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 the10-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 U.S. 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.