Congress is creating conditions for another housing bubble and financial crash
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In an especially memorable scene from the film The Big Short, a Standard and Poor's (S&P) rating analyst tells Steve Carrell's character that her company gives AAA ratings to toxic mortgage-backed securities because "if we deny them the [AAA] rating they'll go to Moody's" and S&P will lose money. The scene captures how a seriously flawed credit rating system helped fuel the housing bubble and subsequent financial crash, triggering the Great Recession. Remarkably, that massive flaw remains. 
 
Credit rating agencies still rely primarily upon an issuer-pays business model, which means they have an incentive to inflate their ratings in order to placate large financial institutions that structure large volumes of bonds. The Dodd-Frank financial reforms were supposed to fix this problem but the issuer-pays model remains in place and the U.S. economy remains vulnerable to systemic credit rating errors. 
 
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As the Senate takes up its financial reform bill, it should not miss the opportunity to clear the path for more competition in the credit rating industry. Today, it is difficult for new agencies to obtain a Securities and Exchange Commission (SEC) license to be a Nationally Recognized Statistical Rating Organizations (NRSRO). To get certified as a rating organization, an applicant must present 10 letters from Qualified Institutional Buyers stating that they've used the prospective NRSRO's services for three years. This is an especially high bar for companies considering entering the market given the fact that their potential customers have the option of simply getting free ratings from the existing big three credit agencies. An aspiring company seeking its NRSRO license is thus faced with the daunting task of trying to convince 10 buyers to pay for an unlicensed product for at least three years — when they can get similar services for free from the entrenched rating agencies.
 
Congress should instruct the SEC to relax NRSRO licensing requirements, or, better yet, eliminate them altogether. Institutional investors, the main consumers of credit ratings, should be smart enough to determine whether a credit rating agency's opinions are worth using without the government's assistance. 
 
More competition would also likely spur analytical advancements the status quo is preventing. With today's abundant and inexpensive computing power it should be relatively easy for new credit rating agencies to set up shop, gather data and quickly analyze large volumes of securities. The federal government could further lower the cost of entering the credit rating business by migrating more financial filings from PDFs to a structured, searchable format such as eXtensible Business Reporting Language (XBRL). Consumers of financial disclosures, such as rating agencies, would thereby have access to large data sets at little or no cost. This reform could be accomplished by the passage of HR 1530, "The Financial Transparency Act of 2017," which requires that all federal financial regulators transition to structured formats.
 
Congress should also eliminate the numerous federal regulations that still reference credit ratings. The government's reliance on credit ratings traces back to the Great Depression when bank examiners were seeking a way to determine which bank assets were "investment grade." Later, regulators extended the use of ratings to broker-dealers and other financial institutions. Although it seemed like a good idea at the time, writing rating agency assessments into federal regulations gave the opinions of for-profit rating companies significant regulatory power. Dodd-Frank identified this as an important problem and instructed regulators to take credit ratings out of their regulations.  However, this mandate hasn't been fully implemented. Congress should insist that regulators complete, and then maintain, a full separation between ratings and regulations. 
 
By fully divorcing credit ratings from regulations, and then lowering the cost of entering the credit rating business, policymakers could significantly reduce the risk that bad credit ratings pose to the financial system and economy. Adding new voices to the credit rating discussion, ideally voices freed from the conflicts inherent in the issuer-pays model, would increase the chances that investors receive accurate credit analysis, helping the country avoid the traps of opaque, poorly understood, toxic debt securities that hammered the economy in 2007. 
 
Hopefully, lawmakers don't need another financial crash to finally fix the credit rating system. 
 
Marc Joffe is a policy analyst at Reason Foundation, former senior director at Moody's Analytics, and author of the new study "Unfinished Business: Despite Dodd-Frank, Credit Rating Agencies Remain the Financial System’s Weakest Link."