From today’s Wall Street Journal

 

This article was published by the Wall Street Journal on September 17, 2009

By LESLIE SCISM and AARON LUCCHETTI

Regulators of some of the biggest bond buyers in the world are considering cutting credit-ratings firms’ role in the market in response to botched ratings of complicated mortgage securities.

Ratings firms including Standard & Poor’s and Moody’s Investors Service are facing fresh dissent from state insurance regulators, who are considering moving away from the firms ratings’ as a way of measuring the health of insurer portfolios of mortgage-backed bonds.

The firms originally assigned high ratings to the securities in the middle of the decade, but they were found to be far less stable when housing prices began declining in 2007.

The move is a notable challenge to a ratings system that has long embedded itself in the markets. Insurers are among the most important users of bond ratings, collectively holding some $3 trillion in rated bonds in their portfolios.

The regulators’ moves are at a preliminary stage, but could change how state regulators gauge the quality of the investments backing insurers’ policies. Currently they use the major ratings firms recognized by the Securities and Exchange Commission.

Insurance regulators are considering whether to substitute analysis from other financial firms with expertise in valuing the securities, officials say. The effects of such a change could trickle throughout the world of bond investing, given insurers’ outsize role in the bond markets.

“We just need to take stock of this reliance on a system that allows that kind of shock,” in the form of swift and severe downgrades, “and frankly evaluate if there are other alternatives,” said New York Insurance Department Deputy Superintendent Hampton Finer in an interview. Amid criticism of ratings agencies, he added, “we’re under quite a bit of pressure to respond.”

Representatives from S&P, a unit of McGraw-Hill Cos., and Fimalac SA’s Fitch Ratings declined to comment on the insurance regulators’ plans. Moody’s, a unit of Moody’s Corp., declined to comment on the plans as well.

The National Association of Insurance Commissioners is scheduled to hold hearings on the matter next week in National Harbor, Md.

The challenge from insurance regulators reflects the relentless criticism directed at ratings firms since the credit crisis began in 2007. The firms have been criticized as being too conflicted or too slow to recognize the risks in billions of bonds they rated as relatively safe.

Just this month, the ratings agencies suffered a setback in one part of a civil lawsuit, in which a U.S. District Court rejected some raters’ argument that ratings were protected from lawsuits by the First Amendment.

Moody’s, which is the largest public company devoted mainly to ratings, also has had one of its largest shareholders, Warren Buffett’s Berkshire Hathaway Inc., sell down his ownership stake. And various congressional bills have been proposed that could further dent the companies’ long-held monopoly on ratings.

Insurers have a lot riding on the outcome of the debate. Life insurers are big owners of mortgage-backed securities, which represent about 8.5% of insurers’ portfolios, according to A.M. Best Co. U.S. life insurers had to ante up a total of $2 billion in capital in 2008 to back up residential mortgage-backed securities to satisfy regulators seeking assurance companies have enough money to pay claims, the American Council of Life Insurers said. As of June 30, the insurers were facing a year-end bill of $11 billion to back up such securities, the trade group said.

Under the current capital guidelines insurers use nationally, the lower the ratings on bonds owned by insurers, the more capital they generally have to set aside to satisfy regulators.

Separate from this hearing on the ratings firms, another group of commissioners is addressing the possibility of regulatory changes that would ease the burden of coming up with capital to meet existing capital guidelines, insurance executives said.

Regulators say they have no plans now to move away from the leading agencies for corporate and other bonds considered less-difficult to rate.

The regulators’ action could subject them to criticism from consumer-advocacy groups that they are bending over backward to help insurers look good on paper, at the possible expense of policy holders. Mr. Finer said regulators aim to move cautiously.

Regulators want to “formulate a thoughtful approach that first and foremost assures consumer protection,” said Michael McRaith, director of the Illinois Department of Insurance.

Regulators say they don’t have a specific vision of an alternative, but one possibility would be to use the services of firms such as BlackRock Inc., the asset manager, or RiskMetrics Group, the research firm, regulators say.

BlackRock has developed an expertise in valuing bonds through its BlackRock Solutions unit, which has done work managing portfolios for the Federal Reserve Bank of New York during the credit crisis. BlackRock declined to comment and a spokeswoman for RiskMetrics had no comment.

Still, it isn’t clear whether other firms would have the interest or capability to deliver the kind of analytical services regulators would require for the variety of mortgage-backed securities held across hundreds of insurance companies.

Also unclear is how any service would be paid for. Currently, bond issuers — in the case of mortgage securities, typically banks — pay the ratings firms for ratings, which are then publicly available.

In a new scenario, one option might be the National Association of Insurance Commissioners paying for the additional analysis, a cost the NAIC could pass on to insurers in the form of fees. Or the issuers could pay for the extra analysis.

Write to Leslie Scism at leslie.scism@wsj.com and Aaron Lucchetti at aaron.lucchetti@wsj.com

Printed in The Wall Street Journal, page M1