Honolulu-based Kamakura Corporation announced today the release of an important research paper by Kamakura Senior Research Fellow Jens Hilscher of Brandeis University and Lecturer Mungo Wilson of Oxford University. The revised version of their paper “Credit ratings and credit risk” meticulously compares the accuracy of modern reduced form default probability models with the accuracy of legacy credit ratings as predictors of default. The authors follow Campbell, Hilscher and Szilagyi’s paper “In Search of Distress Risk” (Journal of Finance, December 2008) in building a modern reduced form model using the default data base provided by Kamakura Risk Information Services and comparing that to a ratings driven default probability model.
The authors conclude “We find that credit ratings are dominated as predictors of corporate failure by a simple model based on publicly available financial information, indicating that ratings are poor measures of raw default probability.” The authors go on to say the following: “Our results in the first part of the paper suggest that if ratings are understood primarily as predictors of default, then they are puzzling for a number of reasons. First, they are easily improved upon using publicly available data. Second, they fail to differentiate between firms: firms with the same rating often have widely different default probabilities and firms with very different ratings often have very similar default probabilities. Third, they fail to capture variation in default probability over time.”
“The Dodd-Frank bill of 2010 makes a major contribution to improved risk management by minimizing regulatory reliance on legacy ratings,” said Kamakura founder and chief executive officer Donald R. van Deventer, “The Hilscher and Wilson paper provides the proof of why this action in the Dodd-Frank bill was necessary: regulators, including the Bank for International Settlements and the Basel Committee on Banking Supervision, have been surprisingly nonchalant about responding to rating agency errors like the failure of AAA-rated FNMA and FHLMC (both ISDA events of default because of the government conservatorship) and the $208 billion failure of AIG, which was rated AAA as recently as January 2005. Regulators and investors owe a debt of gratitude to Professor Hilscher and Lecturer Wilson for their elegant quantification of the magnitude of the problems with legacy ratings. The legacy ratings concept of 90 years ago is neither necessary nor sufficient as a measure of credit risk.”
