What Did the Ratings Agencies Know About AIG?

It’s time to start asking the big credit rating agencies just when they realized that American International Group (AIG) might pose a systemic risk to the global financial system.

And what, if anything, did the rating agencies do to warn financial regulators of the global crisis that might ensue, if AIG’s debt ratings were suddenly slashed.

There’s been a lot of attention paid to the role the credit agencies played in the build-up to the financial crisis by slapping triple A ratings on complex securities built from mortgages to subprime borrowers.

But there’s not been enough scrutiny into the behind-the-scenes work the credit rating agencies did last summer as Lehman Brothers (LEHMQ.PK) lurched toward bankruptcy and AIG’s cash crunch grew increasingly grave.

By virtue of their status as Nationally Recognized Statistical Rating Organizations, the major credit agencies are charged with making sure companies that sell bonds are able to make good on their obligations. Some 30 years ago, securities regulators effectively deputized Moody’s Investors Service (MCO), Standard & Poor’s (MHP) and Fitch Ratings as gatekeepers for the financial system.

And with that lofty and privileged status, there should come a responsibility to help regulators keep an eye out for systemic financial risk.

“We rely on our gatekeepers to help insure that financial markets are safe and information is accurate,” says law professor Frank Partnoy.

Yet there’s no indication that the major credit rating agencies were keeping financial regulators regularly updated last summer on the risk that was building up in the system. If rating agencies were doing that, surely regulators wouldn’t have been as out-to-lunch as they appear to have been the weekend when Lehman Brother filed for bankruptcy.

One thing that’s become clear from the many news stories looking back at the stunning events of last September is that it wasn’t until the weekend Lehman collapsed that Henry Paulson, then Treasury Secretary, realized that a severe downgrade of AIG’s credit rating would force the insurer to pay out tens of billions in cash to the banks that had bought credit default swaps from AIG.

But, presumably, the three major credit rating agencies were well aware before their September 15, 2008 downgrades of AIG’s debt, that such an action would trigger billions of dollars in collateral calls from dozens of U.S. and European banks.

Even AIG, in a regulatory filing from that summer, had predicted that a modest downgrade of its corporate debt could trigger some $13 billion in collateral calls.

Now, maybe the rating agencies didn’t realize the magnitude of the crisis that would ensue. In fairness, few did foresee the financial system going into a near meltdown last autumn.

But it’s hard to think of a single regulator or a company other than AIG itself that had as good a snapshot of AIG’s looming credit exposure as the rating agencies did.

Given their privileged access to a company’s financial records, the rating agencies were in a better position than just about anyone else to realize that every major bank in the world had bought insurance on subprime securities and other toxic assets from AIG.

With that privileged access, comes an obligation to raise a red flag about trouble lurking around the corner.

If the rating agencies either choose not do this, or simply can’t, it may be time to strip them of their vaunted gatekeeper status.

Comments

[User 489664:]

Several of your articles have been making bad comments about AIG. Did you short it?

Thomas

Sep 22 10:34 AM

[ariesl:]

They rated the CDO's as AAA because if they didn't, the J.P. Morgans, etc would go to another rating agency. They were only compensated for the stuff the were asked to rate. The crooks on Wall St. wouldn't bring you anymore business unless you rated their crap as AAA. As long as there was big money to be made, they were going to cash in, whether it was dishonest or not.

Sep 22 11:09 AM

[Nooner:]

Did you really write "few did foresee the financial system going into a near meltdown last autumn."?

Sorry but many most certainly did. My financial adviser moved all my stocks away from those, as did everyone else I spoke to in the little hamlet of Boston. It was only the suckers who lost their shirts and I'd bet the people in those agencies did too.

Sep 22 03:12 PM

[VK9141:]

"They rated the CDO's as AAA because if they didn't, the J.P. Morgans, etc would go to another rating agency."

arielsl, yes, but that's not what Matthew is talking about. Try commenting on the actual point being contended.


