Now its AIG

AIG, the largest insurer in the US and a member of the Dow Jones 30, is the latest financial institution at the center of the storm. The major ratings agencies have issued downgrades (see here) and this is greatly increasing the need an emergency transfusion of cash. As the Wall Street Journal notes:

With AIG now tottering, a crisis that began with falling home prices and went on to engulf Wall Street has reached one of the world's largest insurance companies, threatening to intensify the financial storm and greatly complicate the government's efforts to contain it. The company is such a big player in insuring risk for institutions around the world that its failure could undermine the global financial system.

AIG is a major participant in the market for credit default swaps. It is essentially selling insurance to hedge funds and investment banks. Indeed, it is heavily involved in selling insurance against defaults in the market for mortgage-backed securities. Hence, the sub-prime mess hurt it especially. As its stock falls it needs more capital to fund its positions. As a counterparty to large portions of the financial system its collapse would be hard to contemplate. (I am betting that when I wake up Tuesday, the Fed and Treasury will have announced a plan to prevent this). Tonite the NYTimes reports that:

Federal Reserve officials were in urgent talks with Goldman Sachs and JPMorgan Chase on Monday to put together a $75 billion lending facility to stave off a crisis at the American International Group, the latest financial services company to be pummeled by the turmoil in the housing and credit markets.

Why might AIG be rescued when Lehman was allowed to go bankrupt? Two main differences. First, Lehman had time to adjust and did not. Second, while huge Lehman was not as likely to cause knock-off systemic risk as AIG. It is just too much at the center of action.

One problem AIG is facing is the fallout from the Fannie-Freddie bailout. Secretary Paulson designed that bailout so that shareholders would lose. Investors must thus anticipate that if there is a rescue it will help creditors but not equity holders. But if you anticipate this why would you invest in AIG now? Better to wait and see what Paulson announces.

The other big problem is the demand for liquidity. As everyone tries to improve the quality of their balance sheets, they sell assets. With all sellers and no buyers prices fall further, which requires more sales. It is like standing up to get a better view at the football game. Doesn't work if everybody does it. But if everybody is standing, staying seated is even worse.

Lehman goes bust

Lehman Brothers hurtles towards bankruptcy, see here. The Treasury and the Federal Reserve have clearly chosen to draw the line on bailouts. Whether this stems the tide remains to be seen, but the thinking seems to be that the market had time to adjust to Lehman's problems, so that the chance of a systemic crisis is lessened.

Lehman's troubles arise from a familiar source. As this article in the Washington Post notes,

Lehman, the number one underwriter of mortgage-backed bonds last year, amassed a giant portfolio of properties and mortgage-related securities. But the value of the assets began to sink last year amid a spike in mortgage defaults by homeowners with subprime credit.

One thing to look for now is what happens to the market for credit default swaps. Traders have suggested that even solid firms are finding it hard to buy such insurance now. This could be an interesting weak (note also Bank of America purchasing Merrill Lynch and the problems AIG seems to be facing).

Trade Deficit Swells

The US trade deficit swelled in July. Details here. A big part of the increase was huge oil imports, due to higher volumes and the very high price.

Update on Role of China in Fannie -Freddie bailout

The WSJ has an article on the bailout of Fannie and Freddie which illuminates the role of China and other foreign investors. Here is a relevant portion:

Foreign central banks had been among those voicing concerns in the weeks ahead of the government's seizure of Freddie and Fannie. The banks had steadily reduced their holdings of debt in the two firms in recent weeks as the turmoil around the firms worsened.

China's four biggest commercial banks, too, pared back their holdings in agency debt, with Bank of China Ltd., the largest holder of Fannie and Freddie securities among these banks, saying it sold or allowed to mature $4.6 billion of the $17.3 billion it held as of June 30, down from more than $20 billion at the end of last year.

Treasury tried to head off such concerns by having David McCormick, the undersecretary for international affairs, call foreign central banks and other overseas buyers of the companies' securities or debt to reassure them of the instruments' creditworthiness. Over the weekend, Treasury officials called sovereign-wealth funds in Abu Dhabi and elsewhere in the Middle East, assuring them that they were working on financial issues involving Fannie and Freddie, says an individual apprised of the conversations.

Like many investors, foreign governments, particularly central banks and sovereign-wealth funds, believed the U.S. government implicitly stood behind Fannie and Freddie and would prop them up to prevent a failure.

