Suppose you have a function of time , 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 , 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.