Credit Crunch Claims Two More (Part 2)

Much has happened in the 48 short hours since the first part of this two part series was published.  I’m not too interested in the Lehman Brothers garage sale, or the $34 million that Merrill’s CEO, John Thain, will receive in stock options for brokering the sale of the company that he took over just 10 short months ago.

Instead I would like to discuss AIG and how this massive institution failed.  I am also going to get into some of the outrageous changes the world’s most powerful hedge fund, I mean the Federal Reserve, made to the rule book as well as its reaction to the failing insurer.

AIG: Failing or Flailing

Two weeks ago, AIG stock was trading in the low $20 /share range.  Twelve months ago, you could have sold shares of AIG at $70 /share.  Although markets aren’t yet closed today (Wed.) you can buy a share of AIG at $2.23 as I write.  What causes such a steep and violent decline?

On Monday, the race for capital was on as the credit spreads on AIG were telling us that they were at or near 72 hours of capital away from a potential fire sale of assets and credit ratings slash.  The ratings cut would have resulted in $13 billion in collateral calls and $4.6 billion in swap payments for AIG.  Without a capital infusion, the end game here was most definitely bankruptcy.

The partial answer to the question of AIG’s contraction of capital is one you know.  A few hundred billion dollars in bad leveraged bets on the real estate market is more than enough to destroy massive amounts of capital and equity.  That is a story that has and will continue to be preached going forward, but it’s not what pushed AIG beyond solvency.

The final push towards bankruptcy was the direct result of AIG’s municipal bond insurance wing.  AIG has insured a large amount of non-performing muni bonds.  Here’s how the scenario plays itself out:

Municipalities projected curtain revenues from property taxes when they derived their budgets.  With housing prices in decline, and massive levels of foreclosures, the actual property taxes received by the municipalities are significantly less than forecasted.  Now the municipalities are facing some of their biggest budgeting short falls in history and they don’t have a penny to pay them, or the outstanding bonds.  California, New York, and Illinois are three states with the largest budget deficits.  I expect we haven’t heard the last of the “Muni Bond Credit Crunch,” and I’m sure that printed, I mean federal, money will find its way to the rescue. 

Anyways, because the bonds are non-performing assets, AIG has been forced to pay countless numbers of claims on the munis that they insure causing their capital to disappear.  This is a perfect example of a significant ripple effect from the housing recession.  I’m sure that states with a sales tax are also seeing sales tax revenues dry up as the consumer continues to tighten up.

Rescue Me!“Rescue me and my $600 billion worth of assets,” is exactly what AIG was screaming this past weekend.  Despite the lack of ANY collateral, AIG was looking for a $40 billion from anybody.  They warned that the worst could happen if the money was not received.

The Federal Reserve and Hank Paulson’s immediate reaction to the news was that AIG would NOT receive any federal assistance, and they were adamant.  It was not too far into Monday’s trading day when the Federal Reserve announced that they were ‘strongly urging’ J.P. Morgan and Morgan Stanley to assist AIG by giving them a $75 billion credit line.  With no collateral to hand over, MS and JP said no thanks.  Even after that announcement, and into yesterday’s early evening, the Fed had supposedly dug its heels in and was still denying federal assistance.

Then they cracked, and they cracked to the tune of an $85 billion loan over the next two years.  I would just like to note that there is not a guarantee, or anything close to a guarantee, that the liquidity injection will be enough to keep AIG on its feet over the next two years.  We the taxpayers are left to foot the bill.

The natural progression takes us into what the Federal Reserve has been up to this week and what the recourse of their actions will mean for you and me.

Federal Reserve Rule Book, or Lack There Of

Dear readers of mine, you know that the Federal Reserve and its ever growing involvement in the private sector creates a quasi national-private monster.  With this week’s action, the government has taken another step into solidifying itself as the most powerful hedge fund in the world.

I would like to begin this portion of the article by discussing the rule changes in the lending standards of the discount window.  I’m not going to delve too deep here with the analysis, because I have already written an article regarding the chronology and specifics of the evolution that resulted in the discount window in its current form.  To view that article please click here.

As it goes, the Federal Reserve changed the lending limits (tripled) and the frequency (doubled) of the Term Securities Lending Facility.  The auctions are now done on a weekly basis and may be up to $150 billion in size.
Also, under the encouragement of the Fed, ten commercial banks created a $70 billion emergency lending facility.  This looks awfully familiar to the ‘Super SIV’ fund that was in the process of being created during the initial stages of the credit crunch.  It wasn’t too long ago that the world learned what structured investment vehicles were and how easily they could turn sour.  Regardless, the plans for the fund were abandoned because the lenders decided that it would do nothing to help liquidity…you think?

The final change the Federal Reserve announced on Monday was probably the greatest.  Not only does the Fed now allow ALL investment grade rated bonds (now includes, but not limited to, corporate and muni debt) as collateral at the discount window, but they are also now taking stock certificates as well.
Did a little light just turn on in your head?

Bail Out Via Discount Window or Direct Loan…Who cares

Do you think the Federal Reserve ever had the belief that AIG would find private funding?  With the obvious answer to that question being no, do you think the Fed ever intended to not bail AIG out?

Let’s piece this not so complicated puzzle together.  We first need to understand why AIG had no collateral to receive a loan in the first place.  The reason for that is because they had already gone to the discount window and used their mortgage backed assets as collateral and had received as much Federal Money as they could.  Remember, as previously mentioned, that the muni division of AIG is what pushed them over the edge.  The Fed simply fixed that by taking munis as collateral at the discount window.  There is the first assistance to AIG.
Secondly, the Fed received a 79.9% stake in AIG in exchange for the $85 billion loan (100% printed money).  I mean, THE FEDERAL RESERVE IS A 80% STAKE HOLDER IN A COMPANY THAT WAS COMPLETELY CONTROLLED BY THE PRIVATE SECTOR.  How convenient that the Fed changed the discount lending rules to accept stock certificates as collateral.

I’m not saying that this deal was conducted via the discount window.  Look at it this way, if the Fed starts taking sizeable stock certificates at the window in exchange for capital, doesn’t that make them stake holders in the companies that the certificates are denominated in?  Obviously the terms of the deals may vary some, but the macro goals and consequences are more or less the same.

We have now created is a massive hedge fund that has no governing body and a limitless piggy bank (credit/money growth).  This hedge fund doesn’t report earnings, and controls monetary policy.  I mean, imagine the FOMC being controlled by Wall St. and their cohorts in Greenwich.  Oh wait…it is…or it isn’t…or it could be…or who knows. 

What I’m really trying to say here is that as the line between public and private becomes misconstrued and manipulated, we begin to forget where one ends and the other begins.  We begin to accept this as one influences the other to a greater and greater degree (Ex. the corporate world influences Washington while Washington influences the corporate world), we begin to accept it.  Ex-CEOs begin to show up as U.S. Treasury Secretaries and such.  The very few (Bernanke and Paulson) have been given the ability to distribute sums of money at the snap of their fingers that are the equivalent to smaller nations’ aggregate budgets, and that, without even a vote from Congress (not that it matters).  There are and have been economies that have done this openly and intentionally.  It’s called central planning or socialism.  Although I wouldn’t call the U.S. economy one that is based upon socialism, but what we have learned this week is that we are closer to socialism than true capitalism.

Nicholas Jones
Analyst, Bourbon & Bayonets