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WSJ Analysis: Rating Firms Not Effective at Predicting Government Defaults

Posted on 12 Aug 2011

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The nation's major credit-ratings firms have historically not been effective predictors of a government's risk of defaulting on its debt, according to a Wall Street Journal analysis of 35 years of data.

Standard & Poor's Corp.'s downgrade late Friday of U.S. debt to AA+ from triple-A has highlighted a key role of credit-rating firms: helping investors measure the likelihood of default so they can calculate the appropriate rate of interest to charge on bonds.

But when it comes to government, or "sovereign" debt, it turns out that the ratings—ranging from a lofty triple-A to a lowly double-C—do little to predict whether a nation is going to renege on its debts, the data shows. The firms have especially done a poor job in the 12-month period preceding a government-debt default, the time when investors most need guidance.

Out of the 15 government defaults S&P has tracked since 1975, for instance, the firm rated 12 of the countries single-B or higher one year before the event. Yet S&P says historically a single-B rating has had just a 2% average chance of default within a year. Put another way, S&P drastically underestimated one-year default risk in 80% of those cases.

Similarly, of the 13 governments rated by Moody's Investors Service within one year of a default, 11 were rated B or higher. Three of those were rated Ba, Moody's parlance for double-B, which carries a 0.77% one-year default rate.

To be sure, the investment-grade ratings—meaning triple-B or higher—assigned to sovereign bonds have withstood the test of time: No government has defaulted within fifteen years of holding a triple-A, double-A or even single-A classification.

And the rating firms argue that their grading system is designed to measure relative default risk between countries rather than actual default probability, and that the measured pace of their actions promotes stability. "We give ballast to the markets," says John Chambers, chairman of S&P's sovereign ratings committee. "If people just relied on the (credit-default swaps) to set their risk premium ... they would go up and down like a yo-yo."
Overall, he says, the firm provides a "robust rank ordering of prospective default risk."

Says Elena Duggar, a credit officer in Moody's sovereign-risk unit: "It's a relative ranking system and the lower rankings have higher defaults than the higher ones."

But bond-fund managers say the ratings firms' track record makes them unreliable indicators when picking investments in volatile markets.

"Once a crisis is obvious, it's obvious to everybody and a (ratings) model won't help you at all," says Jerome Booth, research chief at Ashmore Investment Management, who has invested amid sovereign defaults.

While their corporate ratings have historically been better predictors of default, ratings firms have at times been criticized by investors in those bonds. Moody's and S&P both rated Enron Corp. and Lehman Brothers Holdings Inc. investment grade immediately before their collapses, for example.

"Our historical performance for non-financial corporate ratings and rank ordering has been very strong, especially in this recession," says Ken Emery, senior vice president in Moody's credit policy group. "Ninety-five percent of corporate defaults had a rating of B1 or lower one-year prior to default."

However, the firms also stamped their top ratings on mortgage securities, helping to lead to the bubble that burst in 2008.

Less attention has been paid to their sovereign debt ratings.
The modern sovereign-bond-ratings business was born in the mid-1970s, when a change in the tax treatment for interest on foreign debt and a boom in bond markets created a need for standardized credit ratings.

At one point, there were seven rating firms but consolidation shrank the field to S&P and Moody's, with Fitch Ratings a distant third. Issuers paid the firms to rate bonds that earned fees for Wall Street banks and fed hunger from investors for higher-yielding debt than what was previously available. The firms analyze a mix of economic, monetary, fiscal and political data points to determine their rankings.