What to do about the ratings agencies

How about the purchasers of debt securities pay a fee to have their bond purchases rated (instead of the other way around). Then, if the securities default and the security was short-term rated, oh I dunno, say BB- then the purchaser gets that fee back. If the long-term rating was BBB+ and the security defaults then the purchaser gets their money back plus interest plus a penalty fee?

I just thought about this in the last five minutes and I’m a bottle and a half deep into some good Chianti, so this obviously needs to be reworked and thought about in more depth by someone who isn’t drinking.

I don’t agree that public rating agencies are “this is a roundabout and inappropriate solution to the problem of defining a safe harbor for institutional investors. What is needed, simply, is a list of approved investments drawn up by the relevant regulators.”

I don’t see the difference – a regulator is defining what are and aren’t approved investments either way. Moreover, given the proposed mechanism of randomly chosen competing agencies, there’s the increased difficulty of regulatory capture compared to the sorry state of the SEC.

StevenAttewell @3:

If you are going to argue that the issuer pays model always leads to much too high ratings you need to explain why this was never a problem in all the previous decades this same model was in place, or in any of the other asset classes (including sovereign ratings) that rating agencies cover.

Actually the rating agencies do not always use the same scale, as some have begun to use suffixes to identify the asset class. But this is an imperfect solution, as most investors want one single scale for all.

Municipal debt has created, for a variety of historical reasons, its own market approach.

It’s not clear they would lose a lot of business. Contrary to your claims investors value rating agency output. But in any case we won’t know until the legal changes are made.

@7 If you look at rating agency history you can divide their output into two big piles. One are the MBS deals of the last few years. The other is all the rest (including prior MBS deals). Concerns about the quality of the ratings only apply to the first group (there are some other concerns about the comparability of the asset classes, but that’s a different issue). The rest has no such concerns.

In fact, prior to this crisis anyone who followed what rating agencies did would know that, if anything, the argument was that they were too conservative. When I first started working on ABS deals some 15 years ago the big question was why weren’t the structured finance ratings much higher as there were almost no examples of SF defaults.

By the way, note how what Steven says in @3 and John in @6 contradict each other. Steven claims that the issuer pays model leads to inflated ratings. But the same issuer pays model, when applied to municipal debt, appears to lead to lower, not higher ratings (at least when compared to other asset classes).

Steven:

1. I can’t make heads or tails of what you are saying. You keep jumping from one topic to another, We are talking about ratings, why are you bringing up internet stocks? Let’s try to focus on one thing at a time. And what junk bond crisis are you talking about? You do know that junk bond means they are rated very low, right? So what is your argument here?

2. I don’t know if its wrong but it surely is irrelevant. Rating agencies don’t seek to measure currency changes or recessions, only defaults. And as I explained above the record is pretty good.

3. Again, you are not clear. Your argument was that the issuer pays model leads to higher ratings and I just gave you a counterexample.

Apologies in advance, but I can’t help but feel that you’ve been reading blogs about this but have no real understanding of the topics. You seem to jump from one thing to another completely unrelated.

Finally, on Enron. This is another common misunderstanding. Enron was a case of fraud, and rating agencies are not auditors.

John @ 15.

1. First of all, do you have any data on what the ratings of those companies were at the time? I don’t recall. In any case, leaving aside the issue of fraud which I mention above, remember that ratings are probabilities, and can only be judged as such. An A rating does not mean the company can’t default, it only means that it is very unlikely. So you can’t simply pick some individual examples, you need to look at the whole group. That’s what the rating agency default studies do, they look at how cohorts of ratings perform over time. I realize that the “But what about Enron” approach is psychologically powerful but it is also analytically useless.

2. it seems we are changing the argument. The first version of the argument was that issuer-pays leads to inflated ratings, now we are saying that only happens to private issuers? What do you call it when you keep changing the theory to fit the data that is refuting it? In any case even that doesn’t fly, since we have ample examples of private issuer-pays ratings with no problems, namely the corporate ratings, probably the ones with the most empirical information. Again, they are updated every year and show nonne of the problems of the MBS market. On top of that we also have the history of MBS deals prior to the crisis. also issuer paid and, if anything, with much too low ratings.

I’m afraid your theory is not supported by the data.

http://rajivsethi.blogspot.com/2011/08/rating-agencies.html

This is the second post I’ve seen on CT, pooh-poohing something S&P said about America’s credit rating. The other post, I seem to recall, was by Daniel Davies, where he said they were tugging on Superman’s cape.

I suppose, then, there’s nothing to worry about. S&P has had crappy performance at rating derivatives and other baroque instruments, so there’s no reason to credit any dirt they may dish on the good old US of A.

But then, it seems to me, rating derivatives and such must be really, really difficult. You’d have to dig deep into mazes of complexity, slog through mires of corruption, and probably break the law to find out what’s really backing up these securities. That’s if you’re not corrupt yourself, which you have every reason to be, whether in the private or public sector. I doubt whether meaningful ratings can be established at feasible cost, under any rating regime.

On the other hand, it’s not so difficult to pronounce on the credit of the Federal Government. You can skip questions such as “exactly what does my boss want me to say is the pro-rated-by-debt component-adjusted average credit rating of all debtors owing loans bundled in this 27th-order derivative?” and just work with numbers pretty much everyone agrees on. Like GDP, tax revenue, debt, deficit, interest, etc. Further, you can study the political scene to get a clue whether repayment is likely.

Sure, whatever, S&P has no real credibility, they’ve been corruptly jacking up the numbers for some of the stuff they rate. Thing is, I’m pretty sure that includes Uncle Sam. If anything, it’s alarming that S&P took this long to downgrade. Under the circumstances, it’s a wonder there’s any credit anywhere on any terms. Obviously an epic default-by-inflation is coming, and creditors will all be skinned alive.

Or maybe I’m wrong. Maybe, buying US Government debt is still a good call. But how?

Musical mountaineer, you’re completely wrong about how derivatives are evaluated. The issuers of derivatives pay for the ratings, and provide the information. No illegality required.

I’m sure this is naive, but I’ve suggested it before, and haven’t heard good reasons (other than, you know, it won’t happen) why a money-where-one’s-mouth-is rule wouldn’t work. S&P can rate, and sovereigns can require ratings, and S&P is required to issue, call them collateralized ratings obligations, that pay if the pool of rated investments defaults at greater than a certain rate.

That should make the anarchy-capitalists happy, at least.

Ed
1. Ratings have generally a good record, as evidenced by annual defaults studies. This includes sovereign ratings. The one huge exception are the MBS ratings of the mid 2000s.

Good record???? If they do not have a perfect record what is the point in having their opinion? Anyone with a MBA background and a day of research can grade sovereign debt. Sovereign finance should be public record and easy to research. If it is not , then the rating should not be given. Same with “too complex” MBS. If it is so complex so be difficult to analyse then why did they stand behind their rating?

