This is an interesting read on AIG - (it was emailed to me)
Something very strange is happening in the US financial markets. And I can show
you what it is and what it means...
If September didn`t give you enough to worry about, consider what will happen
to real estate prices as unemployment grows steadily over the next several
months. As bad as things are now, they`ll get much worse.
They`ll get worse for the obvious reason: because more people will default on
their mortgages. But they`ll also remain depressed for far longer than anyone
expects, for a reason most people will never understand.
What follows is one of the real secrets to September`s stock market collapse.
Once you understand what really happened last month, the events to come will
be much clearer to you...
Every great bull market has similar characteristics. The speculation must start with a reasonably good idea. Using long-term
mortgages to pay for homes is a good idea, with a few important caveats.
Some of these limitations are obvious to any intelligent observer... like the need for a substantial down payment, the verification of income, an independent appraisal, etc. But human nature dictates that, given enough time and the right incentives, any endeavor will be corrupted. This is one of the two critical elements of a bubble. What was once a good idea becomes a farce. You already know all the stories of how this happened in the housing market, where loans were eventually given without fixed rates, without income verification, without down payments, and without legitimate appraisals. As bad as these practices were, they would not have created a global financial panic without the second, more critical element. For thzings to get really out of control, the farce must evolve further... into fraud.
And this is where AIG comes into the story.
Around the world, banks must comply with what are known as Basel II
regulations. These regulations determine how much capital a bank must maintain
in reserve. The rules are based on the quality of the bank`s loan book. The
riskier the loans a bank owns, the more capital it must keep in reserve. Bank
managers naturally seek to employ as much leverage as they can, especially
when interest rates are low, to maximize profits. AIG appeared to offer banks
a way to get around the [/color][/size][/font]Basel rules, via unregulated insurance contracts,
known as credit default swaps.
Here`s how it worked: Say you`re a major European bank... You have a surplus
of deposits, because in Europe people actually still bother to save money.
You`re looking for something to maximize the spread between what you must pay
for deposits and what you`re able to earn lending. You want it to be safe and
reliable, but also pay the highest possible annual interest. You know you
could buy a portfolio of high-yielding subprime mortgages. But doing so will
limit the amount of leverage you can employ, which will limit returns.
So rather than rule out having any high-yielding securities in your portfolio,
you simply call up the friendly AIG broker you met at a conference in London
last year.
"What would it cost me to insure this subprime security?" you inquire. The
broker, who is selling a five-year policy (but who will be paid a bonus
annually), says, "Not too much." After all, the historical loss rates on
American mortgages is close to zilch.
Using incredibly sophisticated computer models, he agrees to guarantee the
subprime security you`re buying against default for five years for say, 2% of
face value.
Although AIG`s credit default swaps were really insurance contracts, they
weren`t regulated. That meant AIG didn`t have to put up any capital as
collateral on its swaps, as long as it maintained a triple-A credit rating.
There was no real capital cost to selling these swaps; there was no limit. And
thanks to what`s called "mark-to-market" accounting, AIG could book the profit
from a five-year credit default swap as soon as the contract was sold, based
on the expected default rate.
Whatever the computer said AIG was likely to make on the deal, the accountants
would write down as actual profit. The broker who sold the swap would be paid
a bonus at the end of the first year � long before the actual profit on the
contract was made.
With this structure in place, the European bank was able to assure its
regulators it was holding only triple-A credits, instead of a bunch of
subprime "toxic waste." The bank could leverage itself to the full extent
allowable under Basel II. AIG could book hundreds of millions in "profit" each
year, without having to pony up billions in collateral.
It was a fraud. AIG never any capital to back up the insurance it sold. And
the profits it booked never materialized. The default rate on mortgage
securities underwritten in 2005, 2006, and 2007 turned out to be multiples
higher than expected. And they continue to increase. In some cases, the
securities the banks claimed were triple A have ended up being worth less than
$0.15 on the dollar.
Even so, it all worked for years. Banks leveraged deposits to the hilt. Wall
Street packaged and sold dumb mortgages as securities. And AIG sold credit
default swaps without bothering to collateralize the risk. An enormous amount
of capital was created out of thin air and tossed into global real estate
markets.
