Armageddon, Apocalypse, and AIG

Yesterday was the first day of the rest of Wall Street’s life. At the beginning of this year, there were five major broker-dealers. In March, the Bear Stearns Companies were acquired by JP Morgan Chase with a large assist from the Federal Reserve.

Yesterday, Lehman Brothers filed for Chapter 11 bankruptcy. On Sunday, Merrill Lynch agreed to be acquired by the Bank of America.

As we proceeded through the morning hours, I felt that the flurry of selling on nearly all markets wasn’t as disorderly or panic-stricken as could well have been feared, and on the whole things were proceeding reasonably well. That was then.

As the day wore on, reports starting coming in about AIG Inc.,the large insurance holding-company. And things started getting worse.

It’s easy to think that we’re now in the worst financial crisis since the Great Depression. That’s partly because no less a figure than Barack Obama (who would dearly like a chance to show us how little he really knows about finance) has told us so.

But we’ve had several periods of extraordinary and sustained distress quite recently. They just flew under the radar and got little or no mass media attention. The first was last August, and the second was in March.

It’s one thing for messianic but poorly-informed Presidential candidates to use scary words. But when participants in the money and credit markets start using words like “Armageddon,” I take that much more seriously. Yesterday we saw clear signs that the financial world is in the grip of extreme fear, the same signs that were in evidence a year ago and a half-year ago.

Let me tell you what those were…

What happened yesterday was that money markets became severely disrupted again. The Fed Funds rate went as high as 6% at one point, and overnight dollar LIBOR stands well above 6% in London this morning.

The unavailability of short-term funds is the classic sign of financial panic, and it has been from time immemorial. When you’re not sure you’ll get your money back, when there’s even the tiniest speck of doubt in your mind about that, you won’t lend money to anyone, and you’ll pull back all the money you’ve already lent.

This is a liquidity crisis, the same kind we had a year ago summer. And just as then, the Federal Reserve and the European Central Bank issued floods of new liquidity.

We think of the Fed as the regulator of the banking system, the custodian of the mysterious “fed funds rate” and the general panjandrum of good economic health. The truth is that its most important role is to be a lender of last resort in times like this.

When no one wants to lend money, even overnight, someone needs to step in with both the courage and credibility to do so, otherwise panics go from bad to worse.

In our day, this role is more complicated and important than ever, because there are now so many institutions that are engaged in borrowing for short terms and lending for longer ones.

We now have a massive and global “shadow banking system” that is dependent on borrowings in overnight-repo markets, and is at least as large a generator of credit as the normal banking system that takes deposits from the public. It’s also very poorly-understood by regulators. But it’s just as critical to keep it stable as it is to keep the payments that flow between ordinary banks stable.

This should give you a hint of what top financial experts and policymakers were muttering darkly about when they said last March that Bear Stearns, a relatively small broker-dealer, could not be allowed to fail without a government guarantee of its assets.

There are a lot of snakes under this rock. To borrow a phrase from Humphrey Bogart, if Barack Obama thinks that he knows how to get regulatory control over all this, he’s been misinformed. No one knows yet. But it will the most important economic policy debate of the coming years.

This brings to AIG, the insurance holding-company. Twenty-four hours ago, I believed that they would pull through. The fact that they’re now in very serious danger is emblematic of the unusual stresses in the system.

AIG has many very profitable and stable lines of business. It also is a very large insurer of fixed-income securities. As of the end of the second quarter, they had about one trillion dollars in assets, matched by a similar amount of debt (the debt total was about $40 billion lower). They had $80 billion in balance-sheet shareholder equity, and a market capitalization of about $40 billion.

And they’ve lost more than $18 billion over the last three quarters, mostly on losses in mortgage-related debt and derivatives. That means they’re now undercapitalized.

As a member in good standing of the shadow banking system, AIG needs to borrow money continuously to sustain its books of business. And until now, it has relied on its high credit rating to keep its borrowing costs low enough to keep the whole structure afloat.

In good times, this is a marvelous and highly-profitable business. In bad times, the leverage comes around to hurt you.

AIG was already under stress from its losses, and has been seeking to either make its balance sheet smaller or sell equity. It hasn’t been able to do much of the latter with its stock price beaten down so low. And now in the midst of panic selling, it will have a very hard time doing any of the former.

But AIG can’t continue to lose money without triggering defaults in many of its obligations, which include an enormous amount of credit-default swaps on securities that are now suddenly in extreme distress due to the bankruptcy of Lehman Brothers. “Perfect storm” is such a cliché, but there’s not really a better term for this.

AIG has been madly trying to arrange bridge financing from a variety of sources with little success. What they need to do is survive long enough to continue their efforts to sell assets or equity, at what will certainly end up being ruinous prices.

Secretary Paulson and the officials of the Federal Reserve drew the line in the sand this weekend, and said to Wall Street ”no more bailouts!” They were correct to do so and I’m very glad they did. But they may or may not be able to keep this promise in regard to AIG. We’ll know quite shortly.

Bottom line: today is looking a lot uglier than yesterday. And that’s saying something.

Stay tuned.

-Francis Cianfrocca

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