With how quickly things were changing this week, I recused myself from commenting while things were flying, instead preferring to gather data and hopefully provide some insightful analysis. Since – cross your fingers – we don’t look setup to have another wild weekend of will-they-won’t-they debate about intervention involving a major financial institution, here goes part one…

Lehman (LEH) and AIG were actually on opposite ends of the coin. I believe Lehman had adequate liquidity for the time being, but inadequate equity capital to support its devaluing asset base. Eventually, the game had to run out – and when potential investors looked at the feasibility of sinking funds into an institution with negative net worth, they balked. This gave everyone offering Lehman short-term funding an excellent reason to stop doing so, and so the house came down.

AIG had the opposite situation working against it – a very good capital base, but too much of it tied up in non-cash assets. Because of its numerous financial guaranty transactions, AIG had created the possibility where it would have to post massive amounts of cash as additional collateral. Now, I completely realize that part of a management’s job is to provision for adequate liquidity, and I’m not trying to absolve them of general incompetence in destroying as much shareholder wealth as they did, but this isn’t about AIG or their management. This is about the ratings agencies, whose greed masked cluelessness during the boom times and whose fear ultimately led to the pinnacle of recklessness when things turned bad. I read the summary note that S&P - a part of McGraw-Hill (MHP) - issued putting AIG on negative CreditWatch, and was completely blown away by how these efficient market lackeys have abdicated their responsibility to provide fundamental judgments of credit worthiness, and have instead let the tail of market pricing wag the dog of intrinsic worth.

From the horse’s mouth…

On Sept. 12, 2008, Standard & Poor’s Ratings Services placed its ratings on American International Group Inc. (NYSE: AIG) (AA-/A-1+) and subsidiaries on CreditWatch with negative implications.
This action follows a significant decline in AIG’s share price and an increase in credit spreads on the company’s debt. Standard & Poor’s believes that AIG has sufficient capital and liquidity to meet its policy obligations and potential collateral requirements, which are significantly greater than the expected cash losses on the mortgage-related assets. However, additional market value losses will place some strain on the company’s resources. Given the movement in the share price and credit spreads, we now believe AIG’s potential access to the capital market may be more restricted in the short term.

Let’s clarify this – AIG is fundamentally sound, but market speculation is that their credit rating shouldn’t be where S&P believed it is, so the proper and prudent action for S&P is to… buckle and change their answer. I’ve heard “discipline trumps conviction,” but this is pushing a new level of absurdity and irresponsibility. While the ratings agencies are at it, two months ago I went and documented what the credit default swap spreads were saying relative to Moody’s (MCO) ratings; at that point the implied ratings put the average financial in the Dow Industrials as being rated two and a half full letter grades (6.5 notches) higher than they were at the time. A broader view of financial stocks said that the average rating was 5 notches above what the CDS market believed. If S&P and Moody’s were being intellectually honest with their “efficient market”-guided ratings, they would have long ago cut most of the large financial companies to junk. Now they almost have to take actions like that if they hope to achieve some semblance of consistency. That means cutting Bank of America (BAC) to A3, Citigroup (C) to Baa3, and Wachovia (WB) so far into junk that it forces an AIG-style crisis winding up with either:
1. a run on the bank, bringing in the FDIC
2. another government-backed loan or financing facility

This is not meant to be a rant against the ratings agencies; for a long time they were very good at the bread-and-butter of measuring corporate credit risk. But like the monoline insurers, they strayed from their area of competence, and have now come under siege to the point where they are saying they might not know too much at all. It’s all very Taleb-esque, in a tragic sense. Tragic because these institutions are so important for the functioning of the capital markets, and they can’t seem to get their collective act together and say that some financial firms aren’t huge credit risks.

There is an argument that I subscribe to that says the problem in the financial world the last few years was not that too much risk was being taken, but too much risk aversion was being displayed. This led to a willingness to buy anything that was rated AAA/Aaa that displayed a risk premium to Treasuries, even if those assets weren’t really risk free. The ratings agencies were asleep at the wheel for that one, even while maintaining a firm foot on the pedal. Now the problems of driving down a road we don’t really know at full speed for too long are catching up to us, but that doesn’t mean we should shoot the driver and put the person with the loudest voice in charge of navigating.

I’m hoping (as always, being the person whose taxes for the next several decades will go to footing the bill) that the RTC-type buy-crap-and-recapitalize plan will do some tangible good. But maybe I’m too hopeful. My current mental toss-up is whether or not we need to fear inflation (thanks to the massive liquidity injections being done) or deflation (because of asset devaluation and credit contraction) or whether the two will balance out on a statistical basis while creating some Frankenstein-type economical nightmare. This ties in with my emerging view that Europe – at least all of the major lending financial institutions over there – is the next collective domino to fall in what will be a global slowdown thesis. With any luck, that writeup will be complete by Monday afternoon.

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