In today’s Times there’s a harsh look at Standard and Poor’s ratings system, by Nate Silver.
An excerpt:
[T]he evidence from the past five years suggests that it may be worthwhile to adopt a contrarian investing strategy that specifically bets against S.&P.’s ratings. If you were trying to predict a country’s default risk today, based on the market’s perception of its default risk two years ago as well as its S.&P. rating at that time, you would find that accounting for S.&P. ratings actually subtracted value from your model. That is, if the market had priced two countries as having a 20 percent default risk in 2009, but one of them had a AA rating from S.&P. and the other had a BB rating, the country with the worse S.&P. rating is likely to have proven to be the safer bet.
The reason for this is that S.&P. ratings probably have some influence on market perceptions about default risk ”” even though they aren’t very good. If markets evaluate a country as having a 20 percent chance of default, but S.&P. rates it as being quite safe, that price represents a compromise between daft investors who take S.&P.’s ratings to be gospel, and savvier ones who have conducted their own analysis and have concluded that the country is at significant risk of default. By betting against S.&P.’s ratings, you’re taking the side of the smart investors ”” and getting a subsidy from the suckers who think S.&P.’s price is right.
But there is another “tell’ to indicate that S.&P.’s ratings are slow to incorporate new information. It’s something which they seem to think is a feature of their ratings, but which instead is evidence that they are fundamentally flawed.
The giveaway is that S.&P.’s rating changes are serially correlated ”” that is, downgrades tend to follow downgrades, and upgrades tend to follow upgrades. According to the company’s internal analysis, once a country is downgraded it has a 52 percent chance of being downgraded again in the next two years. By contrast, there is just a 9 percent chance that S.&P. will reverse course and upgrade the country.
What this implies is that S.&P.’s ratings are inefficient about how they incorporate new information. If a country is downgraded from AAA to AA, and that implies that the country is quite likely to be downgraded again in the near future, the question is why S.&P. didn’t apply a steeper downgrade in the first place.
Consider the case, for instance, where I had a model to determine the value of shares in Google. Initially, my estimate had been that a price of $600 per share is appropriate. But then there is some shock to the system ”” say, some fresh evidence that the country is on the verge of another recession and that this could adversely affect Google’s profits. I estimate that $500 is now a fair price.
So I tell you that I’m willing to sell you Google shares, today, for $500. But I also tell you that tomorrow, I’m likely to lower my estimate further, so you can probably buy Google stock from me for $400 per share.
No competent brokerage firm would ever convey that kind of information to investors. If I signal to you that I’m likely to accept a cheaper price tomorrow than I am today, nobody would buy at today’s price.
But this is essentially what S.&P. does. Rather than downgrade (or upgrade) a country by several notches, even when there is abundant to support it, they instead do so in stages. Greek debt, for instance, has been downgraded seven times since January 2009, as S.&P. has slowly caught up with the grim realities that investors had long ago perceived.
I suspect the reason that S.&P. behaves this way is because they know that their ratings can have reverberations on the market and are trying to avoid a sudden downgrade that might induce panic.
But in so doing, they are violating their mission of providing the most earnest and accurate assessment of a country’s default risk at any given time. A country that is downgraded from AAA to AA is riskier, in S.&P.’s view, than one that was just upgraded from A to AA ”” even though they now have the same rating ”” since the former country is likely to be downgraded again and the latter is likely to be upgraded again. S.&P. knows this, and smart investors know this. But they won’t tell you this because dumb investors might get spooked, which could rattle the markets.
Read the whole thing here.