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Congress Too Soft on Credit Rating Agencies

Among the chief culprits in the financial crisis were the credit ratings agencies. Which is why it's unfortunate that U.S. lawmakers pushing for financial reform are letting the companies go with a slap on the wrist.

Congress is considering legislation that would impose new restrictions on Fitch, Moody's [MCO] and Standard & Poor's [Disclosure: My wife works for one of those companies, but she's innocent, I swear.] "The Wall Street Reform And Consumer Protection Act Of 2009," the mammoth bill now under debate in the U.S. House, would heighten government oversight over the ratings agencies; require the firms to disclose more information on how they set ratings; and strengthen legal protections for investors burned by bad ratings.

What the bill doesn't do is tackle the real problem with the ratings business -- companies picking the agency based on which one gives them the highest grade on their securities. Says James Lardner, a senior analyst with policy research group Demos, in a new report:

Investors, economists, and political leaders across the spectrum have identified the ratings process as a key breakdown point. And one critic after another has zeroed in on the same basic explanation for the breakdown: the financial dependence of the ratings agencies on the issuers and underwriters of the securities they rate. Yet the remedies so far proposed by the White House, the Securities and Exchange Commission, and committee leaders in the House and Senate would not fundamentally alter the current business model -- one that Sen. Charles Schumer (D-N.Y.) has compared to "allowing students to pay for their grades."
In a brazen conflict of interest, S&P, Moody's and Fitch get paid by issuers. If some principled ratings analyst balks at giving, say, JunkMortgages 'r Us Inc. anything other than an investment grade score, the company can simply cross the street to shop for something more attractive.

Of course, that rarely happened in the years leading up to the financial crisis. In fact, analysts were fired and executives punished for trying to hold the line against soft ratings.

What's the solution? The key is ending the financial co-dependency among debt raters, securities issuers and underwriters. By extension, ratings firms must develop a new business model.

One option is to create an independent clearinghouse that would accept requests from issuers and randomly assign the job to a ratings agency. Payment would consist of a financial transaction fee that would cover the cost of operating the clearinghouse and doing the ratings work.

The clearinghouse would compare the performance of the rating agencies, with the most accurate rewarded with additional assignments. Firms with weak records could be suspended or removed from the pool of available agencies.

It's a smart fix. Writes Lardner:

By changing the incentive structure, the clearinghouse idea lays the foundation for a new and more fruitful form of competition, in which multiple rating agencies search for more accurate and efficient ways of predicting bond performance.
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