Rating agencies are supposed to be PR resistant and analyse only the finance numbers, not to fall for sales pitches as the non-pros do.
Considering that munies are very safe, they still have to be incentivised by tax-free status in order to attract the investors because their low rating. While corporate bonds, MBS, cds (very new product) enjoys better ratings then public debt, it is obvious that rating agencies are susceptible to the hype, just as any person.

I am not for changing it into a completely new system, with new criteria and then to get trough growing pains again, when we know where the weaknesses of this one are. I am for “sprizouse” suggestion of penalty for failing to rate it correctly and timely.

Er, cutoffs.

Who pays for sovereign ratings is rather important though, isn’t it?

I’m pretty sure the UK or the US don’t: in which case the ratings agencies, unless they’re just doing this as a public service, must be being paid by the buyers. In which case (absent the regs about having to hold AAA etc) they’re simply private companies providing a private opinion.

In which case, what’s the problem? They’re of no more moment than a stockbroker issuing a buy or sell rating.

Thank you for the discussion! Anyone else think that the public dance by S&P over the US sovereign rating might be a form of Schmertztverkauf, essentially trying to regain some legitimacy by pointing to others’ ills?

As regards Enron S&P affirmed a BBB+ rating in late 2001. Global Crossing was BBB.

What’s this supposed to prove? BBB is not a high rating category. It’s technically investment grade, but it’s right at the bottom. BBB is the sort of rating the very bottom, or second bottom tranche of a “high risk MBS” gets..

Also, I’d hesitate to make too much hay out of the $2tn error, other than as support for the (true) argument that rating agencies make mistakes and so shouldn’t be relied on over doing the work yourself. The error relates to a baseline projection of nominal GDP growth, according to the Treasury, of just under 5%. Anyone who thinks we’re going to have just under 5% nominal growth for the next ten years will probably think the US is AAA. But I think both are wrong.

John:

My view on the SEC in effect neutralizing the liability rule is opposite yours despite my conclusion being the same.

One of the things corporate issuers and underwriters pay for is the right to use NRSRO ratings in regulatory filings. If such use no longer has real value, issuers/underwriters will reduce or stop paying for them. Which erodes the authority and monopoly pricing power of the CRAs.

I.e, the SEC could have done two good things: Either enforce the liability rule strictly or stop enforcing requirements for NRSRO ratings, and about 50 bad things, most of which you can imagine and all which entail the CRAs having their losses socialized and their profits privatized. As long as the SEC did one of the two good things, I’m satisfied.

What happens to things like Basel standards under the Quiggin Plan?

It seems to me that the Dodd-Frank solution of turning the agencies into legally liable “experts” is the correct one. This isn’t being implemented because House Republicans won’t implement the funds needed to implement it. But by the same token, I think we can assume they won’t agree to any other major reform.

If S&P is now claiming, in response to the $2 trillion error, that they rate based on trajectories rather than levels, then the time to downgrade the USA was 2006, when it was 2 unfunded wars, Medicare expansion, and an objective of permanent tax cuts setting the trajectory of US debt. Maybe all the people who should have been watching the sovereign debt at that time were too busy with the structured debt ratings.

Anyway the appetite for rating agency reform may be bigger tomorrow when we see how far beyond agency debt tomorrow’s additional downgrades extend.

This isn’t particularly difficult. CRA are supposedly in one business and one business only: judging default risk. Since the US, having a fiat currency, cannot actually default (unless by choice and that will not in fact happen this side of the revolution), they should not be in the business of rating their debt, period. They are not “inflation ratings agencies”, after all.

One concludes – and this is backed up by reading the crap their analysts have come out with – that this is a naked political power play aimed at forcing more austerity on the American worker. As Bob McManus posted above, the correct answer would be to destroy S&P and make an example.

There was never going to be “no deal”, it was all theatre. But this doesn’t even matter – S&P did not claim their downgrade came as a judgement of probabilities of future insane TP behaviour, but as a warning that more austerity was needed and the budget deficit should be further reduced. Since there is no level of budget deficit that can lead to default, this makes no sense.

I view the problem as exogenous to the rating agencies.

The problem is with the ease that the big players have with foisting losses onto their embedded society with Ireland being the classic example.

If you make losses hard to avoid, and practical restructuring mandatory on the sight of a bad book, then you’ll have demand for honest ratings agencies.

No honest financiers==no demand for honest rating, and high demand for dishonest ratings.

Andrew F: “I’d much rather a large financial institution be liable than attempt to sue the government for shoddy investment advice.”

Um, if there was any significant ability for people defrauded by the ratings agencies to sue, those agencies would be bankrupt by now.

Please don’t suggest solutions which have clearly failed.

Agreed, P O’Neill — Given the explicit ‘reasoning’ provided by S&P, the timing of this downgrade action should certainly raise many questions. I find myself unable to avoid concluding as christian_h does “that this is a naked political power play aimed at forcing more austerity.”

Ed, your point is taken — the US can default. However, I think the case is that if that happened it would indeed be “by choice.” To me that’s not evidence that S&P’s current rating is “wrong” — instead it seems another pointer toward the coherence of the political action theory. Obama’s lawyers notwithstanding, would a “by choice” default have any possibility of not conflicting with the 14th amendment?

Isn’t William Goldman actually a better guide than the ratings agencies?

(On reason for my cynicism about the agencies is that they seem to me to be in the happy position – happy for them – of being able to influence events with their own predictions.)

How can a monetary sovereign nation with a fiat currency system default?

By choice. There are many examples in the historical default studies.

Not to belabor the obvious, but as long as the US borrows in dollars, it is literally impossible for a failure to raise taxes to cause a default.

Incorrect. There are many examples of nations defaulting on their own currency.

We can make a political decision to default. Maybe we almost did (I don’t think so, but maybe). We’ll have to violate our constitution to do it, but what impediment would that be, really? — a Democratic President seems perfectly willing to ignore it. “Let’s establish a norm of austerity, then I’ll step out into the sunlight to mouth some very weak jobs talk. The rubes’ll buy anything.”

The word “default” implies “no choice” i.e. “unable” to pay the bills.

Incorrect. To default is to not pay on time as originally agreed. It can be because they are unable or because they are unwilling.

Lemuel,

I agree.

“Father [S&P], our heart breaks for America,” Texas Governor Rick Perry said as he led the crowd in prayer. “We see fear in the marketplace. We see anger in the halls of government and as a nation, we have forgotten who made us, who protects us, blesses us, and that we cry out for your forgiveness.”

The political precedent set by the debt ceiling “crisis” makes an eventual default by the U.S. a very high risk. Default is now the desired policy of a significant fraction of, at least, one of two political parties in the U.S. They will find a way to default.

The MMT folks seem to have pressed home half an insight on the nature of a fiat currency: the sovereign can print more, and the sovereign’s ability and willingness to collect taxes in the currency is a support for the currency’s value.

The other half of the insight, obscured too often, is that a fiat currency is back by demand for real goods. It is the expectation that there are goods, which can purchased with the currency, which gives the currency, value, sometimes expressed by the quip that Bernanke can print dollars, but not oil. The U.S. is rapidly disinvesting, beneath the cloak of its insane financialization, and its global empire is teetering on the edge of collapse. If S&P had included this view in its analysis, its opinion would have been exciting reading.

