AT LAST, FINANCIAL REFORM / THE WALL STREET JOURNAL REVIEW & OUTLOOK ( HIGHLY RECOMMENDED READING )

REVIEW & OUTLOOK

JUNE 17, 2010.

At Last, Financial Reform

Barney Frank helps prevent another crisis in the credit markets.

Washington's pending reform of the financial laws will trigger billions in unnecessary costs even as it fails to end bank bailouts. But this week, Rep. Barney Frank (D., Mass.) ensured that at least one part of the bill will help prevent the next credit crisis.

Leading the House negotiating team in a conference committee, Mr. Frank persuaded his Senate counterpart, Chris Dodd, to break the cartel of the credit-ratings agencies. These government-anointed judges of risk—Standard & Poor's, Moody's and Fitch—put triple-A ratings on junk mortgage paper during the housing boom. When the boom turned to bust, the apparently safe assets were revealed to be anything but, with disastrous consequences for investors.

The results were so bad because government policies force many institutional investors to follow these ratings, no matter how flawed. Without this requirement, analysis from the Big Three would have to compete in the marketplace, and investors could decide whose judgments they trust on risk. Money-market fund managers would have to embrace the old-fashioned idea of due diligence.

Mr. Frank's reform, strengthened further by an amendment from Rep. Scott Garrett (R., N.J.), will end the ratings racket enjoyed by S&P and the other "Nationally Recognized Statistical Ratings Organizations." All requirements to use these favored credit judges will be stricken from federal rules as well as laws.

State legislators who haven't already enacted such reform should do the same to ensure that the ratings cartel doesn't maintain a grip on pension and insurance rules.

Say what you will about Congressman Frank's role in protecting the failed mortgage giants Fannie Mae and Freddie Mac—and we've said a lot, little of it admiring—he is close to eliminating one of the root causes of the financial meltdown of 2008. Whatever one's views on the existence of miracles, this one is close.

But there could be a catch. Democratic Senators are still insisting on a provision that would allow the Securities and Exchange Commission, after two years of study, to rebuild the ratings cartel and create a new board to divvy up business among members of the cartel. It's a terrible idea.

We hope Mr. Frank hangs tough on ensuring that investors can ignore the cartel's ratings, and that these ratings carry no legal standing. Then the Senate scheme might simply be a waste of taxpayer resources, rather than a central cause of the next crisis.

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