Ratings are like a spring. They are stable unless they’re stretched too far

It concerns me that the media continues to perpetuate myths about ratings of financial strength and the rating agencies. Perhaps it is time to redress the balance.

One myth touched upon in Insurance Times’ sister title Global Reinsurance in September is the lack of oversight of such ratings and the companies that provide them. However, rating agencies’ regulation is being tightened by the US Securities and Exchange Commission and introduced by the EU. In addition, major institutions employ analysts who use ratings day in, day out, providing their own check on the output of the agencies.

While rating agencies have been criticised in various quarters, many critics don’t understand what a rating is. Indeed, in a way, a key role of ratings is taking the blame when things go wrong.

Starting with the rating of banks, there are two important factors. The first is that a bank’s rating starts with a standalone credit profile – the core strength of the bank. To this are added implicit ratings for systemic support. The second is that agencies talk about the transition profile of ratings, and make every effort to highlight the likelihood of rapid transition of a rating for institutions where this might be an issue. The transition profile – the speed with which the rating may change – has been gentle for most car-makers but steeper for companies in confidence-sensitive industries.

Some critics complain about ratings’ accuracy, but there is an equal number grumbling about their stability. As medium-term indicators, they aim for stability. My analogy for this is Hooke’s Law, which describes elasticity: if you pull a spring it will return to its original shape, except when stretched beyond a point of no return.

Similarly, ratings need to be stable over the medium term, but rated entities change their financial characteristics by the day, or even the minute, so they are always “pulling the spring” – challenging the elasticity.

Rating agencies start by looking at the fundamentals of an entity, and go on to consider how it will cope with normal market stresses and whether the rating will survive such a situation. Sometimes the markets move away from the fundamentals, for instance when there are big changes to share prices or credit default swap spreads that appear to suggest an entity needs a different rating. This has happened dramatically in some cases when, before a collapse, short-term indicators suggest a rating higher than the agencies’ current ratings. In other cases, the ratings remain high even though the markets have lost confidence and the spreads suggest lower ratings.

The key is that in most instances the short-term indicators return to the fundamentals, but sometimes they stay out for so long that they shift the fundamentals: this is the point at which the spring of Hooke’s Law cannot return to its original shape and the rating needs to change.

Ultimately, understanding rating agencies starts with the appreciation that these organisations are trying to predict the future. This can only involve degrees of probability – not the absolute certainty that some market-watchers seem to think they’re indicating. IT

Peter Hughes is founder of ratings consultancy Litmus Analysis