Right now it looks like the government is getting closer to participating in a scheme to provide embattled insurer AIG with an $85 billion dollar “bridge loan” in return for an 80% stake in AIG. So, while Lehman Brothers was allowed to fail, a mere week after the nationalization of Fannie Mae and Freddie Mac, it seems that the authorities are once again consumed by the “too big/too interconnected to fail” specter. And AIG certainly is big: in the words of the Financial Times, it “is the biggest provider of commercial insurance in the US, one of the biggest writers of life assurance there, and the biggest provider of fixed annuities, a popular retirement savings product. It has enormous global operations.”
But, the FT goes on, “it also has a financial products division that acted like an investment bank.” Which means: “It is a counterparty in a large number of swap and hedging transactions. It wrote credit default swaps, which insure against corporate default, some protecting against losses on collateralized debt obligations, which sparked the problems.” Hence, the FT notes, quoting a law professor, “if AIG were to fail, a number of other institutions that thought they were insured against default would find themselves ‘naked and exposed.'” That’s the “too interconnected” bit, in a nutshell.
Lehman fell because Treasury Secretary Henry Paulson would not guarantee its debts: after the takeover of Fannie Mae and Freddie Mac, he thought that to do so would be to tempt investors into selling the shares of other struggling firms, of which there are many (Merrill Lynch doesn’t even count anymore), while investing in their debt, which would rise in value with a government guarantee. He also must have thought that other extraordinary measures the government has taken in the last few months, like making government funds available to investment banks, would make the winding down of Lehman a less potentially disastrous process than the bankruptcy of Bear Stearns would have been in March. But there’s another consideration: surely Paulson fears that foreign investors are getting nervous about all the potential debt that these bailouts could amount too. But here’s the catch: by not bailing out Lehman, Paulson is telling foreign equity investors who, as Anatole Kaletsky notes, are the only ones in a position to provide the funding many of these firms need, that they have no protection. Paulson can’t win for losing.
As for some of the other familiar suspects, like hedge funds, the Financial Times also notes, many of them are taking a pounding because they’re still unwinding their speculative positions in oil and other commodities, which have tanked so precipitously in the last few weeks. Now how are these hedge funds to make back some of these losses? By playing chicken with Paulson, probably: at least that’s what short positions seem to indicate.
What happens now? Very hard to say. One other thing to keep in mind is that even though the Fed didn’t, at their scheduled meeting, lower interest rates, it could well do if markets don’t stabilize upon receiving the news of an AIG rescue. And though Wall Street bucked the global trend on Tuesday and actually rose (after suffering its biggest one-day loss since September, 2001 on Monday), developments in the currency markets are worrying: the dollar rally has stalled against the euro, and the Japanese Yen has posted big gains since last week. This indicates that, notwithstanding the “flight to quality” that resulted in truly extraordinary falls in US bond yields on Monday, foreign investors still fear that the US Treasury may be in over its head, or getting there. And there’s not only AIG to pay for: if Washington Mutual goes down, there is a real concern that the Federal Deposit Insurance Corporation, already bleeding due to the collapse of IndyMac in July, will have to be somehow topped up, especially if other regional banks fail, as many are in danger of doing. And if that weren’t enough, Felix Salmon tells us:
Lehman Brothers has more than $600 billion in assets that will need to be liquidated as part of its bankruptcy. That’s an order of magnitude greater than any bankruptcy the world has ever seen: No one has a clue how to even get started on something so huge, let alone what the repercussions will be. Is there $600 billion in cash sitting on the sidelines of the global financial markets just waiting for an opportunity to snap up assets on the cheap? No. So as Lehman’s assets get liquidated, asset prices in general, and bond prices in particular, are likely to be under a great deal of pressure.
Finally, Russia is experiencing a major financial meltdown of it’s own making, Pakistan has ordered its army to fire at at American troops that cross the border, and the International Atomic Energy Agency declared that its efforts to get Iran to clarify its nuclear potential had ended in failure. This financial crisis has been remarkably mild in many ways on most people in the wealthy countries, given its unprecedented scope, but it really does seem that it may be tipping into unchartered territory altogether. The remainder of this week may be a decisive one in many ways.
One final note: the Financial Times also reported on the the closure of Lehman’s offices worldwide, and some really bizarre stuff went down, indeed. Employees, who have seen their savings disappear (they owned 30% of Lehman’s stock), were told not to expect paychecks at the end of the month, and that they might even be liable for credit-card expenses. The situation was so bad in London that employees there who had money on their canteen cards were “buying hundreds of bars of chocolate, bags of roasted coffee and anything that’s not perishable.” Amazing: the erstwhile masters of the universe, accustomed to trading in derivatives of unprecedented complexity, reduced to little more than barter. And their leaders? Christian Meissner counseled his staff to “look for new work and move on.” Now that’s creative destruction for you.