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.