And now comes the insurance crisis
While we are still digesting the end of Lehman Brothers, a much bigger threat is looming on the horizon. AIG, the world’s second largest insurer, is on the ropes. The collapse of AIG could trigger the second, and potentially more destructive phase of the financial crisis in the form of highly contagious meltdown of the default insurance sector – one of the largest subsegments of the financial market in which AIG has been active. The financial crisis dominates the news coverage of all European and international newspapers, and we devote most of our press review today to cover the news aspects and comments we think are most important.
The bankruptcy of Lehman is clearly yesterday’s story, and today’s subject for commentators. In term of news, the most important story last night is the fight to save AIG, whose bankruptcy would have significantly strong systemtic implications than the demise of Lehman. In New York, talks were continuing all night between the Fed, state regulators (insurance is regulated at state level in the US), private equity groups, and other investment banks, to provide some $75bn(!) in bridge finance to tie AIG over. Meanwhile, several credit rating agencies have begun downgrading AIG’s debt, a situation that was only yesterday described as the worst-case scenario.
Last night, A. M. Best Company, a specialised credit rating organization, began downgrading AIG credit. Fitch Ratings also downgraded, while S&P downgraded its long-term and short-term counterparty ratings. The New York Times reports that none of these downgrades appeared to be trigger events requiring AIG to post billions of dollars of collateral to its swap counterparties. (Under the contractual rules, CDS providers need to post collateral depending on their credit rating). The FT reports that the ratings cut by S&P reflected the large losses on mortgage-related investments and credit derivatives, and that the company would face further downgradings unless it came up quickly with a liquidity scheme by this morning.
The problem with AIG is not just its size, but the threat it poses to the $62 trillion market for credit default swaps, or CDS, an unregulated insurance market in which investors insure against payment default on bonds. A downgrade of AIG would trigger a rise in collateral. Another perhaps even worse threat is a rise in actual CDS insurance payouts, which is inevitable as the economy slows and default rates are rising. AIG wrote CDS contracts on a wide range for collaterlised debt obligations, financial instruments backed by mortgage backed securities and other debt securities. The CDS market has so far held up well, and it is extremely difficult for the authorities to identify what would happen if AIG were to go bust – both in terms of the contracts that AIG has insured, and contracts by third parties who have agreed insurance contracts in respect of AIG’s own debt. The same dual uncertainty also applies to Lehman Brothers, and as we reported here on several occasions it also applied to the Fannie and Freddie rescue, which was technically a credit event.
So it looks that we are moving from what has been a pure banking crisis towards an insurance crisis. The realisation that the entire financial sector is on fire yesterday triggered a bloodbath on equity market with the Dow Jones closing down 500 points, almost 5%, to below 11,000, and the oil price was approach $90pb.
This weakness was not yet reflected by European markets, which are likely to open lower this morning. In Europe and elsewhere, the central banks pumped massive liquidity into the system yesterday, and both the Bundesbank and the Bank of Italy send strong messages to say that their respective national banking and insurance sector in much better shape compared to the US.
So why was Bear Stearns bailed out, and Lehman not, and the implications
The subject most of the commentators focus on was the seeming inconsistency of the Federal Reserve in respect of who it bails out or not. There is the cynical view, expressed by some bloggers, that Bear Stearns behaved so irresponsibly that a bail out would have caused damage to the financial system, while that was not the case at Lehman. So Lehman got penalised – or rather shot – for trying to solve the problems.
Francesco Vela, writing in Lavoce, said the bailout policy of the US Fed sends out contradictory signals about the equilibrium the US government wants to reach between financial stability and protection of the taxpayer. As risk is increasing in the financial system, it is necessary to put in place new instruments to confront liquidity shocks in the financial system. In particular, it is important to define objective criteria by which to judge policy intervention.
Willem Buiter lists the following reasons to explain why the Treasury did not blink in the case of Lehman Brothers. The first, and most important reason is that the Fed has since created the primary dealer facility, a measure that gives broker dealers such as Lehman direct access to Fed funds. That facility was not yet in place during the Bear Stearns crisis. The second difference is Fannie and Freddie, which were rescued by the US government, almost exhausting its potential and appetite for further bail-outs. Buiter also suggestion another explanation: the Bear Stearns bailout may be seen as a mistake by some Treasury officials.
In another post, he makes the case for not saving AIG. He says at the very least it would require some kind of transparent statement of a public interest case, which he says has not been made, and is not likely to be made. If a bail-out happens, which is what he fears, the US would reveal itself as an economy of crony capitalism and socialism for the rich.
Writing in his Econbrowser blog, Menzie Chinn says the real economic effects of yesterday are going to be severe. Yesterday’s news of a 1% fall in industrial production almost went unnoticed amid the hiatus on Wall Street. He makes three fundamental points about the nature of the interrelationship between the financial and the real economy. First, this is a deleveraging crisis, which reduces the availability of credit. Second, the decrease in equity values, if persistent, will further constrain consumption. Third, the problems in credit and equity are trans-Atlantic. Hence, world economic activity will not support the US.
After the demise of Lehman, only two of the five large independent investment banks, are now still in place – Goldman Sachs and Morgan Stanley. John Gapper predicts in his FT column that both of them will also change their status over time, with Goldman Sachs becoming a more specialised buy-side company, and Morgan Stanley searching for an alliance with a large commercial bank. In any case, the almost century of the large independent broker-dealer investment bank is nearing its end.
FT Deutschland makes a similar point in an editorial. It said that the investment bankers are no longer the masters of the universe. We are entering a new era, and nobody really knows what this will look like.
Le Monde on Sarkozy
Sarkozy’s economic policies have become subject to much criticism of late. Le Monde has published a devastating editorial on Sarkozy’s economic approach, saying that the president has one thing in common with Francois Mitterrand in that he does not understand economics, and believes in the all-important power of politics to shape all aspects of the work. He will become a victim of his own ignorance, Le Monde concludes.
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