TIME: Congress mans up on rating agency reform

[Editor’s note: I wrote a story for Time.com, which is now being funneled here, to the Curious Capitalist.  I might have assumed a bit more knowledge had I known it was going to wind up with you, dear readers.]

Credit ratings companies played a key role in the financial crisis by blessing the packages of sliced-and-diced mortgages that big banks were selling, even when there was little evidence that the ever-more-complicated deals would hold up over time. Now, thanks to two amendments passed by the Senate, these companies, which include Moody’s and Standard & Poor’s, could also be among the institutions most changed by the fall-out.

Legal action has already been mounting against the firms—from investors who claim to have been tricked into buying bad investments to authorities like Connecticut’s attorney general who says the firms knowingly lied in order to juice profits. But if the Senate’s amendments, which passed with bipartisan support, make it into the final financial-reform bill, they will go far beyond any other effort to hold the companies accountable. It is one of the boldest moves yet in the entire financial re-regulation saga.

One amendment would establish a board to pick which ratings company gets first crack at each complicated structured-finance security coming to market. The goal would be to avoid the deep conflict of interest embedded in the system right now: the issuer of a security directly pays a firm to rate it. By having the decision made by an intermediary board, comprised of institutional and other investors, as well as a banker and a representative from the credit ratings industry, the transaction would ostensibly be less prone to the sort of coercion and collusion witnessed during the wildest days of mortgage securitization.

The major ratings companies have responded by saying that such a board, to be overseen by the Securities and Exchange Commission (SEC), would reduce competition, since ratings firms would no longer directly vie for business. Whether or not that would hold true in the long-term, in the short-term, competition would almost surely increase as a number of smaller ratings firms, ones that have historically had a hard time winning market share from the largest three, could receive new business based solely on the quality of their ratings and not marketing efforts.

But there could be bigger risks. The next ratings bubble might not come from structured finance—and ordinary bonds, like those issued by cities and companies, wouldn’t fall under the purview of the board. Plus there’s always the chance that the board simply doesn’t clamp down in the next burst of euphoria. Plenty of regulators didn’t in the last go-around.

The other amendment just passed by the Senate would do away with a special designation the federal government has for certain ratings firms—“nationally recognized statistical rating organization,” or NRSRO. The NRSRO label is based on the SEC’s determination that the firm is generally reliable and credible. That label then helps countless investors and regulators shortcut their own due diligence in figuring out the risk of assets. If an NRSRO says a bond is safe, then everyone from banking regulators to mutual fund managers are legally allowed to treat it that way without any further investigation. That leaves most important players in the financial system relying on the opinions of just a few profit-seeking companies.

Abolishing that shortcut will cost a lot of money. Both investors and regulators will have to come up with new ways of assessing the safety of various assets. But one could argue that that’s not an added cost as much as it is a cost that they should have been bearing all along. Plenty of members of the Senate are sympathetic to the cause. The amendment passed by a vote of 61 to 38.