Topics: Barack Obama

Ratings firms often wrong but still strong

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Congress,Barack Obama,SEC,Debt Ceiling,PennAve,Joseph Lawler,Economy,Dodd Frank

As soon as the ink was dry on the agreement to lift the debt ceiling, President Obama turned to an outside source, Fitch Ratings, to criticize Congress for allowing the government to come within days of defaulting on its debt.

The ratings agency had put America’s credit rating on watch for a downgrade, citing “political brinkmanship” as a factor casting doubt on the government’s credit.

“That wasn't a political statement,” Obama said in his speech. “That was an analysis of what's hurting our economy by people whose job it is to analyze these things.”

It was an odd reference, given that Fitch and the two other companies that make up the Big Three of U.S. credit ratings agencies were singled out for regulation in the president’s 2010 financial reform bill because of the role they played in the financial crisis of 2008.

Since 2008, many commentators have faulted the agencies for assigning AAA ratings to mortgage-backed securities that later proved to be high risk. By giving an official sign-off to risky products, the ratings agencies helped stoke the flames of the crisis.

Another high-profile miscue by a ratings agency came in 2011. Standard and Poor's downgraded U.S. debt from AAA to AA+ after a drawn-out debt ceiling battle, drawing worldwide attention for saying that the deal reached between Obama and Republicans did not sufficiently cut the debt. At the time, the yield on the benchmark 10-year U.S. Treasury was a low 2.6 percent – the same rate it was after last week’s agreement. It fell as low as the 1.6 range earlier in 2013.

Despite the ratings agencies' missteps over the years, the Securities and Exchange Commission relies on them for certain regulatory purposes. In particular, money market funds are prohibited from investing in securities that don’t have AAA ratings – meaning that a downgrade of U.S. Treasurys could provoke a collapse in them even if investors aren’t worried about the underlying creditworthiness of the U.S. government.

Many financial economists believe that the ratings agencies’ prognostications cannot beat those of investors who have their own money on the line.

“Ratings agencies serve no useful purpose except inherently to mislead investors,” wrote Adam Posen and David Smick in a 2008 Peterson Institute for International Economics article advocating the disenfranchisement of the agencies, which are officially recognized by the SEC.

Leading to the resolution of the debt ceiling impasse, Fitch was out of step with private investors. Although short-term Treasury yields rose from the near-zero levels they rested at before the debt ceiling deadline, they remained very low in historic terms and relative to other countries’ debt. Other U.S. government bonds showed little or no movement at all throughout the showdown.

“We're giving less reaction to made-up government crises,” one investment strategist told Bloomberg news.

Joe Davis, the chief economist for the mutual fund company Vanguard, explained that "sometimes markets have already priced in" ratings changes, although not always. Davis said the most consequential economic problem facing the United States was not debt ceiling brinkmanship but rising long-term debt. A renewed focus on the debt prompted by another debt ceiling showdown would be worth having, "even if that conversation is messy."

The landmark 2010 Dodd-Frank financial reform law included provisions intended to curtail the ratings agencies’ power, in particular by reforming the way they are paid to avoid conflicts of interest. The firms, however, have been able to dodge some of the most critical regulations at the rulemaking stage.

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