How the Credit Rating Agencies Engineered the Goldman Sachs BailoutS

Last year's financial collapse was made possible by the greed and incompetence of credit rating agencies, who got paid to lie about the value of subprime debt. It turns out they were responsible for the Goldman Sachs bailout, too.

When AIG was bailed out to the tune of $150 billion last year, we were told it was necessary because of the "systemic risk" to the economy that would have been posed had the insurance giant gone into bankruptcy. Turns out $61 billion of that bailout went straight to banks that AIG owed money to, including $14 billion to Goldman Sachs. They would have gotten pennies on the dollar had AIG been allowed to fail, but after the taxpayers stepped in, the banks demanded to be paid in full. And Timothy Geithner, who was running the Federal Reserve Bank of New York at the time and the de facto chief of AIG, caved to those demands. Why? Because the credit rating agencies had a gun to his head.

The Special Inspector General for TARP has released the report of its investigation into exactly why Goldman and the other banks AIG owed money to didn't take a haircut after that bailout, and the extent to which AIG's credit rating was a ticking time-bomb throughout the ordeal is astonishing. Keep in mind that in 2008, if you wanted to sell an insane securitized mortgage concoction premised on prospective cash flow from monthly receipt of soiled envelopes full of change mailed in by hobos, Standard & Poor's, Moody's, and Fitch would have rated it as investment grade. Here's a 2007 IM exchange, uncovered by congressional investigators, between two S&P employees regarding one of the phantom collateralized debt obligations that killed the economy:

S&P Employee #1: btw-that deal is ridiculous

S&P Employee #2: I know right.. model def does not capture half of the risk

S&P Employee #1: we should not be rating it

S&P Employee #2: we rate every deal

S&P Employee #2: it could be structured by cows and we would rate it

S&P Employee #1: but there's a lot of risk associated with it – I personally don't feel comfy signing off as a committee member.

But when it came time to rate AIG's creditworthiness, that ratings agencies suddenly became exacting arbiters of fact, and their cascading downgrades and threats of further downgrades drove Geithner's decision-making as he bailed out AIG and negotiated with the banks AIG owed money to:

On the afternoon of September 15, 2008, the three largest credit rating agencies-Standard and Poor's Financial Services, Moody's Investors Service, Inc., and Fitch Ratings Ltd.-downgraded AIG. On September 16, 2008, because of concerns that an AIG bankruptcy could cause systemic risk to the entire financial system and the American retirement system, the Federal Reserve Board, with the support of Treasury, authorized [the Federal Reserve Bank of New York] to lend up to $85 billion to the firm....

Once the bailout got started, Geithner's choices were limited at every turn by how the ratings agencies would react. When negotiating with the banks, he considered threatening to let AIG go under—thereby inducing them to take what they could get from the government—but decided not to because if word got out, the credit agencies would react by lowering AIG's rating, which would in turn spark a round of defaults:

[The New York Fed] was further concerned – as it was throughout the AIG rescue – about the reaction of the rating agencies. While threatening not to support AIG might have been useful for purposes of forcing concessions by the counterparties, it could also have been viewed by the credit rating agencies as an indication that the [New York Fed] and the U.S. government was not standing fully behind AIG, which could have had a negative impact on AIG's credit rating.

And Geithner's cursory attempt to get the banks to take a haircut—the "negotiation" with Goldman Sachs consisted of one telephone call, according to the report—was conducted under duress because he feared another downgrade was imminent:

The intent in creating Maiden Lane III [the vehicle by which the banks were paid off] may similarly have been the improvement of AIG's liquidity position to avoid further rating agency downgrades, but the direct effect was further payments of nearly $30 billion to AIG counterparties, albeit in return for assets of the same market value. Stated another way, by providing AIG with the capital to make these payments, Federal Reserve officials provided AIG's counterparties with tens of billions of dollars they likely would have not otherwise received had AIG gone into bankruptcy.

In other words, we bailed out AIG because if we didn't, the credit ratings agencies would throw it in to bankruptcy by being honest for once in their lives about its financial condition. And we paid out $61 billion to Goldman and other banks because if we didn't, the credit rating agencies would have downgraded AIG and screwed up the whole bailout. They lied us into a collapse and rated us into a bailout. Oh, and now they're doing about $400 million in business rating securities for the Fed's Term Asset-Backed Securities Loan Facility, which requires that securities purchased through the program have to be rated by two or more "nationally recognized rating agencies."