There has been some confusion about two amendments to the financial reform bill that passed yesterday, one from Sen. Al Franken and the other from his temporary Florida colleague, George Lemieux. Matt Yglesias posted about this yesterday and kindly included an update from yours truly, but I thought I'd expand a bit.
The Franken amendment is designed to attack the conflict-of-interest problem at the heart of the ratings agency disaster: If you're paying someone to rate the product you're selling, and you want that judgment to come out a certain way, it's not too long before a competitive advantage emerges for those firms willing to accommodate your needs, creating an incentive for bad securities to get good ratings. In order to fix that problem, Franken has proposed that the SEC create a new self-regulatory organization that would choose, in a lottery or a rotation, which agency rated a new security, thus acting as a middle-man and eliminating the conflict of interest. Yuu can read about the idea at some length here.
However, this new self-regulatory organization is made up entirely of industry representatives, though from both the buy- and sell-side of the business, and they have discretion to decide how agencies get assigned ratings jobs and who can participate in the process. This worries me, to say the least; one of the original proposals for this idea in 2009 relied on an SEC department to monitor the clearinghouse, not industry insiders.
A potentially stronger ratings agency reform has been described by Lawrence White (and me in this post): Create more competition and accountability for ratings agencies by eliminating their monopolistic status and forcing more responsibility on firms -- the same sort of idea is behind the movement to let investors sue ratings agencies for misleading them.
Luckily, you can still include some of these ideas alongside the Franken provision in an effective way, and that is what Lemieux does: While he doesn't end the practice of certifying certain rating agencies as "official," he does remove all references to the ratings agencies from statute. Previously, regulators would rely on agency ratings to decide whether firms were solvent, too risky, too levered, etc. Now they will have to do their own homework and adopt their own standards, lessening reliance on these unreliable partners. The Lemieux amendment, evaluated here by Mike Konzcal, manages to reduce the monopoly of ratings agencies and hopefully improve government scrutiny, but it doesn't contradict directly with Franken's plan -- only philosophically.
-- Tim Fernholz
