(no subject)

[blorky.livejournal.com]

So here's my solution to solving the excesses of a banking industry that's managed to dump us in the shitpit of financial 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 give it a rating just 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.

OK, Friday afternoon fans - 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.

[edited to fix some typos]

Comments

[gunslnger.livejournal.com]

After 2 seconds of non-consideration, it sounds ok. :)

[blorky.livejournal.com]

Heh - and here I was braced for your disagreement on some grounds I haven't thought of yet.

Cheers.

[gunslnger.livejournal.com]

I don't have time to figure out the problems with it right now, sorry. :)

[jonathankorman.livejournal.com]

Another occasion on which we get to happily agree.

[gunslnger.livejournal.com]

That's a bad sign. If you like it, there must be something wrong with it. ;)

[rasilio.livejournal.com]

Yeah, that's my initial thought.

It looks good one the surface, I might change my opinion after deep reflection on it but it is not the sort of thing that makes me think Oh hell no.

[peristaltor.livejournal.com]

Yes, removing the conflict of interest would help ratings immensely, but what about that Giant Pool of Money the size of which completely overwhelms the pool of available assets on which it should be based?

Ratings are only the tip of the poop-berg.

[blorky.livejournal.com]

Well, to some extent, the giant pool of money only exists because people are being convinced that they're based on legitimate assets due to the rating they receive.

[peristaltor.livejournal.com]

No. Money must be created by lending before it can be invested in assets. Extremely popular assets might be valued at a small amount of money or a gargantuan; all depends upon the amount of money available for asset purchasing.

Of course, if people foolishly borrow to invest (as they did during the housing bubble and, I suspect, during every bubble in history), then yes, money will be created based on fallacious ratings, but the bubble must first be inflated a bit by extra cash gravitating to the pre-bubble assets, and that takes bank action.

I have a theory (http://peristaltor.livejournal.com/183181.html) as to why there seems to be so much money since the repeal of Glass-Steagall, but have no way to investigate it, let alone verify it.

[blorky.livejournal.com]

Well, the money that was created directly off mortgages was a medium size pool of money. The really Big Pool of Money was in the CDO's and CDS's that were derived from that. In other words, if CDO's/CDS's didn't exist, there wouldn't have been the compelling interest for banks to make the bad loans, because they wouldn't have been able to pass along the risk. There was *some* pricing bubble, but the real increases came when badly rated CDO/CDS instruments created a demand for mortgages regardless of quality.

Lewis's "The Big Short" describes this in detail, as does the NPR Magnestar investigations.

[peristaltor.livejournal.com]

Yes, the NPR Magnestar was pretty in depth. Yves Smith also covered Magnestar — and added detail — in her book EConned. Lewis is on the library list.

Remember, though, that Magnestar took advantage of investors who had gotten used to these assets always appreciating. What no one has bothered to explain is how the money that became available for cheap mortgages was created in the first place. Adam Davidson completely missed that in the first NPR/TAL collaboration, "The Giant Pool of Money," saying that the money came from the US selling stuff. I'm sorry, it doesn't matter how much stuff you sell, you cannot increase the money supply that way.

And what no one has yet explained is how the money supply drastically increased after 1999's Gramm-Leach-Bliley Act. The theory to which I linked (done in non-graphic form here (http://peristaltor.livejournal.com/178555.html), if you're into the longer read) offers one possibility.

I do acknowledge that, yes, it is only a theory.

[blorky.livejournal.com]

Both of those questions are answered pretty comprehensively in Lewis's book. "All the Devils are Here" is also useful reading.

[peristaltor.livejournal.com]

Just finished The Big Short. Yes, Lewis does a great job describing why the CDSs and synthetic CDOs were created, but like Yves Smith, he misses the process that actually creates the initial money used to purchase those instruments. Add to that list the authors of This Time is Different.

Some of that CDS money came, of course, from the investment characters that shorted the market in Short (Burry, Lippmann, Eisman, Cornwall, etc.), meaning it was pre-existing money.

Smith was also an investment banker. In EConned, she writes:

Banks hold deposits and pay interest on them. Depositors have the right to demand their funds at any time, but through experience, banks know that only a small percent of the funds they hold in trust will be withdrawn on any given day, and even that might be matched or exceeded by a new inflows. Thus banks, to earn additional profit, lend out a portion of their deposits, typically $9 for every $10, at a higher interest rate than they pay to their depositors.

This is incorrect. The money she claims is a portion of the deposits is actually newly created money. Without this money creation, there would be no increase in the amount of money in circulation, and therefore no money to pay out in depositor interest and shareholder return.

As an investment banker she, like Lewis, probably had no reason to understand money creation through lending, and thus accepted the commonly held mis-perception she describes above. In fact, many working inside commercial lending banks probably have no need to understand the fractional reserve lending system. Only a few at the top need to know. Sadly, therefore, Lewis's book does not disprove my theory.

I'll put Devils on the list as well. Thanks.

[rick-day.livejournal.com]

I agree with everyone else.

Except I have no idea what you are suggesting. But that's OK, I'm free marketing my ass off tonight :)

[artkouros.livejournal.com]

What we really need is a ratings agency to rate the rating agencies. Then, the headline would be "S&P, a ratings agency with a BB- rating, today increased conglomerated real estate holdings certificates to AAA+".

[gunslnger.livejournal.com]

It's turtles all the way down.