An Anatomy of Rating through the Cycle

Using an asset-based model of default, I derive rating characteristics if ratings are meant to look ‘through the cycle’ as opposed to being based on the borrowers’ current condition. The through-the-cycle method, which is employed by most rating agencies, requires a separation of permanent and cyclical components of default risk. In a time series setting, this can be done through the Kalman filter. The analysis shows that many empirical irregularities of agency ratings could be the consequence of such a rating method. The stability of through-the-cycle ratings is higher than that of their currentcondition counterparts, and their correlation with actual default probabilities is relatively low. Though not predictable in the usual sense, rating changes exhibit several properties which call for a reconsideration of the existing evidence.