On Sunday, September 14, the government drew a line in the sand on Lehman Brothers. After orchestrating a bailout of Bear Stearns by JP Morgan (with tens of billions in guarantees) the precedent was set - investment firms in trouble could simply go to the feds. The moral hazard, a term that is suddenly in vogue now when it should have been in vogue in 2005 and 2006, the bailout created was beginning to affect investor thinking. Without risk of failure reckless behavior is encouraged, and the actions of a few managers on Wall Street will be paid for by taxpayers.
So the line was drawn with Lehman. No bailout. It was the right move to restore the natural order of economics.
Two days later the government erased its line in the sand and gave an unbelievable $85 billion in emergency loans to AIG. What happened?
Fear is the answer. In response to the Lehman bankruptcy stock markets in the US and all over the world tanked. The sell-off was the most severe since 2001. But the stock market fear was not the fear the Fed was really worried about with AIG.
During the height of the mortgage boom, the credit derivatives market grew to $34.5 trillion. A lot of the riskier pieces of derivative tranches were paired with credit default swaps (CDS), essentially insurance policies that would pay out in the event of a loss. It was a good business when everything was booming. CDS counterparties collected premiums with very low expectations of actually having to cover losses.
AIG was one of the biggest counterparty issuers of CDS's. That means they are “insuring" losses to nearly every player in the derivative markets. Since the expectations of payouts were low back when the swaps were issued, the amount of capital reserves AIG needed to maintain were minimal.
Now that losses have swamped several financial companies they are looking for their insurance payouts. And AIG does not have the money to cover them.
If the federal government allows the biggest insurer to fail the losses will cascade through the financial system. That systemic shock would likely force several more financial institutions to fail. The shock may, and this is the scenario the Federal Reserve is trying to avoid at all costs, create enough fear to ignite the kind of panic that caused the Great Depression.
These are unprecedented times. After bailing out Fannie Mae and Freddie Mac (legally a conservatorship but technically a takeover) the government is now in the mortgage business. After bailing out AIG the government potentially bought a 79.9% equity stake in the company, and is now in the insurance business. Both moves demonstrate that the Treasury Department and the Federal Reserve are seriously concerned about the systemic health of the banking system - otherwise those moves would never have been made.
Investors need to be very cautious in the near term, and resist the temptations of buying too soon. The outlook for the economy is not good. A sustained credit crunch will not allow the economy to recover, and will push it deeper into contraction. If investors need more evidence of just how serious the crisis is, the fact that the government is now a commercial insurer should be it.
Jeffrey P. Snider is Vice President and Portfolio Manager for Atlantic Capital Management. For more economic and market analysis sample our research at http://www.client-centered.net