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10 Questions for economist Lee Ohanian: Why credit-rating agencies matter

lee ohanianUCLA economist Lee Ohanian answers questions about international rating agencies like Standard and Poor's in the wake of S&P's downgrade of U.S. debt, which kicked off a wild roller-coaster ride in the stock market. Ohanian is professor of economics and director of the Ettinger Family Program in Macroeconomic Research, and conducts research into massive financial crises like the Great Depression.
Why do we need international rating agencies like Standard & Poor's, Moody's Investors Service and Fitch Ratings? What role do they play?

Ratings agencies provide an independent assessment of the quality of securities issued by both governments and private borrowers. This is an important component of the allocation of capital and the pricing of capital in the world economy.

Didn’t these agencies also take some of the blame in the global recession?

Agencies have come under significant criticism for failing to see that some mortgage-backed securities, particularly subprime securities, were much riskier than they realized. Thus, the rating agencies played a role in the world financial crisis of 2008 by giving these securities quality ratings that were much too high.

Who can influence the rating agencies?

Like any corporation, they respond to the interests of their shareholders, and these shareholders are best served by a company that provides high-quality evaluations of securities. If the rating agencies continue to make poor evaluations, then the demand for their service will fall, which in turn will lead to lower profits for shareholders.

Do banks have influence or ownership over the rating agencies?

In principle, a financial service firm could own such an agency, though it would reflect an obvious conflict of interest.

Do politics come into play when rating agencies issue opinions on the riskiness of an investment?

They certainly do in the case of the Standard and Poor's downgrade of U.S. debt. This downgrade reflects the political difficulties that the US Congress has in meaningfully and efficiently cutting the US deficit.
In light of the chaos that the S&P downgrade of U.S. debt touched off in the stock market, what should the little guy do? What’s the strategy for a small-time investor with stock funds in a 403B or a college fund for his or her kids?

Concerns about our long-run fiscal balance, including Social Security, unfunded government pensions and healthcare, combined with investor concerns about a politically polarized Congress, are creating enormous gyrations in the stock market, which are making stocks riskier.

Individual investors should re-assess their investments to see if their portfolios are still consistent with their underlying tolerance for risk. If not, they should consider investments with lower risk, which at the same time probably offer lower expected returns.

Should we trust that rating agencies are fair and objective?

In the past they have been, though the financial crisis of 2008 raises questions about their objectivity.

After the ratings agencies were implicated in the 2008 crash, why didn’t they lose their caché and influence?

The agencies had long track records prior to the financial crisis that were highly respected and accurate regarding the ability of borrowers to repay their debts. When they change the rating of a security, financial markets respond to this significantly.

Is it time for reform?

Competition among the agencies should help provide society with better performance. Outside of the financial crisis, they typically have been responsible and accurate.

Should Europe create its own rating agencies?

More competition would be even better. Europe should be able to just as well, and perhaps better, than the US agencies in assessing the quality of European securities. But they would be susceptible to the same problems that impacted US agencies during the financial crisis.
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