Dean Baker
The Hankyoreh (South Korea), July 3, 2013

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The Securities and Exchange Commission (SEC) had a set of hearings last month that revealed a great deal about the sorry state of financial reform in the United States. The SEC hearing were on a provision of the Dodd-Frank financial reform bill that would have made the SEC responsible for selecting the rating agency that would rate new issues of mortgage backed securities (MBS) by investment banks.

The provision was intended to address an obvious conflict of interest that came to light in the financial meltdown. The bond-rating agencies were being paid by the banks that issued the MBS. This was a very lucrative business at the peak of the housing bubble as the banks were issuing hundreds of billions of dollars a year in MBS.

This meant that the bond-rating agencies had a strong incentive to give their stamp of approval, assigning investment grade ratings, regardless of the actual quality of the MBS. That way they could be assured of continued business from the banks.

This problem was noted by some of the analysts of the rating agencies at the time. In one case, an e-mail showed an analyst complaining that they would give an investment grade rating to a new issue if it were “structured by cows.” Such was the structure of incentives in the industry.

Fortunately there was a fairly simple fix. Take the hiring decision away from the banks. Everything else could follow along exactly the same lines – the banks still pay for the ratings, the agencies still do the ratings – you just remove the choice of rating agency from the bank. This way the rating agency’s future business is not jeopardized by an honest rating of the issue. In fact, honest ratings would be a mark in their favor since fewer subsequent downgrades would entitle them to more business.

This plan was pushed by several economists, including me. It was put forward as an amendment to the larger Dodd-Frank bill by Senator Franken from Minnesota and passed with an overwhelming bi-partisan majority. This seemed like a basic good government issue on which there wasn’t much of a basis for partisan disagreements.

But then the industry went to work. Representative Barney Frank, at the time the powerful head of the House Financial Services Committee, managed to change the amendment in a House-Senate conference committee. Instead of going into effect with the rest of the bill, the SEC would study the issue and issue a recommendation in two years.

This was exactly what the industry needed to derail the reform process. The SEC study was completed dominated by the input received from the industry. The industry can pay people to bury the SEC with arguments; almost no one gets paid to argue the case on the other side.

The industry arguments could not pass the laugh test in a normal discussion, but on an industry-friendly regulatory body, they were enough to carry the day. The main tack the industry took was to make the selection of a rating agency into a very complicated process. (The United States has three that have more than 90 percent of the business.) They implied that there was a big risk that if the SEC took it upon itself to select the rating agency then there was a big risk that it would pick an agency that wasn’t qualified for the task.

This argument is absurd for two reasons. First, it is highly unlikely that one of the big three rating agency would find itself unable to rate a new issue. Their expertise does not differ to any great extent. Furthermore, the correct response from a rating agency that it is presented with work that exceeds its capabilities is to tell the client that they can’t do the work. Under the Franken system there could be no negative consequence from being honest, unlike the current system. In that scenario the only downside would be that an issue might be delayed by a few weeks.

The other absurdity of this industry argument is that we should not want the industry to be issuing complex financial instruments. That was one of the main lessons from the crisis. There were many bond issues that the buyers did not understand. If banks believe that they risk getting a rating agency that can’t understand their new issue and therefore can’t rate it properly, then they have more incentive to keep their issues relatively simple. That is what we want.

But no one was making these arguments at the SEC. The money was all on the other side.  

The Franken amendment was hardly the most important part of the Dodd-Frank bill, but it was a simple and easy part. If this measure could be so easily derailed what does it say about the prospects of more fundamental reforms such as ending too big to fail subsidies or preventing banks from effectively using their government insured deposits to underwrite speculative trading?

The reality is that the U.S. financial industry is more concentrated and more corrupt than ever. The Dodd-Frank reforms have accomplished little to nothing.