Financial Overhaul 101: Bill could improve rating agencies but won’t end conflict of interest

Financial Overhaul 101: Credit rating agencies

WASHINGTON — Before the financial crisis, surging home prices led investors to pour trillions into investments backed by mortgages. Investors felt confident because credit rating agencies had judged these investments to be safe.

They weren’t. The safe ratings had gone to investments backed by some of the riskiest mortgages. When the agencies downgraded them by the billions, it helped trigger the financial crisis.

The financial overhaul bill before Congress aims to hold the agencies accountable for sloppy analysis that produces inaccurate ratings.

Yet it barely addresses the agencies’ central conflict of interest: They’re paid by institutions whose products they rate. Critics say the agencies yielded to pressure to give high ratings to risky investments.

Here are some questions and answers about how rating agencies would be affected by the bill, which Congress is expected to approve:

Q: How would the bill help make the agencies’ ratings more accurate?

A: The agencies could be sued if they recklessly ignored an investment’s risks in assigning a grade. It’s impossible to sue them now. Ratings are considered constitutionally protected free speech.

The agencies would face tighter regulation. A new office within the Securities and Exchange Commission would examine them every year and could fine them for breaking its rules. An agency’s right to issue some kinds of ratings could be revoked if the agency’s ratings too often proved inaccurate.

The agencies also would have to disclose more information about their track records and rating methods.

Q: How would these rules affect financial institutions?

A: Banks will be discouraged from shopping around for an agency that will give the highest rating. The exact method will be decided after regulators study the issue. One option is to have rating agencies assigned randomly, in a process overseen by regulators.

Banks and investment companies might sue agencies that issue inaccurate ratings.

Big investors, like pension funds and asset-management firms, will know more about how agencies assign ratings. That might lead them to shift investment strategies.

Q: How would the changes affect ordinary people?

A: Pension and mutual funds will have better information about where to invest their clients’ money, supporters say. That could make them more stable and profitable.

Individual investors will understand the ratings better. They will now be able to learn, for example, whether an agency’s former employees now work for a bank that received high ratings. That might help them spot potential conflicts and avoid investment losses.

But if more investment companies choose to do their own research, mutual fund fees could rise.

Q: Where does the bill fall short?

A: It fails to fix the conflict of interest at the heart of the credit raters’ business model: They’re paid by the same institutions whose investments they are rating. Many lawmakers say the agencies issued high ratings before the crisis because of pressure from banks and because the agencies wanted more of their business.

Congress failed to include in the final bill a proposal to randomly assign banks to credit rating agencies. That way, banks couldn’t shop for an agency with the easiest standards. Instead, regulators will study the issue and decide what rules to issue.

Critics say increased regulation and legal liability will give investors a false sense of security. They say the changes will cause people to trust the agencies even more, regardless of whether they deserve that trust.