Diamond and Kashyap writing on the Freakonomics blog may be the best primer on the subject so far.
A.I.G. had to raise money because it had written $57 billion of insurance contracts whose payouts depended on the losses incurred on subprime real-estate related investments. While its core insurance businesses and other subsidiaries (such as its large aircraft-leasing operation) were doing fine, these contracts, called credit default swaps (C.D.S.’s), were hemorrhaging.
Furthermore, the possibility of further losses loomed if the housing market continued to deteriorate. The credit-rating agencies looking at the potential losses downgraded A.I.G.’s debt on Monday. With its lower credit ratings, A.I.G.’s insurance contracts required A.I.G. to demonstrate that it had collateral to service the contracts; estimates suggested that it needed roughly $15 billion in immediate collateral.
My question at this time that is not addressed: Did the failure of Lehman cause the failure of AIG? Perhaps indirectly by increasing the prices of CDS and thereby triggering margin requirements. I haven't seen anything that addresses this claim as yet. If this is the case then it must be that the Fed and Treasury underestimated the systemic risks of the Lehman bankruptcy. Alternatively, it is possible that this was deliberate in such a way that the Fed and Treasury would let institutions fail and intervene only when systemic breakdown is "near and present". In this case, if there are a chain of institutions A,B,C and the failure of A does not cause a systemic risk but causes the failure of B which also does not cause a systemic risk the Fed and Treasury are willing to let A and B fail up to the point when it triggers the failure of C which could cause a failure in the system.
My only introduction to derivatives is Introduction of Structured Finance by Frank Fabozzi, Henry Davis, and Moorad Choudhry where the authors espouse the brilliance of structured finance by informing the reader that whenever an entity wishes to issue a security and wants a better rating from the rating agency, it merely enters into a credit default swap. In fact they announce triumphantly that the entity can get any rating it wants (as long as they are willing to trade off a higher cost to enter into CDS).
The credit rating agency rates the security after all the satisfactory documentation has been generated and essentially gives the security a clean bill of health and collects its fee. As the underlying asset decreases in value, the same credit rating agency downgrades the security. If they were going to downgrade then why give the security an investment grade in the first place?
Ah, the credit rating agency says - what happens after we give the initial grade is out of hands. Well, I'm sorry but they don't get off that easily. It is the role of credit rating agencies to assess the risk of the underlying asset and if there is a possibility of a decline in value then it should be priced accordingly. Ah, but they don't want to displease the client - after all, they are the ones paying for the rating. It all smacks a little too much of a transaction where there are a lot of hand shakes, knowing winks and nods and everyone leaves happy. When the s**t starts to hit the roof, its everyone for themselves.
The role of credit rating agencies will also be scrutinized as this financial crisis unfolds.
Update:
Paul Wimott in the NYT:
I spend a great deal of time speaking to people in banks about their mathematical models. I know which are using good models (a very few banks) and which are using bad models (most banks). I know of the dangers present, from a quantitative-finance and risk-management perspective. And for many years I have explained these dangers to anyone who would listen, and I will continue to do so. So it is incredible to think that ratings agencies, which must also have detailed knowledge of the nature and, more important, size of the toxic transactions, will happily give out their multiple A grades without any feeling of shame.
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