“Summer” Rerun: Brace for the Tsunami: Fitch, S&P Downgrade AIG (Updated Again)

This post first appeared on September 15, 2008

I have no idea what the morrow will bring, but if it is only as bad as Monday’s trading, we should all consider ourselves lucky.

Ftich dowgraded AIG to A with a negative watch (hat tip reader Steve)

S&P downgraded AIG to A-2 with a negative outlook as reported on CNBC (hat tip readers Scott and Michael. I don’t see a link to a press release yet on S&P’s site). Update 9:15 PM, it’s now on Bloomberg. The cut was from AA- to A- on senior debt; the A-2 is the counterparty risk rating.

This downgrade triggers the requirement that AIG post more collateral. I am looking for confirmation, but this is what I saw in terms of consequences. From Bloomberg:

A ratings cut may have “a material adverse effect on AIG’s liquidity” and trigger more than $13 billion in collateral calls from debt investors who bought the swaps, the insurer said in an Aug. 6 filing. AIG has already posted $16.5 billion in collateral through July 31. A downgrade could also set off early termination of swaps that may cause $4.6 billion in payments, AIG said.

The is going to lead to massive counterparty defaults in the credit default swaps market, an event we and others had warned about for some time. The CDS market was the most likely culprit to cause a systemic unwind. God help us if the authorities are not prepared.

I will update this post when news hits the wires.

Update 9:30 PM: Moody’s has also downgraded (headline only at WSJ), and reader Scott gives a summary of CNBC:

David Faber saying they have to raise $75 billion tomorrow, or the BK on Wednesday. Maria B and Larry Kudlow noting that there’s a ton of private equity money dying to dive in, but terrible regulatory environment doesn’t allow it. I knew there was a reason I never watch this stuff.

Update 11:00 PM from the Financial Times:

S&P warned the insurer could face further ratings cuts – perhaps even into the lower BBB category – unless it is able to ”implement further liquidity options” and ”the successful sale of at least a portion of its business assets”….

AIG is the biggest provider of commercial insurance in the US,….

But it also has a financial products division that acted like an investment bank and has been at the heart of the current problems. AIG is a counterparty in a large number of swap and hedging transactions. It wrote credit default swaps, which insure against corporate default, some protecting against losses on collateralised debt obligations, complex financial products that have suffered large losses because many of them were backed by assets backed by mortgages.

S&P said on Monday the main ”source of the strain comes from credit default swaps covering multi-sector collateralized debt obligations with mortgage exposure as well as insurance company holdings of residential mortgage-backed securities”.

The Nikkei is down 618 at this hour. A trading halt was imposed in Korea. Central banks in China, Japan,and Korea have made responses, but not as extreme as the Fed’s $70 billion reserve increase today. Back to the original post:

A Financial Times story tells how rattled the CDS market was before this blow:

Alongside the highly complex counterparty issues, Lehman is itself the biggest ever bankruptcy to hit debt markets. This will mean huge payouts on credit default swaps (CDS) bought to protect against losses on its debt, while also causing enormous losses for investors who hold nearly $150bn of its bonds.

Lehman bonds are trading at levels that imply losses on its debt of about $90bn, which assumes a standard recovery rate of 40 per cent. “Insurance companies, mutual funds and money market managers will bear many of these losses,” said Gregory Peters, managing director at Morgan Stanley.

In spite of a specially organised Sunday trading session in New York ahead of Lehman’s bankruptcy filing, the process for banks of working out their derivative counterparty exposures to the bankrupt dealer has only just begun.

In the credit derivatives market, which has been one of the fastest-growing financial sectors – hitting $62,000bn in notional outstanding volumes – short-term volatility and stuttering liquidity were immediately apparent. But the longer term effects on faith and activity in this still young market remain far from certain.

“The derivatives market is shellshocked,” said Brian Yelvington, analyst at CreditSights. “There are many aspects about unwinding trades with Lehman which people just don’t know yet how to resolve. The legal contracts which underpin the markets are not always watertight and this means unintended consequences cannot be ruled out.”….

Eraj Shirvani, a senior Credit Suisse banker and recently elected chairman of the global derivatives industry trade body, insisted that trading had remained smooth given the circumstances of three huge credit events in little more than one week – Lehman’s failure adds to the state bail-out of Fannie Mae and Freddie Mac, the mortgage agencies.

“We could have come to work today and had no trading, no one accepting anyone else’s credit and the market going into total meltdown. The fact that prices are available and that index moves have been relatively limited shows that we have liquidity and that the market is actually operating smoothly,” he said.

However, analysts and traders in the market said that banks were mostly focused on calculating and then looking to offset their own exposures to Lehman first – and so liquidity had been fairly limited. Gavan Nolan, analyst at Markit Group, said the indices had seen their worst ever single-day correction…

Others were not so sanguine. “This is a big threat to the CDS markets as a whole, which is truly scary because that was the last liquid market,” said one hedge fund trader. “Here, we’re all wondering whether Lehman might have blown up the market.”…

Mr Shirvani said that while a central clearing house and other infrastrastructure improvements that are in the pipeline would undoubtedly have helped, the market was capable of dealing with the Lehman failure.

“Compared with the many hedge fund failures seen in recent months, this counterparty failure is much more complicated, the numbers are a lot bigger and there are going to be more bumps in the road, but the process is robust, we have a very good contract and I think the closing out of contracts will happen in an orderly fashion,” he said.

Lehman is the warmup to what we will see with AIG. With Lehman, the issue is the ability of the counterparties on Lehman CDS to make good on their commitments. Because allegedly most of these exposures were hedged with offsetting CDS contracts, the gross amount at risk may considerably overstate the net.

AIG is a completely different beast. It was a massive protection writer, and the belief (we’ll hear more details soon enough) is that it has considerable net exposure. If Bear could not be permitted to fail due to the possible impact on the CDS market, multiply the impact by three or five times for AIG.