October 03, 2019
The Wall Street Journal ran a lengthy piece on how bond rating agencies are again giving inflated ratings, in this case to collateralized loan obligations that include tranches of a variety of bonds and loans. Inflated ratings were a major problem in the housing bubble years, with the major rating agencies giving investment-grade ratings to mortgage-backed securities that were filled with subprime mortgages.
The piece notes the basic incentive problem that the issuer pays the rating agency. This gives rating agencies an incentive to give higher ratings as a way to attract business.
There actually is a simple solution to this incentive problem: have a third party pick the rating agency. Senator Al Franken proposed an amendment to the Dodd-Frank bill that would have had the Securities and Exchange Commission (SEC) pick rating agencies rather than issuers. The amendment passed the Senate with 65 votes, getting strong bi-partisan support.
Under this provision, if JP Morgan wanted to have a new issue rated, instead of calling Moody’s or Standard and Poor, it would call the SEC, which would then decide which agency should do the rating. This means that rating agencies would have no incentive to inflate ratings to gain customers.
In spite of the strong bipartisan support in the Senate, then-Treasury Secretary Timothy Geithner did not want the provision to be included in the bill. As he boasts in his autobiography, he arranged to have it killed in the House-Senate conference.
So, when we see the problem of inflated bond ratings re-emerging, we should all be saying “Thank you, Secretary Geithner.”
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