The proposal would only affect “structured securities,” which are mortgage-backed bonds, asset-backed securities, and other debt-like instruments that declined in value during the financial crisis.

Standard & Poor’s spokesperson Edward Sweeney criticized the amendment for the deleterious effect he said it would have on credit rating agencies’ “incentive to compete with one another, pursue innovation, and improve their models, criteria, and methodologies.”

The provision, proposed by Senator Al Franken (D-MN), passed by 64 to 35, which means it is likely to remain part of the final bill.

Financial expert, market technician and capital market participant Al Franken solves the conflict issue. This is a stupid idea. Is there ever a problem that can’t be solved by “more government”?

CalPERS is accusing the rating agencies of “negligent misrepresentations to CalPERS and CalPERS’ money manager agents, which have caused and will cause CalPERS to suffer substantial investment losses” by overvaluing the SIVs.

CalPERS claims that the agencies were the “only entities” outside those managing the SIVs who knew what assets were held by the opaque structures.

This is hilarious! CalPERS, a huge expert pension fund, was duped by too high of a rating? The California Treasurer complains the muni ratings of the NRSROs were too low!! This all looks like blame shifting.

When speaking on French radio Europe 1, French Economy Minister Christine Lagrade said that France will reinforce control over the rating agencies. “I think certain rules should be fixed … because we don’t degrade a country under the conditions that its rating has been degraded, that’s to precipitate purchases of sales 15 minutes before the close of trading, deplorable for the solidity of the market,” she explained.

In an interview with Le Monde, she also said that the downgrade 15 minutes before markets closed was “crime inducing” because it created a panic among those holding Greek bonds who thoughtlessly offloaded the investments before markets closed, driving values down even further.

Previous European Commissioner for Internal Market Regulation Michel Barnier expressed the opinion that rating agencies should be “disciplined and responsible in their evaluation process.” Mr. Barnier, also of France, had also mentioned that the European Union was considering creating Europe’s own rating agency to balance the valuation opinions of the American agencies.

Vive la France! This is like blaming the thermometer for the heat.

We support Chairman Frank’s efforts to strike the reference and official use of ratings. Ratings can’t be corrupt and useless, AND be the source of regulatory measurement.

The study should model its answer on the NAIC solution to PMBS:

1. Ignore the rating
2. Find a reliable third party to price the assets
3.  Publish the results.

The NAIC has already solved the rating problem, and it works. Let’s just copy that.

Agencies Issue Advance Notice of Proposed Rulemaking… – Board of Governors of the Federal Reserve System, August 10, 2010

Apropos of the report that 91% of AAA-rated, residential mortgage-backed securities issued in 2007 and 96% of similar securities issued in 2006 have now been downgraded below investment grade to junk status, the Commission asked Buffett what he thought of the provision in the bank reform bill that would regulate rating agencies.

Buffett responded that while he “hated” the current system, he wouldn’t go so far as to outright support the measure. “I don’t know the answer to that,” he said. “The wisdom of somebody picking out raters, is that going to be perfect? I don’t know.”

He added that, “When rating agencies come to Berkshire, they have me by the throat. I have no leverage whatsoever. If there were 10 agencies and I took the cheapest one, people would say ‘You took the cheapest, but they didn’t do the work,’ so it’s not an easy answer.”

Buffet’s testimony can be seen at: http://www.cspan.org/Watch/Media/2010/06/02/HP/A/33689/Financial+Crisis+Inquiry+Commission.aspx

The banks involved are Goldman Sachs Group Inc., Morgan Stanley, UBS AG, Credit Suisse, Deutsche Bank AG, Citigroup Inc., Credit Agricole SA and Merrill Lynch & Co (recently acquired by Bank of America Corp.). The major ratings agencies, Moody’s Investors Service, Standard & Poor’s and Fitch Ratings, were also subpoenaed.

Since 2008, New York State and federal regulators have been looking into why the agencies gave top grades to subprime-mortgage backed securities and collateralized debt obligations that later fell dramatically in value.

Reportedly, Mr. Cuomo is also interested in learning why bank mortgage desks hired former rating agency analysts. He is examining whether the analysts’ experience and relationships at the rating agencies contribute to inflated ratings for these mortgage deals.

Data that banks provide to the ratings agencies to evaluate their securities is generally verified through third-party due diligence. It is not known whether these third parties will also be subpoenaed.

Republicans, who are traditional supporters of the free markets that would be adversely affected by many provisions in the bill, are in a difficult position. To fight the bill “on behalf of the banks” could result in voter backlash. There is widespread public support for strengthening banking regulations. To allow it to go forward without challenge would be to abandon their traditional supporters.

The bill is also open to opposition from some Democrats who don’t feel that new regulations are tough enough.

As for how the bill affects credit rating agencies, Senator Bob Corker (R-TN), a member of the Senate Banking Committee who has been working closely with Senator Dodd to craft the bill, commented that the proposed new regulations had not changed from Dodd’s original plan. He said that the bill placed a “pretty big liability burden” on the rating agencies. Generally, Republicans are opposed to this increased risk of litigation. They argue that it will result in frivolous and expensive lawsuits that would serve no good purpose. But the challenge remains:  How can they frame this debate without angering the voter base?

They also note a second conflict of interest. The U.S. and other heavily indebted governments do not want to reform the credit rating agencies because of their own borrowing needs. They could be exposed to potentially expensive downgrades if “true” credit ratings become the industry standard.

Instead, given the vast U.S. and European government debt that is held by Japan, China, South Korea, India and other Asian countries, they argue that it is time that Asians created their own assessment of the true creditworthiness of Western nations.

This agency or agencies would effectively replace the existing three major American agencies.

The Asian countries have another worse option: Stop buying our bonds.

Frank and Kanjorski had it right in the House version. De-recognize the NRSRO designation, strip the reference to ratings from the Federal Register, and let investors (and their advisors) bear the burden of due diligence.  If ratings are worthless without an NRSRO-mandated use, the ratings agencies will fold.

The capital markets are complicated and diverse. Millions of transactions a day defy static and specific rules. Let’s have less rules, more surveillance and prosecution. Enter the capital markets at your OWN RISK. If you expect the upside of an investment, you have to bear the downside. Ratings can’t be used as a substitute for personal due diligence.

House-Senate Talks Drop New Credit-Rating Rules – The New York Times, June 15, 2010

Berman makes a good case for knowing the history of ratings before we try and implement a solution.

We should also know what ratings measure. There is a huge gap between what a rating measures and what the general public (and Congress) thinks it measures. There is also a huge problem in using a single obligor ratings system in a multiple obligor security sector.

 We have two choices:

More government involvement (the Al Franken Plan): Otherwise known as the “how is that working out so far” solution…

Or

The  logical conclusion: De-certify the NRSRO designation, remove the references to ratings from the Federal statutes, and let caveat emptor rule.

If you don’t know what the credit “worthiness” of a bond of an asset is, don’t buy it. If you have an investment manager or a fiduciary representing your interests, it is their responsibility to understand underlying credit. This will let the market establish the usefulness of Credit Ratings Agencies and the concerns of ratings shopping without government involvement or any additional regulation.

We have to know the history of ratings, NRSROs and the mis-application of a ratings system architecture to a modern structured finance asset class. The Franken solution will raise the cost of capital and make it less available. The elimination of the NRSROs will let investors be responsible for their own decisions.

The Credit Raters: How We Got Here – Wall Street Journal, May 25, 2010