Regulatory changes are needed in the bond insurance industry.

While regulation of the bond insurance industry officially is the job of various state insurance departments, the rating agencies have played a quasi-regulatory role in this regard. For many years, the rating agencies have acted as the de facto regulator of the financial guaranty industry and until recently that oversight authority has not been seriously called into question. However, the current credit crisis is leading many to rethink the regulatory framework across Wall Street, including that of the financial guaranty industry.

Recently New York announced several regulatory changes for the industry, including raising the minimum capital requirement to $150 million from its previous level of $65 million. While we applaud the effort, we believe these changes may not be enough to re-establish the New York State Insurance Department as the preeminent regulator of the industry.

The model under which financial guaranty insurers interact with the rating agencies also raises questions. While the "issuer pays" business model under which rating agencies evaluate and rate bonds creates the appearance of a conflict of interest for rating agencies, the model for evaluating and rating the financial guaranty industry in particular creates an absolute conflict of interest.

The late Ken Hall once said that "financial guaranty companies are nothing more than the franchise operations of the rating agencies." As a result, no financial guaranty company has ever insured a transaction, or class of transactions, that did not have the prior approval of the rating agencies.

The history of the financial guaranty industry has demonstrated that the rating agencies have crossed a line and are now far from being the detached arbiters and commentators of credit quality they once were. Now that this relationship has been revealed, the question becomes how best should the financial guaranty industry be regulated and what, if any, changes should be made to the regulation of the rating agencies themselves?

As it relates to the financial guaranty industry, we believe that investor confidence will be enhanced by an increased transparency in the transactions insured. As originally conceived, financial guaranty insurance was designed "to make a good credit more marketable" and not "to make a bad credit good." Following that approach, we believe that the rating agencies should be required to publicly disclose their credit rating on the underlying transaction, without reference to the presence of bond insurance. Furthermore, their credit rating should be maintained and updated when necessary to reflect any changes in the underlying issuer's credit quality for the life of the transaction.

In looking to increase transparency and promoting non-conflicting credit analysis, the question becomes, does the Securities and Exchange Commission have the ability and the nerve to effectively reform the conflicts of interests the rating agencies have with respect to the financial guaranty industry? If not, would the credit markets be better served by empowering a new regulatory body to more closely administer the rating agencies and their franchisees?

The authors represent HRF Associates. For more information, contact Robert Smith at or 530-620-7128.

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