How Wall Street Ratings Deception Entrapped Two Million Americans in Failed Insurance
Personal_Finance / Insurance Nov 21, 2010 - 06:12 AM GMTBy: Martin_D_Weiss
Let’s say you put a big chunk of your nest egg in a life insurance policy with an A+ company.
You invest another sizable amount in a portfolio of high-rated corporate bonds and tax-free municipal bonds.
Then, feeling safe and secure with most of your funds, you take a flyer on a few stocks that a dozen separate research analysts have unanimously rated as a “buy” or at least a “hold.”
You assume you’ve made informed decisions based on the best research the world has to offer.
The reality: Even in the absence of bubbles, busts, recessions or dollar collapses, you could suffer wipeout losses.
Hard to believe this could actually happen? Actually, it already has happened; and I want to make absolutely certain you don’t get caught in Wall Street deceptions like these in the future. So this morning, let me tell you what they are.
Their primary source: Legalized payola and massive conflicts of interest.
The primary result: Distorted research and inflated ratings on hundreds of thousands of companies, bonds, stocks, and investments of all kinds.
The threat to you: Far bigger losses in your investments than you would have anticipated otherwise.
Today, I’ll tell you about deceptions in the insurance industry. Next time, we can talk about equally egregious deceptions in other financial sectors.
“Weiss Had Better Shut the @!%# Up or Get a Bodyguard.”
The year was 1988, and I had been rating the financial strength of the nation’s banks and S&Ls for over a decade.
My father, J. Irving Weiss, already an octogenarian, was helping me with the analysis. And one afternoon I told him that my ratings firm, Weiss Ratings was going to start rating insurance companies.
I can never forget his first words: “Check out First Executive [the parent of Executive Life Insurance],” he said. “Fred Carr’s running it. He’s trouble, and he’s knee deep in junk bonds. Follow the junk and you will find your answers.”
I did, and I found quite a few life insurance companies that were loaded with junk bonds, one of which was First Capital Life, to which we gave a financial strength rating of D-.
I was generous. The company should have gotten an F.
But within days of my widely-publicized warnings on First Capital Life, a gaggle of the company’s lawyers and top executives flew down to our office. They ranted. They raved. They swore they’d slap me with a massive lawsuit and put me out of business if I didn’t give them a better rating. “All the Wall Street ratings agencies give us high grades,” they said. “Who the hell do you think you are?”
I politely explained that we never let personal threats affect our ratings. And unlike other rating agencies, Weiss Ratings never accepts a dime from the companies we rate. “We work for individuals,” I said, “not big corporations. Besides,” I continued, opening up the company’s most recent quarterly report, “your own financial statements prove your company is in trouble.”
That’s when one of them delivered the ultimate threat: “Weiss better shut the @!%# up,” he whispered to my associate, “or get a bodyguard.”
We did neither. To the contrary, we intensified our warnings. And within weeks, the company went belly-up, just as Weiss Ratings had warned — still boasting high ratings from major Wall Street firms on the very day they failed.
In fact, the leading insurance rating agency, A.M. Best, didn’t downgrade First Capital Life to a warning level until five days after it failed. Needless to say, it was too late for policyholders.
It was a grisly sight — not just for policyholders, but for shareholders as well: The company’s stock crashed 99 percent, crucifying millions of unwitting investors. Then the stock died, wiped off the face of the Earth. Three of the company’s closest competitors also bit the dust. Unwitting investors — who did not have access to my ratings — lost $4 billion, $4.5 billion, and $13 billion, respectively.
Fortunately, those who had seen our ratings were ready. Weiss Ratings warned them long before these companies went bust. Nobody who heeded our warning lost a cent.
In fact, the contrast between anyone who relied on Weiss Ratings and anyone who didn’t was so stark, even the U.S. Congress couldn’t help but notice.
Congress asked: How was it possible for Weiss — a small firm in Florida — to identify companies that were about to fail, when Wall Street told us they were still “superior” or “excellent” right up to the day they failed?
To find an answer, Congress called all the rating agencies — Standard & Poor’s (S&P), Moody’s, A.M. Best, Duff & Phelps, and Weiss — to testify. But we were the only ones among them who showed up.
So Congress asked its auditing arm, the U.S. Government Accountability Office (GAO), to conduct a detailed study on the Weiss ratings in comparison to the ratings of the other major rating agencies.
