Editors' Cuts

Rating Agencies Revolt?

Bill Kenealy
Insurance Experts' Forum, July 23, 2010

Well, that didn’t take long.

With the ink on President Obama’s signature on the Dodd-Frank bill still wet, the first repercussions of the landmark are becoming evident in the bond market.

Yesterday, the Wall Street Journal reported that a little-discussed provision in the broad-gauge legislation is having a major impact as the three major rating agencies are refusing to allow their ratings to be used in documentation for new bond sales.

A.M. Best will not consent to the use of its ratings in registration statements and related prospectuses,” the Oldwick, N.J. company said in a statement.

Dodd-Frank rescinded Securities and Exchange Commission Rule 436(g), which spared credit-rating agencies the indignity of being from being treated as “experts” under the U.S. Securities Act. Why would rating agencies want to return their amateur status? To stay out of court. With the safe harbor provisions afforded under 436 (g) in place, agencies were able to give their imprimatur with relative impunity. In its absence, rating agencies fear they can be hauled into court by aggrieved investors.

Yet, with the role of triple-A rated toxic assets in the financial crisis still fresh, many say the rescission of 436(g) is long overdue. Writing in BNET, financial blogger Alain Sherter summed it up.

"The raters have exploited this safe harbor for years,” Sherter wrote. “It allows them to pose as experts, like a doctor prescribing medicine (take a “AAA” rating and call me in the morning), without accepting full legal responsibility for their services. Critics have long pressed the SEC to drop 436(g), and — kudos to Congress and the SEC — it’s finally happened."

In the wake of the bill becoming law, rating agencies issued a flurry of statements explicating their newfound recalcitrance, noting that in addition to greater legal exposure, the law will hamper their ability to elicit certain information of a material, non-public nature from issuers. Indeed, considering the centrality of the rating agencies to the debt issuing process, this impasse has the potential to significantly alter the availability of bonds, a staple of insurers’ investment portfolios.

Not surprisingly, given their exposures, the agencies are now professing caution.

“A.M. Best is carefully examining its current practices in light of the new requirements in the Act and will explore ways to ensure that it can fully meet the needs of the marketplace while effectively mitigating its risks under the new law,” the company said. “If necessary, A.M. Best will take additional steps to mitigate any potential risks associated with the new law.”

Insurers now need hope that the agencies’ efforts at risk mitigation don’t undermine their own.

Bill Kenealy is a senior editor with Insurance Networking News.

Readers are encouraged to respond to Bill by using the “Add Your Comments” box below. He can also be reached at william.kenealy@sourcemedia.com.

This blog was exclusively written for Insurance Networking News. It may not be reposted or reused without permission from Insurance Networking News.

The opinions of bloggers on www.insurancenetworking.com do not necessarily reflect those of Insurance Networking News.

Comments (4)

Thanks for the feedback. I think Peter makes a very salient point that for some ratings became a substitute for diligence on the part of investors.

Given their role in the meltdown, I am still somewhat amazed that the rating agencies managed to make through it through regulatory reform unscathed. I'm not sure if the defeated Franken Amendment, which would have created Credit Rating Agency Board to assign raters to issuers at random, was the way to
go, but there has to be some way to eliminate the inherent conflict of interest between the agencies and the issuers who pay them.

One interesting approach I heard is to drop the mandate that banks and insurers only invest in investment grade debt instruments. The idea behind
this is that with their customers not longer obligated to buy their products, ratings agencies would be forced to offer more honest assessments.

Bill Kenealy

Posted by: william.kenealy | July 29, 2010 12:33 PM

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It's always bothered me that rating agencies would publish an opinion based on financial data that is
18-24 months out of date by the time it becomes public. Insurers must want to know where they stand
on a monthly basis. Guaranteed profits are not a realistic expectation, yet reliance on the quality rating of a particular investment should not be an
exercise in open speculation, after all, who has the
experience, and resources to properly investigate each
issue independently?

Mister Insurance Broker, CA

Posted by: Tony V. | July 23, 2010 6:26 PM

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Ed does make some credible points. Missing in the general news reporting however, is a basic understanding of ratings. I was taught that ratings were a guide at best and should be seen as a snapshot of a credit at a point in time. After all, today's AAA is tomorrow's BBB, if you see that logic. Said another way, take a look at the AAA credits from the 60s and 70s. Where are they today? But I generally agree with the rating agencies today because there is no substitute for an investors internal credit analysis together with the fact that I remain unable to find a section of the U.S. Constitution which guarantees investments shall always be good. The investor MUST take responsibility for monitoring their portfolios. Lazy portfolio managers relied too heavily on ratings and in some cases have paid the price. Also, almost all State regulations require a "minimum" rating for investments made by state entities, giving ratings greater credibility than they deserve. And so it goes. Dodd and Frank should be chastized for practing law making without the necessary intellectual foundation to engage in that practice.

Posted by: omaha | July 23, 2010 3:13 PM

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Absolutely ridiculous behavior on the part of the rating agencies. But even before the new regs, many large enterprises have been increasingly foregoing rating agency opinions in favor of internal research and due diligence that is much more comprehensive and reliable than rating agency product. That trend will continue.

Given their history of poor performance, the marketplace is ripe for competition in the rating arena. This knee jerk reaction by the big agencies simply accelerates that process.

Edward Kalbaugh,
President & CEO, Allegent Advisors

Posted by: Edward Kalbaugh | July 23, 2010 12:52 PM

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