We don’t and never will.

That’s your opinion. That’s OK.

The Chinese government jumped on the downgrade and demanded protection of its dollar assets. QE, coupled with the monetization that more debt would likely require, has raised the specter that the Chinese government would diversify out of its dollar holdings or retaliate in some way. Robert Rubin who was guiding Obama through his acolytes has openly and repeatedly spoken over the last year of the need to get the US fiscal house in order to make sure confidence in the dollar (and the trade in dollar-denominated assets) remains strong. A one-two punch from the Chinese government and Goldman Sachs seems to have given the S&P the confidence to issue a historic downgrade of the most powerful state in the world.

Zamfir,

Yes, I agree. That’s why they are called ‘sovereigns’ after all.

Paul,

If you think that the US will never choose to default, that’s your opinion and that’s OK. If you think that it is literally impossible for the US to default, then you are incorrect.

Zamfir @71

Businesses do voluntarily default all the time. On what planet have you been asleep?

And, there are provisions of the bankruptcy code, which allow the management to retain control of the business, which are, of course, the provisions most often used.

One would need much more careful argument to show that the positive effect on net exports would outweigh the negative effects from possibly higher interest rates in such a highly leveraged economy; moreover, US exports don’t depend as much on the relative value of the dollar as the strength of accumulation abroad on which dollar devaluation would have little effect. Lastly, the industries in which the US has a quasi monopoly position would actually stand to lose from a weaker dollar.

What a difference a downgrade makes!

Before: Obama caved and didn’t stick to principles; most of his party furious with him.

After: the Tea Party is so uninformed and politically uncompromising as to be un-American. On every non-Murdoch medium.

If they had accepted Obama’s offer, all would have been well (S&P report, page 4, bottom). And the Tea Party would have been in brilliant political shape.

It will soon be realized by everyone with a functioning brain that the Boehner-Cantor-Teas own the debacle.

Only 2 questions remain: (1) How long before senior Republicans start leaving their party; and (2) How long before the Limpbagh-Murdocracy enters a terminal psychological crisis.

Historically, the end of Republican Party.

Next up, for those concerned about the future of the United States: SHORT-TERM SPENDING IS NOT THE LONG-TERM PROBLEM. Government planning is necessary for healthcare.

Most empirical studies of US trade and exchange rates find an export price elasticity of between 0.5 an 1.0, i.e. a one percent devaluation boosts US exports by between half a percent and one percent. Measured import elasticities are much lower — always less than 0.25, and not significantly different from zero in many studies — mainly because most exchange rate changes are not reflected in the dollar price of US imports. A typical estimate of exchange-rate passthrough would be around 0.3 — that’s what the OECD uses in its standard macro model (and it’s also what I found when I looked at this for my dissertation, which I really should be working on now instead of commenting here.) Put those together with current trade flows, and you find that a 20 percent dollar depreciation (about the largest one can realistically imagine) gives a boost to US net exports of between 1.5 and 2 percent of GDP, spread out over two or three years. That would probably reduce unemployment by between half a point and a point — not a trivial improvement, but not a big one either. On the other hand, that assumes that a dollar depreciation wouldn’t lead to slower growth, lower inflation or lower real tradables-goods wages in US trade partners — something that can’t be taken for granted.

On the other hand, changes in the bilateral US-China exchange rate would have no macroeconomic benefit at all.

I discussed these issues a while back in some posts on my blog (the older ones especially).

LP,
I was relying on a paper by Warner and Sachs on the effects of dollar devaluation on exports. It had been cited by James Galbraith, and I ran it down. It’s an old paper. I read it ten years ago.

they decided to go ahead with their downgrade because they had already notified some of their clients they were making the change

Completely false and made up.

BertCT: If you think that, you have some free money to pick up. I don’t think the market budged, thanks to the weirdness that is a liquidity trap, but if people were listening to S&P under normal conditions it would have and you could have made some money. Why would you tell us about market manipulation? Furthermore S&P is no different then any analyst: they cannot self deal, but (IANAL) there’s nothing that stops you from having a first tier and second tier of customers.

It’s not a gambit.

If you want to understand ratings you need to understand that they have a pretty good track record. Why they failed the way they did on recent MBS (but not on previous MBS, for example) is an interesting topic and if there is ever a thread on this I may post my views.

Barry @51: Um, if there was any significant ability for people defrauded by the ratings agencies to sue, those agencies would be bankrupt by now. Please don’t suggest solutions which have clearly failed.

No Barry, you’ve misread my comment at 34. The point is that by shifting responsibility from investment managers to a regulatory agency one deprives investors of the means to sue the managers.

And investment managers have been sued very successfully.

Lemuel @61: Also, I still want to know what specific institutions would have to reduce their holdings of Treasury securities if another agency dropped its AAA rating. I’m skeptical that this factor is as important as lots of people, including John Q. in the original post, are asserting.

It is frequently the case that US Government backed debt is explicitly noted as an approved type of security for a given allocation in various agreements; and that elsewhere it is explicitly noted as an approved type of collateral.

And even where that is not the case, generally being rated at the highest level by at least two of big three is a qualifying feature – which is why Quiggin is concerned about a second downgrade.

Still, one suspects that not all agreements explicitly name US Government backed debt, and that a second downgrade might prompt a rewriting of those that do.

“How can a monetary sovereign nation with a fiat currency system default?

By choice. There are many examples in the historical default studies.”

Surely, you understood what the OP meant when s/he said “cannot default” as in “cannot be forced to” vs. “would never choose to.” Who on Earth believes that there is some sort of metaphysical constraint on gov’ts so that they are literally incapable of choosing default? Obviously, what the OP meant is that nations which print their own currency can’t default due to constraints on borrowing or lack of export earnings — and you know that. Why do you insist on making cutesy, bad-faith arguments based on grammatical errors? This is starting to seem like trolling.

Lee Arnold could very well be right about the imminent collapse of the Republicans.

But like a prediction of the collapse of Southern chattel slavery say around 1850, Arnold might be slightly underestimating the challenges of the transition phase and the collateral damage.

Zamfir 08.07.11 at 4:43 pm

” Paul, the reason that businesses do not voluntarily default is that the legal bankruptcy procedures are set up to take control and all remaining assets of such a business out of the owners hands. A higher authority explicitly enforces that default is not attractive.

That’s not relevant for sovereign debt, which has by definition no higher authority that could enforce such procedures (although the IMF etc. are arguably a weak version of it, but the US of course doesn’t have to fear loss of sovereignity).

Reputation damage is the only (but big) thing sovereigns have to fear in a default. That could mean they still hand over some assets and control to external parties (like the IMF), as part of an attempt to manage the reputation loss. But that step would be voluntary, especially for the US.”

The economic catastrophe which would sweep the world into something where the Great Depression looks like paradise would be an obvious deterrent. Now, the TP doesn’t know/doesn’t care. However, Wall St and the elites of Big Oil would.

Surely, you understood what the OP meant when s/he said “cannot default” as in “cannot be forced to” vs. “would never choose to.”