On September 15, all of the major credit-rating agencies downgraded AIG �
the world`s largest insurance company. At issue were the soaring losses in its
credit default swaps. The first big writeoff came in the fourth quarter of
2007, when AIG reported an $11 billion charge. It was able to raise capital
once, to repair the damage. But the losses kept growing. The moment the
downgrade came, AIG was forced to come up with tens of billions of additional
collateral, immediately. This was on top of the billions it owed to its
trading partners. It didn`t have the money. The world`s largest insurance
company was bankrupt.
The dominoes fell over immediately. Lehman Brothers failed on the same day.
Merrill was sold to Bank of America. The Fed stepped in and agreed to lend AIG
$85 billion to facilitate an orderly sell off of its assets in exchange for
essentially all the company`s equity.
Most people never understood how AIG was the linchpin to the entire system.
And there`s one more secret yet to come out...
AIG`s largest trading partner wasn`t a nameless European bank. It was Goldman
Sachs.
I`d wondered for years how Goldman avoided the kind of huge mortgage-related
writedowns that plagued all the other investment banks. And now we know:
Goldman hedged its exposure via credit default swaps with AIG. Sources inside
Goldman say the company`s exposure to AIG exceeded $20 billion, meaning the
moment AIG was downgraded, Goldman had to begin marking down the value of its
assets. And the moment AIG went bankrupt, Goldman lost $20 billion. Goldman
immediately sought out Warren Buffett to raise $5 billion of additional
capital, which also helped it raise another $5 billion via a public offering.
The collapse of the credit default swap market also meant the investment banks
� all of them � had no way to borrow money, because no one would insure
their obligations.
To fund their daily operations, they`ve become totally reliant on the Federal
Reserve, which has allowed them to formally become commercial banks. To date,
banks, insurance firms, and investment banks have borrowed $348 billion from
the Federal Reserve � nearly all of this lending took place following AIG`s
failure. Things are so bad at the investment banks, the Fed had to change the
rules to allow Merrill, Morgan Stanley, and Goldman the ability to use
equities as collateral for these loans, an unprecedented step.
The mainstream press hasn`t reported this either: A provision in the $700
billion bailout bill permits the Fed to pay interest on the collateral it`s
holding, which is simply a way to funnel taxpayer dollars directly into the
investment banks.
Why do you need to know all of these details?
First, you must understand that without the government`s actions, the collapse
of AIG could have caused every major bank in the world to fail.
Second, without the credit default swap market, there`s no way banks can
report the true state of their assets � they`d all be in default of Basel
II. That`s why the government will push through a measure that requires the
suspension of mark-to-market accounting. Essentially, banks will be allowed to
pretend they have far higher-quality loans than they actually do. AIG can`t
cover for them anymore.
And third, and most importantly, without the huge fraud perpetrated by AIG,
the mortgage bubble could have never grown as large as it did. Yes, other
factors contributed, like the role of Fannie and Freddie in particular. But
the key to enabling the huge global growth in credit during the last decade
can be tied directly to AIG`s sale of credit default swaps without collateral.
That was the barn door. And it was left open for nearly a decade.
There`s no way to replace this massive credit-building machine, which makes me
very skeptical of the government`s bailout plan. Quite simply, we can`t/>replace the credit that existed in the world before September 15 because it
didn`t deserve to be there in the first place. While the government can, and
certainly will, paper over the gaping holes left by this enormous credit
collapse, it can`t actually replace the trust and credit that existed...
because it was a fraud.
And that leads me to believe the coming economic contraction will be longer
and deeper than most people understand.
You might find this strange... but this is great news for those who understand
what`s going on. Knowing why the economy is shrinking and knowing it`s not
going to rebound quickly gives you a huge advantage over most investors, who
don`t understand what`s happening and can`t plan to take advantage of it.
How can you take advantage? First, make sure you have at least 10% of your net
worth in precious metals. I prefer gold bullion. World governments` gigantic
liabilities will vastly decrease the value of paper currencies.
Second, I can tell you we`re either at or approaching a moment of maximum
pessimism in the markets. These kinds of panics give you the chance to buy
world-class businesses incredibly cheaply. A few worth mentioning are
ExxonMobil, Intel, and Microsoft. I have several stocks like these in the
portfolio of my Investment Advisory.
Third, if you`re comfortable short selling stocks (betting they`ll fall in
price), now is the time to be doing it... simply as a hedge against further
declines.
Keep the fraud of AIG in mind when you form your investment plan for the
coming years. By following these three strategies, you`ll survive and prosper
while most investors sit back and wonder what the hell is going on.
