"…the swings in almost all financial markets this month have made dispersed risk suddenly morph into dispersed mistrust." -The Economist, August 16, 2007

"The oldest and strongest emotion of mankind is fear, and the oldest and strongest kind of fear is fear of the unknown." - H.P. Lovecraft

As markets seek to recover from what one hopes is the bottom of the fear/greed cycle, it may be worthwhile to continue thinking about how the insurance regulators will react.  In my prior post, I noted the potential huge problems in valuing securities in an illiquid market.  Apparently, the SVO and the NY Insurance Department have been thinking about valuation long before the current market.

Back in November, 2006 the Valuation of Securities Task Force of the NAIC exposed for comment a valuation proposal that would allow insurers to choose their valuation source and note the source as follows:

"1" - SVO database, "2" - an approved pricing service, "3" - a stock exchange, "4" - a broker or custodian, or "5" - determined by the insurer.

Thank you to Chris Anderson at Merrill Lynch for providing the latest on this interesting valuation proposal from the NAIC.  Chris has noted this may be approved at the VOS Task Force as early as next month.

Although a step in the direction, I think a bit more disclosure as to the name of the source might be useful, much as is now required for the broker used on trades.  Importantly, this should not result in a ‘wild west’ of pricing, as the SVO would develop a mechanism to compare reported prices for a given CUSIP to those reported by all insurers holding that CUSIP.

Given the current (and potential state of the financial markets at year end), we applaud the SVO and the NY Insurance Department for moving in the right direction.  Transparency and disclosure are a strong antidote to fear and mistrust.

Based upon historical behavior, the NAIC and other insurance regulators will react like generals fighting the last war. 

First, they will wait to see if and how the overall repricing of risk impacts insurers.  Amazingly, reductions in earnings and risk capital are not the biggest issue here.  Potential insolvencies or rehabilitations are.  Depending upon the ultimate impact on individual insurers, the NAIC will then slowly make changes, most likely, through the various model law vehicles.

But, what if the threat to common sense regulation of insurers is not the NAIC and others regulating with their eyes squarely on the rear view mirror? 

What if the real threat comes from the Securities Valuation Office (SVO) of the NAIC? 

Insurers must use pricing as noted by the SVO when filing statutory financials at year end.  However, what if the craziness of pricing ABS, CMOs, CDOs, etc. that is occurring now, persists at year end?  How will the SVO get accurate pricing for use by insurers?  And, how realistic would those prices be?  Of course, unrealistically low prices could feed into lower risk capital and increased pressure on insurer financial condition.

Also, as many of you know, the insurance industry worked for several years to convince the NAIC that the SVO should use the ratings of the rating agencies with a ‘look-up table’ to determine the SVO rating.  (i.e. A- or higher meant SVO 1, BBB meant SVO 2, etc.).  Before this change, one of the insurers holding a given rated security or tranche would have to pay a fee to the SVO for their imprimatur.  (Non-rated securities have always required independent credit review by the SVO.)  With many of the problems that have started with sub prime mortgages aided and abetted by the rating agencies to some degree, will the NAIC change its tune?  Will the SVO now be required to rate all securities, irrespective of rating agency letter rating?  And, how much more in resources (read: fees from insurers) will this require? 

On top of this, the SVO has not exactly developed a reputation for accuracy and reasonableness in their rating process.

From a small acorn, a large oak can grow.  It’s starting to look increasingly like the small acorn of sub prime mortgage problems will grow into a large oak of problems and challenges previously unimagined.

Your comments are much appreciated.

18 months is a good estimate.  We’ve said that before (see previous post) and now others have more eloquently presented supporting evidence.

David Leonhardt of the NY Times has an excellent piece on this today.  (registration may be required)  Basically, he says what we’ve been telling our clients for over a year now:  The problems with the residential real estate market is not one of valuation (the overly hyped ‘wealth effect’ in reverse), but one of upwardly adjusting mortgages challenging borrowers (both good and bad credit risks).  Take a peek at the graph below.

And Chris Whalen of Institutional Risk Analytics takes a more detailed look at Countrywide’s results, especially its banking subsidiary (thanks to details required in public filings to regulators).  Chris’ article backs up David’s article: "you would know (or at least suspect) that loan defaults were likely to bounce sharply in 2007-2009 as CFC and the rest of the mortgage peer group revert to the LT mean — figure at least two standard deviations from year-end 2006 levels."
 

Thank you to both David and Chris for continued excellent writing on this and related subjects.

We continue to counsel detailed monitoring of all non-GSE residential mortgage exposures, especially any tranche tied to a subprime deal or whose rating has not been updated/reviewed recently.