Right. And just to complete the thought, the importance of the distinction is that the probability of being forced to default is closely related to your ability to raise sufficient funds through taxation to cover expenditures, and the size of the existing debt. The probability of a default by choice is not closely linked to those factors. So the S&P’s stated reasons for the downgrade would make sense for a private borrower or sovereign borrowing in a foreign currency, but are largely irrelevant for the US.

The AAA requirement is mainly for money market funds and similar: http://www2.goldmansachs.com/gsam/glm/education/guide-to-mmf/first-and-second-tier/index.html. There’s a much lower standard of “investment grade” securities (those outside this class are “junk bonds”).

OK. And yes, I know the distinction between investment-grade and junk status — the lower limit of the former is generally considered to be BB+, as I mentioned upthread. However, I have the impression that most MMFs and the like have an explicit exception for US federal debt.

I continue to believe that the only long-term effect of this downgrade will be demonstrate the irrelevance of the rating agencies to demand for US debt, and by extension the absence of financial constraints on US fiscal policy. In that sense — to go all Lee A. Arnold for a moment — I think it is clearly a positive development.

I know the distinction between investment-grade and junk status—the lower limit of the former is generally considered to be BB+

Sorry, wrong again. Investment grade is BBB- and higher (Baa3 in Moody’s scale). Junk is anything below that.

What I wrote is that for non-sovereign borrowers, the probability of default is closely linked to the relationship of revenue and expenditure and the size of the existing debt stock. For sovereign borrowers, where default is a political choice, its probability is not closely linked to those factors. So the stated reasons for the downgrade are not relevant in the case of the US.

Not true. The more debt you have the more likely you are of defaulting, all other things equal. This is true for both local and foreign currency debt. Of course, the breaking point, the point at which a government decides to default, will vary by country and by institutional setting (and vary a lot). But no sovereign credit analyst, be they at a rating agency or someplace else, will ignore debt ratios simply because a government’s debt is all in local currency.

The AAA requirement is mainly for money market funds and similar

Per the SEC rules, though, “first tier security” includes “any government security.” (2a-7(14(iv)).

So I don’t see how this will force a sell off.

I think the solution is simple; take rating agencies at their word. When they say that they just collect some data and offer opinions, give them exactly as much credence as anyone else who just collects data and offers opinions.

This should obviously apply to legislation as well.

But if a financial institution wants to outsource its credit department, let them, to some institution which accepts liability – i.e. which is not a CRA. Currently the “regulator and taxpayer” are effectively acting as a deposit insurer for our banks. Let that continue for a tightly defined and well understood collection of loan classes, e.g. resi mortgage. But for other loans, an outsourced credit department should also have outsourced capital.

Actually there are many rating agencies. And Fitch is French owned and based out of London.

@114 : WTF?

Sanity has left the building.

> Moreover, both Rubin and Obama believe that there cannot be
> long term debt reduction without long term growth

Please note that since 2001 the United States has undertaken 3 wars, has borrowed every dollar spent in undertaking those wars, and has _cut_ its tax rates three times. The income tax increases that would be needed to pay for those wars and – wait for it – reduce the debt! – would be very very modest compared to the tax rates during WWII and the Korean War, and would in no way affect “long term growth”. In fact, demonstrating to the world and “the markets” that we are mature enough to pay for what we buy would very likely provide that reduction in uncertainty that everyone is hoping for.

So let’s not go down the Norquist path of assuming that cuts in badly needed federal programs are the only way to reduce the debt.

Cranky

Reality check on the basic competence level of S&P. I love the bit about the managing director who didn’t know grade-school arithmetic.

If you want to understand ratings you need to understand that they have a pretty good track record.

Not really no. With emerging market sovereigns, they have a pretty good track record of being no more than six months behind the market. With developed sovereigns, they have a pretty bad track record of doing things like giving Ireland a AAA rating, downgrading Japan (with no very obvious market consequences), upgrading Iceland right at the top tick, and now this.

@Barry: Isn’t this just an application of the EMH. Since sovereign ratings are made on the basis of public information, the markets have to anticipate them.

For whom was S&P doing a favor?

I do wonder. One of the things about this lunacy that’s puzzled me the most is why, given the President’s servile capitulation to Goldman Sachs, et al., is there such a visceral campaign of hatred against him? Part of it is race, I suppose, despite denials all around, and part of it is undoubtedly paranoia about socialists like Van Jones or Elizabeth Warren lurking somewhere in the wings, looking for an opportunity to do collectivist evil, but surely someone who plays golf with John Boehner deserves at least a little credibility from the malefactors of great wealth.

Do they really think that they can elect the worry-free Mitt Romney next time around? Do they really discount the possibility that they might wind up with Michele Bachmann bossing them around? I’m sure that the Krupps and the Bayers were just as confident back in the day. Perhaps whoever is benefitting from S&P’s favors should ponder that for a while.

Meanwhile, the markets have spoken and their assessment is “meh”.

http://krugman.blogs.nytimes.com/2011/08/08/what-if-they-announced-a-downgrade-and-nobody-cared/

The purpose is to provide information above and beyond what was already available and priced in,

Sorry, you don’t get come up with your own personal definition. What ratings are is clearly spelled out. If you don’t find them useful then you can simply ignore them.

” Consider, in particular, the case of Japan, which S.& P. downgraded back in 2002. Well, nine years later Japan is still able to borrow freely and cheaply. As of Friday, in fact, the interest rate on Japanese 10-year bonds was just 1 percent.”

Japan’s public debt as a % of GDP has gone up nearly 75% since the downgrade. Regardless of the interest rate on Japanese debt, the risk of default is higher than 2002, simply because of the size of the debt relative to national income.

In any event, the yield is a poor indicator of credit risk when the BoJ can buy bonds at any interest rate of its choosing either directly or through the banks.

@Lemuel: It’s that second question that forces investors to consider future events. That’s what is ment by confidence.

> dsquared @ 2:27
> Nate Silver comes up with the goods on S&P ratings quality.

Oh my, that’s brutal. Paired with Krugman’s more qualitative posts it doesn’t doesn’t even leave many scraps of the corpse behind.

Cranky

It’s sort of amazing how low of a bar the ratings agencies want to set for themselves. “Well, it says clearly right here that these are just some letters that felt right to us. A Ouija board may have been involved. It’s pure advisory. Just go with the flow, man!” I’m guessing that’s not part of their pitch to clients.

The whole thing has turned out much more embarrassing than I expected. I initially thought that they had some mechanical model for sovereigns, and the debt ceiling crisis gave them the courage to apply the model to the US. But after the $2 billion error, the “political favor” explanation looks like the explanation that reflects least badly on S&P.

Coming up with a rank order of sovereign default has got to be the easiest job anyone has ever given themselves in the history of the world. I bet I could come up with a purely statistical model that does as well as S&P. (In fact, I bet some economist already has such a model, somewhere out there in the billion papers on sovereign default.) Is there a convenient database of sovereign defaults?

