Thursday, September 25, 2008

What exactly does a rating rate?

(Felix Salmon) S&P is defending the single-A rating that Lehman had when it went bust.

"In our view, Lehman LEHNG.PK had a strong franchise across its core investment banking, trading, and investment management business," analyst Scott Sprinzen said in a statement...
"We believe the downfall of Lehman reflected escalating fears that led to a loss of confidence -- ultimately becoming a real threat to Lehman's viability in a way that fundamental credit analysis could not have anticipated with greater levels of certainty," he said.

I think this is exactly the wrong message for S&P to be sending, for two reasons.

Firstly, when people look to a ratings agency to guide them on the subject of default risk, they don't think to themselves "well, the ratings agency will only give me the default risk that fundamental credit analysis can anticipate with certainty; I need to calculate the other types of default risk on my own". No -- the role of a ratings agency is to come up with a rating which encompasses all possibly relevant default risks.

And secondly, the defensive stance from S&P strikes me as very similar to the people who say things like "InTrade said X only had a 10% chance of winning, but then X won. That proves prediction markets are crap."

A rating gives an idea of the probability of default. If that probability is zero, then the asset in question will have a triple-A rating. If that probability is nonzero, then sometimes entities with that rating will default. Lehman Brothers was a case of a single-A credit defaulting. This happens, sometimes. That's what it means to be single-A and not risk-free.

Now we know that the ratings agencies were far off the mark when they were rating structured products. So far, however, they seem to have been doing OK when it comes to plain-vanilla corporate defaults. If the percentage of single-A companies defaulting were much larger than it should be, S&P would have something to be worried about. But I'm pretty sure it isn't. So really there's no need for this kind of defensiveness.

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