AIG and the continuing saga of government intervention

The title of this episode in history will likely be The Great Liquidity Crisis, and the catch-phrase is going to be "we just need to buy time". When a big financial firm begins to fail everyone wants to see an orderly liquidation of the firms assets, and there are some very compelling reasons for this. The biggest reason is that liquid assets have continuous real-time pricing, and those prices affect others in the industry that hold similar liquid assets. If a fire-sale occurs it affects not only the liquidating firm but can have a material impact on firms that are far removed from the one that's in trouble.

To explain the difference between an orderly liquidation and a disorderly liquidation we can use the example of a ship needing to unload it's cargo. A disorderly liquidation is akin to the ship's cargo getting unloaded by a violent storm that smashes the ship into every other boat in the harbor then destroys the vessel on the rocks and leaves the cargo strewn along the beach. An orderly liquidation is more like the ship pulling up to the dock, the deck hands unloading the cargo, and then they sink the ship. Bernanke and Paulson (who I may have to begin referring to as the dynamic duo) are committed to the orderly variety of liquidation for firms that pose systemic risk.

Systemic Risk is a risk that poses a danger not only to those involved in a particular enterprise but to the entire system itself. Systemic risk is evidenced by a firm that through it's size, scope, or it's position at a strategically important junction in the market can pose such risk that if they fail they would create a far wider swath of destruction than the size of their footprint might suggest. In the governments view AIG is such a creature.

AIG is reportedly the largest insurance company in the world, they are one of the top 10 largest companies of ANY type in the world, and if not for the Fed and the US Treasury they would have been the second firm this WEEK to break the record for "Largest US Bankruptcy in History". Two world records in a week. That is a staggering fact. The financial sector is becoming the Michael Phelps of bankruptcies.

The last two weeks have been a liquidity nightmare in the financial markets. We all saw the Fed Funds effective rate trading at 8% on Monday after Lehman fell. That was a giant flashing neon sign that we had a liquidity problem. The spread between the Fed Funds effective rate and the Target rate blew out to a 10 year high this week. In the last two weeks I've seen AAA rated corporate bonds go with no bid, I've seen $10 million blocks of TBA mortgages have 3 out of 4 street firms pass on bidding, I've seen a $5 million block of 20 year 5% MBS go with no bid at all. In short I've seen very liquid instruments hit a brick wall when it came time to sell them this week. There are only two things you can do in this situation: wait until the market calms down, or lower the price to try to unload it. To this short list of options the government has added a third; they might give you a loan you can use to buy enough time to pull off an orderly liquidation. If they loan you 50 billion against your 70 billion portfolio the theory is that you'll have enough time to sell your assets at a pace the market can digest without causing prices to drop. It's a great theory, just typing it made me feel better and it soothed my frazzled fixed-income nerves. The problem is that the entire market knows you're in trouble, the entire market knows there are more firms in trouble behind you, and the number of potential buyers for your product is getting smaller every month...Bear is gone, Lehman is gone, Merrill is gone, Countrywide is gone...

So back to our liquidity problem: why didn't the street want to bid on bonds? Why wouldn't anyone position inventory? In part it was because everyone saw Lehman and AIG and Washington Mutual all teetering on the edge of bankruptcy. If someone was asking you to position $50 million of a bond in your inventory, and you KNEW that three large players might have to sell everything they own in a matter of days at fire-sale prices, would you start building inventory today? Heck no you wouldn't. You'd get your head handed to you when those firms began dumping massive volumes on the market and pushed prices through the floor. A much more attractive alternative is to step onto the tracks after that train has passed.

Here is a pretty typical example of how the liquidity trap goes. A firm gets downgraded due to any number of reasons. When your credit rating gets cut your borrowing costs go up and your creditors will eventually begin calling your liquidity lines. If you need liquidity you have to sell securities. In a credit crisis, market liquidity goes away and if you are the guy that is forced into selling (think margin calls) you will see all support fall out from under you. The more you have to sell the faster the prices will fall, the more prices fall the less your collateral is worth which triggers MORE margin calls and you'll have to sell even more to generate sufficient liquidity, which pushes prices down further and so on and so forth until you spiral into the deck. This situation will become a self sustaining and all consuming process of destruction. It's like trying to swim with an anvil on your back. So how do you avoid this? You buy time. Unfortunately you can't really buy time...you have to beg for it or sell your soul for it.

In the case of AIG they begged first, and then still had to sell their soul. Their first attempts to get a loan from the Fed were met with a deaf ear. Paulson and Bernanke were adamant that no public funds would be used to help the beleaguered firm. The dynamic duo then turned to JP Morgan and Goldman Sachs and asked them to come up with a way to raise the money needed. I envision a conversation that went something like this:

Dynamic Duo: We need you to round up $75 Billion by midnight eastern to help save AIG

Street firms: You want us to go find $75 billion to put into a firm that's about to become the "new" largest bankruptcy in history?

Dynamic Duo: Yeah.

Street firms: We'll get back to you...if the phone ain't ringin'...it's us.

Now the Dynamic Duo is back to looking disorderly liquidation straight in the face. When the sun comes up and the world sees AIG getting smashed on the rocks there will be panic selling, there will be mark to market losses everywhere, there will be capital write-downs, there will be a lot of failed firms left in their wake. There will be many otherwise sound institutions and investors that had nothing to do with this behemoth getting dragged down in it's draft. That is the reason an orderly liquidation is needed. RBG estimated yesterday that the damage from AIG failing would have been around $180 Billion. AIG provided insurance on $441 Billion worth of fixed income investments.

I don't like it, and I imagine this event will keep lawmakers and regulators busy for years, but I'm in the camp with the folks that "reluctantly accept" the Treasuries decision as the best decision that could be made from the group of ugly choices presented. The shareholders of AIG are getting wiped out, so it doesn't look like the government is rewarding the risk takers. In December of 2000 AIG was trading at $100 a share, it closed yesterday at $3.75 and last night the government took over 80% of what's left.

Paulson laid down a plan where the government could keep a huge number of innocent bystanders from getting crushed, while at the same time providing for an orderly liquidation and letting the stockholders meet the fate they created for themselves. AIG got an $85 Billion loan, and the Treasury got an 80% ownership stake in AIG. So Paulson will loan you the money, but you don't get to steer the ship anymore. And oh by the way...the loan is Libor + 8.50% (11.50%) and management is fired...hardly a sweet deal.

Ultimately I think Paulson and Bernanke are playing the hand that was dealt to them as well as they can. The shareholders of Bear Stearns, Lehman, and AIG have all been driven to the poor house, and the fallout to the innocent has been minimized. If all goes well the loans will get repaid and the taxpayer impact from these events will be minimized. I know that's a big IF and my gut tells me that even if the Treasury does make money doing this congress will probably take it all and the taxpayer will still be on the hook.

It's almost midnight Eastern time currently and I picture Bernanke and Paulson knocking back long-necks in a smoke filled piano bar somewhere in the nations Capitol wondering how they will EVER top a week in which they spent over $200 billion. As the camera begins to fade they share a knowing look and simultaneously agree...Vegas...