Matthew - I agree in principal. The rating agencies in their privileged position ought to have raised flags. However how many of us unless we have absolute belief in something (such as a contraversial view in 2005 that it was dangerously possible that a couple of notch AIG downgrade could be systemically catastrophic) would willingly offer information?

Perhaps nobody asked so nobody talked? Perhaps it never occurred to the regulators that they ought to talk to the rating agencies?

I think things were moving so fast they were blindsided. I read in Michael Lewis's Vanity Fair article that suggested when AIG FP went from insuring corporate credits to sub-prime the adding of a downgrade clause (to post additional collateral) was given little thought, ie the company itself was to an extent oblivious?

It's hard to say what could have made a meaningful difference. My opinion is we all need to be better citizens and ask questions, share information sooner and if necessary act (self regulate to a degree).

Sep 23 05:38 AM

[Moon Kil Woong:]

Gatekeeper is a laughable status to call them. They more closely resemble a rubber stamp put on all securities issued. I think companies think of them as a tax. Perhaps we should build them a forbidden city and call them Mandarins. They have long divorced themselves from reality.

Itr didn't take a brain scientist to know AIG didn't have the assets to cover $3+ trillion in derivatives obligations. Nor does it take a mathemetician to figure out the reason banks don't disclose their current percentage of the $600 trillion derivatives market is because they can't cover the liability either. Rather they just keep rolling it over. The US only is worth $60 trillion. It would take a lot of hyperinflating too even cover 10% of the liability should ratings agencies declare the derviatives counter party risk to be moderately significant.

So far the market looks stable merely because no one is demanding anyone to come clean anymore. As far as I can tell nothing real has been fixed even though the ratings agencies are busy upgrading everything for renewed bond issuances. Buyer beware!

Sep 23 06:16 AM

[lark:]

Aig should die, it distorts the market.

Sep 23 09:38 AM

[kotika98:]

the rating agencies should have been downgrading AIG all along as it was piling up the 200$B in financial insurance, a notch for every extra 20$B added. If they did that AIG might have stopped before it was too late. I personally realized something was fishy when the CFO proudly declared that AIG was unlikely to pay out even a dollar on all those financial insurance products it wrote - when was that? Sometime in 2007?

Sep 23 11:55 AM

[Nettligent:]

SEC along with Rating Agencies are the root cause of our financial crisis and collapse. Snakes guard hen house.
For a right price, you can get a reasonable recommendation.

Sep 23 12:15 PM

[Jeff Nielson:]

The ratings agencies can all use the "Seargeant Schultz" defense:

"I know nothing...NOTHING!"

The reason for this is that these companies have already admitted they NEVER hired enough staff to INDEPENDENTLY evaluate the scam-products being sold by Wall Street fraud-factories (including the bogus, "credit default swaps" of AIG).

Thus, for many years they have LITERALLY been nothing more than clueless, rubber-stamps (see www.bullionbullscanada...).

Sep 23 01:01 PM

[a fat panda:]

"And what, if anything, did the rating agencies do to warn financial regulators of the global crisis that might ensue, if AIG’s debt ratings were suddenly slashed."

What if anything could anyone have said that would have made our relagulators listen. Here is what Buffett said, and they didn't listen :

".. the macro picture is dangerous and getting more so. Large amounts of risk, particularly credit risk, have become concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one other. The troubles of one could quickly infect the others. On top of that, these dealers are owed huge amounts by non-dealer counterparties. Some of these counterparties, as I’ve mentioned, are linked in ways that could cause them to contemporaneously run into a problem because of a single event (such as the implosion of the telecom industry or the precipitous decline in the value of merchant power projects). Linkage, when it suddenly surfaces, can trigger serious systemic problems."

What the blazes are you going to say to someone (Bernanke) who said "(the subprime fallout) will not affect the economy overall.'' in July of 2007 or someone (Paulson) who said in July of 2008 "it's a safe banking system, a sound banking system. Our regulators are on top of it. This is a very manageable situation." At that point, you realize that nothing said to the government would have changed a dollar of the loss.

Sep 23 11:43 PM