@Ed, it’s far from obvious that situations like this can be modelled as probabilistic events. That assumes we can see this situation as a draw from a large set of data of similar events, where the difference between those events can reasonably be assumed to be caused by independent random factors.

That’s a sort-of reasonable claim for some situations, but hardly for a default of the US. Arguably, the US has a unique economic position without any comparison in modern history, in which case our relevant data set consists of those all those other times the US did or did not default. But even if you take the set of “similar” situations broader, you are still restricted to a very small number of defaults from situations that vaguely resemble the economic situation of the current US.

That makes it highly important to look at those individual events, to decide whether they can really be included in the set to be used for probabilistic arguments.

Japan’s public debt as a % of GDP has gone up nearly 75% since the downgrade. Regardless of the interest rate on Japanese debt, the risk of default is higher than 2002, simply because of the size of the debt relative to national income.

In any event, the yield is a poor indicator of credit risk when the BoJ can buy bonds at any interest rate of its choosing either directly or through the banks.

This extends the erroneous assumption that Japan’s default risk is significantly related to it’s debt/GDP ratio. It is a wrong assumption for Japan or the US for reasons that have been rehashed a number of times. I can only assume that people who don’t understand these arguments are missing something, but I’m not going to presume to know what it is. Based on the reputation of S&P personnel, I would assume that they are in this group. There is clearly a default risk in the United States as long as we have tea party members and a Republican majority in the House, but again, this has nothing to do with debt ratios.

@Zamfir: Have you ever heard of Bayes theorem? We can estimate probabilities for things we only see once, like the mass of Saturn being within certain ranges. Credit defaults might not be amenable to frequentist analysis, but that doesn’t mean one can’t use probability theory to analyze them.

More from Silver, regarding European sovereign debt ratings:

S.&P.’s bond ratings from five years ago would have told you almost nothing about the risk of a default today. They had no insight about the threats in European markets, nor about which countries in Europe were relatively more likely to default. (Norway, which remains among the most solvent countries in the world, had a AAA rating in 2006, but so did Ireland and Spain.)

So with notably rare exceptions involving MBS and sovereign debt, S&P has done well with its ratings.

Panic is not a solid basis on which to project US creditworthiness.

Let me put it another way: for the same debt/GDP ratio, the same current year’s deficit, and the same political system, a country’s monetary system has an enormous impact on likelihood of default. And you see no actual appreciation of this basic economic fact with these ratings agencies. The Euro is really the worst possible circumstance. Italy, for example, has no control over monetary policy, no central bank which can purchase it’s sovereign debt and no way to devalue it’s currency. Italy would have no debt crisis (and their bond rates would be far lower) if they were still borrowing in lira.

Japan and the United States are in the opposite position. And conta Ed, I am not aware of any sovereign default in which the debt was denominated in a fiat sovereign currency. If all conditions are not met, guarantee does not apply. And this is why Argentina is not actually a counter-example.

Credit risk is based on the willingless and ability of the borrower to repay. Not very difficult, and, while not a political expert, I believe there is a strong political consensus in the US to not raise taxes OR cut spending. I can see that political dynamic continuing until China, Japan and Russia stop funding these deficits. At that point, yes, I believe the probability of default is a non-zero number. I know most liberals I speak with would chose social security payments to poor people over interest payments to billionaires.

Again, this view reflects a misunderstanding of important macroeconomic facts. As long as China wants to buy US treasuries, their purchases have a deflationary impact on the US dollar which is bad for domestically generated growth and bad for a our trade deficit (ie, bad for external demand). Once China stops buying treasuries, it will be much easier for the US economy to grow and reduce our effective debt level even without legislative changes.

That’s why you need to look at the whole picture.

Which is what Nate did, in his regression analysis, isn’t it? And also what the works he cited did, isn’t it? And they didn’t reach this Slate-like contrarian view of yours that, with or without notable exceptions, credit rating agencies have got a really good track record. They’ve actually got, as I said above, a really good track record of being more or less useless lagging indicators in emerging markets, and a pretty bad track record in developed markets.

So Ed, you think the S&P’s view that Spain is less at risk for default than Japan is defensible*?

*I’m not asking if you think it’s right. Just asking if you think it’s defensible.

“S.&P.’s bond ratings from five years ago would have told you almost nothing about the risk of a default today.”

But don’t S&P’s ratings use a 3-5 year time horizon? You wouldn’t expect ratings from 2006 to tell us anything about the risk of a default today. Spain and Ireland were given AAA ratings and have yet to default. If you bought a five year bond based on that rating you’d have got your money back, and AAA’s the maximum likelihood estimate in that case and you can’t fault S&P. Or am I missing something???

If you bought a five year bond based on that rating you’d have got your money back, and AAA’s the maximum likelihood estimate in that case and you can’t fault S&P. Or am I missing something???

No, you aren’t. Silver is the one who is confused because he seems to think that ratings predict CDS spreads.

No, what i’m saying is that they are simply expressing an opinion. That’s all it is. If you look at the historical evidence their default predictions have done pretty well, but they are by no means perfect.

I also repeat that people like Krugman and dsquared that talk of how ratings simply lag market moves appear unaware of the very different credit rankings you get if you look at markets carefully. In some cases such rankings directly contradict what these analysts have been saying (krugman and Japan). That’s why you can’t simply pick and choose some individual cases.

That’s not very convincing.

I know. When your mind is already made up nothing can convince you.

You do know that I think you’re all missing the story. S&P’s downgrade is an expression of Chinese power: it wants to limit the alacrity with which the US runs up debt only to inflate it away. It is threatening to diversify out of Treasuries or even retaliate in some way. Aware of mounting Chinese frustration, Obama, under the guidance of Robert Rubin, himself pushed for a $400 bn debt reduction plan and tried to use the debt ceiling deadline to push for it–he could have tied a rise in the debt ceiling to an extension of the Bush tax cuts. But he knew that he had to pressure both parties to accept a big debt reduction plan, and wanted to use the debt ceiling deadline to get a mix of revenue increases and spending cuts. He played a high risk game, and almost got burned to political death.

China is doing what it can to protect its not insignificant trillion dollar investment. This may prove to be a failed attempt at a transition to a post-hegemonic or multi-polar but the process has begun. I haven’t read Giovanni Arrighi yet, but he is probably more relevant in this context than S&P’s general credibility.

I have read the very loud announcements coming from Chinese officials. Have you been ignoring them? They are clearly not on the same page as you are. They want a long-term debt reduction plan of the kind that Rubin has proposed (no short term cuts); that is what Obama tried to deliver. Of course China wants to continue to lend to the US but it does not want its debt inflated away. Chinese officials don’t think it’s silly to worry about several hundred billions of dollars “paper” losses .

I read it. Nothing there about fears of US inflation. Which isn’t surprising, since the Chinese government isn’t, you know, crazy.

The Chinese government is concerned about the Chinese economy. The tradeoff is between keeping the RMB low to boost export demand, and letting it rise to help control inflation. Capital gains and losses on reserves are completely irrelevant.

hartal:

Chinese officialdom isn’t economically ignorant and they realized a long time ago that their $ reserve accumulations would eventually be subject to devaluation, with proportionate capital losses. Maybe they are being loud now for domestic consumption, eh?

