US government nationalises AIG, and injects $85bn
This is a lot bigger than a simple bail-out, or a large bridging loan. The US government yesterday nationalised AIG and injected $85bn into the ailing insurance company to keep it afloat. The loan is to be repaid through the sale of operating companies (who are they kidding? They are not going to raise so much in a firesale in the current financial climate). The Financial Times quoted a Fed staffer as saying that most likely outcome was an orderly liquidation of AIG. The $85bn loan comes at Libor plus 300bp. The Fed said in its statement that “a disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth and materially weaker economic performance.”
And, by the way, the Fed did not cut interest rates.
Barry Ritholtz, writing in Big Picture blog, made four observations that in our view were spot on. He said the following are worth thinking about:
1) AIG, the world's biggest insurer, was too big to fail; Had they gone belly up, they might have turned the current recession into a depression;
2) AIG was a huge Credit Default Swap writer, and that insurance required collateral to be posted, depending upon such factors as credit rating and credit spreads;
3) Hence,[it is worth thinking about] why this was a liquidity issue, not an insolvency problem;
4) Moral Hazard, successful avoided in the Lehman Brothers bankruptcy, was mostly put aside.
Mario Draghi says banks need to raise another $350bn in capital
The Wall Street Journal economics blog has an entry on a Berlin speech by BoI governor Mario Draghi, who is reported to have estimated that global banks would need to raise their capital by another $350bn to be able to weather more extreme risks. He said there are fundamental two responses to a financial crisis, emergency and structure. The first is clearly up to national authorities. But given the extent of financial globalisation, the latter will require global policy co-ordination.
The link to house prices
The Calculated Risk blog likes the current serial crises to house prices, making the point that this crisis will continue until banks realise the fall in prices is much larger than they had accounted for. The blog one prediction of 40-45% peak-to-through in nominal terms (which is the highest we have heard yet, as this would imply a real fall of more than 50%), while the futures markets predict a number of only 33%.
Cost of credit protection soars
The collapse of Lehman and the uncertainty about AIG has led to extreme nervousness in the CDS market, according to the FT, where the cost of credit protection rose significantly yesterday. The European benchmark for high-risk bonds, the iTraxx Crossover, reached 640bp, having opened at 600bp. All the indices improve a little later in the day as a rescue of AIG became more probable. The biggest spike came for HBOS, where the cost of protection rose from a little over 300bp to 500bp.
John Plender on the crisis
Writing in the Financial Times, John Plender says this crisis is dangerous for a number of reasons. One if the extreme degree of opacity so that regulators and central banks do not fully understand what is going on. Another is the insufficient capital base of investment banks, which makes their business unsustainable in the long run. Plender also makes an interesting point about moral hazard. While letting Lehman go bust was intended to counteract moral hazard, it will accelerate the concentration process in the industry, and lead to even larger too-big-to-fail financial institutions.
Martin Wolf on the crisis
In his FT column, Martin Wolf makes the point that among the many lessons to be drawn from this crisis by regulators is no longer a presumption of competence in the industry. What may seem rational from the vantage point of an individual instation may not be rational at all from the perspective of the market as a whole. So we must prepare for much more intrusive regulation. He also said that he has become much more sceptical about our ability to manage a benign outcome to this crisis.
Harold James on the crisis
Writing in the FT, Harold James makes the point that history offers no easy lessons for today’s crisis. Even Walter Bagehot’s convenient division into liquidity and solvency was next to useless during the Great Depression. It was not clear then whether banks were illiquid or insolvent, nor is this clear today. Policy in the Great Depression was inconsistent. Today we face the choice of either doing to little, and accelerating the crisis, or doing too much, and producing damaging side effects. But we should not look back to history for answers.
Now for the CDS crisis
Wolfgang Munchau, writing in FT Deutschland, says after the subprime crisis, the CDS crisis may be next. AIG is essentially insolvent, as it is not only incapable to post higher collateral for its CDS contracts, but that a rise in CDS payouts is now inevitable, given the downturn in the global economy. Even without a proper CDS crisis, the subprime crisis would have wrecked havoc on the banking sector. If you add a CDS crisis to the mix, the situation could get quite disturbing. For this reason the events at AIG are far more important than the collapse of Lehman Brothers.
What about Europe?
FT Deutschland has a thoughtful editorial about the transatlantic interlinkages. It says that there is no evidence that the financial crisis is about to spill over to Europe. Europe does not have an economic downturn due to this crisis, but it has an economic downturn due to other factors – the overshooting oil and the recent strength of the euro. It says the priority has to be to stabilise the economy, and not to continue deficit cutting. This is simply not the time for such heroics.
Fixing DSGE Models
Writing in Vox, Malin Adolfson, Stefan Laséen, Jesper Lindé and Lars Svensson (he now deputy governor of the central bank of Sweden), have an article that addresses some of the weakness of the current generation of DSGE models, which are so popular in central banks. They say among several weakness of these models is that they have a rather rudimentary description of the financial sector There are some attempts to incorporate various types of financial frictions, such as the role of collateral and borrowing constraints, into these models, and it remains to be see whether this improves the models’ forecasting accuracy. They say there are empirical indications that the current generation of DSGE models are misspecified.
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