Tuesday, July 27, 2010

Dodd-Frank VI: Punting on Credit Ratings

The credit rating agencies played a central role in the entire subprime debacle, and as is evident from the chart at left profited mightily from the very bubble they helped inflate. The credit agencies work for investment banks that pay them, not investors. Thus it is no surprise that Congress found that section 931 that: "In the recent financial crisis, the ratings on structured financial products have proven to be inaccurate. This inaccuracy contributed significantly to the mismanagement of risks by financial institutions and investors, which in turn adversely impacted the health of the economy in the United States and around the world. Such inaccuracy necessitates increased accountability on the part of credit rating agencies."

What is surprising in that Congress took no real action to stop a repeat of the misconduct they so clearly identified. Section 931 further states: "In certain activities, particularly in advising arrangers of structured financial products on potential ratings of such products, credit rating agencies face conflicts of interest that need to be carefully monitored and that therefore should be addressed explicitly in legislation in order to give clearer authority to the Securities and Exchange Commission."

So what does Dodd-Frank do about this inherent conflict? Section 939D mandates a study within 18 months to address: "alternative means for compensating nationally recognized statistical rating organizations in order to create incentives for nationally recognized statistical rating organizations to provide more accurate credit ratings, including any statutory changes that would be required to facilitate the use of an alternative means of compensation."

This can only be termed a monumental punt.

To be fair, the Act does enhance the ratings agencies’ exposure to securities fraud liability (section 933 and 939G) and takes small steps toward professionalizing the ratings industry (section 936). The Act also lessons the clout of the ratings agencies (section 939). But these changes seem highly incremental. Does anyone really expect, for example, federal judges to suddenly see the perverse incentives they have created in recent years for credit rating agencies by consistently insulating them from liability? I confess to a high degree of skeptcism.

More dramatic and fundamental change was needed here, and my sense is that Congress simply stalled.


  1. You don't need to worry about the credit rating agencies anymore; "financial reform" is already producing unintended consequences:

    Standard & Poor's, Moody's Investors Service and Fitch Ratings are all refusing to allow their ratings to be used in documentation for new bond sales, each said in statements in recent days. Each says it fears being exposed to new legal liability created by the landmark Dodd-Frank financial reform law.

    The new law will make ratings firms liable for the quality of their ratings decisions, effective immediately. The companies say that, until they get a better understanding of their legal exposure, they are refusing to let bond issuers use their ratings.

    That is important because some bonds, notably those that are made up of consumer loans, are required by law to include ratings in their official documentation. That means new bond sales in the $1.4 trillion market for mortgages, autos, student loans and credit cards could effectively shut down.


    Maybe we can get a bunch of financially illiterate left-wing lawyers to do the rating instead. After all, they're doing such a great job with everything else.

  2. Professor Ramirez,

    Thanks for a terrific post. The Credit Rating Agencies were complicit, indeed a root cause, of the global financial crisis. That they rated CDOs and asset backed securities triple A, that were in fact nothing more than thousands of bundled subprime and Alt-A loans is a farce. Greed drove the madness.