Sunday, 7 July 2013

Ratings - From an Opinion to Science

In January 2011 The Financial Crisis Inquiry Committee claimed that "The three credit rating agencies were key enablers of the financial meltdown". Failing investment banks and large corprations enjoyed investment-grade ratings days before collapse. Rating agencies claimed that ratings represent a mere opinion. And this is precisely the problem. Rating agencies represent a fundamental source of information for investors. Investors will evidently tend to invest in assets that are judged as investment-grade rather than junk. However, the First Amendment of the U.S. Constitution protects "publishers" guaranteeing them the freedom of speech.  

The original business model for the rating agencies, established when John Moody published the first publicly available ratings in 1909, was an “investor pays” model. Moody, and subsequently other rating agencies, sold thick “rating manuals” to bond investors. In the early 1970s the Big Three changed to an “issuer pays” business model, which means that an issuer of bonds pays fees to the rating agency that rates its bonds. This model continues today. This means plenty of things, conflict of interest being one.
Independent of whether the "issuer payes" or the "investor pays" model, the problem is that in their current form ratings can be manipulated.  You can steer a sophisticated Monte Carlo Simulation to a desired result without any major problems. Stochastic Simulation and Stochastic Calculus are so complicated, there are so many Monte Carlo sampling methods, that very few people are able to question it. Definitely not many investors. 

But let's get to the core of the matter, to the main claim in this blog. Why is it that even the Big Three agencies don't always agree on a rating of a country or a corporation? There exist many rating methods. Each method is based on models which require assumptions (like "let's suppose that the value of real estate never goes down"), etc., etc. Just multiply the number of agencies by the number of computational methods.... you get hundreds of combinations. Hundreds of ways of computing a rating. There should be one. In many sectors of the industry, even in science, there exist standards and protocols. But finance is de-regulated. The lack of regulations, which the financial industry so fiercly opposes, was what enabled the folly which has collapsed the economy. The financial industry doesn't want regulation or limits to leverage and speculation. This is why there are so many means of computing a rating which, with the current model, is a highly complex, subjective and therefore maneuverable instrument. Opinions can't be regulated. 

A method of rating does not have to be perfect (is financial data 100% accurate?). But it has to be consistent. Serious science starts with consistent measurements. You can always improve a metric, make it more accurate, but you must use it consistently. If you don't then mathematics indeed becomes an opinion and we don't want that. 

Because measuring the Probability of Default (PoD) of a company is physically impossible - this is precisely why ratings can be manipulated so easily, because it is not physics - it is necessary to take a different and new look at ratings:

1. A rating should not estimate the PoD of a company but something based on the physical properties of a company seen as a dynamical system. A good candidate is resilience. Resilience is not an opinion, it is a physical property and may be computed based on Balance Sheet, Consolidated Income Statements and Cash Flow data which listed companies publish periodically. See here how this may be done.

2. Ratings cannot be verified by investors. Suppose company X gets a rating of ABC. How can you verify it? How do you know it is correct? You don't. The only way to trust the result is to do it yourself. This is simpler than you think:

go to

and run the analysis yourself. With data YOU trust.
3. Because the system is available on the web it is available to anyone. Anyone can download the same financial reports and verify your calculations. It becomes impossible to manipulate the results.

4. The algorithm to compute the resilience of a business is based on physics. It doesn't change.

There are many things that need to be done to fix the economy. One of them is to change the philosophy of ratings. Ratings need to be democratized, they must become a commodity. When this happens rating agencies will become obsolete.