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Archive for November 8th, 2012

Eliminating the Rating Agencies, Part 2

Thursday, November 8th, 2012

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.

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.

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.

Disclaimer


David Merkel is an investment professional, and like every investment professional, he makes mistakes. David encourages you to do your own independent "due diligence" on any idea that he talks about, because he could be wrong. Nothing written here, at RealMoney, Wall Street All-Stars, or anywhere else David may write is an invitation to buy or sell any particular security; at most, David is handing out educated guesses as to what the markets may do. David is fond of saying, "The markets always find a new way to make a fool out of you," and so he encourages caution in investing. Risk control wins the game in the long run, not bold moves. Even the best strategies of the past fail, sometimes spectacularly, when you least expect it. David is not immune to that, so please understand that any past success of his will be probably be followed by failures.


Also, though David runs Aleph Investments, LLC, this blog is not a part of that business. This blog exists to educate investors, and give something back. It is not intended as advertisement for Aleph Investments; David is not soliciting business through it. When David, or a client of David's has an interest in a security mentioned, full disclosure will be given, as has been past practice for all that David does on the web. Disclosure is the breakfast of champions.


Additionally, David may occasionally write about accounting, actuarial, insurance, and tax topics, but nothing written here, at RealMoney, or anywhere else is meant to be formal "advice" in those areas. Consult a reputable professional in those areas to get personal, tailored advice that meets the specialized needs that David can have no knowledge of.

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