The Uncertainty of Credit Safety

Abstract

Credit grades are ordinal measures of default risk that are used to rank the relative creditworthiness of different borrowers rather than the relative safety of different environments. They are assigned by specialized rating agencies, which face short-term pressures to fudge their rankings and long-term pressures to nurture a reputation for insight and objectivity. Their biggest analytic challenge is to find enough data with enough explanatory power to justify their rankings. For quantitative modeling, credit grades are best viewed as multipliers on a fluctuating aggregate default risk . Experience shows that the scale is roughly logarithmic, with each full-letter drop in credit grade roughly quadrupling the default risk. The regularities suggest that credit grades are usually assigned correctly or near-correctly. However, the pool of relevant servicing history is not always large enough to measure high safety well. The triple-A grade should arguably be dropped and most tiering of A-grade sovereign credits ended. However, this need not coarsen overall ratings. Instead, ratings agencies should be encouraged to offer a second dimension of rating geared to perceived stability. A highly stable double-A rating would offer everything a triple-A rating does. For long bonds from A-grades, higher rated stability might be more valuable than a higher grade.