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  Issue 12 | Archive August 2012

A Lead-Lag Investigation of RMI PD and CRA Ratings

An RMI staff article

In a recent article appearing in the second issue of RMI’s Global Credit Review, RMI staff present the results of an investigation into the timing differences between outputs from RMI’s probability of default (PD) model and corporate credit ratings from credit rating agencies (CRAs).

The article covers three well known default cases: MF Global, Lehman Brothers and Enron. Each of these companies was rated investment-grade by the Big Three CRAs until each firm declared bankruptcy. In the aftermath of these default events, CRAs received significant criticism from many financial professionals, politicians and commentators, with a majority expressing doubt about the accuracy of CRA ratings, and CRAs’ ability to complete rating actions in a timely manner. These three default events, and other CRA failings, provide a strong justification for market participants to make use of alternative indicators of credit risk, such as RMI’s PD model.

This article demonstrates that RMI’s PD model is a more timely measure of credit risk that provides useful and necessary information to financial markets. In all three cases, outputs from RMI’s PD model responded to declines in credit quality well before CRAs started to revise their ratings.

A summary of the findings is listed below:

MF Global

RMI PD first indicated the company’s credit profile was significantly deteriorating in August 2011. The CRAs on the other hand only started downgrading the company in the final days before its bankruptcy filing at the end of October that year.

MF Global was an international brokerage firm specializing in commodities and derivatives, with a history stretching back over 200 years. The now infamous proprietary bet on eurozone sovereign debt caused the firm to file for bankruptcy. Despite roots in a traditionally safe part of the financial sector, total losses of over $570 m, incurred while the firm was a publicly listed entity between July 2007 and October 2011, underlined large failures in risk management, internal control and business strategy. However, the firm was consistently rated above investment grade by the Big Three CRAs. CRI data shows that default was never a remote possibility for MF Global, especially in the final few months prior to the firm’s bankruptcy.


RMI PD from 1995 to 2008 shows that Lehman Brothers should not have been consistently rated above investment grade by the major ratings agencies, yet the company was only downgraded below investment grade when Lehman filed for bankruptcy on September 15, 2008.

The failure and subsequent sale of Bear Stearns to J.P. Morgan in March 2008 had significantly increased the scrutiny of Lehman’s financial position by market participants in the months leading up to the Lehman’s September bankruptcy. Despite major debate amongst market participants regarding Lehman’s health during this period, the ratings agencies did not downgrade the bank significantly. Throughout this period CRI data showed that the risk of default at Lehman was, and had historically been, much higher than that implied by external credit ratings.


In comparison to the static ratings from the CRAs, a gradual increase in Enron’s RMI PD highlighted the upward trend in credit risk the company faced throughout 2000 before its eventual default at the end of 2001.

Throughout the nineties, Enron’s stock had been on a constant rise, with the company’s stock price soaring in 1999 and 2000, recording respective year-on-year increases of 56% and 87%. By December 31, 2000 Enron’s market capitalization exceeded $60 bn, four times the company’s book value; financial markets were impressed by the conglomerate Enron had become. Enron had been able to operate a questionable business model, conceal true performance and hype its stock but eventually the company was forced to file for bankruptcy in December 2001. The firm was rated investment grade by all of the Big Three credit rating agencies until four days before it filed for Chapter 11 bankruptcy protection.

The article supports RMI’s view that quantitative models are contributing to the critical area of credit ratings in a non-biased way.

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Published quarterly by Risk Management Institute, NUS
Editor: Ivy Wang (rmiwy@nus.edu.sg)