AIG situation looks critical

One reason I came out this morning against the Fed and the U.S. Treasury’s decision to allow Lehman Brothers to go bankrupt is the arbitrariness of its decision-making process. Lehman is easily more of a systemic risk than Bear Stearns and is certainly a larger company. Why let Lehman fail? Why rescue Fannie and Freddie? Why rescue Bear?

Now, it appears a rescue of AIG is in the offing. If this rescue proceeds, it will make Paulson and Bernanke look like idiots for letting Lehman fail.

Alice Cook over at UK Bubble says it best:

Where is the consistency?

Why did the U.S. authorities bail out Bear Stearns, but throw Lehman to the wolves? It is possible to cobble together an unconvincing story about Bear presenting more systemic risk that Lehman. Nevertheless, decision-making at the Fed does seem arbitrary.

Previously, the thinking was that the Fed would come to the rescue if a major bank were in trouble. Now, we know that is not true. However, no one knows the criteria for a bail-out. Risk premia will rise accordingly.
–Dealing with the shock, UK Bubble

The Fed and the Treasury have it all wrong. They need a consistent well thought-out approach to this crisis. This is what I tried to present in my post this morning Lehman’s bankruptcy: putting the cart before the horse. But instead we get a Russian roulette approach of you’re saved, you’re saved, you fail, you’re saved.

The prospects of a private market solution to the deterioration of the American International Group appeared to be faltering on Tuesday, as talks involving the Federal Reserve and several banks turned to the possibility of using government money to shore up the ailing insurance giant, people briefed on the negotiations said Tuesday morning.

Fed officials were still meeting with A.I.G., JPMorgan Chase, Goldman Sachs, Morgan Stanley and others at the Federal Reserve Bank of New York Tuesday morning to discuss possible options. It isn’t clear that any solution, including one involving government money, will emerge, this person said.

If a financing solution is not reached, A.I.G. may file for bankruptcy as soon as Wednesday, a person briefed on the matter said Monday night.

-Deal Book

I certainly admit that I did not see this one coming. Just in August I said the following about AIG after it wrote down billions in losses:

AIG has long been one of the largest and best-capitalized insurance and financial-services organization in the world. Before recent scandals, it was one of a few S&P 500 corporations in the U.S. with a AAA rating. Yet, it just reported a massive $11 billion writedown to go alongside it’s other previous writedowns, causing its stock to suffer its worse day ever. Moreover, it has not ruled out further capital raising in order to shore up its weakening balance sheet.

AIG is a pretty solid company with a huge amount of capital and a solid balance sheet. Bloomberg says:

AIG held $112.2 billion in capital at June 30, the insurer said in a slide presentation, more than the $102.7 billion at the end of the first quarter. The company raised $20.3 billion in May by selling debt and equity.
–Bloomberg, 7 Aug 2008

However, the risks AIG took on during the housing bubble have led to a crisis of confidence among the firm’s investors. What the AIG story should tell investors is that there are a lot more writedowns to come — not just at AIG, but across the board. Furthermore, while companies like AIG will survive with massive dilution to their current shareholders, others will not.

Note my last sentence in that post. I assumed that AIG was a solid company with hundreds of billions of dollars in capital which would weather the storm. I still do.

In my view, the AIG situation is a perfect example of what I discussed when I said that crisis brings bankruptcy to perfectly good companies with the bad.

One problem with financial crises is that perfectly healthy companies, perfectly healthy financial institutions can go bankrupt just because they temporarily lack the funds to pay their creditors. This is what the lack of liquidity in our financial system can do. The real problem of crisis is that healthy institutions are often dragged down with unhealthy ones, leading to a dead weight loss and a negative feedback loop in the real economy.

If AIG fails, it will roil the equity, debt, derivatives, and currency markets. It will affect precious metals and commodities too. This is a failure that would have catastrophic ramifications worldwide. In short, AIG is too big to fail.

In the face of such problems, we do not need the shoot from the hip, laissez-faire free markets ideological jumble that we are getting from U.S. monetary authorities. Ben Bernanke claims to be a student of the Great Depression. This is supposed to be his area of expertise.

Show me, Ben. If there was ever a time, it is now. Show me you know what you are doing because we are as close to a collapse of the U.S. banking system as we have been in 80 years.

Related posts
Lehman’s bankruptcy: putting the cart before the horse, Sep 2008
AIG: looking to raise $20 billion, Sep 2008
Solvency, Sep 2008
What AIG’s losses mean, Aug 2008
AIG Poised to Absorb $5 Billion Losses, Jun 2008
Look who needs money now: AIG, May 2008