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Al Franken: The rating agencies had 'a reason to be stupid'

Franken-Official Portrait-200dpi.jpgSen. Al Franken's mostly kept a low-profile in the Senate. But he's recently announced his intention to bring a major amendment reshaping the rating agency business to the financial-regulation bill. Joining him as co-sponsors are Sens. Bill Nelson and Chuck Schumer. I spoke with Franken this afternoon, and a lightly edited transcript follows.

Why did you decide to focus on the rating agencies?

The agencies were an enormous part of the problem. They were giving AAA ratings to products that didn't deserve them. There's this inherent conflict of interest where the issuers of these financial products were shopping for raters. It's become very clear that what's going on was they had an incentive to inflate the ratings to get more business. In some cases the agencies were just stupid, but there was also a reason to be stupid. They had motive.

How does your amendment fix the problem?

Instead of the issuer shopping for ratings, we'd form a board under the SEC that would decide which rating agency rates each instrument. I don't mandate how they do it. But it wouldn't have to be totally random. The board would be comprised mainly of investors and people who manage pensions and university endowments. One of the advantages of this is that it'd inject more competitions into the business. Right now, we have Moody's and Standard & Poor's and Fitch doing 94 percent of the ratings. This board could give business to smaller agencies. You'd be rewarded on accuracy and so the incentive would be to be more accurate.

And that, you hope, takes care of the problem wherein the rating agencies actually do a worse job because they're now guaranteed to get business?

Right. Depending on the nature of the product, you'd be able to judge the accuracy over some period of time. Developing a track record of accuracy would be in your interest as opposed to rewarding the exact thing we don't want, which is inflating ratings on behalf of the banks.

Another criticism people have raised about this approach is that giving the government more power over the agencies will leave them more beholden to the government. Right now, the agencies have been criticized for downgrading Greece, and in the future, with our deficit, you could imagine them downgrading America. But not if they rely on the federal government for work.

Well, maybe there'd be part of this where they're not rating government securities. I'm not sure how that would work. But this is about the securities that got us into trouble. So it might not be how we'd do a Treasury bond.

Rather than bringing them further into the government's embrace, why not just kick the rating agencies out altogether? Right now, the government credentials them, uses their "AAA" rating in certain laws and generally makes sure they're central to the system. Why not let them rise or fall on their own?

I think that would be a problem. You could say let's just not have any rating agencies. But we'd have a problem if we didn't have rating agencies at all. I think what you want are rating agencies that do a good job.

To press you on that, though, you'd still have rating agencies. It just wouldn't be the government saying you have to listen to them. And that seems like a good thing to me. Even if you get rid of the conflict-of-interest problem, it still seems to me that these players exist to tell Wall Street that it doesn't really need to know what it's doing. You can be an English literature major who's only been on Wall Street for five months and as long as you know it's "AAA" or "BBB," you're good to go.

I think the government sanction in this amendment would incentivize accuracy and mean that these agencies would do their due diligence and compete and be a bit smarter than the ones in Michael Lewis's book, who seemed particularly easy to fool.

It has occasionally seemed to me that the best reform would be to tax the banks and use the money to make the people at the rating agencies the highest-paid folks on Wall Street.

Well, there might be something to that. I don't prescribe how much they'll get paid but if you are rewarded by your track record, people who do a better job will be paid more.

Do you know if your amendment will get a vote?

I'm not certain. But probably next week sometime. We've been talking to the banking committee staff and I hope that it does come up next week, either as is or in some form. We're very prescriptive in this for how the board will look and there are other ways to skin this cat.

By Ezra Klein  |  May 7, 2010; 3:55 PM ET
Categories:  Explaining financial regulation , Interviews  
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Comments

Ezra, you've repeatedly had posts that suggest ratings don't add anything -- that portfolio managers should do their homework and not rely on the crutch the rating agencies provide. But you're overlooking how essential ratings are for those who are clients of portfolio managers (whether pension fund trustees or invidividuals). They're critical for both establishing agreed upon investment objectives and holding managers accountable.

As an individual investor, I want and need ratings. If I want to put my pension savings in debt rather than equity, I'm going to want a mutual fund that invests in bonds. And I'll want to be able to choose a risk/yield profile -- frex, better yield than US gov (I'll take some added risk) but safer than junk (I'm not an out-and-out yield chaser). Right now, I can choose among several different levels of risk (as well as other factors like currency of issuance, geography, corporate vs sovereign, sector, type of instrument, average maturity and so forth).

The only way I am able to choose among levels of risk offered by competing funds -- and that each bond fund can communicate to me the level of risk they're going to invest in -- is via ratings as stipulated in each fund's investment policy. That doesn't take the fund off the hook for choosing individual investments, but it does limit the universe of investments among which they can select that will fit my personal investment objectives. Without ratings, there's no way to compare the risk level of investment policies among competing bond funds.

Posted by: nadezhda04 | May 7, 2010 5:02 PM | Report abuse

I like Larry Kotlikoff's plan more:

Have a financial regulator provide ratings (or provide a signal of danger by refusing to rate opague/complex securities). The existing rating agencies can stay, but there will be a federal rating agency as well.

http://www.dollars-and-nonsense.com/wall-street-hucksters-risk-breakup-in-kotlikoff-plan-books

Posted by: justin84 | May 7, 2010 5:24 PM | Report abuse

Rating should be done by an independent government rating agency funded by taxes on the big banks and financial firms. give them 10 year nonrenewable contracts. Don't allow raters to go to work for the companies they rated. Make their decision making process public.

Posted by: srw3 | May 7, 2010 5:55 PM | Report abuse

An even bigger driver is the use of the ratings by the government in determining the leverage requirements. If debt gets downgraded, banks need to get more liquidity. Just imagine what happens when Treasuries lose AAA.

Posted by: staticvars | May 7, 2010 8:54 PM | Report abuse

One of the advantages of this is that it'd inject more competitionS into the business

Dude, you are working too hard. Take it easy and boil a few eggs

Posted by: makhija | May 7, 2010 10:22 PM | Report abuse

OK - then downgrade the US treasuries. They aren't worth a AAA rating - they are worthless.

Posted by: NO-bama | May 7, 2010 10:50 PM | Report abuse

It's really 'enlightening' to have (literally) a clown that has never held a public office in his life or run a business elected to the Democrat caucus.

Few take this idiot seriously.

Because he's inexperienced enough, and stupid enough...and doggone it, people just don't like him

Posted by: WrongfulDeath | May 8, 2010 3:52 PM | Report abuse

I'd like Franken, Ezra, or any big-time liberal to stand up and tell us all exactly what they think Greece did wrong and how this could have been prevented.

We're all listening....

Posted by: WrongfulDeath | May 8, 2010 3:55 PM | Report abuse

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