Losses due to dollar depreciation are not the same as inflation. And no, I did not see anything about debt monetization. Which, again, would be a remarkably silly thing to worry about when Treasury yields are at record lows.

Look, Chinese officials may not like holding US debtm but they definitely don’t want further dollar depreciation. To prevent it, they have to keep buying dollar assets. So they’re stuck.

And of course, if the downgrade had raised yields, that would have produced exactly the capital losses on reserves the Chinese government is supposed to be working so hard to avoid.

Right now, the Chinese central bank can stop buying US assets, which has the benefit of freeing up foreign exchange for other things than accumulating excess reserves, and the disadvantage of causing the RMB to appreciate against the dollar. Or they can keep buying US assets, holding the RMB down but keeping the reserve pile growing. Since they are free to stop buying Treasuries any time why want, the fact that they haven’t proves that they regard the costs of RMB appreciation to be higher than the costs of accumulating more reserves. If they change their mind, all they have to do is stop buying dollars.

Now suppose, instead of stopping their own purchases, they put pressure on the S&P to downgrade US debt, causing other people to stop purchasing dollars instead. Then they get the downside — RMB appreciation — without the benefit of ending the growth of reserves. It’s strictly inferior to just ending their own dollar purchases.

Your theory doesn’t work.

Beyonder-

(1) It’s not at all clear that the US ‘came within a hair’s breadth of default.” We don’t how the Treasury would have handled a failure to lift the debt ceiling. It’s very likely that they would have prioritized debt payments, in which case current revenues would have been more than sufficient to avoid default.

(2) S&P justified their decision on the basis of budget issues completely irrelevant to the political factors that might cause default. Reducing Medicare expenditures has nothing to with the toxic political environment.

(3) S&P has no special expertise in the political process. The financial factors that guide ratings for private borrowers are not relevant to the US or other developed sovereigns. This action seems to be a political move to encourage austerity policies favored by owners of financial assets. It adds no useful information and undermines whatever credibility S&P has within its core business.

I actually thought that their stated position was that they would not prioritize payments.

Lemuel.

(1) whether it was a hair’s breath, or whether it was simply, as you put it, a case where “we don’t (know) how the treasury would handle” the failure to lift the debt ceiling, more than enough uncertainty was injected into the process to justify the downgrade. Very hard to say after that debacle that there was almost no chance of default on a US ten year bond.

(2) I agree that reducing medicare expenditures has nothing to do with the toxicity of the political process, but neither I, nor s&p, said that it did. Unaddressed spiraling medicare costs are, however, highly relevant to whether the US can meet its debt obligations, especially in the absence of tax increases.

(3) I’m not sure what sort of special expertise you propose they should cultivate to satisfy your requirement that analysts be “experts in the political process”. In any event, the CRAs do not use remotely the same rating process to rate sovereigns as they do private companies. The Analysts responsible for sovereign ratings do so exclusively. They routinely are required to assess political risk, and calculate its effect on creditworthiness. It falls within the core of their expertise.

Steve.

Are you suggesting that because the downgrade isn’t reflected in the market price of the debt, the rating must be wrong? Seems a strange argument for this board. In any event, lots of ratings changes (downgrades and upgrades alike) have no effect on spreads.

Why haven’t other rating agencies changed their ratings? Stay tuned. S&P is the lead CRA, and while it is not uncommon for there to be small disagreements of a notch or two among ratings agencies, they tend to speak with the same voice.

Just to be clear, is it only S&P we say are crooked and worthless, or is it all of the Cra’s? Because if it’s all of them we can’t rely selectively on Moody’s and Fitch to justify our position when it suits us.

nor actual bond investors seem to be following S&P’s lead

The relevant market measure, CDS rates, shows that the market has agrees with the downgrade.

This is what happens when you trust people like Krugman, that lie or don’t know what the right market measures are.

Steve,

You are looking at the wrong market numbers.

No, not stock prices.

Ratings are measures of credit risk. Bond yields are not. If Country A has a yield of 5% and Country B of 10% you can’t argue that the market thinks that Country B has more credit risk, since other factors, like inflation, could explain the difference.

But there is a market measure designed to estimate credit risk. It’s the CDS market, where investors buy protection against potential government defaults. You can calculate the implied rating from these CDS rates.

And the market has spoken and already downgraded the US. CDS rates for the US are now at the AA category level. This is something Krugman will conveniently forget to mention.

If Country A has a yield of 5% and Country B of 10% you can’t argue that the market thinks that Country B has more credit risk, since other factors, like inflation, could explain the difference.

We’re not talking about cross-country comparisons. We’re calking about the same country over a short time period. Why would anybody bid up the price of an asset if they believed there was genuine new negative information about its risk?

The rise in CDS rates on Treasuries was unimpressive (still well below the recent highs) and I don’t see any basis for claiming that it supports the soundness of S&P’s action.

The rise in CDS rates on Treasuries was unimpressive

Irrelevant.

What is relevant is that the correct market measure, CDS rates and not bond yields, show the market also agrees that the US is not AAA.

No Steve.

I don’t defend anyone. I simply point out nonsense.

People like Krugman claim the market does not agree with S&P but that’s just because he is using the wrong market measure. The same happens with his Japan arguments, which dsquared has mentioned here. Once you look at the correct measure the whole argument falls apart.

it even admitted that one reason it didn’t reexamine its rating of US credit was their clients had already gotten the information and, by inference, acted upon it. BEFORE the general public got the same info.

Did you just make this up?

Ed, with the CDS rate, you’re not measuring default here, but merely market perceptions of defaults. I have it on the highest authority (Ed in comment 152 and elsewhere) that this is inappropriate in this context.

Yes, I understand that S&P trails the CDS market in rendering opinions on potential defaults – but that’s my point, not yours. Until now.

Certainly, I’m not arguing that AA is an inappropriate rating for U.S. debt – just that S&P adds almost no information that wasn’t already in the market.

“Certainly, I’m not arguing that AA is an inappropriate rating for U.S. debt – just that S&P adds almost no information that wasn’t already in the market.”

That seems too high a burden – short of breaking into the Treasury, CIA or Fort Knox, what material non-public information could you expect them to have? Their value is their analysis and conclusion – you can attack that, but saying they didn’t turn over something completely new to the market is too much.

“Yes, I understand that S&P trails the CDS market in rendering opinions on potential defaults – but that’s my point, not yours. ”

But isn’t that Ed’s point with Australia – how do you know that S&P is “trailing” the CDS, unless you have already determined they will face a down fiscal scenario? Australia still has among the fastest growth, lowest unemployment, lowest fiscal deficit, overall debt to GDP, good population growth and immigration … May be S&P is the voice of reason in a market full of emotion?

@200:

You might be right that Obama is towing the line for Rubinomic deficit/debt superstitions, and certainly the Chinese would have a long-run interest in a different FX system than the “BW2” /US$ as sole reserve currency one. But public pronouncements by Chinese officials or their acolytes doesn’t amount to reliable evidence. The real “action” occurs behind the scene.

