How Rating Agencies Achieve Rating Stability
by Edward I. Altman of New York University, and
Abstract: 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.
Keywords: Rating agencies, through-the-cycle rating methodology, migration policy, credit-scoring models, default prediction.
Published in: Journal of Banking & Finance, Vol. 28, No. 11, (November 2004), pp. 2679-2714.