AIG May Capture Biggest Red Flag

This post first appeared on Minyanville.

If there was ever a Monday to skip that morning coffee and run on pure adrenaline, this is it.

As Lehman Brothers (LEH) and Merrill Lynch (MER) jockey for top placement in this morning’s headlines, American International Group (AIG) is dramatically staking a claim for the financial market’s biggest red flag.

Lehman and Merrill, already collapsed into the hands of bankruptcy courts and Bank of America (BAC), respectively, have well-publicized and largely understood troubles. Loaded up with securities tied to US mortgage debt, their capital bases have been eroded by losses and writedowns on bad assets.

Although losses have been hard to quantify -- due to obfuscation by management and underhanded accounting aimed at hiding the true extent of the damage -- most investors can at least wrap their heads around the issues.

The US’s largest insurer, on the other hand, is besieged by losses in its opaque credit products division and is rushing to sell assets and raise capital to stay alive. Professor Sedacca has been eyeing the firm as a potential cancer for weeks, in fear that its mammoth exposure to the credit markets may put the entire system at risk.

AIG has seen its balance sheet destroyed by losses on complex derivative instruments known as credit default swaps. The company sold these insurance contracts to other financial institutions that owned mortgage-backed securities, putting AIG on the hook for any losses that may occur. And they have indeed occurred.

Although many such obligations are yet to be paid out, the value of these assets have opened a gaping hole in AIG’s balance sheet.

The company, which has raised over $20 billion this year, is seeking another $40 billion. To that end, it's asked the Federal Reserve for a bridge loan to give it time to find the cash, according to the Wall Street Journal. AIG’s -- and indeed Wall Street’s -- concern is that ratings agencies Moody’s (MCO) and Standard and Poor’s may not wait around to downgrade the company's debt.

The New York Times reports the company may not last more than a couple days if such a downgrade were to occur.

AIG, and indeed all financial institutions, covet high credit ratings to keep their borrowing costs and capital requirements low.

Rating Agency Overhaul Falls Short

This post first appeared on Minyanville.

So much for accountability.

The Wall Street Journal reported yesterday of the striking of a preliminary deal between New York Attorney General Andrew Cuomo and Standard & Poor's (MHP), Moody's Investment Corporation (MCO) and Fitch Ratings.

Under the proposed settlement, the three major debt rating firms will change the way they're paid for evaluating non-prime mortgage-backed securities. No fines will be imposed for their role in the collapse in value of bonds they once rated as investment grade. Despite the billions of dollars lost as a result of their shoddy reviews, the agencies will not admit (nor be forced to admit) any wrongdoing.

Cuomo hopes the new plan allows rating companies to be tough on issuers, while still generating income. Simply, agencies will charge issuers for reviewing potential securities and, if selected to rate the deal, earn an additional service fee. Additionally, agencies must disclose on a quarterly basis which deals they've reviewed. It's expected the increased transparency will help investors better evaluate the relationship between issuer and rater.

While the new fee structure is a step in the right direction, it fails to address the root of the issue. As I noted earlier this year:

The problem is one of incentives. As long as rating agencies are paid by the issuers of securities rather than investors, they'll be financially motivated to hand out generous ratings. In the for-profit business of rating debt, business is awarded to the firm that provides the best ratings.

Any marginal benefit from increased transparency will be wiped out by the impact of higher borrowing costs. The new fee structure is likely to increases ratings-related expenses, which will no doubt be passed on to investors. Investment banks like Lehman Brothers (LEH), Goldman Sachs (GS) and Merrill Lynch (MER) -- already under intense pressure to sustain profit margins -- aren't about to shoulder the extra burden alone.

The rating agencies were an integral part of Wall Street's debt experiment gone wrong. Regulators had the opportunity to make a bold statement: That those responsible for the implosion of the credit markets would be held accountable. Instead, the lack of material change in the relationship between issuer and rating agency demonstrates the ongoing unwillingness of regulators to police the very markets they're charged with monitoring.

Professor Macke's take on Moody's and S&P is perhaps blunt, but not unreasonable: "[The rating agencies] don't have to justify the myriad 'one off' mistakes they've made over the years, but rather their very existence."