Al Franken’s Complex Legacy and the Credit Rating Business

Al Franken’s announcement of his pending resignation completes his descent from Progressive Saint to something of a pariah figure. But like others whose stars have fallen during this moment of reckoning for alleged sexual harassment, Franken is neither all good nor all evil. Instead, he leaves a complex legacy with both pluses and minuses. Such was his impact in the realm of financial regulation, where he correctly diagnosed an important problem but misunderstood its genesis, putting forward an ill-conceived solution.

Before being outed as a serial groper, Franken built a reputation as an entertainer, a pundit and finally a serious-minded US Senator. Although fans of the free market rarely liked his political positions, it is hard to deny that he brought a quick wit, keen intellect and passion for justice to his work. When deliberating over the 2010 Dodd-Frank Act, a measure intended to remedy the causes of the 2008 financial crisis, Franken recognized that it didn’t adequately address credit rating agencies. He realized that these firms triggered the crisis by assigning gold-plated AAA ratings to thousands of low quality mortgage-backed securities. These rating errors attracted excess capital into the housing finance market, driving down the cost of getting a home loan and inflating the home price bubble. Importantly, Franken understood the complex interplay in the market, recognizing that the bad ratings were a byproduct of the credit rating business model, in which the agencies are compensated by bond issuers rather than investors. In the oligopolistic rating market – dominated by three firms – bond issuers could pit rating agencies against one another, offering to hire the agency willing to apply the lowest credit standards to their bonds. Until this business practice changed, the economy would remain vulnerable to another financial crisis.

Franken’s diagnosis was buttressed by the fact that rating agencies have made many other errors. (As I discuss in a forthcoming Reason Foundation study, rating agencies also assigned inflated ratings to Enron, Worldcom, and municipal bond insurers like Ambac and MBIA, among others). Although Franken’s analysis was correct, his proposed solution was flawed. His idea was to break the nexus between bond issuers and rating agencies by inserting government as a middleman. Rather than select rating agencies on their own, bond issuers would have to ask a government bureau to select raters on their behalf. This so-called Franken Amendment to Dodd Frank was stripped from the bill, so we cannot be certain how this solution would have worked. But with all likelihood, the core problem would remain, and the “selection agency” function would similarly be exposed to capture by the industry, not to mention any other number of unintended consequence. Likely, there would have been multiple unintended consequences including the eventual capture of the selection agency by industry interests.

The issue with the rating model is that the government is involved, unnecessarily, and not in a way that advances or incentivizes accurate measurement. The solution, then, is not to increase government involvement.

We can easily identify a better solution by understanding how the credit rating business became distorted and then removing the causes of this distortion. In the early 20th Century, Moody’s and its competitors were small firms that sold rating manuals to investors. After Depression-era bank failures and the inception of federal deposit insurance, bank regulators began using the ratings manuals to determine which companies banks could lend to. Since the 1970s, regulations based on credit ratings were extended to other financial players, and the SEC began to license and regulate rating agencies. These interventions created barriers to entry for competitors while making the ratings themselves valuable to bond issuers – since the ratings determined whether many types of investors could buy certain bonds. As a result, credit rating agencies had been handed a powerful and exclusive tool – one they could monetize by selling ratings to bond issuers. Instead of adding more bureaucracy as Franken proposed, a better solution is to dismantle the entire regulatory apparatus. Let’s allow anyone to issue credit ratings on a level playing field and divorce these ratings from all financial regulation. It will then become the investor’s responsibility to choose which rating agency to trust, giving credit raters – both incumbents and disruptors – the incentive to provide better ratings.

Although Franken was a smart legislator, his policy positions may have been compromised by a worship for power, just as the various groping allegations appear to have been the result of an abusive exercise of power. Likewise, increasing financial power through regulation – as Franken proposed to do –creates opportunities for abuse. Rather than concentrate power we should be trying to disperse it – in Washington, on Wall Street and beyond. In this way, we can prompt financial market participants to be more accountable for their own investment decisions, and more directly responsible.

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