Insurance Regulators Want the Fox to Watch the Chicken Coop

It's no secret that insurance companies, and the state regulators that watch them, are dissatisfied with the performance of the three credit rating agencies. The three: Standard & Poor's, Moody's Investors Service and Fitch Ratings, rated many toxic mortgage bonds Triple A (the top rating) and then, in 2008, downgraded them to junk.

Both moves not only showed ineptitude, but also left insurers with much less capital to put against their obligations to policyholders. Arguably, the rush of rating downgrades after the collapse of Lehman Brothers led to the disaster at American International Group's Financial Products unit, and the $182 billion federal bailout.

Regulators, who are represented by the National Association of Insurance Commissioners (also known as the NAIC), do not take kindly to this. Their first obligation is to make sure insurers have enough in the bank to pay off policyholders. When they don't, everyone looks bad, especially state elected officials, who are sometimes the insurance commissioners themselves.

The credit raters were called in for a well-deserved whipping at a hearing last month. But that doesn't appear to be the end of it. The NAIC appears to be looking at others who can rate these mortgage securities, effectively taking the business away from the rating agencies.

That would be a serious blow to the credit agencies. They earn their bread and butter from people who come to them to get their bonds rated. It's also the flaw in their model; they get paid by the same people they are evaluating, so they have every reason to make them look good.
The Wall Street Journal reports that the NAIC is considering Blackrock Inc., one of Wall Street's biggest money management firms, to rate the mortgage bonds in insurers' proposals. But, as they say in the singles' bars, nobody's perfect. Blackrock is the company that virtually invented the mortgage-backed securities market. Wikipedia calls Blackrock "the pioneer" of the industry. In other words, Blackrock was the one that sold us the toxic stuff in first place and made lots of money doing it. Now, after a Wall Street crash and a recession, Blackrock is going to make even more money helping to evaluate what's left in the junk pile.

Yes, that's a simplistic analysis. And, for the record, Blackrock has been hired by the New York Federal Reserve to help handle AIG's mortgage mess. What could be a better endorsement than that?

But in a situation such as this one, you always need to sniff out the game inside the game. No one has yet said exactly how the "Blackstone model" will work. Who pays Blackstone and for what? If it is the insurers, there's another imbedded conflict. Life insurers would like nothing better than to have their mortgage bond portfolios upgraded. That means they would have to keep less capital in reserve against their obligations.

So who's going to watch the henhouse, and how many eggs will be left when they're done? The NAIC had better answer that question correctly.