Senate Takes Aim at Credit Rating Agency Conflicts

The U.S. Senate has approved an amendment to its financial reform bill aimed at preventing conflicts of interest between credit rating agencies and investment banks. If it becomes law, the amendment would prevent investment banks from shopping around among credit rating agencies for a security’s initial rating.

During the housing boom, Moody’s Investors Service, Standard & Poor’s and Fitch Ratings gave top grades to subprime-mortgage backed securities and collateralized debt obligations that lost value after the collapse of the housing market. Investors who lost millions in the collapse had relied heavily on these agencies’ ratings to decide whether to buy mortgage securities.

A recent New York Times investigation detailed questionable tactics banks used to influence ratings. The investigation found that investment banks frequently hired away some of the very people who had devised the formulas rating agencies used to evaluate securities. Those hires often went on to help create mortgage deals that got better ratings than they deserved. The Times also found that rating agencies may have facilitated the banks’ actions by publishing their rating models on their corporate Web sites. One former rating agency employee told the Times that this enabled banks to “reverse engineer” their mortgage securities to garner higher ratings.

An 18-month Senate investigation into the relationship between ratings agencies and Wall Street also found that the major agencies were understaffed, didn’t have enough data about the mortgage securities they were rating and were pressured by each other and investment bankers to issue overly rosy ratings.

The “Restore Integrity To Credit Ratings” amendment would direct the Securities and Exchange Commission to appoint a panel to develop a system that would independently pick credit raters for packaged securities such as mortgage securities issued by a financial institutions. As it stands now, investment banks pay for a rating. Critics have charged that this system allows securities issuers to shop for the best rating it can get for the lowest price.

Fifty-three Democrats, 10 Republicans and one independent voted for the amendment.

However, there is no guarantee it will become law. A financial reform bill passed by the House does not include such a measure, and the House and Senate bills will need to be reconciled before they become law.

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