International Economics

Taming Rating Agencies

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By Dr. Kurtulus Gemici | 01 June 2010


Panorama_clip3Alchemy thrived in seeking how to turn ordinary, worthless metals into gold. To the dismay of countless alchemists, that goal has been rather elusive in the world of metals. Not so in the world of modern finance. The business of making golden assets out of worthless ones, a relatively recent innovation, has been a particularly lucrative practice in financial markets. The name of this game is structured finance and securitization. It uses the tools of modern finance to transform highly risky or junk assets into something shinier. Once these securities receive good ratings from institutions such asMoody’s or Standard & Poor’s, they become legitimate investment instruments that can be used in all types of financial transactions. This is, then, the alchemy of contemporary finance: converting assets once considered unacceptable for financial transactions into prime investment commodities. There is a growing consensus that this alchemy was a crucial element of the financial boom—so much fool’s gold—that ended with the meltdown of the world financial system between 2007 and 2008.

 

Convinced that the financial meltdown of 2007-2008 was at least partially a consequence of deregulation and lax supervision, American politicians are eager to pass legislation to curb the power of financial markets and its institutions. A new amendment to the financial regulation bill, proposed by Sen. Al Franken and approved in the Senate on May 13, aims to limit the considerable influence a handful of agencies exercise over credit ratings. The central idea is to establish a board, consisting largely of private investors, to determine which agency would rate newly issued asset-backed securities. This regulatory entity, named The Credit Rating Agency Board in the amendment, will also supervise the performance of rating agencies. The avowed goal of this legislation is to put a stop to the practice of inflating ratings on securities backed by assets such as house mortgages.


 

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