06/02/2010 08:07 pm ET Updated May 25, 2011

Questions Raised As Feds Look To Become More Intertwined With Credit Rating Agencies

Senator Al Franken's proposed Credit Rating Agency Board will reward the most "accurate" credit rating agencies with more accounts, but the panel's methodology for assessing agencies remains unclear, he acknowledged Wednesday.

Instead of directly selecting a credit rating agency, all new financial securities will be sent to a self-regulating clearinghouse to dole out rating assignments based on the panel's own criteria of an agency's performance, according to Franken's amendment, which was adopted by the Senate in the financial reform bill it passed on May 20. That criteria, though, was not defined in the bill.

"Each agency will compete to be accurate," Franken, a Minnesota Democrat, said during a Wednesday conference call with reporters. "The incentive will be accuracy as opposed to over-inflation."

When the success of a company depends on favorable credit ratings, there is incentive to inflate ratings to retain customers, and those flaws in the credit rating system contributed to the financial meltdown, he argued.

The three major firms, Moody's Investors Service, Standard and Poor's, and Fitch Ratings, built their businesses by pandering to their customers, critics allege. The three control 94 percent of the credit rating market.

Increased government regulation of credit rating agencies will afford smaller ratings firms the opportunity to gain a larger market share of the rating industry since the industry will no longer be based on standing relationships with debt issuers, proponents of Franken's measure say.

"There is a glaring built-in conflict of interest," said James Lardner, a senior policy analyst at the advocacy organization Demos. "There are effectively no sanctions for lying." Demos supports Franken's provision.

Of the hundreds of billions of dollars in securitized assets issued in 2006, 93 percent have been downgraded from the coveted AAA rating -- implying virtually no risk of default -- to junk bond status, the provision's supporters said on the conference call. Credit agencies deflected their guilt of misleading the public by contending that Americans should not rely on the ratings to make investments, said the amendment's supporters.

But by passing Franken's amendment into law the federal government effectively may continue to mandate the use of credit rating agencies and their ratings, legitimizing their opinion as a valid source of investment information.

The legal requirement of newly-issued financial instruments to receive a credit rating could establish a false sense of security for investors to place more trust in these credit ratings.

The creation of a clearinghouse places the government in the position of middleman in assessing rating agencies, and a successful pairing of issuer to agency will depend on the board's ability to evaluate the accuracy of the agencies' ratings.

What defines an "accurate" rating, though, remains undefined. When asked what metrics will be used to evaluate the reliability of each rating agency, Franken punted.

"That will be up to the board," he said.