Eliminating the Rating Agencies

Yes, I’m the same guy that wrote the series that culminated with In Defense of the Rating Agencies – V (summary, and hopefully final).  But I’ve heard enough unintelligent kvetching about the rating agencies, post Dodd-Frank.  You would think that some of them would realize there is something more fundamental going on here, but no, they don’t get the fact that the regulators have outsourced the credit risk function to the rating agencies, and that is the main factor driving the problem.  Okay, so let me give you a simple way to manage credit risk without having rating agencies, even if it is draconian.

Let’s go back to first principles.  As a wise British actuary said, “Risk premiums must be taken as earned, and never capitalized,” even so should regulatory accounting aim itself.

In general, earning Treasury rates is a reliable benchmark for an insurance company.  Match assets and liabilities, and never assume that you can earn more than Treasury yields.

But what if we turned that into a regulation?  Take every fixed income instrument, and chop it in two.  Take the bond, and calculate the price as if it had a Treasury coupon.  Then take the difference between that price and the actual price, and put it up as required capital.

I can hear the screams already.  “Bring back the rating agencies!”  But my proposal would eliminate the rating agencies.  All yields above treasury yields are speculative, and should be reserved against loss.  If the whole industry were forced to do this, the main effect would be to raise the costs of financial services.  It would be a level playing field.  Insurance premiums would rise, and banks would charge for checking accounts.

Such a proposal, if adopted, would simplify life for regulators, reduce risk for most financial companies, and lead to higher costs for consumers.  That’s why it will not be adopted, easy as it would be to use.

About David Merkel 144 Articles

Affiliation: Finacorp Securities

David J. Merkel, CFA, FSA — From 2003-2007, I was a leading commentator at the excellent investment website RealMoney.com (http://www.RealMoney.com). Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and now I write 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 still contribute to RealMoney, but I have 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 one year of operation, I believe I have achieved that.

In 2008, I became the Chief Economist and Director of Research of Finacorp Securities. 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.

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.

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.

Visit: The Aleph Blog

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