FYI | Sep 16 2008
By Greg Peel
The most notable thing about the death of Leman Bros – a 156 year-old firm which began as a cotton broker and rose to be the fourth biggest investment bank on Wall Street – is that it wasn’t a shock. While fifth biggest investment bank Bear Stearns was clearly the most in trouble when the credit crunch hit, its demise in March very much came out of the blue. It was all over in the matter of a couple of days.
From that point on the market had always assumed Lehman would be the next to go if the global credit situation and the US housing situation failed to improve. Neither did, so the stock market began to factor in Lehman’s departure and the end result was thus no great shock. It was not even a shock that the government failed to save Lehman – the government just can’t save every firm on Wall Street – as it had already opened up emergency facilities to be accessed if need be.
When Enron collapsed in 2001 with assets of US$63bn, it was by far the biggest corporate failure in US history. Enron was then topped by WorldCom in 2002, going down with assets of US$103bn. To put things into perspective, Lehman Bros has now gone down with US$639bn, according to its most recent filing. To put things into even clearer perspective, the last time the world thought the global financial system would collapse was when Long Term Capital Management went down in 1998 owing US$6bn.
Thus the Lehman failure can not be underestimated. As we speak, banks and institutions across the globe are furiously calculating just what counterparty risk they hold with Lehman, and hence what extent of write-offs (not write-downs this time) will be forthcoming. The top ten US financial institutions on the weekend pledged to put US$7bn each of emergency lending facility into a pool to be available for all institutions facing a Lehman fallout. This was a necessary move because (a) neither the government nor the Fed was prepared to provide such a facility and (b) while most businesses are happy when a competitor goes under, in the case of financial institutions risk positions are so intricately interwoven that the demise of any one has an effect on all. Imagine a team of mountain climbers tied together and one falls into a crevasse, but there is no means of cutting that weight loose.
The assets of the American International Group are estimated to exceed US$1 trillion. AIG is basically a general insurer, so the question is why is a general insurer now caught up in this mess? As of last night its shares had taken the same 95% tumble that preceded the bail-out of Fannie and Freddie and the end of Lehman. While Lehman’s bankruptcy should have been the biggest headline this year, and perhaps this decade, by mid-session last night the spotlight had swung firmly away from Lehman and on to AIG. Once again the call went out: This company is too big to be allowed to fail!
The reason AIG is part of the problem is firstly that it also provides financial services and wealth management, but most importantly that it provides insurance against default of financial derivative instruments such as collateralised debt obligations (CDOs) – the instrument at the heart of the global credit crunch. AIG is the world’s biggest insurer, so while the default of Lehman debt will cause serious pain in the market the default of any debt across the financial sector has ramifications for AIG.
It is estimated that the last time Lehman wrote down the value of its credit positions, the same positions covered by AIG insurance were still being carried on AIG’s books at twice that value. In other words, while all financial institutions have been slow to mark their toxic exposures to realistic prices, AIG has been even slower. One reason AIG has been able to “get away” with such valuations is that no visible market exists – there is no clear way of assessing true value. But the writing was on the wall the day Merrill Lynch sold a good proportion of its CDOs a month ago. Once sold, a price is clearly established. At around 20 cents in the dollar that price would have sent shivers through AIG.
It certainly sent shivers through Wall Street, as the market has sent AIG shares on a slippery slope ever since.
AIG began to start looking for a capital injection. When none was forthcoming, its shares fell further and its emergency capital requirement grew. While the US Treasury and Fed spent the weekend trying to arrange the sale of Lehman, AIG was on the other phone asking for a US$40bn hand-out. As an insurance company, AIG has no access to the Fed’s “discount window” emergency facilities, which were initially available to commercial banks and, since Bear Stearns, now available to investment banks. AIG pleaded with the Fed to extend the facility further. The Fed said no.
While Lehman’s demise will impact thousands of hard-working support staff as well as the overpaid cowboys in the team, it’s still hard for Main Street to feel anything but justice has been served. However, in the case of AIG there are many thousands more Average-Joe employees involved, and AIG is the general insurer to a vast number of Americans. If AIG goes down it will hit all of Main Street.
To top things off, AIG is about to be hit by another round of extraordinary claims in the wakes of hurricanes Gustav and Ike.
AIG has every cause to compare itself with Dow-component compatriot General Motors. The US government has extended a US$25bn facility to GM, provided it use the money to build fuel-efficient cars. The Treasury may top that up to US$50bn. Apart form GM’s iconic American status, the company employs thousands of blue collar workers. Hence the government’s preparedness to put up emergency funding.
Is AIG different? One might argue that it has caused its own demise through Wall Street folly, and thus should pay the price. But GM also brought about its own near-collapse by refusing to see the oil market writing on the wall – equally foolishly. Where does the difference lie?
The difference probably lies in the fact the US government simply cannot afford to bail out everyone. This is certainly the case since last week’s US$200bn commitment to Fannie and Freddie. The Fed ‘bailed out” Bear Stearns only because its sudden demise had the potential to bring down the entire global financial market overnight. The Fed thus bought time. Lehman has had that time, so now the Fed will not act again to save an investment bank. And it has also turned AIG away.
So for AIG, the future hangs in the balance. Instead of providing its own backstop, the US government has asked leading institutions JP Morgan and Goldman Sachs to arrange a consortium to provide AIG with US$75bn in funding.
On the weekend AIG was only asking for US$40bn. That’s how quickly the situation has deteriorated.
The emergency funding is all well and good, but where is it going to come from? Every financial institution across the globe is presently trying hard to shore up its own balance sheet. A consortium of banks has just committed US$70bn to contain the Lehman bankruptcy fallout. Now they’re being asked for another US$75bn. Bank of America has just spent US$44bn in acquiring Merrill Lynch (thus saving the third biggest investment bank from collapse). BA has also absorbed Countrywide. JP Morgan has absorbed Bear Stearns and also declined to take on Washington Mutual.
Who has the money?
Once again, the opposite may be just too scary to contemplate. The demise of AIG would have even greater ramifications for world financial markets than that of Lehman. AIG is a much greater weight on that mountain climbers’ rope. Something, somewhere, will have to give.
In the meantime, Wall Street has begun to assume AIG will not see out the week.