Three years later, after extensive research and review, the GAO published its conclusion: Weiss beat its leading competitor, A.M. Best, by a factor of three to one in forecasting future financial troubles. The three other Wall Street firms weren’t even competition.
But the GAO never answered the original question — why?
I can assure you it wasn’t because of better access to information than our competitors. Nor were we smarter than they were. The real answer was contained in one four-letter word: Bias.
To this day, the other rating agencies are paid huge fees by the issuers of bonds, insurance policies and other investments that you buy. In other words, their ratings are literally bought and paid for by the same companies they rate.
These conflicts and bias in the ratings business are no trivial matter.
How Deceptive Ratings Entrapped Nearly Two Million Americans in Failed Insurance — and Why It Could Happen to You!
If you have insurance, don’t blindly assume it’s safe. In a moment, I’ll show you how two million others once made that mistake and lived to regret it. And to help you avoid repeating their error, it’s vital that you understand their story from start to finish.
The problems began in the early 1980s when insurance companies had guaranteed to pay high yields to investors of 10 percent or more, but the best they could earn on safe bonds was 8, 7, or 6 percent. They had to do something to bridge that gap — and quickly.
So how do you deliver high guaranteed yields when interest rates are going down? Their solution: Buy the bonds of financially weaker companies.
Consider, for a moment, what bonds are and you’ll understand the situation. When you buy a bond, all you’re doing, in essence, is making a loan. If you make the loan to a strong, secure borrower, like the U.S. government or a financially robust corporation, you won’t be able to collect a very high rate of interest.
If you want a truly high interest rate, you need to take the risk of lending your money to a less secure borrower — maybe a start-up company or perhaps a company that’s had some ups and downs in recent years. And you can earn even more interest from companies that have been having “a bit of trouble” paying their bills lately. (Whether you’ll actually be able to collect that interest or get back your principal is another matter entirely.)
What’s secure and what’s risky? In the corporate bond world, everyone agreed to use the standard rating scales originally established by the two leading bond rating agencies — Moody’s and S&P. The two agencies use slightly different letters, but their scale is basically the same: Triple-A, double-A, single-A; triple-B, double-B, single-B; and so on.
If a bond is triple-B or better, it’s investment grade. That’s considered relatively secure. If the bond is double-B or lower, it’s speculative grade, or simply “junk.” It’s not garbage you’d necessarily throw into the trashcan, but in the parlance of Wall Street, it’s officially known as junk.
And that’s what insurance companies started to buy: Junk. They bought double-B bonds. They bought single-B bonds. They even bought unrated bonds that, if rated, would have been classified as junk.
The key to their success was to keep the junk bond aspect hush-hush, while exploiting the faith people still had in the inherent safety of insurance. To make the scheme work, they needed two more elements: The blessing of the Wall Street ratings agencies and the cooperation of the state insurance commissioners, many of whom had worked for — or would later join — those same insurance companies.
The blessing of the rating agencies was relatively easy. Indeed, for years, the standard operating procedure of the leading insurance company rating agency, A.M. Best & Co., was to “work closely” with the insurers.
If you ran an insurance company and wanted a rating, the deal that Best offered you was very favorable indeed. Best said, in effect: “We give you a rating. If you don’t like it, we won’t publish it. If you like it, you pay us to print up thousands of rating cards and reports that your salespeople can use to sell insurance. It’s a win-win.”
The ratings process was stacked in favor of the companies from start to finish. They were empowered to decide when and if they wanted to be rated. They got a “sneak preview” of their rating before it was revealed to the public. They could appeal the rating if they didn’t like it. And if they still didn’t get a rating they agreed with, they could take it out of circulation by suppressing its publication.
Three newer entrants to the business of rating insurance companies — Moody’s, S&P, and Duff & Phelps (now Fitch) — offered essentially the same deal.
But instead of earning their money from reprints of ratings reports, they simply charged the insurance companies a fat flat fee for each rating — anywhere from $10,000 to $50,000 per insurance company subsidiary, per year. Later, Best decided to change its price structure to match the other three, charging the rated companies similar up-front fees.
Not surprisingly, the rating agencies gave out good grades like candy. At A.M. Best, the grade inflation got so far out of hand that no industry insider would be caught alive buying insurance from a company rated “good” by Best. Nearly everyone (except the customers) knew that Best’s “good” was actually bad.
