Originally Posted by
Snoopy
I don't disagree with anything you have written above regarding probability theory Axe.
But I do think that in relation to any particular example (in this case Heartland) that just because you are applying probability theory, that doesn't mean that all years in which Heartland operates neatly organize themselves into "independent events." For example, consider Heartland's non-core property portfolio.
If the bad property is a drag on the company one year, and there is no significant improvement in selling down that portfolio or writing it down over that year, then it will be a drag on the company the next year too. IOW because loans 'span the years', this means that successive years in which Heartland operates are clearly not independent of each other.
I would imagine the statisticians who draw up these loan ratings know that each business year of Heartland is not independent of the next. So they will have adjusted their risk model to compensate. To give a very simple (oversimplified for any reality, but useful for explaining the concept) example of this to make the point.
Consider 30 years of a financial institution in business, made up of two types of years: 'good' years and 'bad' years. Let's assume for the purposes of this example that there are an equal number of 'good' and 'bad' years. Let's assume that the chance of going bust in a 'bad' year is 1 in 15. Let's further assume that the chance of going bust in a 'good' year is 1 in 45. Because there are an equal number of 'good' years and 'bad' years the average chance of going bust when any year is picked at random, with no knowledge as to whether that year is good or bad, is 1 in 30. Spookily similar to a finance institution with a BBB rating!
So when you see a BBB rating applied to a finance institution like this, what is the chance that in any particular year the chance of going bust is 1 in 30? There is actually no chance at all that this will happen! But that doesn't mean the 1 in 30 year risk ratio when applied to this particular financial organization is wrong.
SNOOPY