Merrill bought, Lehman bankrupt

[hoyatables]

Pushy - this is great analysis. Thanks.

[Filo]

Back to the falling knives...

Couldn't help taking a flier on AIG today... Pretty similar to playing in Vegas, but I like the chances that it is not allowed to go under.

[PushyGuyFanClub]

I have no insight on what will happen with AIG. They need a credit lifeline and they had the audacity to turn down an offer from JC Flowers not too long ago. Given their hubris over there, their atrocious customer service, and the way they've manufactured earnings in the past, this is not a firm we should be crying about going down. Others will pick up their lines of business.

But should they get access to capital, there is certainly value in its insurance and wealth management businesses. Just remember though, as was the case with Fannie and Freddie, they can get bailed out and shareholders can still get hosed via warrants, convertibles, and the like. AIG's not really bargaining from a position of power at this point, so they're going to have to accept the terms that come to them. Common shareholders will be very far from their mind, IMO.

[strummer8526]

BREAKING NEWS:

CNN--AIG is getting bailed out by federal government.

Headline News--Caylee's mom was let out of jail again. They'll never find that poor kid's corpse.

[TC]

This is Republican socialism. In a capitalist system, entities that do not perform are supposed to fail.

[hoya4ever]

Ah, but when they do and they take you with them, you are more than willing to throw them a line, not cause you like em, but because your success depends on it.

[strummer8526]

This all makes me think of that West Wing where Barlett decided to bail out the software company that was "a HUGE contributor" b/c it made responsible but very costly recalls. It was a tough decision to bail out one company. Yes, granted, it's a fictional TV show, but I think that it conveys what the general impression is of the government bailing out FOUR w/ a fifth going bankrupt and a sixth getting bought out. This is getting ugly and very, very expensive.

[AustinHoya03]

Since we appear to have some finance/econ minds hanging around this thread, I'd like to know if there is any substance at all to either Obama's or McCain's proposals for economic oversight reform. It seems to me there is currently a lot of bluster on both sides but not much sensible talk about how current problems can be solved/future problems can be avoided.

[TC]

Sept 16, 2008 20:15:14 GMT -5 hoya4ever said:

Ah, but when they do and they take you with them, you are more than willing to throw them a line, not cause you like em, but because your success depends on it.

The end result will still be the same, it'll just be spread out over multiple years. I can't wait to hear the calls to privatize AIG come - and they will, once a little time has passed.

There's always an entry on the other end of the balance sheet. What's next? GM? Chrysler? Ford? Once you start down the slippery slope of "too big to fail", everyone lines up to get in that line. We are doing this with absolutely no checks and balances, it is abusive, and it will fail.

[PushyGuyFanClub]

I think Obama and McCain are both mostly bluster at this point, but I do believe both know this is now an important issue and working on a sensible platform to present.

As for the charge of Republican socialism, the government is actually getting a pretty good deal here in terms of profit potential. Unlike with Freddie and Fannie which will likely never go public again rendering the warrants the government received actually worthless, it looks like the government, by giving AIG access to credit, has the potential to own up to an 80% convertible stake. If AIG can recover here, this one move could pay for all of the bailing out that's been going on. I have to do some more studying here of the clauses, but this *looks* like the smartest deal the government has done so far in terms of being compensated for its assistance.

[PushyGuyFanClub]

Just to tack on a point here because, well, this helps me organize my thoughts...

I do a lot of work with China stocks now, and in China, as people probably either know or can guess, the banks are all state run. They're also a very active agent for the government when it comes to determining which businesses fail and which succeed. If they want you to fail, they will simply deny any and all loan applications. This is why so many small Chinese companies have used reverse mergers to escape China's regulatory regime in order to tap western capital.

Now, this is -- ideologically speaking (for me, at least) -- an extremely unpalatable system. But it's worked extremely well in China in terms of producing the greatest economic growth story the world has ever seen. China, though much work remains to be done in the country, has lifted more people out of povery over the past 20 years than at any other time in human civilization (seriously, you can look it up).

What's going on right now in our country is that due to excessive risk taking on the part of former stalwarts, our government is now being put in the awkward position of explicitly deciding who fails and who succeeds. And while this could work out, I don't think anybody here likes the precedent, the risks, or the potential costs. The good news about the AIG deal it seems, is that we're essentially giving them access to $85 billion worth of loans they need to stay liquid at a reasonable interest rate for both sides (LIBOR+850 basis points) and because no one in the private sector was willing to do this, also getting equity participation of up to an 80% stake. Now, AIG is in shambles right now, so we the government are assuming substantial execution risk. But AIG's general insurance arm alone earns about $4 billion per year. If it were a standalone business, it would probably be worth $40 to $60 billion. Then there's AIG's asset management division, the life insurance division, the bizarre things like the airplane fleet. These operations all have significant value. Unfortunately, AIG's toiling in the credit default swap market now has significant negative value forcing margin calls on the other sides of the business. If it can get access to the money it needs to survive this rough patch, then as I said previously, the government could make a heckuva profit.

It's also worth noting that our own accounting standards have exacerbated this month. Many of these derivative securities are classified as level 3 securities, meaning they have few observable inputs as to their value. (Common stocks, since they're quoted by the second, are classed as level 1 securities.). One of the ways companies have to value level 3 securities is by finding a group of peers and seeing what they traded for last. This is then often considered to be the value of their own level 3 stuff since there's really no way to do it. It's an imperfect system and as the market for these types of securities has dried up amid an enomrous risk aversion movement on Wall St and elsewhere, companies like AIG that are holding level 3 securities have had to mark them down very close to 0. (Hansen Natural actually also had to do this with a portion of their balance sheet.) But what sets Hansen apart from AIG is that Hansen has the financial flexibility to hold these securities to maturity and get the annual yield. In other words, it's not really worth zero to them today because they don't have to sell it today.

