Downgrade the ratings agencies

The credit ratings agencies are crap, according to this post by Olaf Storbeck and this one by Jonathan Portes, Director of the National Institute of Economic and Social Research.

Portes outlines how he had a go at the European delegation that visited him recently.

These agencies have repeatedly been proved wrong; they have flawed and frequently conflicted business models; and their ratings have no predictive power.  All this is well established. Moreover, when it comes to assessing sovereign debt “credit risk” they – and I mean this quite literally – do not know what they are talking about.

Earlier in the year Portes argued that:

The misdeeds and incompetence of the credit ratings agencies in the run-up to the financial crisis has been well documented. What is less well understood is that when it comes to rating sovereign debt… they do not even understand what their own credit ratings mean.

Storbeck quotes new research by Jens Hilscher of Brandeis University International Business School and Mungo Wilson from the Saïd Business School at the University of Oxford showing that credit ratings do not contain much information about the actual chances of default.

“The informational value of credit ratings is surprisingly low,” says Hilscher in summarising the key findings of the paper entitled “Credit Ratings and Credit Risk.”

Hilscher and Wilson look at all assessments that have been given between 1986 and 2008. Additionally, they constructed an alternative indicator that is meant to gauge the default risk of the bond issuers. The economists only use publicly available information for this “failure score”, mainly balance sheet data like profitability, leverage and cash holdings.

Hilscher and Wilson compare the S&P ratings and their own failure score with actual defaults and come to a straightforward conclusion: Their simple indicator delivers much better predictions about expected defaults than the verdicts of the rating agencies. According to the paper, the failure score is almost twice as reliable:

“We find that this measure (…) is substantially more accurate than rating at predicting failure at horizons of 1 to 10 years. The higher accuracy in predicting the cumulative failure probability is driven by a much higher ability of failure score at predicting marginal default probabilities at horizons of up to 2 years and the fact that credit rating adds little information to marginal default prediction at horizons up to 5 years.”

In his bestseller The Big Short, Michael Lewis further details the incompetence of Moody’s and S&P, showing how they recruit second-rate graduates who are easily outmanouvered by their Wall Street counterparts.

Incompetence is a charge not often laid at the feet of the agencies, at least not in the mainstream press. Portes suggests that governments simply ignore the agencies, whose ratings demonstrably have little long-term effect on bond yields. I have always found it weird that a small group of private companies are seen to wield such power — effectively the ability to decide social spending for entire nations. I hadn’t understood that this power is endowed by a credulous press and government.

But clearly some financial models need a measure of risk, and it’s almost as if any one will do even if it’s methodologically doubtful. Ratings changes also create news, and news creates volatility, which is the life-blood of traders. The banks and financial institutions need the agencies, and vice versa. It’d be a difficult job unwinding such a close relationship.