Getting the insurance regulators to cooperate was not quite as easy. In fact, the state insurance commissioners around the country were getting so concerned about the industry’s bulging investments in junk and unrated bonds, they decided to set up a special office in New York — the Securities Valuation Office — to monitor the situation.
What’s a junk bond? The answer, as I’ve explained, was undisputed: any bond with a rating from S&P or Moody’s of double-B or lower. But the insurance companies didn’t like that definition. “You can’t do that to us,” they told the insurance commissioners. “If you use that definition, everybody will see how much junk we have.” The commissioners struggled with this request, but amazingly, they obliged. It was like rewriting history to suit the new king.
This went on for several years. Finally, however, after a few of us screamed and hollered about this sham, the insurance commissioners finally realized they simply could not be a party to the junk bond cover-up any longer. They decided to bite the bullet. They adopted the standard double-B definition, and reclassified over $30 billion in “secure” bonds as junk bonds. It was the beginning of the final act for the giant junk bond insurance companies.
The New York Times was one of the first to pick up the story. Newspapers all over the country soon followed. That’s when the large life and health insurance companies began to fall like dominoes — Executive Life of California, Executive Life of New York, Fidelity Bankers Life, First Capital Life — each and every one dragged down by large junk bond holdings.
And this was just the prelude to the biggest failure of all — Mutual Benefit Life of New Jersey, which fell under the weight of losses in speculative real estate.
How many people were affected? I checked the records of each failed company:
In total, they had exactly 5,950,422 policyholders.
And among these, 1.9 million were fixed annuities and other policies with cash value. If you were one of the 1.9 million, your money was frozen. The authorities wouldn’t let you cash out your policy. They wouldn’t even let you borrow on your policy.
What about the legal mandate for the guarantee funds to reimburse policyholders in failed companies? The authorities put their heads together and came up with a “creative” solution:
To avoid invoking the guarantee system, they simply decided to change the definition of when a failed company fails. Instead of declaring that the bankrupt companies were bankrupt, they decided to call them “financially impaired,” or “in rehabilitation.”
Then, after many months, the authorities created new companies with new, reformed annuities yielding far less than the original policies. They gave policyholders two choices. Either:
- “Opt in” to the new company and accept a loss of yield for years to come, or …
- “Opt out” and accept their share of whatever cash was available, often as little as 50 cents on the dollar.
It was the greatest disaster in the history of insurance!
So You’d Think That the Insurance Industry Would Have Learned Its Lessons. Not So!
Like the failed insurers of the 1990s, several large U.S. insurance companies, on the prowl for high yields, invested again in high-risk instruments. Junk bonds were still stigmatized, but a handy substitute for junk was readily available: Subprime mortgages.
And to make things even more exciting, some insurers added a whole new layer of risk: A special kind of bet known as a credit default swap (CDS) — a bet placed on the probability of another company’s failure.
Remember, in the prior episode, the rating agencies collected large fees from the companies for each grade. That, in turn, introduced serious conflicts of interest into the process and often biased the ratings in favor of the companies.
This time around, they did precisely the same thing: They collected the same kind of big fees. They gave out the same kind of top-notch ratings. And they covered up the same kind of massive risks.
In addition, S&P, Moody’s, and Fitch created a whole new layer of conflicts and bias: They hired themselves out as consultants to help create newfangled debt-backed securities, giving them a true lock on the industry: They created the securities.
They rated the securities. And then they rated the companies that bought the securities, collecting fat fees at each stage of the process.
Not only did that pad the bottom line of the rating agencies, it also gave them stronger reasons to inflate the ratings, ignore warning signs, postpone downgrades, and avoid anything that might bring down the debt pyramid they had helped to create.
The repercussions of this disaster were at the heart of the debt crisis, and as a part of the Regulatory Reform Act of 2010, Congress sought to address them. But …
The Fundamental Business Model of the Big Four Rating Agencies Has Not Changed.
To this day, the insurance companies are still rated by the same rating agencies, in the same way with the same conflicts of interest.
This is also how the Wall Street rating agencies rate every issuer of corporate bonds, municipal bonds, mortgage-backed securities, and more.
ALL of the Big Four rating agencies — Moody’s, Standard & Poor’s, Fitch, and A.M. Best — continue to collect large fees from the companies they rate.
And the obvious conflict of interest that naturally flows from that financial relationship persists, leaving the danger of more ratings fiascos to come.
Next month, I will provide a solution to help you make sure your money is safe and STAYS safe. Stand by.
Good luck and God bless!
Martin
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