Aug. 19th, 2011

blorky: (Omar coming!)
So here's my solution to solving the excesses of a banking industry that's managed to dump us in the shitpit of finanical crashes on a regular basis:

Drop nearly all regulation on financial instruments other than a simple one on the ratings agencies. When S&P/Fitch/Moody's issues a rating, they're paid a base fee that's up to them, but they are obliged to take on some portion of the credit default swap related to that instrument. The amount of that portion is progressive based on the actual rating. In other words, if they give something an AAA rating, they're obliged to take on, let's make up a number, a CDS for .07% of the instrument value. If they give something a CA rating, they're obliged to take on .002% of the instrument value. That way, the income stream from the policy on AAA offsets the tiny expenses of having to cover their portion of CA instruments that go belly up. For bank and institution ratings, the fee would similarly be based off a CDS off the bonds those institutions issue.

The advantage to this is that it is as close as we'll get to the ideal state that free market advocates purport to desire - that risks are clearly understood, with consequences that enforce best information/best practices. If you rate shit as gold, the expenses when your AAA CDO fails will eat you up. If you become overly conservative, you'll eke out a living getting tiny income streams from AAA quality instruments that you rated as CA. Here's the important part: If you have no way of determining the quality of the instrument that an investment bank has brought you, **YOU DON'T ISSUE THE RATING**. In other words, if you have skin in the game, you won't just take the word of anybody who says "yeah, this stuff is pure gold.". If the quality of the information about the assets which back the instrument is so opaque that your models can't reliably issue a value judgment about it's likely outcome, you don't just give it a rating because you get the base fee.

There's a potential argument that this would go too far towards reducing the overall risk in the market and drive out people who want to pursue high risk/high reward strategies. I really doubt it. There would still be institutions that put together batches of NINA loans. It would get rated as shit, and if people wanted to buy it, at least they'd know what they were buying. If this method actually drove high risk instruments out of circulation, then the reason is that the market has spoken. What's the value of something nobody wants to buy? I've got a buddy who's an expert in shit nobody wants to buy. Let me call him over and we can see what it's worth. Turns out: nothing.

Other than the banking industry simply not wanting any regulation that would force them to act as a non-sociopathic member of society, what's the downside? This one regulation, this one method, akin to "don't put radium in the baby food", implements what the banking industry and libertarian free marketers purport to want - the market enforcing the consequences of bad decisions.


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