Regulators Consider Reducing Reliance On Rating Agencies

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This morning, I read an article that warmed my heart. It looks like at least some regulators are beginning to realize that relying on a government-enforced oligopoly of rating agencies might not be particularly good for investors. The Wall Street Journal reports that when bond insurers are involved in mortgage-backed securities transactions, financial firms with valuation expertise might be looked to rather than the rating agencies. Sounds like a great idea to me.

Let me provide a little background. Some bond deals, such as mortgage- or asset-backed securities (MBS/ABS), need a little extra protection in order to achieve higher ratings. One option is to turn to bond insurers. Such firms obtain a fee for providing a guarantee on the bonds issued. So if the underlying collateral (mortgages, credit cards, or whatever else) sustains significant losses, the bond insurer covers those losses so that investors keep getting paid.

The problem, however, is that some of these bond insurers, just like almost everyone else, made some poor assumptions about the bonds they were guaranteeing. During the housing bubble, they were forced to cover losses far greater than they anticipated on the securities they were obligated to protect. That caused the ratings of these insurers to be largely downgraded. As a result, the securities they guaranteed were deemed far riskier than people had originally thought: the firms hired to protect them might not be able to afford to. Eventually, this bond insurance became seen as virtually useless by investors.

And this highlighted yet another error in the judgment of the rating agencies. They first made a mistake in giving many bonds, like MBS, ratings that were too high. But they also were mistaken in thinking that the health of the bond insurers involved in many of these transactions could withstand what the market had in store for real estate. That's where today's news comes in.

Here's some detail, from the WSJ:

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."

So just who would be doing this work instead? The WSJ notes a few possibilities:

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.

I think this is a step in the right direction. Regulators need to wean investors off of the rating agencies. This might serve as a good first step. As I've argued before, they should continue to do so. Bonds could also be evaluated by financial research firms or the investors themselves much like stocks are given buy, hold and sell ratings or price targets by equity research analysts. Given the technology available today to analyze even complex bond deals, there's no reason investors should have to rely on a couple of rating agencies.

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Daniel Indiviglio was an associate editor at The Atlantic from 2009 through 2011. He is now the Washington, D.C.-based columnist for Reuters Breakingviews. He is also a 2011 Robert Novak Journalism Fellow through the Phillips Foundation. More

Indiviglio has also written for Forbes. Prior to becoming a journalist, he spent several years working as an investment banker and a consultant.
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