Wall Street’s Next Big Problem
Wall St.’s Turmoil Sends Stocks Reeling (September 16, 2008) WHEN I drove to the Beverly Hills offices of Drexel Burnham Lambert on Feb. 13, 1990, the last thing I expected to hear was that the investment bank where I worked was going under. Yet early that morning, we were told that the company was filing for bankruptcy. I was, to put it mildly, blown away. At the time, Drexel had $3.5 billion in assets and was the biggest underwriter of junk bonds.
It all seemed like a very big deal at the time. But what’s happening this week makes me pine for the good old days.
When Lehman Brothers filed for bankruptcy on Monday, it became the latest but surely not the last victim of the subprime mortgage collapse. Lehman owned more than $600 billion in assets. Financial institutions around the world have already reported more than half a trillion dollars of mortgage-related losses and that figure will most likely double or triple before the crisis exhausts itself.
But there is a bigger potential failure lurking: the American International Group, the insurance giant. It poses a much larger threat to the financial system than Lehman Brothers ever did because it plays an integral role in several key markets: credit derivatives, mortgages, corporate loans and hedge funds.
Late Monday, A.I.G. was downgraded by the major credit rating agencies (which inexplicably still retain an enormous amount of power in the marketplace despite having gutted their credibility with unreliable ratings for mortgage-backed securities during the housing boom). This credit downgrade could require A.I.G. to post billions of dollars of additional collateral for its mortgage derivative contracts.
Fat chance. That’s collateral A.I.G. does not have. There is therefore a substantial possibility that A.I.G. will be unable to meet its obligations and be forced into liquidation. A side effect: Its collapse would be as close to an extinction-level event as the financial markets have seen since the Great Depression.
A.I.G. does business with virtually every financial institution in the world. Most important, it is a central player in the unregulated, Brobdingnagian credit default swap market that is reported to be at least $60 trillion in size.
Nobody knows this market’s real size, or who owes what to whom, because there is no central clearinghouse or regulator for it. Credit default swaps are a type of credit insurance contract in which one party pays another party to protect it from the risk of default on a particular debt instrument. If that debt instrument (a bond, a bank loan, a mortgage) defaults, the insurer compensates the insured for his loss. The insurer (which could be a bank, an investment bank or a hedge fund) is required to post collateral to support its payment obligation, but in the insane credit environment that preceded the credit crisis, this collateral deposit was generally too small.
As a result, the credit default market is best described as an insurance market where many of the individual trades are undercapitalized. But even worse, many of the insurers are grossly undercapitalized. In one case in the New York courts, the Swiss banking giant UBS is suing a hedge fund that said it would insure nearly $1.5 billion in bonds but was unable to do so. No wonder " the hedge fund had only $200 million in assets.
If A.I.G. collapsed, its hundreds of billions of dollars of mortgage-related assets would be added to those being sold by other financial institutions. This would just depress values further. The counterparties around the world to A.I.G.’s credit default swaps may be unable to collect on their trades. As a large hedge-fund investor, A.I.G. would suddenly become a large redeemer from hedge funds, forcing fund managers to sell positions and probably driving down prices in the world’s financial markets. More failures, particularly of hedge funds, could follow.
Regulators knew that if Lehman went down, the world wouldn’t end. But Wall Street isn’t remotely prepared for the inestimable damage the financial system would suffer if A.I.G. collapsed.
While Gov. David A. Paterson of New York on Monday allowed A.I.G. to borrow $20 billion from its subsidiaries, that move will only postpone the day of reckoning. The Federal Reserve was also trying to arrange at least $70 billion in loans from investment banks, but it’s hard to see how Wall Street could come up with that much money.
More promisingly, A.I.G. asked the Federal Reserve for a bridge loan. True, there is no precedent for the central bank to extend assistance to an insurance company. But these are unprecedented times, and the Federal Reserve should provide A.I.G. with some form of financial support while the company liquidates its mortgage-related assets in an orderly manner.
The Fed cannot afford to stand on principle. The myth of free markets ended with the takeover of Fannie Mae and Freddie Mac. Actually, it ended with their creation.
Michael Lewitt is the president of a money management firm.
AIG downgraded as it struggles to shore up books
Tuesday September 16, 1:05 am ET
By Ieva M. Augstums and Stephen Bernard, AP Business Writers
AIG hit by downgrades as it seeks funds to shore up its beleaguered books
CHARLOTTE, N.C. (AP) -- American International Group Inc., the world's largest insurer, was hit by a wave of downgrades by credit-rating agencies worried that the deteriorating housing market is further undermining the company's battered finances.
All three major agencies -- Standard & Poor's, Moody's Investors Services and Fitch Ratings -- dropped AIG's ratings at least two notches late Monday. While the new ratings are all still considered investment grade, the downgrades add to the pressure on AIG as it seeks billions of dollars to strengthen its balance sheet.
AIG spokesmen did not return calls seeking comment on the impact of the downgrades. But last month, the company estimated in a regulatory filing that a one-notch downgrade of its long-term senior debt ratings by both S&P and Moody's would force it to post $13.3 billion in extra collateral.
