Credit rating agencies faced a growing threat to their business model yesterday after the Senate voted to establish a government-appointed panel to decide who rates an individual asset-backed security.
“There is a staggering conflict of interest affecting the credit-rating industry,” said Mr Franken. “Issuers of securities are paying for the credit ratings. They shop around for their ratings.”
Among the more dramatic changes to be considered are a ban on “naked” credit default swaps – with which traders buy protection against a bond’s default without owning the underlying security – and tougher restrictions on proprietary trading.
Senate aides predict a slight chance for the naked CDS ban, put forward by Byron Dorgan, a Democrat from North Dakota. That proposal, like Mr Franken’s, does not have the support of the Democratic authors of the bill but shows the propensity for changes coming from the left in the final few days of debate.
Under the new credit rating agency plan, a board set up by the Securities and Exchange Commission would decide which agencies get which business to eliminate ratings shopping and potentially allow new entrants to capture market share.
“Having the rating agency assigned by a third party, whether the government or its designee, could lead investors to believe the resulting ratings were endorsed by the government, thereby encouraging over-reliance on the ratings,” warned Chris Atkins, a spokesman for S&P, which is owned by McGraw-Hill.
He added that the firms “would have less incentive to compete with one another, pursue innovation and improve their models, criteria and methodologies” if the new system was adopted. Senators are in the final stages of modifying the bill, with a final vote expected next week.
Moody’s and Standard & Poor’s dominate the credit rating business and both have been criticised for giving investment grade ratings to mortgage-backed securities that proved to be riddled with bad loans.
The agencies’ problems intensified at a Senate hearing last month when Carl Levin, a Democrat in charge of an investigations subcommittee, published e-mails from rating agency employees revealing their misgivings about ratings for bonds linked to risky mortgages.
Mr Levin said he hoped the findings would influence pending financial regulation, which he claims does not go far enough to untangle the conflict of interest between rating agencies and investment banks that pay companies like Moody’s and S&P for their services.
Since the hearing, the share prices of Moody’s and McGraw-Hill – owner of S&P – have fallen sharply. Moody’s fell 6.8 per cent after yesterday’s vote but recovered to trade down 2.7 per cent at $21.70.
A final vote is expected on the bill next week. Even if it is approved, there is no certainty that any provision will become law until after the bill is merged with a House version and the joint product is signed by President Barack Obama.
A separate amendment to remove a federal “seal of approval” given to rating agencies was also approved. George LeMieux, a Republican from Florida, who authored the change, said: “There is a handful of federally-approved rating agencies that gave their top marks to some of the worst investments.”
Mr LeMieux added: ”Removing their federal endorsement will end the dangerous over-reliance on these ratings and allow sound measures of risk to re-emerge in the marketplace-giving investors confidence an investment’s true risk is known.”
Among other rules likely to come into law is a proposal for a change in the liability standards. Rating agencies hotly oppose the law, which they say would make them less likely to rate risky companies, thus limiting their access to capital.
“What [it] really means is that any time there is a rating change, somebody can sue us, even if the business environment has changed or the economic environment has changed or the business is doing something different,” said Deven Sharma, president of S&P, in a recent interview.
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