Saturday, June 2, 2012

Make Rating Agencies into Insurance Agencies

I just watched this video interview between Paul Krugman & Charles Stross.  An interesting issue that Krugman brought up concerned how the change in Intellectual Property (i.e. the increasing difficulty of protecting one's IP) changed the rating agencies' monetization strategies and ended up contributing to the financial crisis. Specifically Krugman argues that because no one was buying their books anymore the rating agencies switched to a monetization strategy where the issuer of the security paid for the rating.  The obvious conflict of interest (and the shopping around by the issuer for a better recommendation) caused junk securities to get rated as triple A.  Krugman bemoans the question of how this is every going to get fixed.  I suggest that the fix is fairly obvious and centuries old: insurance.

Suppose that the ratings agencies were also security insurance agencies.  As a customer buying a security you would buy an insurance policy from the agency who also rated the risk of that security.  Under that scenario, the insurance / rating agency has every incentive in the world to judge the value of security assets accurately (and refuse to insure incomprehensible derivatives for example) as they would stand to lose considerable money if they judge the security incorrectly and make maximal profits by calling it right.

The question is, how might one convert the financial industry -- and by this I don't mean Wall Street, but rather collection of all fund managers around the world -- to buy these insurance policies.

One: The insurance product has to exist.  If the rating agencies see themselves going out of business then it's time that they start converting themselves into insurance companies or insurance companies need to get into the ratings business.  Market opportunity!

Two: Regulation / Information.  Start bottom-up.  If fund holders -- for example, retirement account holders (i.e. everyone) -- got a big fat health warning on their yearly statements that said something like: "WARNING: Your retirement savings are un-insured.  The Finance General of the United States suggests you consider moving your funds to an insured policy.  Talk to your account manager about your options." Then suddenly you'd find a lot of pressure to create these policies.  One might also consider a top-down approach where funds over a certain size or containing more than X% of retirement funds are required to carry insurance.