Frank bill mandates credit rating agencies to repeat subprime mistakes

by John Berlau on July 30, 2008

in Economy, Legal, Nanny State, Politics as Usual, Precaution & Risk

Due to their failures in the subprime mess, it has long been expected that Congress would take up regulation of the credit rating agencies to attempt to make the ratings stronger.

But the first rating agency bill to move forward — the Municipal Bond Fairness Act sponsored by House Financial Services Committee Chairman Barney Frank, D-Mass. — has the almost explicit goal of making the rating weaker for a certain type of security. Scheduled to be marked up in the financial services committee today, the bill would limit the risks agencies can look at in examining municipal bonds. It very purpose, according to a press release from Frank, is to “increase demand for certain municipal bonds and therefore lower borrowing costs for issuers.” It would limit municipal bond ratings to long-term default, overlooking issues such as short-term liquidity that turned out to be important overlooked risks for mortgage securities.

The bill also raises First Amendment issues, according to longtime media attorney Floyd Abrams, who defended the press in landmark free speech cases such as the “Penatagon Papers” case, New York Times Co. v. United States. The credit rating agencies, Abrams argues and courts have apparently upheld, are a form of media so long as they aren’t structuring the security they rate.

The problem during the subprime mess was lack of competition and overreliance on rating agencies. The Securities and Exchange Commission, to its credit, has moved in the direction of recognizing more competitors and lifting requirements that financial instituions rely on the word of rating agencies.

As a recent op-ed in the Financial Times puts it: “The issues with credit ratings are not so much that they got their assumptions so wrong on a subset of US residential mortgage-backed securities. It is why the markets swallowed these assumptions apparently without challenge.”

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