Ontonix: Ratings – From an Opinion to Science
Monday, 31 October, 2011 Leave a comment
In January 2011 The Financial Crisis Inquiry Committee claimed that “The three credit rating agencies were key enablers of the financial meltdown”. Failing investment banks and large corporations enjoyed investment-grade ratings days before collapse.
Rating agencies claimed that ratings represent a mere opinion. And this is precisely the problem. Rating agencies represent a fundamental source of information for investors. Investors will evidently tend to invest in assets that are judged as investment-grade rather than junk. However, the First Amendment of the U.S. Constitution protects “publishers” guaranteeing them the freedom of speech.
A method of rating does not have to be perfect (is financial data 100% accurate?). But it has to be consistent. Serious science starts with consistent measurements. You can always improve a metric, make it more accurate, but you must use it consistently. If you don’t then mathematics indeed becomes an opinion and we don’t want that.
Because measuring the Probability of Default (PoD) of a company is physically impossible – this is precisely why ratings can be manipulated so easily, because it is not physics – it is necessary to take a different and new look at ratings:
- A rating should not estimate the PoD of a company but something based on the physical properties of a company seen as a dynamical system. A good candidate is resilience.
- Resilience is not an opinion, it is a physical property and may be computed based on Balance Sheet, Consolidated Income Statements and Cash Flow data which listed companies publish periodically. See here how this may be done.
- Ratings cannot be verified by investors. Suppose company X gets a rating of ABC. How can you verify it? How do you know it is correct? You don’t. The only way to trust the result is to do it yourself. This is simpler than you think:
– download the last 12 quarters of financial statements from the Investor Relations pages of a company’s website
– go to http://www.rate-a-business.com/Downloads/ and download an MS-Excel template (see logo below)
– populate the template with the data you have downloaded
– upload it and have it processed
– get your rating report. See how resilient the company is. See an example here
– decide if you want to invest in this company
– repeat every quarter
- Because the system is available on the web it is available to anyone. Anyone can download the same financial reports and verify your calculations. It becomes impossible to manipulate the results.
- The algorithm to compute the resilience of a business is based on physics. It doesn’t change.
There are many things that need to be done to fix the economy. One of them is to change the philosophy of ratings. Ratings need to be democratized, they must become a commodity. When this happens rating agencies will become obsolete.