How We Can Eliminate the Rating Agencies

After writing Eliminating the Rating Agencies, I felt there was room for improvement. Part of that stems from reading critiques of the rating agencies that really don’t understand why ratings exist.  Ratings don’t exist to help average people, they exist to allow regulators to evaluate the credit risks of financial institutions.

How We Can Eliminate the Rating Agencies

The beauty of my prior proposal is that it can be applied to any credit instrument, even private placements for which there is no market.  Let me give an example.  In mid-2002 with the ten-year Treasury yielding 4.5% an investment banker approached me with a private bond deal — $50 million in total to finance the owner of real estate where the US Government had old computers that would be difficult to do away with.  The yield offered was 8% for 10 years, and S&P shadow-rated it “A.”  We bought 20% of the deal.  We were the biggest holder at $10 million.

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Following my procedure in the prior article, the amount of capital that would have to be put up would be almost $2.2 million.  Now, that is likely too severe, but maybe the regulators would choose a percentage of that amount as the right amount for all fixed income securities.  Other securities that are not hedges would be considered deductions from capital.

Is the bond illiquid?  More spread -> more capital required.  The beauty of this system is that it does not care where the excess spread is coming from.  It just measures the present value of the uncertain spread, and realizes that it is a very good proxy for credit risk.  It can be applied to any bond, preferred stock, etc. fairly easily.

There would have to an additional analysis for asset-liability mismatch, but existing methods for measuring that are adequate.  In any case, the rating agencies would no longer be needed for measuring credit risk.  Regulators would simply review the calculations of the actuaries/quants, as they file their annual/quarterly statements.  The value of the uncertain portion of the fixed income assets would be the proxy for the total credit risk of the firm.  No rating agency needed to calculate that.

By: alephblog

 

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.