An anatomy of rating through the cycle

Using a structural 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 several empirical irregularities of agency ratings could be the consequence of such a rating method. The stability of through-the-cycle ratings is relatively high, while their default prediction power is low. Though not predictable in the usual sense, rating changes exhibit properties that call for a reconsideration of the existing evidence. (C) 2003 Elsevier B.V. All rights reserved.