My latest paper* focuses on the difficulties that rating agencies face in setting a credit score that accurately reflects the credit quality of a borrower, but also takes into account the effect that score will have on the borrower’s credit quality in the future. When a rating agency cuts a given company’s credit rating, investor confidence in that company’s ability to meet its debt obligations is undermined, making it very difficult for the company to raise cash. The downgrade often becomes a self-fulfilling prophecy.
In my paper I talk about the ideal accurate credit rating environment. It’s important to note that there may be several possible ratings that are accurate for a particular firm or country at any point in time, but some of these ratings lead to more distress than others. I believe rating agencies ought to be careful to select the best rating: one that provides an accurate portrayal of the company’s credit worthiness, but also takes into account the continued existence of the company in question. These ratings – where the agencies have a small bias towards the ultimate survival of the companies they evaluate – allow the companies to borrow money at a lower interest rate and therefore improve their chances of withstanding any financial shocks that may arise.
As a former pension consultant-turned MIT Sloan professor, I get asked to speak at my fair share of pension conferences. I recently spoke at a symposium for trustees of Taft-Hartley funds, which are pension funds for unionized workers jointly trusteed by union representatives and management. After my talk, something unexpected happened: the audience gave me a hearty round of applause. This was unusual because often when I speak at these events, it seems people want to throw things at me.
Allow me to explain. I worked for over a decade in the pensions industry, and during that time and since, I’ve observed intense politicization around whether public (state and local) pension plans are adequately funded, and especially whether the actuarial rules for determining how much funding is necessary are up to the task. On one side are plan sponsors and actuaries who say that, based on traditional actuarial methods, the funds are in decent shape; and on the other side are economists (and a few actuaries) who contend that traditional actuarial methods understate and obfuscate the pension commitments state and local governments have made, and that the plans are in far worse shape than is generally acknowledged.