What did rating agencies know about AIG?

September 21, 2009

It’s time to start asking the big credit rating agencies just when they realized that American International Group 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 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, Standard & Poor’s 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.

Update: A report from the Government Accountability Office, released yesterday, makes clear that the rating agencies weren’t talking to the regulators about the brewing storm at AIG. On page 16 of the GAO report, we learn that the New York branch of the Federal Reserve didn’t become aware of the problems at AIG until Sept. 12, 2008, when the central bank was contacted by AIG.

Says the report:

FRBNY officials said that prior to these discussions, they had no nonpublic information on AIG operations because they did not supervise the company.

Moody’s, S&P, what say you?


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