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Andy Kroll has a good piece up about “Five Fights to Watch” in the upcoming battle over financial regulatory reform. The whole thing is worth reading, but it’s #2 that I have the hardest time figuring out how to fix:

2) The Ratings Agencies’ Conflict of Interest Problem
The toxic mortgage bonds and other products that helped demolish the economy were stamped with blue-chip ratings from the big three ratings agencies — Moody’s, Standard and Poor’s, and Fitch. Why did they affix their seal of approval to junk investments? The answer is complex, but largely centers on the fundamental conflict of interest with the rating agencies: they get paid by the same firms that are seeking ratings for their products. This arrangement allowed banks to shop around for the highest score regardless of whether the product deserved it or not.

It’s not clear whether the Senate bill will fix this problem. Senate banking committee chair Chris Dodd (D-Conn.) has proposed creating a new watchdog within the Securities and Exchange Commission to keep an eye on the agencies. The bill would also give investors the right to sue them for “a knowing or reckless failure” to thoroughly investigate a product before issuing a rating. But will that SEC watchdog address the conflict of interest in how rating agencies get paid? Will it revisit the pseudo-governmental role played by the Big Three agencies, whom the SEC has used as official arbiters of safety in the markets? These questions, raised by academics, experts, journalists, and others, have yet to be fully addressed by the Senate.

This is a head scratcher. Ratings agencies made a ton of money out of the housing bubble. Basically, banks came to them with a swelling array of rocket-science securities and paid them to provide a rating. Because these structured securities were complex, the fees for figuring out the rating were high, and it turned into a lucrative source of business.

The conflict of interest is obvious: banks wanted high ratings and the agencies wanted lots of deal flow. That meant they were motivated to push the envelope in order to insure a steady stream of business. After all, if you get a little too picky about things, clients will just head across the street to see if a different agency might treat them a little better.

So the problem is pretty clear. But what’s the solution? Ideally, someone else should pay the ratings agencies. But there’s no one to do that, so that’s out. Regulation might work, but then again, it might not. Complex securities really are complex, and figuring out the right model to apply is genuinely difficult. What’s more, the guys structuring the deals are a lot smarter than the working stiffs at the agencies. It’s really not a fair fight. Another idea is to open up the industry to more competition, but I’ve never really understood how that would improve things. The basic conflict of interest is still there no matter how many federally approved ratings agencies there are.

The lawsuit idea is an interesting one, though. Ratings agencies are immune from suits right now because years ago the courts bought their argument that ratings are just opinions and therefore protected by the First Amendment. You know, just like George Will and Paul Krugman are protected for their opinions. That sounds silly, but hey — the law is an ass. But even if that gets changed, “knowing or reckless failure” is a pretty high standard and it’s not clear to me that it would really provide much of a brake on reckless behavior. Maybe worth a try, though.

Luckily, I don’t think ratings agencies were really at the core of the financial meltdown. They helped things along for sure, but other stuff was a lot more fundamental. It would still be nice to come up with some kind of compelling fix for the conflict of interest at the heart of the ratings business, though. I’m just not sure what it is.

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