The biggest credit rating agencies lost credibility in recent years after doling out top ratings to securities backed by mortgage pools that later proved to be very troubled. Dodd-Frank responded by changing the regulatory framework for credit rating agencies. Most importantly, it ordered the elimination of government mandates to rely on ratings produced by the handful of government-sanctioned credit rating agencies. This change reminds investors that they--not the government--are responsible for deciding whether credit rating agencies are doing a good job.
Unfortunately, other parts of Dodd-Frank could have the opposite effect--further lulling investors into complacency. One of the most troubling provisions was the subject of a recently released Securities and Exchange Commission staff study. The study considered the merits of establishing a quasi-governmental board charged with selecting a credit rating agency to rate each asset-backed security and with grading credit rating agencies' performance.
To its credit, the SEC staff highlighted many of the potential problems with such an approach, including the possibility that it "could lead investors to believe that these ratings are government-sanctioned and encourage them to forego additional due diligence." The staff also noted the difficulties the board would face in objectively assessing the accuracy of ratings. These and the staff's numerous other concerns should be sufficient to overcome Dodd-Frank's urging that the SEC establish a new bureaucracy to manage the credit rating process.