Are We Witnessing the Start of a Ratings Revolution?

Published Tue, May 8th, 2012   Matthew Weinschenk, Senior Analyst

Ratings agencies are useless.

They rated subprime debt as AAA bonds, completely missed the financial crisis, and – seeing as big firms like Standard & Poor’s or Moody’s charge for ratings – they have a notable conflict of interest.

If that’s not enough, the European debt crisis has exposed even more of the ratings agencies’ shortcomings. Namely, when it comes to rating the sovereign debt of countries and municipalities (as opposed to corporations), the agencies don’t fare much better.

Ireland, for instance, was rated AAA until well after its financial troubles were made public knowledge. Spain had a AAA rating until 2009. And Greece’s bonds were considered investment-grade until March 2010, just two months before the riots started.

Given all that miscalculation, it’s not surprising that research shows sovereign debt ratings are a lagging indicator.

So where exactly do S&P and Moody’s go wrong? No one can say, since they keep their analysis process secret.

Rating agencies are simply trying to protect their “competitive advantage.” But since these agencies rate the debt of our government and determine what our mutual funds and pensions can invest in, shouldn’t they be giving us insight into how these ratings are decided?

From the outside, they appear to have little rhyme or reason. Nate Silver has tried to track what economic indicators the ratings agencies are using and the ratings seem to come out of nowhere… or from human bias.

This closed-door policy may have cost the United States billions in interest payments. You see, when S&P downgraded U.S. debt, it made a $2 trillion calculation error. S&P denied making the error, of course, but because it keeps its models a secret, we’ll never be quite sure of what the real story is.

But the days of obscurity may be behind us. A new ratings system, released on May 2, could induce the financial system to become more open and transparent…

Opening the Door to Transparent Ratings

This week, PF2 Securities released the Public Sector Credit Framework (or PSCF) – powerful modeling software that outputs the probability of default for national, state, or local governments.

Here’s how it works…

First, the user sets a wide range of assumption for GDP growth, tax revenue, expenditures, population and inflation, to name a few.

Second, they set what thresholds should be considered as a default.

Finally, the software simulates thousands of outcomes using a mathematical model called a Monte-Carlo simulation to determine the probability of default. And, voila! You have the basis for a credit rating.

Of course, every bank, investment firm and ratings agency has software like this. But the thing that makes PSCF different is that PF2 Securities released the software’s entire code to the public as open source.

Using the open-source development model allows anyone to freely access, examine, improve and redistribute the software that PF2 has developed. This typically means that additional features and improvements in the code happen at a much faster rate than with closed source (or proprietary) software.

But the point isn’t more efficient software development, nor is it for individual investors to start modeling default scenarios. It’s not even to give people an edge in the market. Instead, the real purpose of releasing the software as open source is to allow for transparent, honest comparisons between ratings.

After all, the real crux of an accurate prediction is the method of analysis and economic assumptions made – precisely what S&P and Moody’s are keeping secret.

What PSCF achieves – and what S&P and Moody’s prevent – is a common language, method and framework for discussing risk for investors and policy makers.

So rather than accept the big firms’ rating as gospel, anyone can investigate scenarios based on their own ideas and predictions.

PSCF is an important step toward transparency among the financial institutions that wield so much power (especially since the creator, Marc Joffe, is a former senior director at Moody’s).

Similar projects that describe how mortgage applications are approved or how federal allocations affect the budget would serve the public interest significantly.

So let’s hope that this move encourages a trend of increasing transparency in our financial markets. Given that we’re starting from almost complete secrecy, even a small change helps.

Ahead of the tape,

Matthew Weinschenk