The following is an excerpt from Chapter 8 of my book, Predicting the Markets: A Professional Autobiography.

LLOYD BLANKFEIN, CEO of Goldman Sachs, wrote an article in the February 8, 2009 Financial Times titled “Do Not Destroy the Essential Catalyst of Risk.”[1] He observed that it should have been obvious something wasn’t right about CDOs: “In January 2008, there were 12 triple A-rated companies in the world. At the same time, there were 64,000 structured finance instruments, such as collateralised debt obligations, rated triple A.” It was a belated warning, to say the least! “It is easy and appropriate to blame the rating agencies for lapses in their credit judgments,” Blankfein continued. “But the blame for the result is not theirs alone. Every financial institution that participated in the process has to accept its share of the responsibility.” It’s easier to spout mea culpas after all the profit opportunity has dried up. What good do they do then, besides silencing critics with the same incriminating points to make?

As Blankfein admitted, the most obvious perpetrator of the 2008 financial crisis was the credit insurance industry. This industry emerged following the first of the three Basel Accords. In Basel I, the banking regulators of the major industrial nations agreed to impose uniform capital requirements on banks. Risky assets required more capital. The credit insurance industry employed an army of financial engineers whose innovations magically transformed subprime mortgages, junk bonds, liars’ loans, and other trashy debts into AAA-rated credits. Many of these products were defective. This financial engineering was a great business while it lasted. But it represented huge fraud at worst or negligent malpractice at best.

Among the major contributors to the debacle were the credit-rating agencies that had awarded AAA ratings to thousands of CDO tranches, as Goldman’s Blankfein belatedly observed. The FCIC’s January 2011 report was correct to call the rating agencies “essential cogs in the wheel of financial destruction” and “key enablers of the financial meltdown.” There were only three big rating agencies—Moody’s Investors Service, Standard & Poor’s, and Fitch Ratings.

The FCIC concluded: “The three credit rating agencies were key enablers of the financial meltdown. The mortgage-related securities at the heart of the crisis could not have been marketed and sold without their seal of approval. Investors relied on them, often blindly. In some cases, they were obligated to use them, or regulatory capital standards were hinged on them. This crisis could not have happened without the rating agencies. Their ratings helped the market soar and their downgrades through 2007 and 2008 wreaked havoc across markets and firms.”[2]

The securitization business brought the agencies huge fees. The raters were paid by the issuers to rate the CDOs that included bunches of tranched ABS. The more complex the security, the greater the fee generated. By the time Moody’s became a public company, structured finance was its top source of revenue. Gretchen Morgenson of The New York Times reported on December 6, 2008 that Moody’s fees for rating mortgage pools were four to five times more than fees for rating similarly sized municipal bonds.[3]

The rating agencies were operating as a government-sanctioned oligopoly without any government regulation—no federal agency was charged with oversight. Washington finally recognized that the rating agencies were running amok and needed to be reined in, so Congress passed the Credit Rating Agency Reform Act, and President George W. Bush signed it into law in late 2006.

Under the Act, the SEC filled the void and became the agencies’ regulator. While the new law gave the Commission new powers to inspect and punish the agencies, it also prevented the SEC from regulating how ratings were determined. The SEC had no authority to make rules governing the agencies’ business or to subject them to examinations as nationally recognized statistical rating organizations (NRSROs).

The Commission established its formal regulatory program for NRSROs in June 2007; seven firms applied to be registered, and all were approved. As SEC Chairman Christopher Cox testified on April 22, 2008, before the US Senate Committee on Banking, Housing and Urban Affairs, “as of the end of September 2007, seven credit rating agencies—including those that were most active in rating subprime RMBS [residential mortgage-backed securities] and CDOs—became subject to the Commission’s new oversight authority, and subject as well to our newly adopted rules.”[4]

But September 2007 was too late. When the delinquency rates of mortgages started escalating in early 2007, calling into question the AAA ratings on many CDOs with subprime loan exposure, the rating agencies didn’t fail to notice. The rating agencies lowered their credit ratings on $1.9 trillion in MBSs from the third quarter of 2007 through the second quarter of 2008, with dire implications for the credit quality of the CDOs composed of the downgraded MBSs. In other words, CDOs began to hit the fan.

Why hadn’t Moody’s noticed the rising delinquencies in early 2007? Moody’s did have a US residential mortgage bond team in place to track troublesome developments, according to the October 17, 2008 issue of the Financial Times.[5] But the rising delinquencies seen in January 2007 didn’t compel Moody’s to take action. That’s because rising delinquencies alone was only the first of three cautionary signals in Moody’s alarm system—which was still flashing a “green light.” True, the speed of delinquency escalation shocked analysts, but their system told them to sit tight. The Financial Times noted: “According to a report in March 2007, the risks of the defaults in subprime mortgage bond pools climbing further up the structured finance chain were ‘mild to moderate.’” Soon after, the amber light flashed when the number of delinquencies exceeding 90 days shot through the roof. Still, “[o]utwardly, the agencies were sanguine,” reported the Financial Times.

As US mortgages continued to sour at a breakneck pace, Moody’s analysts, upon inputting the new data, were stunned by the severity of the mortgage crisis. In the final few months of 2007, the rating agency downgraded more bonds than it had over the previous 19 years combined, reported the Financial Times. Similar revelations must have occurred in the offices of Standard & Poor’s and Fitch, which also began downgrading like mad.

