Because everything unraveled so quickly, no one scrutinized Standard & Poor's flip-flop on AIG. On Friday, September 12, 2008,S&P said it would, "continue discussions with the company over the coming weeks regarding liquidity and capital plans. Once we have more clarity on these issues, we could affirm the current ratings on the holding company and operating companies or lower them by one to three notches."
Of course, that never happened. S&P did not wait, and issued a downgrade the following Monday. It had at least one conversation with AIG that day, when only two things were clear: Nothing at AIG was settled, and the contagion effect from the Lehman Brothers bankruptcy was huge. The discussions could not have been especially detailed, since AIG's financial staff was preoccupied in its negotiations with Hank Paulson's deputy,Dan Jester, Goldman and JPMorgan Chase, who ostensibly were trying to put together a bank deal that would address S&P's concerns.
For S&P, the only way to find clarity at AIG was to peer into its own reflection. AIG's liquidity was dependent on its credit ratings, or more specifically, ratings triggers. And AIG's biggest problem - its unsettled disputes over the valuation of $62 billion worth of CDOs - was traceable to the reliance on AAA credit ratings of those CDOs.
For a financial company like AIG, liquidity is like oxygen; it can't live very long without it. To take the analogy a bit further, solvency is more like food; you'll die without it, but your lack of nourishment won't be apparent for a while. Around 6:40 p.m. on September 15, 2008,Fitch announced its downgrade of AIG, and few hours later S&P and Moody's followed suit. Whether or not the rating agencies acted independently, or in good faith, is an open question. But there is no doubt that they all knew the consequences of their actions. The rating agencies cut off part of AIG's oxygen supply.
More specifically, AIG's unregulated subsidiary, AIG Financial Products, which operated under the financial guaranty of its parent, had hundreds of billions of dollars of trading positions in all sorts of derivatives. AIGFP's obligation to post cash margin on those trading positions was based on its credit ratings. The lower the credit ratings, the more cash margin required. As of September 12, 2008, if AIG were downgraded one notch by one credit agency, its expected liquidity drain would have been about $10.5 billion; if it were downgraded one notch by two agencies, the damage would have been $13.3 billion. During the evening of September 15, 2008, S&P downgraded AIG threenotches, from AA- to A-, and downgraded it's short-term rating from A-1 to A-2. Those downgrades, plus the downgrades at Moody's and Fitch, precipitated a $32 billion liquidity drain by month-end.
On September 16, 2008, when the government hurriedly put together a bailout package for AIG, everyone was focused on AIG's immediate liquidity needs. Certain ratings triggers, with 30-day lead times, were not given top priority. Those triggers had been tripped by downgrades from S&P, and not by those at Moody's. But 18 days later, after AIG had become a ward of the state, Moody's decided that it too would start the 30-day countdown on the ratings triggers of some other CDOs. On October 3, 2008, Moody's downgraded AIG from A2 to A3.
The timing these embedded rating triggers were part of the backdrop of Thomas Baxter's testimony for the House Oversight Committee on February 27, 2010. Baxter, the general counsel for the New York Fed, was part of the team that oversaw negotiations with banks holding credit default swaps on $62.1 billion worth of CDOs that the government purchased at par. Baxter gave some of the most important testimony of that day's hearings:
First of all, there was a critical deadline, Congressman, of November 10th. And that was the day that AIG was going to announce a $25 billion loss in its 10-Q for the third quarter. So we were looking at that.And we were being told by the credit rating agencies that unless something happened with respect to the credit default swaps, on or before November 10th, that there was a strong probability of a downgrade.
Now, a downgrade would have been catastrophic. It would have brought us back to where we were in September, on the brink of an AIG bankruptcy.
So from those of us who were working on -- at the New York Fed, we looked at that as a hard deadline. And the execution risk of failing to get the credit default swaps torn up by that date was -- was -- it would put us back on the brink of bankruptcy.
So that was -- that was the risk of deal failure. That was the execution risk. So we had to get the deal done.
AIG had been unable, as Mr. [Elias] Habayeb[AIGFP's CFO when a lot of those toxic assets were booked] has testified, to get that -- those credit default swaps torn up.
On November 6th, Congressman, we got formal authorization from Stasia Kelly, who was then AIG's general counsel, to take over and see whether we could get those credit default swaps terminated by deadline.
So we were operating against the clock to do that.
Our choices were, should we push for concessions and try to use whatever leverage we had to get those concessions, or should we simply go to par, which would apply to every counterparty -- and the way par works is you offset the collateral that these counterparties had been pulling out of AIG against you offset that collateral against the par price of the bonds.
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