Are raters accurate?
Credit markets are about taking risk to earn more return.
A way to think of this on a personal level is if you loan $1,000 to a steady, well-employed neighbor, you are likely to get it back because they have cash flow to repay the loan. Since the steady neighbor could likely borrow from many others, you can’t command a high interest rate. But if your chronically-broke, unemployed, woman-chasing neighbor wants to borrow $1,000 from you to fix his motorcycle, you could demand a higher interest rate to compensate for the risk. Maybe you’re the only one willing to loan to the risky neighbor.
The risk is that the broke neighbor might take your loan, fix his bike and ride off into the sunset and you may not get the money back. Bond markets call this type of borrower “speculative grade” because you are speculating that you will get your money back. The steady, settled neighbor would be called “investment grade” because you are investing your money with high likelihood of being repaid.
If you have a good sum of money to lend out, but not too much time, you probably would have to have some group investigate your neighbors and give you some feedback on their ability and willingness to pay. In the fixed-income markets this is what credit rating agencies do. They are very powerful because they have collected decades of data on issuers and their borrowing and repayment habits. It’s this process of monitoring and evaluating the creditworthiness of borrowers that makes raters central gatekeepers for bond markets. They are always watching the neighbors so you are relieved of the trouble.
Here is the policy at Standard & Poor’s for their process: General Description of the Credit Rating Process (as of 25 March 2011).
There are thousands of banks, corporations, state and local governments who borrow in the financial markets, and investors want credit rating agencies to tell them how much specific risk there is in bonds and issuers. Investors use this rating information, along with market prices, to buy securities and monitor their portfolio. The idea that investors would start to do this credit analysis themselves is naive at best. Only the very largest financial firms have the expertise and resources to do this.
I know that I am unusual in my defense of raters. I am optimistic because we have the laws in place to require raters to monitor and disclose conflicts of interests and make their level of accuracy public. I said in a post yesterday that a lot of fuss arose because the role of raters in financial markets, their practices and how they were regulated is so little understood. It is a complex area for those who don’t participate in bond markets but I think I can clear away a little of the smoke. Here is what I wrote to Congress in January, 2008.
Our regulatory framework embodies the expectation that NRSROs ["Nationally Recognized Statistical Rating Organizations"] will consistently and accurately judge the relative creditworthiness of issuers and securities.
But how does the law monitor whether raters (NRSROs) ”consistently and accurately judge creditworthiness?” A federal law called the Credit Rating Agency Reform Act of 2006 takes the approach of radical transparency for the raters. The SEC’s rules that implemented the law require that raters publish the default statistics for their ratings. Default statistics give us an opportunity to see how accurate rating agencies have been over a period of years.
Major rating agencies assign hundreds of thousands of ratings. The law requires that they separate out default stats for these ratings into distinct classes of bonds including municipal, sovereign, corporate and structured finance. The data must be provided for 1-, 3- and 10-year periods and made public on the website of the rating agency.
In muniland you often here people say that muni bonds rarely default. According to the data that is true. Here is the 2010 default data from Standard & Poor’s for municipal bonds that the law requires be made public:
|Rating||Year 1||Year 3||Year 10|
© Multiple-Markets 2011
U.S. Public Finance Defaults and Rating Transition Data: 2010 Update (2 March 2011) Table 22, page 49 “One-, Three-, and 10-Year USPF Obligor Default Rates By Rating Modifier (%)”
You can see from this data that S&P municipal bond ratings have had almost no defaults until you reach the BBB- level. The Credit Rating Agency Reform Act of 2006 requires that we have access to this data. Pretty revealing, eh? One caveat though: default data for ratings is backward-looking. If we enter a multi-year recession or depression that would present a macro environment that exceeds the conditions that this default data was generated from. In that case, all bets are off. But generally you can see that muniland is a quiet backwater. The law allows us to see that. I’ll be writing more about credit rating regulation. It’s the heart of a stable financial system.
For the curious here is the default data for sovereign ratings from S&P: 2010 Sovereign rating default report