Rating the raters


in Economics, Geek stuff, Law, Politics

Nate Silver of FiveThirtyEight has an interesting post about sovereign public debt default ratings from Standard & Poor’s. He argues that their ratings from five years ago did not reflect the risks that arose with the financial crisis.

Despite their potentially misleading character, the financial system relies on such ratings to be a proxy for probability of default. A bondholder with a good rating should be less likely to default than one with a poor rating, and a highly rated security should be a safe investment, If the ratings produced by rating agencies are not a good proxy for risk, it may be a mistake to continue to give them such an important role within the financial system and financial regulation.

Of course, that raises the question of what to use as a superior indicator for risk.

{ 2 comments… read them below or add one }

. August 9, 2011 at 11:16 pm

How Rating Firms’ Calls Fueled Subprime Mess
Aaron Lucchetti,Serena Ng / Wall Street Journal / Aug 2007

By 2006, S&P was making its own study of such loans’ performance. It singled out 639,981 loans made in 2002 to see if its benign assumptions had held up. They hadn’t. Loans with piggybacks were 43% more likely to default than other loans, S&P found.

In April 2006, S&P said it would raise by July the amount of collateral underwriters must include in many new mortgage portfolios. For instance, S&P could require that mortgage pools have extra loans in them, since it now expected a larger number to go bad.

Still, S&P didn’t lower its ratings on existing securities, saying it had to further monitor the performance of loans backing them. It thus helped the market for these loans hold up through the end of 2006.

. August 10, 2011 at 5:36 pm

In a document provided to Treasury on Friday afternoon, Standard and Poor’s (S&P) presented a judgment about the credit rating of the U.S. that was based on a $2 trillion mistake. After Treasury pointed out this error — a basic math error of significant consequence — S&P still chose to proceed with their flawed judgment by simply changing their principal rationale for their credit rating decision from an economic one to a political one. S&P incorrectly added that same $2.1 trillion in deficit reduction to an entirely different baseline where discretionary funding levels grow with nominal GDP over the next 10 years. Relative to this alternative baseline, the Budget Control Act will save more than $4 trillion over ten years — or over $2 trillion more than S&P calculated. S&P acknowledged this error — in private conversations with Treasury on Friday afternoon and then publicly early Saturday morning. In the interim, they chose to issue a downgrade of the U.S. credit rating.

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