NU Online News Service, Sept. 25, 1:35 p.m. EDT

NATIONAL HARBOR, MD-The nation's insurance regulators after a hearing examining the flawed performance of the rating agencies left unresolved what their next move will be.

The session was held at the Fall National Meeting of the National Association of Insurance Commissioners which employs rating agency evaluations to determine insurers' risk-based capital requirements.

During the proceedings the regulators discussed whether rating agencies' failures leading up to the nation's credit crisis were caused by conflicts of interest related to the agencies' for-profit business model or misunderstanding the risks associated with the structured securities they were rating.

Commissioners at the NAIC's Rating Agency Insurance Working Group, agreed their level of reliance on rating agencies needs to be re-examined, but left unclear what alternatives might emerge.

Plans for the NAIC to take on rating responsibilities itself remain on the table, though Chris Evangel, managing director of the NAIC Securities Valuation Office cited in testimony some logistical difficulties with that strategy.

Still, commissioners said for now, every option will be considered. "We owe it to consumers to be thoughtful and deliberate," Connecticut Commissioner Tom Sullivan said.

As for where rating agencies went wrong in the credit crisis, commissioners disagreed.

The rating agencies themselves admitted they erred in rating residential mortgage backed securities, but said that was the exception to a long history of success.

Agency representatives said they have taken steps in the areas of governance, compliance, and an institutional rotation of analysts to guard against future failures. They also charged that the information they provide has been misused, or even used with a degree of naivety, by those who had come to rely on their services.

Jerome Fons, principal with Fons Risk Solutions, a New York-based credit risk consulting firm who is also a former employee of Moody's, suggested in testimony that the rating agencies' for-profit model creates a conflict of interest that contributed to the current crisis. He said rating agencies "traded their reputation for profits."

David Marks, executive vice president and chief investment officer of Madison, Wis.-based CUNA mutual group said he does not believe it was the for-profit model, but rather a lack of understanding of the types of structured securities being rated that created the rating agencies' missteps.

Commissioners were divided. Commissioner Sullivan said he sees inherent conflicts in how rating agencies operate and said the for-profit model, combined with the pressure within rating agencies to be the first to upgrade and first to downgrade, creates a "conflicted model" that has evolved over time and cannot be changed overnight.

"While I hear what rating agencies are saying about governance and compliance and all those other nice things, until you change the structural underpinnings of how they operate, I don't think you can fundamentally change how they rate," he said.

He also challenged the notion that regulators have misused the ratings, accusing the rating agencies of "double talk."

"On the one hand, they're saying you shouldn't rely so heavily on us, and then on the other hand they're saying, 'we've been around for decades and our reputation is everything to us.' That to me is a little bit of double-talk," said Mr. Sullivan

New York Insurance Superintendent James Wrynn, co-chair of the Rating Agency Working Group, attributed rating agencies' failures more to misunderstanding what it was they were rating.

He said regulators will look at the issuer pay model of the rating agencies, "but I wouldn't say that was the primary cause of the problem. I think it's more the nature and combination of factors that converged at once."

Superintendent Wrynn noted the "inability to see what was going on with the underlying assets of these structured securities."

Regarding future use of rating agencies, he said he still sees them as a tool, just not the only tool. "There really wasn't an issue with the rating agencies until 2000," when issues such as Worldcom arose, Superintendent Wrynn said. The telecommunications giant went bankrupt after an accounting scandal.

Mr. Wrynn said that rating agencies will have to work to restore the public's confidence.

Illinois Insurance Director Michael McRaith, co-chair of the Rating Agency Working Group, said he was unsure whether the problem rested with the rating agencies' for-profit model or misunderstanding the structured securities they were rating.

He said rating agency representatives were not forthcoming with their responses.

"It's fair to say that as regulators we were frustrated by the explanation from the rating agencies in response to that question," Director McRaith said.

"I think it's fair to assume, because it wasn't said, that it was a failure of methodology, it was a failure of leadership and governance, and ultimately it was a failure to acknowledge what was happening in the world." He noted that economists and others raised red flags about residential mortgage backed securities well before rating agencies took any action.

"There was not a lot of fact-based comment about what happened and how we got here," he said. "It was disappointing not to hear the rating agencies offer more reflection on their failures."

As for next steps on how regulators should use ratings to help ensure the solvency of regulated entities, testimony was given on a range of options that included establishing an independent, non-profit rating entity that would be funded by insurance companies, and promoting more competition among rating agencies by breaking the virtual monopoly of the "big three" – Standard & Poor's, Moody's and Fitch.

Director McRaith asked multiple witnesses how much weight regulators should give to ratings from the big three.

Matt Richardson, Charles E. Simon professor of financial economics and director, Salomon Center, New York University said rating agency figures have value as long as their model is fixed first.

He said the models are imprecise now because of the complexity of the products they are modeling. These products are more sensitive to the initial values used in the models, he said, and different input at the outset will cause wide variety in the results.

Several who testified noted the difficulty in effectively rating newer structured securities that emerged in the marketplace as opposed to corporate debt.

Mr. Richardson also said rating agencies do not model some of the information regulators are looking for. Revised models can measure default risk, he said, but as of now they cannot model liquidity risk and market risk.

Director McRaith said interested parties have until Oct. 7 to submit comments before regulators make a decision on how to move forward.

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