Moody’s abundant AAA ratings on pools tainted with subprime allowed for little possibility that the housing boom might go bust—even though Moody’s very own in-house chief economist, Mark Zandi, had been warning of a US housing downturn since May 2006! According to the Financial Times, Zandi wrote in May 2006 that the housing market “feels increasingly ripe for some type of financial event.”

We now know that the 800-pound gorilla in the credit insurance industry was AIG. In the Mayfair neighborhood of London dubbed “hedge fund alley” were the offices of AIG Financial Products—the business unit from which AIG issued its credit default swaps. It had been run for 21 years by American Joseph Cassano.[6] Most of those years were great ones financially, for both the high-performing subsidiary and its highly compensated leader. That all changed at the end of 2007. Cassano had built the credit default swap business so successfully that AIG Financial Products provided guarantees on more than $500 billion of assets by that point, including $61.4 billion in securities tied to subprime mortgages.[7]

An accounting shift that affected how the Financial Products unit valued collateral resulted in the markdown of these credit default swaps—and poof went $34 billion. In contrast to standard practice, AIG Financial Products did not hedge its exposure to a possible fall in the CDS market. When AIG’s accountants asked the insurer to change the way it valued CDSs, the comparatively small base of capital on which AIG Financial Products had built a mountain of business became visible. This began the unravelling that led to AIG’s central role in sparking the globalization of the US financial crisis, because many European banks had purchased AIG credit derivatives to insure their loan portfolios and bonds.[8]

On September 16, 2008, AIG suffered a liquidity crisis when its credit rating was downgraded. To avoid a financial meltdown, the US Treasury Department extended an $85 billion credit line in exchange for just under 80% of its equity. On March 2, 2009, AIG announced fourth-quarter 2008 results representing “the biggest quarterly corporate loss in US history,” according to a March 4 Washington Post article: a loss of $61.7 billion.[9] The US government at about the same time re-restructured the terms of AIG’s total bailout package, which by then had swelled to $152 billion—providing another $30 billion in taxpayer funds, eliminating dividend payments, and granting the government stakes in two of AIG’s big insurance subsidiaries.

On Tuesday, March 3, 2009, testifying at a Senate hearing on the federal budget, Fed Chairman Ben Bernanke was really mad: “[I can’t think of] a single episode in this entire 18 months that has made me more angry . . . than AIG.” That was the first time the characteristically reserved central banker had publicly displayed any emotion about the financial crisis. What most got his goat reportedly was the way AIG had strayed from its core insurance business to take unmonitored and unnecessary risks; writing billions of dollars in exotic derivative contracts had nearly destroyed the company. “AIG exploited a huge gap in the regulatory system,” Bernanke said. “There was no oversight of the Financial Products division. This was a hedge fund, basically, that was attached to a large and stable insurance company, made huge numbers of irresponsible bets—took huge losses. There was no regulatory oversight because there was a gap in the system.”

On the same day that the Fed chairman was castigating AIG before the Senate, Treasury Secretary Timothy Geithner was over in the House trying to defend the government’s ever-growing rescue of AIG to fuming lawmakers. The March 4, 2009 Washington Post quoted some of his testimony before the House Ways and Means Committee: “AIG is a huge, complex, global insurance company, attached to a very complicated investment bank hedge fund that built—that was allowed to build up without any adult supervision, with inadequate capital against the risks they were taking, putting your government in a terribly difficult position. . . . And your government made the judgment back in the fall that there was no way that you could allow default to happen without catastrophic damage to the American people.”

In his mea culpa article on behalf of the financial industry, Blankfein admitted that it was all about making lots of money: “We rationalised and justified the downward pricing of risk on the grounds that it was different. We did so because our self-interest in preserving and expanding our market share, as competitors, sometimes blinds us—especially when exuberance is at its peak.”

Blankfein didn’t mention that his firm had been dangerously exposed to AIG. In 2007, Goldman began marking down the value of CDOs on its books that had been insured by AIG against the possibility of default. When Goldman requested that AIG put up more collateral to cover those losses, the insurance company sometimes posted half or less of the amount demanded, disputing Goldman’s valuations. When the government took over AIG, its creditors, including Goldman, were made nearly whole. An April 15, 2009 editorial in The Wall Street Journal argued that the government’s takeover of AIG amounted to a bailout of Goldman, though the firm claimed it had “no material economic exposure to AIG” when the insurer collapsed.[10]



[1] “Do Not Destroy the Essential Catalyst of Risk,” Blankfein’s Financial Times op-ed of February 8, 2009.

[2] The Financial Crisis Inquiry Report, p. xxv.

[3] “Debt Watchdogs: Tamed or Caught Napping?” Morgenson’s article in The New York Times, December 6, 2008.

[4] “Testimony Concerning Oversight of Nationally Recognized Statistical Rating Organizations,” Cox’s April 22, 2008 congressional testimony.

[5] “How Moody’s Faltered,” Financial Times, October 17, 2008.

[6] “AIG Trail Leads to London ‘Casino’,” The Telegraph, October 18, 2008.

[7] “AIG Said to Pay $450 Million to Retain Swaps Staff (Update1),” Bloomberg News, January 27, 2009.

[8] Again, see “AIG Trail Leads to London ‘Casino’.”

[9] “Bernanke Blasts AIG for ‘Irresponsible Bets’ that Led to Bailouts,” The Washington Post, March 4, 2009.

[10] “The Goldman Two-Step,” The Wall Street Journal, April 15, 2009.