"The Law of Unintended Consequences Hits Dodd-Frank"

Sydney M. Williams

Thought of the Day

“The Law of Unintended Consequences Hits Dodd-Frank”

July 23, 2010

As President Obama was signing the financial reform bill, an unintended consequence of the bill was playing out on Wall Street. (At least I presume it was unintentional.) Included in the finance reform bill is a provision making it easier for investors to sue credit rating agencies for assigning unrealistically high ratings –a warning to the rating agencies and a sop to trial lawyers.

I am no fan of the rating agencies, as anyone who read the piece I wrote on May 3rd will recall (“Rating Agencies – Do We Need Them?”), and I have little respect for trial lawyers who have taken an honorable profession and have turned it into a vehicle to realize extraordinary personal gain. The fact that they are one of the Democrat’s largest political contributors endears them to that Party, a relationship which has become symbiotic.

The finance arm of Ford Motor Company was unable on Wednesday to sell a series of asset-backed securities because of the aforementioned provision. The always-alert Vince Farrell did mention the incident from his vacation haunt in Nantucket; however, the only report that I saw yesterday in the New York papers was in the Wall Street Journal, brought to my attention by Neil Crespi’s youngest son, Michael. They reported: “the law says that the rating firms can be held legally liable for the quality of their ratings” and that, “the trouble is that asset-backed bonds are required by law to include ratings in official documents.” “The result has been,” continued Anusha Shrivastava in her article, “a shutdown of the market for asset-backed securities, a $1.4 trillion market that only recently clawed its way back to health after being nearly shuttered by the financial crisis.”

While I have little sympathy with rating agencies and feel that they definitely should be held responsible for the ratings they assign, equating them as “experts”, in line with auditors and lawyers, overlooks the fact that their ratings are based on estimates as to future events – an inexact science, at best – as opposed to offering an opinion on existing facts, as do auditors and lawyers. The rating agencies, in collusion with the banks whose products they were rating, brought this problem on themselves in providing ratings that did not reflect the real value of the securitized products being sold. But the market for asset-backed securities, at $1.4 trillion, is large, and the securitization of these loans is integral to the auto finance and credit card industries and, therefore, to consumers.

The issue will get resolved, but it will likely result in the rating agencies demanding higher fees to offset the risks of lawsuits; the cost will be borne by consumers (as always) in higher auto loan and credit card interest rates. The problem points to the complexity of integrating government intrusion into market economies. Greed, an unhealthy coziness between Washington and Wall Street, and lack of enforcement of existing rules helped create the problem. As much as anything, this incident points out the fact that the reform bill, despite being 2300 pages long (or 35 times longer than Sarbanes-Oxley), will have consequences, both intended and otherwise.