AIG, on the other hand, needs to have a certain amount of assets at all times in order to meet certain regulatory requirements and maintain its credit ratings (necessary for an insurer). When it marks these securities to zero, its creditors all of a sudden freeze up. AIG has no more assets, they think. Now, this is not necessarily the case. AIG's portfolio may not be all garbage. They simply no longer have the luxury of time.

So it's sort of a bizarre catch-22. Regulatory requirements mean companies like AIG no longer have the time they need to know if they've made good investments. It's not necessarily clear, therefore, that they've become a total failure worthy of bankruptcy. Now, I don't have a high opinion of AIG. The company chases earnings at the expense of good corporate governance. But I do have some sympathy for the time issue. If all the government's role here is to give them some breathing room, I don't think that's too terrible.

But the more I think of this, the more I believe that one of the first bills introduced in the next administration will be some kind of reprise of the Glass-Steagall act, which was repealed in 1999 (cough*signed by President Clinton*cough). While in force, it prevented banks from becoming brokers and brokers from becoming banks. It other words, it tried to make sure that nothing was "too big to fail." Since its repeal we've seen Citigroup get into retail banking, Bank of America buy up everything in sight and get into investment banking, etc. The increased competition is, in part, what made the people at Lehman, Bear, and others take on greater risk in order to earn better returns than their peers.

Going forward, this looks like it will be a temporary solution, and hopefully all we do is give these organizations some time to unwind their troubles. Then, I think, we stick with free market principles but step in with legislation that keeps some kind of separation of powers in the financial industry. That's all I got. Let's see what happens. (And I'd like to thank Boz andn hoyatables for their kind words and support.)

[Bando]

Pushy, I don't know if you know the answer to this (maybe HoyaDrummer?) but how exactly does Bernake have the power to commit such a large amount of taxpayer money to nationalize AIG? I mean, he obviously does have that power, I just thought at the very least some legislation would be needed to do something like this.

[FewFAC]

We're likely to see the same thing happen over the next several days that happened with Lehman: the Fed toughtalks commercial banks into extending loans, the commercial banks balk, the Fed steps in to provide loans to cover liquidity to unwind positions, and AIG crashes like it was originally supposed to do, only with some lucky commercial bank extracting billions of dollars from the Fed to recoup costs incurred in agreeing to catch falling knives in the interest of public duty by promoting an orderly wind down. Good money thrown after bad.

[TC]

Sept 16, 2008 23:32:43 GMT -5 PushyGuyFanClub said:

But the more I think of this, the more I believe that one of the first bills introduced in the next administration will be some kind of reprise of the Glass-Steagall act, which was repealed in 1999 (cough*signed by President Clinton*cough).

Be fair - Phil Gramm (McCain camp) was the sponsor of that bill. You're basically suggesting that the same guy who introduced it will be the one who says "whoops, my bad" 10 years later.

[Coast2CoastHoya]

Thanks for the cogent analysis, PGFC.

[DrumsGoBang]

I was a little confused by what I read in the paper this morning as well. It kept saying that the Fed and not the Treasury were the ones providing the loan. I had always thought the Fed was a seperate institution and if they wanted money they just invented it. Is it really taxpayer money the Fed is loaning or is it just a injection of money into the market?

[PushyGuyFanClub]

I was just pointing out that this is a truly bipartisan crisis. It's irresponsible to blame one party or the other. But you're right that Gramm was the driving force behind tha tbill.

The Fed can't just invent money; that would cause insane inflation. Rather, they issue government debt and then they fund things like this with the proceeds. The US government, for the time being, is considered an extremely safe investment.

According to Barney Frank this morning, the Fed didn't need them to pass any additional legislation extending its authority to get this done. I'm not sure where the authority explicitly comes form, but it may have been contained within the legislation enabling the government to put Fannie and Freddie in conservatorship. Sorry I'm not more help.

[TC]

Sept 17, 2008 8:46:20 GMT -5 PushyGuyFanClub said:

According to Barney Frank this morning, the Fed didn't need them to pass any additional legislation extending its authority to get this done. I'm not sure where the authority explicitly comes form, but it may have been contained within the legislation enabling the government to put Fannie and Freddie in conservatorship. Sorry I'm not more help.

Here's where it comes from :
globaleconomicanalysis.blogspot.com/2008/09/aig-bailout-fed-loophole-133.html

It just seems to me like this is a terrible way to do things - if we're going to go out and spend somewhere between $300B and $1T in less than a week, then there should be some checks and balances on it.

[PushyGuyFanClub]

Section 13(3) of the Federal Reserve Act:
federalreserve.gov/aboutthefed/section13.htm

I'm not a lawyer, but these conditions do seem unusual and exigent.

[Filo]

My understanding of the AIG deal is that warrants may not kick in if the loan is repaid within a certain period of time. So the Fed may not get anything out of this (other than interest on the loan). May be a pipe dream for AIG to be able to repay the loan, unless the whole idea was to buy some time for AIG to get the funds from a private sector source.

On another note, here's another potential area to star worrying about (from NYT):
Money Market Fund Says Customers Could Lose Money

In a new sign of market turbulence, managers of a multibillion-dollar money market fund said on Tuesday that customers might lose money in the fund, a type of investment that has long been considered as safe and risk-free as a bank savings account.

The announcement was made by the Primary Fund, which had almost $65 billion in assets at the end of May. It is part of the Reserve Fund, a group whose founder helped invent the money market fund more than 30 years ago

The fund said that because the value of some investments had fallen, customers now have only 97 cents for each dollar they had invested....