The need for that extra capital would put a constraint on AIG's day-to-day liquidity position, which is why the company has been seeking new financing or capital investments.
AIG is in a precarious position, in part, because of concerns about its credit ratings and how that would affect its portfolio of financial instruments known as credit default swaps. The swaps are essentially insurance coverage to protect investors against defaulting bonds or debt.
Moody's said it downgraded AIG "in light of the continuing deterioration in the U.S. housing market and the consequent impact on the group's liquidity and capital position due to its related investment and derivative exposures."
AIG has been battered over the past year by billions of dollars of losses tied to deterioration in the mortgage and credit markets. On Monday its shares fell $7.38, or 60.8 percent, to close at $4.76.
The Federal Reserve has asked Goldman Sachs Group Inc. to work with JPMorgan Chase & Co. about a possible short-term loan to keep AIG in business, according to a person familiar with the request who could not speak publicly because talks were still ongoing. The loan could be for about $70 billion, the person said.
JPMorgan is a financial adviser for AIG. Calls to Goldman Sachs were not immediately returned. Treasury spokeswoman Brookly McLaughlin declined to comment when asked about the possible financing efforts.
New York Gov. David Paterson, meanwhile, stepped to the company's aid by saying the state will allow AIG to use $20 billion of assets held by its subsidiaries to provide cash needed to stay in business.
Paterson asked New York state insurance regulators to essentially allow New York-based AIG to provide a bridge loan to itself. The governor has also asked the head of New York's insurance department to talk with federal regulators about providing an additional bridge loan to AIG.
"AIG still remains financially sound," Paterson said.
The move will allow AIG to use those assets as collateral to borrow cash to fund its day-to-day operations, Paterson explained.
It also helps AIG by "giving them what they need most, which is time," said Keefe Bruyette & Woods analyst Cliff Gallant, who added that the relaxation of insurance regulations is "unprecedented."
Typically, a state insurance commissioner's priority is to protect the policyholder, and that includes making it very difficult for an insurer to access the funds that are used to pay claims.
AIG's chief executive, Robert Willumstad, who has been CEO since June, has indicated he is willing to shed some assets, saying about a month ago that a "less complex AIG would be a better competitor."
Eesh, I should call my buddies who work @ AIG, see if I can help 'em out at all if they need references. Damn.
AIG is on one side of a great many bets in the credit default swaps (CDS), which banks use to hedge the risks of losses on their loans. A report Tuesday from Royal Bank of Canada's investment dealer arm pegs AIG's net exposure to credit default swaps at $441-billion (U.S.) Those swaps serve as insurance on the bank's loans and credit portfolios, known as collateralized debt obligations, or CDOs.
The fate of the American International Group now lies with the Federal Reserve, as the likelihood of a $75 billion credit line financed by a bank syndicate appears remote, people briefed on the matter said on Tuesday afternoon.
It is not known whether the Fed would now change course and agree to provide an emergency infusion of capital to the cash-starved insurance giant, or what form such aid would take. If the Fed decides not to intervene, A.I.G. will probably file for bankruptcy by Wednesday, these people said.
Cat -- are you @ AIG? Seriously? I used to work for in-house counsel on Long Island, but it was a good 18 years ago.
By David S. Hilzenrath And Zachary A. Goldfarb
Washington Post Staff Writers
Tuesday, September 16, 2008; 4:27 PM
Insurance giant AIG faces disaster if it can't line up as much as $80 billion of financing by tomorrow, the governor of New York said today.
"I think they have a day," Gov. David A. Paterson (D) said on CNBC. "Right now we're in a terrible situation if we let the world's largest industrial and commercial insurance company go down."
so are the taxpayers looking at a choice of putting about $100 billion into AIG with-in the next 24 hours or certain meltdown of the financial system?? I think this is what our national leaders must decide between tonight.
Reuters) - The Federal Reserve is negotiating a $85-90 billion secured bridge loan for American International Group Inc. (AIG.N), according to a report on CNBC.
Shareholders would be severely diluted by the bailout that involves the bridge loan. The government would receive AIG warrants for most of its equity in the bailout being negotiated. CNBC said the deal would give AIG incentive to sell its assets quickly to help pay off the bridge loan.
ask the people who were at Bear, Merrell and Lehman how they felt about their firms chances days before the knife fell.....see my point??
In an extraordinary turn, the Federal Reserve agreed Tuesday night to take a nearly 80 percent stake in the troubled giant insurance company, the American International Group, in exchange for an $85 billion loan.
In a statement, the Fed said Tuesday night that it had decided to step in because, given the current financial turmoil, “a disorderly failure of A.I.G. could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth and materially weaker economic performance.”
The loan, which is for 24 months, is expected to be repaid from the proceeds of the sale of the firm’s assets, the statement said. “The loan is collateralized by all the assets of A.I.G., and of its primary non-regulated subsidiaries, and of its primary non-regulated subsidiaries.”