Their value is their analysis and conclusion – you can attack that, but saying they didn’t turn over something completely new to the market is too much.

We agree. I don’t expect S&P to uncover inside information. All of the value of their work is in their analysis and conclusions. Every bit of it. I’m just unable to see what the value is.

But isn’t that Ed’s point with Australia – how do you know that S&P is “trailing” the CDS, unless you have already determined they will face a down fiscal scenario?

Ed explained this at some length above. I don’t claim that the market has a better read on Australia or anyplace else. My claim is that the market generally has a better read on these things.

My claim is that the market generally has a better read on these things.

To be clear, I don’t necessarily disagree. My only point is that if you are going to judge market measures vs ratings, you can’t simply cherry pick. You need to look at the whole enchilada. And the results become much less clear once you do that. Do you think Belgium’s default risk is higher than Guatemala’s? That’s what CDS spreads are showing.

“The CDS market disagrees, pushing France’s five-year CDS spread out to nearly 160 basis points, Citi analysts note, almost three times as wide as US CDS spreads. The market thinks the US is more AAA than France.” – WSJ

John,

I’m afraid Krugman hasn’t. Krugman picks and chooses the data that supports his views but ignores that which doesn’t. That’s why he uses bond yields in his examples about Japan because if he used CDS spreads his whole argument collapses.

I’m also afraid Nate SIlver did not do a very good job. You see, he tested S&P’s ratings against CDS spreads. It seems he is unaware that rating agencies don’t try to predict CDS spreads, just defaults. Of course, he could have tried to do a real default study but that requires a lot more work, and he couldn’t have done that in time to get a good link-bait article for his blog.

It’s funny how these memes spread. Now you and others will continue to repeat that Nate Silver demolished S&P even though a quick look shows Nate Silver does not even understand what rating agencies measure.

John, take a look at the CDS spreads which you and others claim are so superior to ratings, so that ratings add no value. Right now Australia is in the A category according to the CDS rates, but AAA by the rating agencies. Who do you think is right? As for France, the CDS spreads are indicating that there is little difference between France and Guatemala on credit risk. Do you agree with that, or do you agree with the rating agencies, that think that France is a much better credit?

So Watson, you think France is a worse credit risk than Guatemala?

It seems he is unaware that rating agencies don’t try to predict CDS spreads, just defaults.

You didn’t actually read what Nate Silver wrote:

One might reasonably protest that my study (although not Ms. Reinhart’s) is comparing apples to oranges. Whereas S.&P. is attempting to forecast actual defaults, I’m instead looking at the market’s perceived risk of default as of today. None of these countries have actually defaulted yet. There’s still the chance that the markets turn out to be wrong and S.&P. turns out to be right.

Here’s the problem with that: 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.

Most of the rest of the piece goes on to expand on that point.

I did read it. Nate Silver simply created his own definition and thus the whole study is useless.

Rating agencies don’t try to predict CDS spreads, so Silver’s analysis is wrong.

And if he is going to claim rating agencies lag the market he needs to provide detailed proof, and explain all the examples. For example Latvia. Or Mexico. Or Australia. I could go on.

More on the useless Silver study. He claims to have found evidence that S&P seeks to minimize rating changes. What a genius! This is part of the dual mandate rating agencies have, and which Silver seems not to understand. Rating agencies know they will be slower to react because that’s part of their explicit mandate. That’s why ratings are much less volatile than CDS spreads. In fact, it’s explained in the IMF review of sovereign ratings.

This is yet another example of someone opining about something they only half understand.

F,

I claim two things:

1. That if you want to look at market perception of default risk you need to look at CDS spreads, since that’s what they are designed to do. You can’t do as Krugman does and use bond yields just because it fits your line of argument.

2. But just because CDS spreads are the market measure of credit risk does not mean they are perfect. So if you do use them or consider they are better than ratings, you need to understand their limitations. One key limitation is that they are much more volatile than ratings, and this is by design. That’s why so many regulators and investment funds prefer to use ratings instead of CDS spreads to determine cutoff points. Because if they used CDS spreads they would have to make huge changes to their portfolios all the time.

Points 1. and 2. are not contradictory. They simply address different issues.

None, at least from the market. You could have a contrarian view if you thought the market measures were wrong though.

IOW, your point is all the things that I cited in favor of my point don’t actually favor my point, and in order to believe it, you must be a contrarian.

Ed, the problem with looking at the CDS spread for US debt is that the market is quite small.

Moreover, the spread itself doesn’t make your point. Compare the US to Austria, France, Germany, and other AAA rated sovereigns.

As to yields, you’re certainly correct that there are factors other than credit risk which play a role, but if you assume that those other factors, such as inflation risk, haven’t changed much in the last several months, then it becomes difficult to explain why the low yield is not indicative of stability in credit risk as well.

Rating agencies don’t try to predict CDS spreads, so Silver’s analysis is wrong.

So not only didn’t you read Nate Silver, you didn’t even read the part I quoted. Silver’s argument is not that S&P is failing to predict CDS spreads, but that S&P’s ratings lag behind CDS rates and thus fail to add value as a predictor of defaults.

F @222-223 Apologies if I am not clear. I thought I tried to explain how I see CDS as the correct market measure of credit risk but how it also has important limitations. I guess I wasn’t succesful.

John @224 I use a market report that translates CDS spreads into implied ratings.

Andrew @225 True, CDS spreads have their issues. But so do bond yields. There are technical reasons that support low yields for the US, which are good for the US funding but don’t really reflect comparative credi risk views, which the CDS market does seek to measure.

Consumatopia @226. Silver makes several mistakes which make his analysis useless to understand ratings (but probably very successful as blog bait). Not only does he confuse CDS spreads with actual defaults (I quote him on that) but he is unaware of rating agencies’ dual mandate, which includes ratings stability. This second mandate, explained in part in the IMF report on sovereign ratings, is something the CDS market does not have and explains why rating agencies will generally lag the market when a country finally downgrades but also explains why they overshoot much less, which is very valuable to many market participants. I gave the example of Latvia but there are others. If you want to measure what information rating agencies provide that the market does not you need to look at all the many market “false positives”. That’s why I gave all the examples I did, such as France and Guatemala.

So despite Ed’s attempts to fool us otherwise, it seems pretty clear that the ratings agencies have a surprisingly poor track record of evaluating default risk. Since sovereign debt has got to be the easiest to evaluate, you have to wonder why the ratings agencies persist in an activity that they seem so poorly suited for. This was particularly obvious for S&P after their bizarre arithmetic error. I always assumed that it served as an advertising function, but after the bad publicity it must be essentially a service that they provide for their most valued customers, like the big investment banks. One goal seems to be to influence public policy. David Dayen mentions a case where S&P used their ratings business to help eliminate government regulation that was inconvenient for Wall Street.

“Since sovereign debt has got to be the easiest to evaluate, you have to wonder why the ratings agencies persist in an activity that they seem so poorly suited for.”

