09
Aug
11

### Shooting the messenger

Suppose you have a function of time $c(t) = 1 - 0.01t, t \in (0, 100)$, where c stands for completely-arbitrary and not confidence or creditworthiness.  Some people care about c(t) directly, but most people are only interested in $r(t) = \lceil c(t)-(0.5+\epsilon) \rceil$, where r is the rounding function rather than any sort of rating agency, because this is totally not a forced and thinly-veiled allegory.  Everyone can agree that at t=0 everything’s just hunky-dory, but as t starts to increase some of the first crowd start making ominous noises (perhaps they took the derivative).  The rest of the population scoffs, pointing at the sterling record of r(t) — hasn’t its first derivative been zero all this time? — and accuse the c-watchers of scaremongering, worry-wartism, and worse.  But as t approaches 50, ripples of discontent rumble through the broader population.  Politicians bicker; markets oscillate wildly; bloggers pound at their keyboards.

Then Der Tag arrives: t becomes 50, and r(t) = 0.  Panic breaks out.  Andrew Sullivan rails against r‘s inconsistency, channeling the rage of a throng of — not unreasonable — people who point out that c(t) isn’t so different from c(t-ε) and — more unreasonably — see dark motives in r‘s reversal.  Nate Silver excoriates the predictive power of a low-resolution discrete function in a continuous world.  Italy raids r‘s offices… okay, so much for allegory.

Credit ratings are pretty blunt instruments, and as the credit crisis should have shown us they’re not fantastic predictors of the future, either.  As Silver notes in his (as-usual) thorough analysis:

S.&P. ratings tend to lag, rather than lead, the market. That is, in cases where the market’s view of default risk is misaligned with S.&P.’s, S.&P. is a good bet to change their rating to catch up to market perception.

I’d be interested to see Silver’s analysis applied to other ratings agencies, particularly Moody’s and Fitch.  In any case, my simple-minded impression is that credit ratings like these aren’t predictors of default or deterioration so much as reality checks.  When S&P downgrades your debt, it’s not a cunning prediction of future problems no-one else can see: it’s a slap upside the head and a “Hey, stupid!  You can’t keep ignoring this!”

Update: In the comments, SmartDogs points out this excellent article by Felix Salmon explaining just what precisely ratings from ratings agencies are intended to accomplish, and how S&P’s rating differs from Moody’s:

In particular, regarding Nate Silver’s article from above:

Silver goes on to complain that credit ratings are a lagging indicator: upgrades and downgrades tend to lag the market, rather than anticipate it. Again, this is a complaint only if you think of the ratings agencies as being some kind of guide to help people beat the market. But they’re not. Sovereign upgrades and downgrades are big, important things, and the ratings agencies take their time over them — they’d much rather err on the side of caution and act too late than jump onto some wave of excitement and then regret doing so a few weeks later. That kind of activity they’re happy to leave to markets.

#### 6 Responses to “Shooting the messenger”

1. August 9, 2011 at 20:10

Isn’t an S&P rating directly analogous to a credit scores for an individual – an algorithm you feed data into that spits out a number that provides a rough measure of the subject’s financial stability?

If so, did the algorithm suddenly morph into something evil or are S&P algorithms a lot more ambiguous than the ones used for credit scores?

Or – has S&P (and Moodys and Fitch) been a whole heckuva lot more forgiving of our national finances than Equifax, Experian and TransUnion would be of an individual with similar spending habits?

• August 9, 2011 at 20:16

Oh – a friend just sent me this. There *is* a reason it was S&P and not Moodys:

http://blogs.reuters.com/felix-salmon/2011/08/09/the-difference-between-sp-and-moodys/

• August 9, 2011 at 20:22

Nate Silver’s article goes over the deficiencies in S&P’s ratings better than I can. Reading through that would probably give you a pretty good idea of how S&P ratings correlate to actual risk.

I can think of a couple other reasons why investment ratings (S&P, Moody’s, etc) would differ from credit scores, though:

– The ratings agencies have just been caught sleeping on the job, giving AAA ratings to mortgage-backed securities we now know to have been utter crap. There’s a fair bit of speculation going around that S&P’s downgrade of US Treasury debt is an attempt to be seen to toughen up and regain some credibility.

– Publicly-traded debt has a lot of indicators of risk — first of all price. When S&P downgraded US debt and the market went right back and bought lots of it, some people explained the phenomenon by claiming that the risk of default was priced into the T-bills to begin with: they had been cheaper than “true” AAA US debt ought to have been. Credit default swap prices also come to mind. Personal credit doesn’t have nearly as many public risk indicators, particularly indicators as easily analyzed as price time series.

• August 9, 2011 at 22:17

And S&P ranks risk of default, not ROI (like Moodys sort of does) and as the article points out, S&P still rates the US Treasury as AA+ because you will still get your money even if a default occurs. You’ll just be paid late.

My question now is – do any of the agencies rate the inflation adjusted return on investment? Because if another mass of bills get printed, those debts may be paid, even paid on time. But they’ll be paid at a deflated value.

• August 9, 2011 at 22:27

I imagine that Moody’s takes inflation into account, based on Felix Salmon’s article. It seems like a terribly obvious thing to do if your main concern is how likely investors are to get their money back. Heck, Reinhart and Rogoff consider “payment by inflation” to be just another form of sovereign default. For the moment I’m not too worried about inflation on this continent. The Eurozone, on the other hand….