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How Ratings Agencies Achieve Rating Stability

Surveys on the use of agency credit ratings reveal that some
investors believe that rating agencies are relatively slow in
adjusting their ratings. A well-accepted explanation for this
perception on the timeliness of ratings is the "through-the-cycle"
methodology that agencies use. According to Moody's, through-the-cycle
ratings are stable because they are intended to measure the risk of
default risk over long investment horizons, and because they are
changed only when agencies are confident that observed changes in a
company's risk profile are likely to be permanent. To verify this
explanation, we quantify the impact of the long-term default horizon
and the prudent migration policy on rating stability from the
perspective of an investor - with no desire for rating stability. This
is done by benchmarking agency ratings with a financial ratio-based
(credit scoring) agency-rating prediction model and (credit scoring)
default-prediction models of various time horizons. We also examine
rating migration practices. Final result is a better quantitative
understanding of the through-the-cycle methodology.

By varying the time horizon in the estimation of default-prediction
models, we search for a best match with the agency-rating prediction
model. Consistent with the agencies' stated objectives, we conclude
that agency ratings are focused on the long term. In contrast to
one-year default prediction models, agency ratings place less weight
on short-term indicators of credit quality.

We also demonstrate that the focus of agencies on long investment
horizons explains only part of the relative stability of agency
ratings. The other aspect of through-the-cycle rating methodology -
agency rating-migration policy - is an even more important factor
underlying the stability of agency ratings. We find that rating
migrations are triggered when the difference between the actual agency
rating and the model predicted rating exceeds a certain threshold
level. When rating migrations are triggered, agencies adjust their
ratings only partially, consistent with the known serial dependency of
agency rating migrations.

How Ratings Agencies Achieve Rating Stability

by Edward I. Altman of New York University, and
Herbert A. Rijken of Vrije Universiteit Amsterdam

April 2004.

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