Credit rating firms could be losing more business

Payback can be a pain, and credit-rating firms may soon be paying in spades for missing the warning signs that led to the financial meltdown. Thursday's Wall Street Journal reported that the National Association of Insurance Commissioners (NAIC) may award bond analysis work on residential mortgage-backed assets to BlackRock (BLK), rather than depend on major credit rating firms. In a related story, the Journal reported that the Fed announced it would open the door to more credit raters for its Term Asset-Backed Securities Loan Facility (TALF).

It appears that regulators want to break the choke hold the credit-rating agencies and Wall Street investment banks have on determining the value of assets to be traded. Insurance regulators want to change the game by improving the methods used to value portfolios held by insurance companies. Any changes they implement will have an impact on the value of assets that pension funds and other investors hold. But beyond that, investors should welcome anything the insurance regulators and the Fed can do to increase the scrutiny of credit ratings.

If the NAIC decides to move its ratings work to BlackRock, that would be a major power shift away from credit-rating agencies and Wall Street. The work that the NAIC wants to contract out entails analyzing risk in bonds backed by residential mortgages that are held by insurers. Before the real estate market collapsed, insurers were buying AAA mortgage bonds, but they quickly found themselves with securities that had been rapidly downgraded to junk because of the many signs of trouble that the credit-rating agencies missed in their initial ratings. The NAIC grew disappointed with the work of the ratings agencies and is now seeking alternatives for rating portfolios held by insurers.

In response, Wall Street investment banks have created so-called re-remics (short for "resecuritization of real estate mortgage investment conduits"), which unwind complicated collaterallized debt obligations (CDOs), combinations of securities that often include mortgage-backed securities. These re-remics, rated by the very same credit agencies that rated the original securities, try to break out the well-performing mortgage-backed assets from the poor performers to create new tradable assets. While the NAIC likes the idea of unwinding CDOs, the regulators aren't convinced they trust the credit rating agencies to handle re-remics. They also balk at the high fees the agencies are charging for rating these re-remics.

In the past, insurance regulators have relied on ratings agencies to determine how much capital insurers needed to keep in reserve to back up their bond holdings. After the meltdown, the NAIC started investigating the problem, and at a recent hearing investment pros and even the ratings firms said insurance regulators shouldn't rely on the residential mortgage-bond ratings as heavily as they do.

What could the new contract be worth to BlackRock and any other firms chosen for the work? That price tag hasn't been set, but insurers are among the nation's largest bond consumers, holding $3 trillion in bonds. Based on industry figures, they own more than 18,000 different residential-mortgage bonds, which total more than $366 billion.

Insurers believe that the ratings downgrades overstate the problems in many of their bonds, because the ratings don't distinguish the size of the possible loss. They hope that by hiring an analytical firm to estimate potential losses, their year-end capital reserving bill will shrink.

The NAIC isn't considering just BlackRock for the work. Insurance regulators also talked to Pimco Advisory, Promontory Financial Group and Andrew Davidson & Co. All have extensive experience in analyzing complex financial instruments.

The proposal now under consideration by the NAIC, which will likely vote on it next week, would entail awarding a contract for valuing insurers' portfolios, estimating losses and possibly working to unwind some of the complicated CDOs. That work would then be used to set backup capital amounts insurers need to hold. Insurers would pay the required fees.

This type of work wouldn't be new to BlackRock, which won contracts to help the government assess complex securities at collapsed Bear Stearns, at nearly collapsed American International Group Inc., and at mortgage giants Fannie Mae and Freddie Mac. It's also one of the fund managers in the Treasury Department's Public Private Investment Program.

While the NAIC contract is aimed primarily at assessing insurers' portfolios, it comes with a side benefit for all investors: It would open the door to more competition in the credit-rating business. And the need for that is one of the many things the financial meltdown has made abundantly clear.

Lita Epstein has written more than 25 books including Reading Financial Reports for Dummies and The Complete idiot's Guide to Value Investing.

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