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Franklin Strier: How Credit Ratings Rate
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Caption BulletPhoto by Joanie Harmon

Franklin Strier: How Credit Ratings Rate

Franklin Strier had his article “Rating the Raters: Conflicts of Interest in the Credit Rating Firms,” published in the Dec. 2008 issue of Business and Society Review. In it, the professor of business law at California State University, Dominguez Hills examines one of the key causes of the sub-prime mortgage crisis and related solutions. He says that bond rating agencies were one of the chief contributors to the problem, as they typically gave mortgage-backed securities a AAA, the highest rating possible, to the bonds of companies that sold collateralized debt obligations (CDOs) in order help them sell the bonds. In addition, the agencies often served as consultants in designing the bonds.

“If a corporation wanted to issue a bond, they would often also ask a credit rating firm like Moody’s to consult on the design of it,” he says. “Moody’s would help with the design of the security and later issue a rating on it. In effect, the rating agency that gives you the rating... is getting a consulting fee in addition to the fee for the rating.”

In his article, Strier looks at reforms to the industry that could effectively eliminate such conflicts of interest, and could apply to other areas of corporate governance. He says that solutions such as full disclosure of default rates of bonds rated by the agencies, altering the relationship between rating agencies and clients, and more stringent oversight from the Securities and Exchange Commission would help solve these issues. He also says that the government should take a hard line on bogus credit ratings by allowing agencies to be sued if the bonds fail.

“Right now, these agencies are protected under the First Amendment,” he notes. “What the courts have said is that when the agencies give an opinion that constitutes commercial speech. Say you bought one of these inherently risky bonds that received an AAA rating. You want to sue, but the courts say [the credit rating] is just an opinion, a matter of speech.”

Currently, Strier is writing a book on conflicts of interest in fields where they would not be expected and would have serious ramifications, such as in medicine.

“There are some high level research doctors getting funds from the National Institutes of Health,” he says. “They are hired to make unbiased evaluations of drugs, but – they’re . . . also getting hefty consulting fees from the drug companies that make those drugs.”

- Joanie Harmon


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Last updated Thursday, February 5, 2009, 1:48 p.m., by Joanie Harmon