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.
Marc Joffe is a Senior
Policy Analyst at the Reason Foundation and a researcher in the credit
assessment field. He previously worked as a Senior Director at Moody’s
Analytics. This article reflects his personal opinion, and not necessarily
those of PF2 Securities.
