Meltdown

If you're feeling apocalyptic today, this will go right along with your mood. From AIG has ‘a day’ to stay afloat Financial Times 09/16/08:

AIG, the troubled insurer that sits at the heart of the financial system, has one more day to come up with the capital to stay afloat, according to David Paterson, New York governor.

Speaking to CNBC, Mr Paterson also explained that without a capital-raising deal, AIG would not be able to benefit from the $20bn lifeline thrown by state regulators on Monday.

Fear that one of the largest financial institutions in the world could go down sent investors into a panic. AIG’s share price plunged over 60 per cent in early trading but recovered to just 10 per cent down after CNBC said it might get government assistance.

The cost of insuring $10m of AIG bonds for five years on Tuesday rose to $5.8m upfront plus $500,000 per year, up 66 per cent from the $3.5m upfront quoted on Monday. This implied that capital markets were getting ready for AIG to default. [my emphasis]

AIG's problems could actually turn out to be a bigger deal (so to speak) than Lehman Brothers' demise and Merrill Lynch's fire sale to Bank of America. I'll be genuinely surprised if BofA doesn't develop some severe problems of its own in the next couple of years, having just purchased two very troubled financial companies, Countrywide and Merrill, albeit at fire-sale prices.

Nanette Byrnes gives some of the grim details on AIG's problems in The Unraveling of AIG Business Week Online:

AIG - a company with $110 billion in revenues last year and $1 trillion in assets - has suddenly gone from being the gold standard in its industry to fighting for survival. The sheer speed of its descent has stunned employees, customers, and many in the industry. "It's staggering to see just how much has changed in a very short time," says David Schiff, editor of Schiff's Insurance Observer, and a longtime critic of the company. Even more staggering are the ever-rising estimates of how much capital AIG now needs to cover its obligations. "That's a scary thing. It can be that some things are just unknowable in the high-wire finance a lot of these companies are in."

Incidentally, that comment that, "It can be that some things are just unknowable", is a refutation of the basic assumption of conventional economics. All their "free market" models are build on the assumption that market actors of fully informed about their choices and risks. This is a particularly egregious assumption when we're talking about capital markets. The substantially unregulated market in capital is the biggest cause of our current problems, kicked off by the bursting of the housing bubble.

AIG's problems are related to the mortgage meltdown. AIG has issued a large number of "credit default swaps", a "financial derivative" instrument that essentially mitigates the risk to the purchaser from other high-risk/high-return investments. That's how an insurance company gets nailed by a mortgage crisis.

Paul Krugman's Financial Russian Roulette New York Times on the current crisis is well worth reading:

Like many financial institutions, Lehman has a huge balance sheet — it owes vast sums, and is owed vast sums in return. Trying to liquidate that balance sheet quickly could lead to panic across the financial system. That’s why government officials and private bankers have spent the weekend huddled at the New York Fed, trying to put together a deal that would save Lehman, or at least let it fail more slowly.

But Henry Paulson, the Treasury secretary, was adamant that he wouldn’t sweeten the deal by putting more public funds on the line. Many people thought he was bluffing. I was all ready to start today’s column, “When life hands you Lehman, make Lehman aid.” But there was no aid, and apparently no deal. Mr. Paulson seems to be betting that the financial system — bolstered, it must be said, by those special credit lines — can handle the shock of a Lehman failure. We’ll find out soon whether he was brave or foolish.

The real answer to the current problem would, of course, have been to take preventive action before we reached this point. Even leaving aside the obvious need to regulate the shadow banking system — if institutions need to be rescued like banks, they should be regulated like banks — why were we so unprepared for this latest shock? When Bear went under, many people talked about the need for a mechanism for "orderly liquidation" of failing investment banks. Well, that was six months ago. Where’s the mechanism?

And so here we are, with Mr. Paulson apparently feeling that playing Russian roulette with the U.S. financial system was his best option. Yikes.

For more on the crisis, see Memeorandum.

Tags: paul krugman