Insurance regulators looking to redefine bond-rating process

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Standard & Poor's, Moody's (MCO) and Fitch will likely loose their stranglehold on bond ratings now that the National Association of Insurance Commissions has added its voice to the growing call for an end to the ratings agencies' oligopoly over bond ratings.

The ratings agencies lost their favored position when they failed to expose the risks investors were taking with the purchases of complicated mortgage securities.

The NAIC has gotten involved because insurers are among the most important users of bond ratings. They collectively hold $3 trillion in rated bonds and most states require a certain level of rating from one of the bond rating agencies to determine the health of an insurer's portfolio.

But the NAIC will be holding hearings next week to determine whether that method of measuring an insurer's health still works, now that the ratings agencies failed so miserably with the assessment of mortgage-backed securities. Numerous studies have shown the agencies often cut corners and failed to recognize conflicts of interest.

In fact, in a 2008 SEC report one agency employee's message showed how incestuous the process for ratings had become with this message sent internally, "[We] are meeting with your group this week to discuss adjusting criteria for rating CDOs of real estate assets this week because of the ongoing threat of losing deals."

Clearly, making money was at the top of the list of credit rating agencies, not their public role of adequately rating bond issues to protect investors planning to buy those bond issues. Australian Prime Minister Kevin Rudd summed it up well in the Monthly when he wrote, "Dependent as they were on the banks for their revenue, the agencies were hopelessly conflicted by the lure of big profits in return for easy ratings."

Now the NAIC is looking at alternatives to ratings from other financial firms with expertise in valuing securities. Regulators haven't picked any alternatives but research firms such as BlackRock and RiskMetrics are on the list, regulators told The Wall Street Journal. BlackRock values bonds through its BlackRock Solutions unit, which manages portfolios for the Federal Reserve.

While no one knows what the ratings game will look like in the future, the one thing we can be sure of is that there will be a major change. Some key moves toward that change can be seen in recent actions:

* A federal judge refused to accept the First Amendment defense offered as protection by S&P and Moody's as they try to defend themselves by hiding behind that amendment.

* The SEC is considering new rules for credit-rating companies after lawmakers faulted Moody's, S&P and Fitch for assigning mortgage bonds their highest AAA rankings and maintaining those grades after the underlying loans began defaulting in 2007. The SEC proposals include forcing banks selling securities to disclose any ratings received while shopping among credit-rating companies. Investors would then have information that might show a competing ratings firm thought there was a greater risk of default.

* The Australian Securities and Investments Commission is considering removing a loophole that saved ratings agencies from being held liable for ratings used in product disclosure statements. Beginning January 1 ratings agencies will need to get an Australian Financial Services License.

The winds of change for the ratings agencies are blowing strongly. They likely will find they can no longer operate as money-making machines with no regulatory supervision. The old days of putting money-making before the interests of the investors they serve will soon be gone. Even Warren Buffett sees the writing on the wall as he reduces his stake in Moody's.

I say good riddance to the agencies. We need to restructure the entire bond rating system into one that will no longer allow a small group of people to get rich while everyone else takes major financial losses.

Lita Epstein has written more than 25 books including Reading Financial Reports for Dummies.

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