Achilles’ Heel and Those Damn Chickens
September 17th, 2008 | by Jet Netwal |
Yesterday was wait and see time. For the jocks of the financial world, it’s fourth and one with less than a minute to go. AIG is the Patriots, and unlike in the NFL, cheaters might not prosper.
I think it might be helpful to understand what is actually happening with AIG. Some people may look at the stock market and believe that the market is taking a hit but not a crash like in ‘29, so this is just another correction and there isn’t really anything to worry about. That would be unwise.
AIG is an insurer, not a financial entity like Lehman. As an insurance concern, A.I.G. has wholly different regulators and capital requirements than the banks and Wall Street firms that have suffered most of the huge losses so far. What this means, for example, is that the three-card Monty that passed for risk management assessment on the subprime loans is our first chicken coming home to roost. By selling these derivatives contracts in a largely unregulated arena meant that the risk was spread, but nobody could say with any degree of certainty which companies held how much. Essentially, the big companies were propping each other up, acting as counterparties to each other and to a huge number of little guys.
So what is happening? Why is AIG such a big deal?
We all know that AIG’s stock has dropped, and consequently its value as a company is diminished. Think of it as a big merry-go-round.
But reflecting the parlous situation, its (AIG’s) shares plunged 61% Monday while the cost of insuring AIG debt soared to astronomical levels.
“The move highlights the circular dilemma facing financials with capital concerns,” writes Bank of America credit analyst Jeffrey Rosenberg. “The lack of capital-raising prompts a downgrade, further worsening the credit risk of the company, further constraining the capital-raising potential.”
The downward spiral also extends to the equity side. The sliding stock price makes the cost of raising equity capital and the potential dilution of current shareholders prohibitive, while the inability to raise capital further pressures the stock price. Barrons.com
In other words, by holding too many bad derivatives and needing cash to pay out on them, AIG can’t raise money fast enough. This earned them a downgrade, which means it’s even harder to raise cash to cover their butts. Conversely, as their market value plummets, it becomes harder and harder to borrow, which drives their stock lower, and so on.
This brings us to chicken number two. AIG has so much debt in the derivatives market that in order to cover all the bad paper they have out there, the downgrades cause them to react from a position they haven’t really earned. Basically AIG is huge, and most of it is healthy, but the assets from the healthy stuff are either unavailable to tap because of the structures governing insurers, or they aren’t enough. However, they are screwed because they got downgraded.
That’s reflected in the draconian price being exacted to insure AIG debt in the derivatives market. The all-in cost virtually doubled, to a 1722 basis points, an increase of 820 basis points, according to Tim Backshall, chief strategist at Credit Derivatives Research. That would normally translate to a cost of $1.722 million annually to insure $10 million of AIG debt for five years. But, because the market fears an accident sooner, AIG CDS require an upfront payment — some $3.05 million — plus $500,000 annually.
That reflects what AIG is up against. While its credit ratings remain well within investment-grade range, the downgrades could result in AIG’s counterparties demanding an additional $14.5 billion in collateral — in effect, a margin call, according to an SEC filing made last month, according to published reports. – Barrons.com
AIG is an enormous concern, but even they can’t crap 14.5 B on a whim, and that’s what a margin call is. Think of it as a run on the bank. Banks can demonstrate all their assets on paper, but they are not liquid cash. If every depositor showed up and demanded all their money at once, the bank would be unable to do so. This is the gist of what is happening to AIG. None of the other counterparties want to get caught holding the bag, so the hot potato is flying. They are betting AIG will fold, and they want their money out now. Unless AIG can secure not the usual amount, but cover the run, they are in deep shit. Despite their size and relative solvency, the temptation of unregulated instruments proved their Achilles heel.
What is critical for the average person to understand is that if AIG falls, every major bank in the world will take a hit because they are all counterparties to AIG; a large number of smaller ones will suffer as well. The domino effect will begin. By the time the stock market reflects the impact of bank after bank downgrading or taking significant hits, it will be all over but the shouting. The market is not an indicator in this problem at all. Pointing to a rosy market is missing the point.
Let’s dig in to what else this means. First off, the Fed said Monday it didn’t want to step in this time because they don’t want to set a precedence of rewarding irresponsibility (too late), but my thought was that 85B is a big freakin’ Band-Aid. (We’re hardly is a rosy financial scenario ourselves. Think where we’d be in China ran the equivalent of a margin call on us. Yikes.) The Fed wanted Goldman Sachs and JPMorgan Chase to figure out a way to float the AIG Titanic. Additionally, the State of New York said it would temporarily lift a restriction allowing AIG to borrow 20B from its profitable subsidiaries (an option normally not available to insurers) until Wednesday. This meant AIG had to find the rest of the cash or they couldn’t do that.
Today we find a different set of balls looking at the same problem. The Fed agreed to pony up the 85B in a two-year loan. This means that AIG will sell off a lot of assets in order to get out from under their fat sack of crappy derivatives. AIG will not be forced to sell everything at fire-sale prices, and we won’t have them borrowing against themselves and setting a precedence for future BS. Overall, I am ok with this, provided the following things happen:
- First, regulation, regulation, regulation. Period. If you didn’t want regulation, you should have run it clean the first time.
- Second, this 85B is not borrowed by us to give to AIG. We’ve got enough Dragons in our closets.
- Third, we get the fuck out of Iraq and stop POURING money away.
- Fourth, we NEVER do another bailout. This is it. Take your lumps and work it out, bail each other out, whatever. I don’t really care other than I’m tired of paying for willful miscreants. That includes fat CEO exit pay and any other malarkey. You do it on my dime, and you get the same treatment as I do. I’m sick of US corporations acting like whiney teenagers with no sense of accountability or place in the world.
Currently, there are 305,178,646 people in the United States. That means this bailout will cost every man, woman and child in this country $278.53. EACH. For my family of five, that’s $1,392.65. Since I earn less than 2% of what AIG’s CEO is compensated, am not a stockholder, and bought my insurance from MetLife, that seems fair. Not.
It’s a relief to finally know where to spend my stimulus check. I was going to do something stupid like buy chicken feed, but these days I can hardly get through the day without getting mired in bird poop bailouts.
These damn chickens keep coming home to roost.
2 Responses to “Achilles’ Heel and Those Damn Chickens”
By Dusty on Sep 17, 2008 | Reply
Chickens coming home to roost..woot!
By Liberal Jarhead on Sep 18, 2008 | Reply
Great explanation. Thank you.
The ultimate result of the Great Depression – along with massive amounts of homelessness, starvation, and a near-revolution – was public recognition of the damage that had been done by Republican corruption, greed, and irresponsibility very similar to what we’ve seen since 1980 (including some on the part of the Clinton administration); re-regulation of the financial industry in areas where deregulation had made the train wreck possible; and a re-awakening of the sense of community and mutual responsibility that was embodied in the New Deal.
I hope it doesn’t take another Great Depression for a solid majority of Americans to finally and emphatically reclaim control of America from the corporatists and neocons, but it may.