AIG to survive?

So, the latest company on the perverbial chopping block is AIG, one of the largest insurers and reinsurers in the world. Rumors abound this afternoon that the Fed and the Treasury are busily working on behind the scenes type deals similar to the JP Morgan/Bear Stearns bailout. What is the difference between Lehman Brothers and AIG you may ask? Great question, and honestly one I'm not sure what the answer is. I'd suspect the difference is that one company was a global investment house with an emphasis on bond investments, the other is a global insurer with significant ties to the CDS markets. While Lehman Brothers will without a doubt have a negative impact on the CDS markets, the failure of one of the largest CDS market participants and one of the largest insurers in the world, would at the very least have far reaching negative financial consequences and, worst case, could lead to a financial meltdown similar to the 1930's. So, while I'm not a fan of enabling Wall Street's continued bad behaviors, I think AIG is one player that is indeed too big to fail. Therefore, don't be surprised if we see deal announced after normal trading hours either tonight or tomorrow night that includes either a direct investment on behalf of the Federal Reserve and/or the U.S. Treasury, or a deal that allows another player to prop up AIG with backing from the Fed, similar to what happened with Bear Stearns. Bear Stearns was another global investment bank that had significant CDS market exposure were it to fail. In fact, Bear Stearns held some 40% of JP Morgan's CDS contracts, so it is no surprise that the Fed stepped in given the failure of Bear Stearns would have led to serious capitalization and solvency concerns for JP Morgan itself. Since JP Morgan is one of the largest commercial banks in the world, the failure of such a bedrock banking institution would lead to crisis of confidence in the financial sector that would contribute to the systemic risk of a serious financial meltdown. I've always felt that the key decision factor on whether any bailout would retain Fed backing will be tied to CDS market exposure. If confidence in the CDS markets, nominally valued at some 60 trillion dollars of insurance investment contracts, is called into question, we will almost without question see a systemic problem that will lead to a systemic financial meltdown that will in turn lead to a major recession at the very least, and quite possibly a depression. This would occur regardless of the failsafes that are available to prevent relatively minor failures on occasion within the financial system itself, i.e. the failsafe institutions were never meant to serve as a backdrop to a major financial meltdown, these institutions, just like the banks themselves, are not properly capitalized to be able to prevent such large scale problems from occurring.

The Fed held steady on the fed funds and discount rates today. I believe this was also wise on the part of Ben Bernanke given we still have latent inflationary economic pressures that the Fed must remain concerned about. It will be most interesting to see if the Fed does move into unprecedented territory if no entity in the private sector steps up to bail out AIG, meaning if some type of lending window will be opened up to include insurers such as AIG. Already, the Fed expanded the TAF and created the TSLF that enabled non-commercial banking institutions to either obtain liquid funds from the TAF, or trade in essentially toxic securities as collateral and to receive Treasury bonds in return. This is a fancy way, in my view, of allowing the investment houses to trade in worthless securities and receive investment grade T-bonds in return to help shore up their balance sheets. In many cases, it appears on the surface at least that the Fed is, for example, taking billions of dollars of nominally valued derivative contracts onto it's books, and handing back like amounts of T-bonds in return. Trouble is, those derivative investments are likely worth no where near the amounts stated. So, who eats the loss? I don't have a real answer to that question, but my sense is it's us, the U.S. taxpayers, eventually, one way or another. This is just a masked form of a bailout that isn't as obvious to those that don't understand the complexities of the dealmaking that is ongoing behind the scenes.

Well, time to hang it up for now. More on the various exciting finance topics when I can find the time! :-)