The presidential hopeful says the industry has a major conflict of interest. He's not wrong.
01/07/2016 11:38 am ET
- Ben Walsh Business Reporter, The Huffington Post
Dennis Van Tine/ABACA USA
When it comes to credit rating agencies, Democratic presidential candidate Bernie Sanders wants to remove profits from the picture entirely.
Bernie Sanders' financial reform plan is chock-full of clear goals, even if it's not always clear whether he can actually achieve them. He wants to break up the big banks. He wants to send financial fraudsters to prison. He wants to put a cap on ATM fees. And he wants to turn the country's credit rating agencies into nonprofits.
The push to overhaul the rating agencies is one of the wonkier proposals to come from the Vermont senator. Why reform credit rating agencies? Despite what their name implies, these companies, such as Moody's and Standard & Poor's, are private, for-profit businesses that make money evaluating how risky debt is.
The problem is that they were spectacularly bad at evaluating risk when it came to the junk mortgage debt that triggered the financial crisis. Tens of thousands of mortgage securities were given triple-A ratings in the runup to the crisis, the Financial Crisis Inquiry Commission found. At the same time, there were only six triple-A-rated companies.
Of course, the rating agencies weren't the only parties that got it disastrously wrong on housing-related debt. They do, however, have a very specific conflict of interest: They are paid by the issuers of the debt, but they provide their services to the investors in the debt.
As a result, the rating agencies' business model includes a built-in incentive to produce shiny ratings that make issuers happy. And in the case of mortgage securities, those issuers were the banks.
Sanders' proposal is to change that business model -- to make it, in fact, not a for-profit business model at all.
Investors would not have bought the risky mortgage backed derivatives that led to the Great Recession if credit agencies did not give these worthless financial products triple-A ratings -- ratings that they knew were bogus.
And, the reason these risky financial schemes were given such favorable ratings is simple. Wall Street paid for them.
Under my administration, we will turn for-profit credit rating agencies into non-profit institutions, independent from Wall Street. No longer will Wall Street be able to pick and choose which credit agency will rate their products.
Take away the profit motive, the thinking goes, and the rating agencies will produce fairer assessments of risk for investors.
The strong implication is that under this plan, the banks and companies won't pay for the debt they issue to be rated. This is called the "issuer pays" model. The Sanders campaign did not respond to questions about who would pay and other specifics of the plan.
And so, the question is: If the issuers aren't going to pay for the credit ratings, then who is? Sen. Al Franken (D-Minn.) has a plan to randomly assign ratings work to different companies. Under this plan, the more accurately a company rates the riskiness of the debt it's assigned, the more business it gets. The issuer still pays, but the incentives are changed.
Or Sanders could try to make debt markets more like equity markets, where there are lots of analysts putting ratings on stocks. There is tension inherent in that model for stock research, and there have been glaring conflicts exposed in the past, but on the whole, because there are so many stock analysts, the individual stock ratings by themselves have very limited power.
There's also the question of why investors, who were harmed by the rating agencies' bad work, haven't taken it upon themselves to solve this issue. After the financial crisis, you might have expected a critical mass of pension funds and other investors not just suing credit rating agencies, but demanding that the agencies eliminate the conflict of interest by paying for their own credit ratings, rather than relying on the people issuing the debt to foot the bill. It didn't happen.
Maybe that's because big investors are expense-obsessed right now, largely for good reasons. Or maybe it's just logistically easier for the seller of the debt to pay for the rating. After all, while a single debt security can have thousands of potential buyers, it's only got one issuer.
But the trickier issue is that paying directly for ratings would require big investors to take more immediate responsibility for what they buy -- rather than just gobbling up anything with the right letters of the alphabet slapped on it, and blaming someone else when it turns out to be worthless.