{"text":[[{"start":6.85,"text":"Earlier this month, Erik Gordon, an American finance professor, posed a pointed question relating to Fool’s Gold, my book about the 2008 financial crisis: should we now feel some déjà vu? Not because of what is happening with tech stocks nor with Wall Street demands for deregulation. Rather, the issue (once again) is credit ratings. "}],[{"start":29.1,"text":"Before the 2008 crisis, there was a proliferation of financial products that could be used for regulatory arbitrage, playing with the Basel rules to enable banks to reduce the capital reserves they held against defaults. Credit ratings were crucial to this."}],[{"start":46.45,"text":"To invoke a Fool’s Gold analogy, this game of regulatory arbitrage turned bankers into financial chefs: they sliced up risky loans (like meat scraps), remixed them into new products (like fancy sausages), which got seals of approval from rating agencies (like food critics). And it worked well until rotten meat entered the sausage mix and investors panicked in a financial food poisoning scare. "}],[{"start":70.35,"text":"Thankfully, the subprime mortgage bubble is in the past. But regulatory arbitrage has not disappeared. Consider what is happening in the private credit and insurance world. Until recently, insurance groups were (in)famous for mostly just investing in boring, safe assets. But recently they have moved into private credit to boost returns. "}],[{"start":92.8,"text":"Moody’s calculates that insurance groups now hold $807bn of illiquid and opaque credit instruments, accounting for 20 per cent of their $4tn-worth of fixed-income holdings. Meanwhile, private capital firms have been buying insurance companies too, creating the appearance (if not the reality) of circular ties. More striking still, those insurance companies are increasingly turning to private credit ratings to evaluate those opaque, illiquid assets. These are often commissioned from agencies such as Morningstar, Egan-Jones and Kroll, instead of the bigger traditional players like Moody’s, S&P and Fitch."}],[{"start":131.25,"text":"Why are they doing this? A key reason may be, as the Bank for International Settlements recently warned, that private ratings seem to be “systematically” inflated compared with public ratings, creating a flattering aura of safety that permits insurance companies to cut their capital reserves. That boosts current profits but also reduces their future resilience to shocks."}],[{"start":153.15,"text":"A trio of economists — Xuelin Li, Sangmin Oh and Giacomo Ricciardi — has just quantified this in startling new research. They note “a 10-fold increase in the use of private ratings since 2018, predominantly in opaque securities and concentrated among large and PE-owned insurers”. Indeed, privately rated assets now represent 12 per cent of all US life insurance groups’ portfolios — but a whopping 36 per cent at Everlake (owned by Blackstone), 28 per cent at NZC Capital (owned by Eldridge) and 24 per cent at Athene (owned by Apollo). "}],[{"start":189.05,"text":"The trio calculate that “eliminating this gap [between public and private ratings] would increase the required capital charges on insurers’ bond holdings by $4.5bn per year”. In plain English: they think insurers are undercapitalised by that amount."}],[{"start":204.85000000000002,"text":"Unsurprisingly, some industry players disagree. Morningstar, for instance, insists that the research has “errors and assumptions”. And when Fitch recently criticised private ratings, this sparked fury from Kroll — and claims that the large incumbents are just trying to protect themselves from new entrants. "}],[{"start":223.40000000000003,"text":"More striking, in 2024, the National Association of Insurance Commissioners (NAIC) released its own research, which suggested that private ratings are on “average 2.74 notches higher” than public ones. However, there was such a strong backlash from private capital groups and new rating agencies that it was forced to retract the paper. Thankfully, it can still be found online, and it has influenced analysis from the European Central Bank, IMF and the Financial Stability Board, who are all warning about the risks."}],[{"start":255.05000000000004,"text":"However, private credit groups keep doubling down and are now pitching innovations such as “rated note feeders” to help banks reduce reserves."}],[{"start":263.45000000000005,"text":"So should we worry that there is a systemic problem here? That $4.5bn capital gap is small(ish) by overall standards and credit defaults remain low(ish) by historical standards. Moreover, regulators are more alert than before. The US Treasury recently discussed these risks with insurance groups and the Securities and Exchange Commission is scrutinising Egan-Jones. Another 2008-style shock therefore seems unlikely."}],[{"start":291.80000000000007,"text":"But, if nothing else, this story shows that financiers remain addicted to regulatory arbitrage — and that financial memories are short. Yes, some investors can see the undercapitalisation risks: insurance company bonds have underperformed and short sellers are circling. But these reactions remain muted."}],[{"start":310.1500000000001,"text":"So I hope that the NAIC grows a spine and releases an updated report. History shows that when murky regulatory arbitrage goes unchecked, it snowballs. Which, of course, is why we need more public scrutiny of that private credit world — for the sake of insurers, and everyone else."}],[{"start":337.1500000000001,"text":""}]],"url":"https://audio.ftcn.net.cn/album/a_1781855533_1779.mp3"}