The Mystery of Rating Agencies

Calculated Risk has a routine post about S&P increasing its loss projections for subprime and Alt-A loans and for the mortgage-backed securities built out of those loans. These announcements have been so common over the last several months that I usually don’t even think about them. But today I had a thought about them: these are forecasts, which means that they should not get worse just because the economy is getting worse. Forecasts should only change when there is new news that affects expectations about the future. So if you take these rating agency reports at face value, they imply not only that the economy is getting worse (by traditional measures such as the unemployment rate), but that there is new bad news about the future of the economy, despite all this talk you hear about green shoots and a recovery. If there is only old news, then that should have been “priced in” to S&P’s forecasts already.

So what gives? Do the rating agencies see some new perils in the economy that are being overlooked? Or are they just stretching out a writedown in their forecasts over several quarters? Under the latter theory, they should have known what would happen to subprime and Alt-A loans the same time people like Calculated Risk did – that is, several months ago – but it would be too embarrassing to do a massive writedown all at once, so they are spreading it out over time for respectability.

By James Kwak

18 responses to “The Mystery of Rating Agencies

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  2. This crisis will be over the day a forecast has to be revised upwards.

    In the meantime, you are seeing refusal to recognize losses on a massive scale. The banks held off long enough that they were able to change the rules and not have to do so any more (which of course perversely benefits the biggest liars). The economic forecasting teams are no different. They are under tremendous pressure to avoid making sudden moves, so they lag the recognition of less-conflicted market commentators such as CR.

    Don’t worry, though, they’ll be quick to ratchet things back up once they get the green light.

  3. DesolationRow

    “Moody’s rated Lehman Brothers’ debt A2, putting it squarely in the investment-grade range, days before the company filed for bankruptcy. And Moody’s gave the senior unsecured debt of the American International Group, the insurance behemoth, an Aa3 rating — which is even stronger than A2 — the week before the government had to step in and take over the company in September as part of what has become a $170 billion bailout.”

    Listening to any of the rating agencies today is like saying your books are clean because the guys that did Enron’s books said so.

  4. S&P and the other ratings agencies generally lag the macroeconomic situation.

    There is no pricing mechanism (ie no market) that would make them ‘price in’ anything.

    What probably happened is that housing prices fell farther, and unemployment went higher, than they expected since the last time they did projections. They wouldn’t be the only ones who underestimated these things.

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  6. I agree with q. My experience with ratings agencies is that they typically react to events rather than anticipate them. This is one of the many reasons that investors should never make an investment decision based on how something is rated.

    To be fair, however, if the rating agencies actually had spines and amended ratings when they thought something would change versus when they could demonstrate that something had changed, they would probably be criticized for that too (especially if what they forecast did not materialize).

  7. “But today I had a thought about them: these are forecasts, which means that they should not get worse just because the economy is getting worse. Forecasts should only change when there is new news that affects expectations about the future.”

    Like stock prices, aren’t forecasts almost random walks? ;)

    Seriously, there are many ways that a forecast can come about. There is a cloud of uncertainty. The larger the cloud, the less certain the forecast, and the closer the forecast approaches the mean, in general. (If there is no cloud of uncertainty, there is no “regression towards the mean”.) As the time of the forecast approaches, the cloud becomes smaller. This is the case, even if the current data is close to previous expectations. It is not too surprising, then, if a new forecast incorporating new data is further from the mean than previous forecasts, even if the new data is not surprising.

  8. That being said, I expect that the main reason is as q says: The new economic data are surprising.

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  10. It’s possible that Q is right, in that they needed a downward revision because of the latest reports, and they’re also trying to spread the corrections over a few months. It’s also possible that they’re writing ratings down on pieces of paper and putting them in a hat, and passing it around the office when it comes time to assign a grade. Does anyone really think Moody’s has some special insight into what’s going to happen in the next year?

    None of this would matter, of course, except that the ratings are used for capital ratio requirements. But I think we need to do away with the ratings, as they are just another way to game the system.

    If we need to be able to rate bonds in order to allow higher leverage, but can’t find a way to rate bonds, then we need to reduce the allowable leverage.

    A false sense of security is very dangerous.

  11. The original idea of credit ratings was so people could be well AWARE of the risks they were taking and therefor make better decisions about what to invest in. NOW the credit ratings agencies’ job is to sell packaged securities stuffed with garbage. The only reason to buy a ratings agency publication now is if you’re short on toilet paper.

  12. The whole thing is silly and an exercise in futility until they change the incentives structure for the ratings agencies. You shouldn’t believe ANYTHING the ratings agencies write now anyway. Unless you believe in the Larry Summers’ New (and advanced) Credit Ratings Theory. Larry Summers has a new, ADVANCED theory on credit ratings called “They’ll Get It Right Next Time”.

  13. I forgot to mention, that Larry Summers came up with his new theory on credit ratings (“They’ll Get It Right Next Time”), during a moment of clairvoyance while talking to female math professors at the University of Harvard.

  14. We all know that rating agencies have been so historically poor at performing ratings, so why would anyone actually follow what they speculate about. A rating analyst is most often someone who couldn’t get a job on the Street and receive millions, so they lived vicariously. Good ratings when they were taken out to expensive lunches and given court side seats; and, now lesser rating to show the Street who’s Boss. Just another smoke and mirror joke from New York.

  15. I think the later hypothesis (stretching out write downs for image reasons) is the dominate influence here. However I think there are two other influences that you omitted. 1. The rating agencies only regrade securities periodically after a formal review process. 2. The ratings become something of a self fulfilling prophecy given the incestuous nature of the too-big-to-fail financial companies. The thought process being… the longer we can stretch out the downgrade, the more time we can give the Banks to hedge their loses, and thus minimize our ratings error.

  16. Apparently banks have decided they’re not accepting California’s IOUs. They are a BBB rated debtor. I had a friend (a friend mind you) that used to give IOUs to neighborhood stores when he bought wine and beer in China. I guess they thought he was a Triple A kind of guy. Life is so unfair huh? Here’s the link to the story on the Calculated Risk blog and originally taken from WSJ

    http://www.calculatedriskblog.com/2009/07/banks-will-stop-accepting-california.html

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