The point to remember is that foreign investors hold a lot more (an order of magnitude more) US assets then their holdings in Freddie and Fannie. So the threat to withdraw even some of them could have destroyed many other financial institutions.

More on the bailout

Most of the analysis of the Treasury's takeover of Fannie and Freddie focuses on the need to cope with the housing crisis. But the most important motivation to do this now was to prevent a financial crisis. It is important to note that a large portion of the debt of the two corporations was held by foreigners.

The top five foreign holders of Freddie and Fannie long-term debt are China, Japan, the Cayman Islands, Luxembourg, and Belgium. In total foreign investors hold over $1.3 trillion in these agency bonds, according to the U.S. Treasury's most recent "Report on Foreign Portfolio Holdings of U.S. Securities."

This capital inflow is a response to large US current account deficits. The debt of the GSE's, while not explicitly guaranteed, clearly bore an implicit Federal guarantee (as is now totally evident). Foreign investors who purchased GSE debt were naturally worried. If the GSE's went bankrupt they would perhaps gain cents on the dollar. The bailout announced by the Treasury will hurt shareholders, but will probably keep bondholders whole. Hence, the bailout reassures foreign investors at a time when we need them.

Of course what remains to be seen is whether the current bailout plan will suffice. As many have noted (for example, Paul Krugman here, or Mohamed El-Erian here), we are now in a process of de-leveraging. This is the reverse of the process in the boom when leverage is used to maximize returns. Now the race to safety means a rush to sell assets to bolster balance sheets. But what is good for the individual may not work for the economy as a whole. The rush to sell drives down prices which further worsens balance sheets and leads to more selling. Liquidity dries up. This is Irving Fisher's debt deflation. Japan went through this in the 1990's. Can we escape it?

Fannie and Freddie Nationalized

The Federal Government announced today its takeover of Fannie Mae and Freddie Mac. Floyd Norris has a good column on the announcement. The problems there were a classic case of moral hazard. The two institutions had at least implicit federal guarantees, so they could borrow at low rates. But they were privately managed so they took risk to bolster profits. As Norris notes, they served two masters, and this really got them into trouble.

It was during the long housing boom that the seeds of destruction were sowed for Fannie and Freddie. They appeared to be very profitable, so pressures mounted for them to find ways to finance housing for poorer Americans, often living in areas where banks had historically been hesitant to lend. Congress set goals for such lending.

As the housing boom proceeded the share of home loans that they purchased increased dramatically. See this article from Jim Hamilton for some excellent analysis of the role of Fannie and Freddie in generating our current crisis. As Jim notes,

The fraction of outstanding home mortgage debt that was either held or guaranteed by the GSEs (known as their "total book of business") rose from 6% in 1971 to 51% in 2003. Book of business relative to annual GDP went from 1.6% to 33%.

The question is why did these two Government Sponsored Enterprises grow so fast? Part of it is the fact that Congress wanted more mortgage loans made to expand home ownership. And the bigger part is that Fannie and Freddie grew to earn more profits, using their borrowing advantage to grow their market share, with the taxpayer bearing the risk.

Financial Crashes and Incentives

Joseph Stiglitz, Nobel Prize winning economist, has an article in the New Republic on excessive risk taking and our financial crisis. He writes:

In recent years, financial markets created a giant rich man's casino, in which well-off players could take trillion dollar bets against each other. I am among those who believe that consenting adults should be allowed great freedom in what they do--as long as they don't harm others. But there's the rub. These high-rollers weren't just gambling their own money. They were gambling other people's money. They were putting at risk the entire financial system--indeed, our entire economic system. And now we are all paying the price.

Stiglitz discusses the incentives to take excessive risks, not surprising for someone who earned his Nobel Prize for information economics.

I think that this is the right focus, but I think the discussion could be sharpened by asking why hedge funds have incentive schemes that reward managers for excessive risk taking. Specifically, why has the system of "2 and 20" (two percent management fee and 20% of profits) survived. This system rewards excessive risk taking since in any good year the manager will earn large profits but the losses go to the shareholders. Other financial institutions face regulations to prevent excessive risk-taking but hedge funds keep their strategies as proprietary secrets -- after all, it is their trading strategies that is the only source of their rents. But why would rich people invest in funds with such incentive schemes? That is the question. We know why managers love it. This is the puzzle we need to solve.