Oh really? Sounds like we need you to work at the ECB – perhaps your ease of evaluating sovereign debt would have helped save the Euro from near collapse because of the sovereign default of one of its (lowest rated) members. I don’t believe Greece will escape without a debt “restructuring”, whether the ECB calls it a default or not.

I’m not arguing any larger point about S&P or Nate Silver,

In that case then why are you arguing at all? Nate Silver made a mistake that makes his study useless. It doesn’t matter that he acknowledges the mistake, it’s still an error. if I say “I know an oven is supposed to be used to bake things, but i’m going to measure how well it does as a swimming coach” that is still a meaningless exercise.

Ratings are meant to predict defaults, which they do pretty well. In fact, Silver links to a study by Reinhart that says just that, but glosses over it. Ratings are not meant to predict CDS spreads, so any econometric exercise that does that is simply useless. Well, not completely useless. It helps him raise the hit count in his blog.

In that case then why are you arguing at all?

You said something that was simply false, I pointed it out. If you can’t see your simplest mistake, there’s no point in me trying to correct any of your slightly more complicated misreadings, as others have repeatedly tried to. Nate Silver’s analysis does not assume that ratings are meant to predict CDS spreads.

Ed, if you’re going to argue that Silver erred in his use of swaps, you actually have to engage his argument. You’ve repeatedly said that swaps aren’t the same thing as defaults, but Silver himself says this, and explains his choice. If you’re going to talk about this, you have to engage that explanation.

Further, you say that Silver erred in saying that ratings follow the market because it is part of the S&P’s mandate to follow the market. That looks to me like you are saying Silver is exactly right, but trivial. I disagree that this is a trivial point, but I probably come to this discussion with a different background and different set of interests.

Krugman is an interesting case. Fetching his most recent discussion of S&P and Japan, he (tentatively) argues that S&P ratings are useless for two reasons: They’re sometimes wrong; and they add no information to the market. He puts the Japan case in the “wrong” category, whereas you make a plausible case that they are in the “following the market” category. Either way, he understands the irrelevance of S&P information to the actual bonds being rated, and using that irrelevance, he was able to correctly call the bond market’s response to Treasuries after the U.S. downgrade. That’s still helpful, though I’d like to see him confront your argument to see if you and I are missing something.

As PaulB said, Silver said one thing when he meant another. You could tell that he meant another thing if you had actually read the rest of the post (which you either will not or cannot), or even just the portion I quoted @213 (ditto). He’s comparing two different predictors of defaults, not assuming that one predictor is intended to predict the other.

You need to do more understanding, not more explaining.

PF,

There are two related but separate issues. First, do sovereign ratings do their job, which is to rank order credit risk. Studies that look at this, both published by rating agencies and by academics like Reinhart, show that yes, they do. So when Nate Silver uses a regression to see if ratings predict CDS spreads he is doing nonsense, since that is not what ratings do and the results tell us nothing about how good the ratings are. It allows him to publish serious looking regression outputs but they are meaningless.

The second issue is, even if ratings do correctly rank order credit risk, is there an alternative mechanism that does the same but faster, ie do ratings simply repeat with a lag what the market says. This is something Nate Silver tries to address. (Note that his regression trying to see if ratings predict CDS spreads is of no use to answer this question). This is actually a very interesting question and one that, if answered appropriately, could support the idea that rating agencies provide little information. But it has to be done right, and Nate Silver does not do that.

Rating agencies have a dual mandate, not only to rank order credit risk, but also to have reduced volatility. For both investors and regulators there is a lot of value in avoiding ’false positives’ even, in some cases, at the risk of having some ‘false negatives’. This is something Silver is unaware of, although it doesn’t stop him from offering an opinion.

Let me try to elaborate on this with an example. Suppose you are a regulator that wants to make sure certain funds are not invested in risky assets and decide to use some sort of credit trigger (same logic applies to a portfolio manager). You have two options, ratings or CDS spreads. CDS spreads are much more volatile than ratings, and so the ‘trigger’ is hit much more often, with plenty of false alarms. Note that this is perfectly consistent with CDS spreads correctly predicting defaults. Yet it still creates problems because of all the times the markets signal worsening credit problems only to change their mind after a while. This is what happened to Latvia last year. It is, I’d argue, what is happening to Australia today, which the markets have ‘downgraded’. There are plenty of other examples, and also examples of false positives going up the rating scale.

This is, in fact, one of the main values of ratings. It is, I suspect, why so many studies show sovereign ratings can impact rates, even when the market had all the information. Since market measures tend to overshoot there is a ‘cry wolf’ aspect to this, and so maybe when a rating agency acts it has a different impact. At least it is something to be studied.

Silver does none of this. He does do a one time prediction of ratings based on CDS spreads, and this is the kind of analysis that if fully carried out could be useful. But it does not support the title of his blog and requires a lot of hard work, so he avoids that.

As for Krugman, note that while he was correct that there would be no impact on Treasuries after the downgrade that’s contradicted by the many many times ratings have led to yield changes in other countries, including other countries that are also very well studied. A honest analyst would ask himself why the difference (I have some theories) but Krugman chose the easy way out.

Ed @229: True, CDS spreads have their issues. But so do bond yields. There are technical reasons that support low yields for the US, which are good for the US funding but don’t really reflect comparative credi risk views, which the CDS market does seek to measure.

The problem with using CDS spreads on the US in particular, though, is that the small size of the market means that you have a number of problems deducing comparative risk information from the spread. This is a problem in addition to other issues with deducing comparative credit risk from spreads generally.

And again, even if we did, the spread on the US is quite low. I can’t think of any market indicator, in fact, showing agreement with S&P.

I don’t have a problem with the ratings agencies generally, but I do think S&P may have overreacted to the debt ceiling negotiations. I say this without having looked at their model; my opinion is based purely on their press release. However, they’ve also been warning of this for months, and they were the most aggressive of the big three in their language, so there’s also a strong argument that the trigger was more quantitative (in the form of insufficient deficit reduction plans) than qualitative.

Ed, I didn’t say that CDS spreads are never useful. I said that they’re less useful in the case of the US, because the market for them is quite small. If you have a much larger market with greater liquidity, then CDS spreads become more useful. Yields are also useful, though of course like all kinds of market indications they are subject to many influences.

As to the ratings agencies, I do consider them useful. But that doesn’t mean there any indicators that show the markets agreeing with S&P. Far from it.

Nor would I judge a ratings agency based on whether it gets right the distinction between AAA and AA+ with respect to a single issuer. That said, there’s something stubborn and stupid about downgrading an issuer as uniquely situated as the US, based on qualitative factors, from AAA to AA+, when so few agree with your assessment.

I’ll rate S&P Aa3 for balls and Baa2 for brains.

I have a problem with inconsistencies.

Is that why you spend half your comments talking about how the market agrees with S&P, and the other half talking about how it doesn’t matter if the market agrees with S&P or not? You don’t sound like a lover of consistency, you sound like a rating agency apologist.

Lemuel,
Read China’s lips

http://www.project-syndicate.org/commentary/roach7/English