the board also would include a representative of the ratings agencies and financial companies. In addition, the board would be encouraged to choose from a wider choice of ratings agencies, thus breaking the hold of the big-three agencies, Moody’s Investors Service Inc., Standard & Poor’s Financial Services LLC and Fitch Ratings Ltd., on the credit-rating business.

If the issuer decided to seek an additional rating from another agency, and it differed from that of the assigned rater, the issuer would have to disclose both ratings.

These provisions should encourage better ratings by minimizing the conflicts of interest arising when the firm that sought the rating also was paying for the rating.

However, there are two potential flaws in the Franken provision. First is the possibility of “agency capture.” This occurs when employees or leaders of a government agency develop close relationships with those they regulate, leading to lax oversight.

The phenomenon appears to have occurred at the SEC, which was supposed to be regulating Wall Street as the mortgage bubble inflated. It also appears to have occurred at the agency overseeing oil drilling in the Gulf of Mexico, contributing to careless oversight and leading to the disastrous oil spill.

Agency capture could result in some credit ratings agencies’ receiving more than their share of business, or to ratings standards’ again becoming sloppy.

A second unintended consequence of the Franken amendment is that by spreading the business among more ratings agencies, profitability of the business might be reduced to the point where the agencies skimp on research or hiring, again weakening ratings standards.

Possibly offsetting these potential flaws, both the House and Senate reform bills attempt to make it easier for investors to sue the ratings agencies for false or misleading statements about securities. This might provide additional incentive to the agencies to provide the most accurate possible ratings.

It seems likely that as a result of the efforts to reform the way the ratings agencies are regulated and do business, investors will be able to have more confidence in the fixed-income securities they buy, especially the exotic ones.