S&P Rubbish

from Peter Radford

As an afterword on the whole downgrade silliness, the world has been full of S&P critiques. Quite why we need to add to the very obvious fact that S&P is clueless as to risk, and very likely corrupt to boot, seems beyond me. Anyone who believed the magical stardust sub-prime mortgage lead into AAA gold alchemy is clearly incapable of even the most simple analytical process. Alchemy is alchemy no matter how you dress it up, and no matter how many MIT economics PhD’s devote their mathematical skills to the problem.

Nonetheless there appear to be a few hardy souls who still take S&P seriously. So to help them kick the habit I want to direct their attention to Nate Silver’s excellent thorough and complete destruction of S&P value. To put it bluntly: S&P adds no value at all to the sober assessment of default risk. Indeed it may actually muddy the waters sufficiently that an investor is misled. The key moment in Silver’s analysis is when he concludes that including an S&P rating in a model designed to predict default makes that model less likely to succeed. In simple parlance: S&P reduces the amount of information in the marketplace. This is the polar opposite of its avowed intention, and totally undermines the value it claims to represent when it charges investors for its services.

Its ratings are rotten. Worse, they are so rotten that it would be worth an investor betting against whatever S&P says is likely to happen.

This is not, obviously, what a rating agency is supposed to do, but S&P manages to be a negative force by ensuring that its opinion is worthless.

Think about this finding of Silver’s: S&P takes pride in the serial correlation of its ratings. This means that when it downgrades a bond rating, the next move is likely to be a downgrade as well. S&P talks openly about this. What does this mean? Basically it implies that S&P, when it downgrades a rating, has already enough information to downgrade again. So, we are reasonable to ask, why not go the whole hog in one go? Why take these stutter steps? Why hide the information from the market? Why sow confusion instead of clarity?

Who knows? But the one thing we can conclude is that S&P is a truly bad rater of debt default liability. And since that is what it does for a living we can further conclude that the bond market, to the extent it takes notice of S&P is full of easily duped investors.

I happen to think that the bond market isn’t so easily fooled. After all it had re-priced Greek debt way before S&P downgraded it. Indeed as Silver also points out: the pricing of debt in the general market is a pretty good guide to what S&P is likely to do with its ratings … two years later.

Why anyone listens to these fools I don’t know. Perhaps they are good friends. Perhaps they feel sorry for S&P and its band of overpaid incompetents. Perhaps inertia stops them from eliminating S&P from the list of information sources. Or, perhaps, they are simply too lazy or cheap to do their own analysis. In which case they’ve lost a lot of money along the way.

I happen to think it is this latter explanation. The banks, in their frenzy to cut costs, eliminated the staff who did the in house analysis. They outsourced credit analysis to S&P and their ilk for bonds, and to the credit rating agencies for consumer default risk. The credit bureaus are extraordinarily poor at analysis and have very weak systems. S&P is now exposed as worse than useless – literally since it destroys an investors ability to predict default. Combine the two, as in the rating of those toxic derivatives built upon a foundation of credit scored mortgages, and it is easy to see why then banks blew up. They were buying into alchemy on a grand scale. They still are. On an equally grand scale. Which means that the banks are no safer or better at pricing risk than they were before the entire edifice collapsed a few years back.

As a last word: if the US wants to issue AAA rated bonds in the near future perhaps it should learn some of those old derivative tricks. Maybe, I am just suggesting, it should merge its debt issuing with that of Greece. Given a suitable sprinkling of market magic dust, the right combination of debt into tranches that only lawyers understand, and the earnest incantations of the right number of math wizards – from MIT of course to ensure impeccable pedigree – and BAM! the US could produce AAA bonds comprised entirely of subpar material. The market would swallow it whole. After all S&P blessed it.

They would, wouldn’t they? After all they’ve done it before.

Oh. Wait. They were paid off for that service. So clearly the US Treasury needs to throw a few bucks S&P’s way to grease the analysis.

S&P rubbish. Indeed.

  1. August 11, 2011 at 8:57 pm

    Basically all the down-to-earth bond traders are not clueless. They give a shit about S&P or Moody’s ratings. Everybody knows these people have no idea what they are talking about.

    Moody’s did this with Japan several times. In November 1998, the day after the Japanese Government announced a large-scale fiscal stimulus to its ailing economy, Moody’s made the first of a series of downgradings of the Japanese Government’s yen-denominated bonds, by taking the Aaa (triple A) rating away. By December 2001, they further downgraded Japanese sovereign debt to Aa3 from Aa2. Then on May 31, 2002, they cut Japan’s long-term credit rating by a further two grades to A2, or below that given to Botswana. And what happened to bonds? Nothing. Zero. The bond market ignored the Moody’s idiots. A Japanese treasury official recommended to Moody’s: to take a long walk off a short pier.

  2. August 11, 2011 at 9:09 pm

    addendum: But of course as a sophisticated bond trader you take advantage of the public panic following such (non)events. The whole world thinks the sky is falling and wants US treasuries. So be it. You sell them. Hoard central bank money. And move in again once the panic has settled and buy the same long-term bonds for a discount you’ve just sold some time ago.

  3. Merijn Knibbe
    August 12, 2011 at 9:10 am


    though I completely agree with your downgrading of S&P – I do get the impressions that

    a. the Tea Party has serious political power in the USA
    b. and that they want to forbid the USA government to raise additional taxes as well as to borrow any more money (not even a cent) and that they don’t mind default

    As far as I’m concerned, the Tea Party did damage the reputation of the USA goverment and the USA political system. I’m not important. But China is. The USA has a little less power than it used to have.

  4. August 13, 2011 at 1:32 pm

    What do you think of the Weiss ratings? Weiss is not paid by the agencies they rate.

    • Peter Radford
      August 15, 2011 at 10:45 pm

      Fred: I don’t know enough about them, but their independence from those they rate is a major point in their favor. As is the comment that the S&P downgrade by one step being an odd/weak move: given the analysis – whatever we think of it – the downgrade should have been more dramatic. Do you agree?

      • August 17, 2011 at 5:45 pm

        I agree. It seems that they did not want to admit their $2 trillion error, so they went ahead with the downgrade to avoid looking foolish. If their rating is near term, it is incorrect. If it is long-term, it is irrelevant to near-term T-bond interest payments. The bond market still likes T-bonds, and that is what really counts.

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