The Article was retrieved by the Royal Statistical Society
As turbulence in global financial markets continues in the wake of the downgrading of US debt by Standard & Poor’s (S&P), statistician Nate Silver has made a withering critique of the agency's "fundamentally flawed" ratings.
Objective statistical measures have been proved to be more reliable than S&P's ratings, in part says Silver because ratings changes are serially correlated – a move either way is likely to be one of a successive series. Hence the ratings are "inefficient about how they incorporate new information."
He opines: "No competent brokerage firm would ever convey that kind of information to investors. If I signal to you that I’m likely to accept a cheaper price tomorrow than I am today, nobody would buy at today’s price."
In Why S. & P.’s Ratings Are Substandard and Porous, published in his fiverthirtyeight column in the New York Times, Silver uses various analytical approaches to test the ratings' reliability and to "reverse-engineer" them to determine how S&P reaches its conclusions.
He notes that S&P takes account of GDP, sovereign debt, debt:GDP ratio, inflation rate, annual and long-term deficits but "also places very heavy emphasis on subjective views about a country’s political environment … these political factors are at least as important as economic variables in determining their ratings".
Silver says that S&P's ratings "have an extremely strong relationship" withTransparency International's Corruption Perceptions Index, a governance indicator which has been criticised in some quarters as too subjective. Using regression analysis on S&P's ratings, he concludes that "the subjective Corruption Perceptions Index is more closely related to the S&P ratings than any of these economic fundamentals."
Making the point that he doesn't necessarily disagree with downgrade of the US rating, Silver comments on S&P's historic ratings of debt-worthiness for countries including Ireland, Spain, Iceland and Greece. He concludes these gave "no insight … about which countries in Europe were relatively more likely to default."
Using a country’s ratio of net debt to GDP – a poor measure in objective terms – "would have been a better predictor of default," he says, citing research from Carmen M. Reinhart published by the US National Bureau of Economic Research which found that objective, statistical indicators significantly outperformed S&P ratings as predictors of default.
As recent events show, there is a relationship between credit agencies' ratings and market sentiment and investors' behaviour. But Silver finds that "S&P ratings tend to lag, rather than lead, the market … in cases where the market’s view of default risk is misaligned with S&P’s, S&P is a good bet to change their rating to catch up to market perception".
He tests this by putting S&P ratings for countries from June 2009 into a regression equation with credit default swap prices - which indicate market perception of default risk – from the same date. The credit default swap prices proves to be "a statistically significant predictor" of S&P’s 2011 rating, implying "that the markets pick up on salient information about the countries’ default risk before S&P does".
Taking this a step further, "Evidence from the past five years suggests that it may be worthwhile to adopt a contrarian investing strategy that specifically bets against S&P’s ratings," says Silver. S&P does influence market perceptions but actual debt prices are a "compromise between daft investors who take S&P’s ratings to be gospel, and savvier ones who have conducted their own analysis and have concluded that the country is at significant risk of default. By betting against S&P’s ratings, you’re taking the side of the smart investors — and getting a subsidy from the suckers who think S&P’s price is right."
In conclusion, Silver writes that "relying on the consensus of the market is almost certainly better than relying on Standard & Poor’s, whose advice has more often than not led investors toward the losing side of bets. The fact that billions of dollars in wealth are tied up in the judgments of a company with such a poor record is all the proof you should require that the global financial system is in need of reform."
Original Link: http://www.rssenews.org.uk/articles/20110809_1