Ratings Agencies – Grade F

27 02 2010

Category: Finance

In my post about some of the financial jiggery-pokery that got the economy where it is I mentioned the problems involved in getting accurate valuations by the ratings agencies. This was well illustrated by the Economist recently with a table of information compiled by Donald Mackenzie of the University of Edinburgh:

With mortgage-backed securities it’s clear the ratings agencies simply got it wrong; dead wrong. They were supposed to be assessing risk, they didn’t do a particularly good job of it…

I’ve taken the predicted default rate and worked out by what ratio they were wrong for each rating class. For example the estimated default for AAA, the top rate, was 0.001 and the actual default rate was 0.10. That’s an actual default rate of 100 times the expected rate; here’s the full list:

Imagine an expert is asked to predict something and he gets it wrong by a factor of double or triple or quadruple. Sounds like a pretty lousy expert. These experts got it wrong by a factor of 350 times.

For all the ‘ah yes but global crisis’ and ‘unforseeable events’ they’d claim, a blinfolded monkey throwing his own muck at a large board covered with random numbers would have made a better job of predicting the risk of default than these experts did.

It’s startling to consider the numbers themselves. For the BBB rating, it was expected that less than one in 200 would default. More than half defaulted. Not one in two hundred; one in two. For BBB-, it was predicted that fewer than one in a hundred would fail; two thirds defaulted. I wonder what kind of bonus scheme those ratings experts are on.

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