Lehman bankruptcy, AIG downgrade are leading to more turmoil

September 16, 2008

AIG has been downgraded by all three of the ratings agencies, and this will trigger around $13-17 billion in collateral calls from debt investors. There’re plans to support it with $70 billion to $75 billion in loans arranged by Goldman Sachs and JPMorgan, but the plan of this bailout appears similar to the SIV bailout plan of last year, which failed to materialise back then. These banks also failed to create a pool for saving Lehman just last week. AIG sold banks and other investors protection on $441 billion of fixed-income assets, including $57.8 billion in securities tied to subprime mortgages, according to Bloomberg.

The size of this company, the widepsread exposure of the financial system, its proximity in time to the bankruptcy of Lehman, and the general state of panic in the markets should assure government involvement in the resolution of this issue. Nonetheless, both the Fed and the Treasury have refused to bail out or backstop a bailout of this firm so far, and it’s unclear if this is a mere bluff. There appears to be a genuine conviction that the finances of the public are not deep enough to rescue all the large financial firms. The Federal Reserve will probably try to alleviate the symptoms of this crisis by ever increasing liquidity measures, and rate cuts, while Mr. Paulson keeps reassuring the public that the financial system is sound, and that the long term prospects of US are the best in the world. But one should by no means discount the possibility of future government bailouts.

As expected, CDS and corporate bond spreads are widening, with spreads doubling in many cases. In the CDS markets, yesterday’s early quiet appears to have been replaced by heavy activity to cover positions and determine exposure to AIG, Lehman, and the failed GSE’s. The rollover of indexes has been postponed because of uncertainty over pricing.  Overnight dollar libor rose to a massive 6 percent at one point yesterday, three times the Fed’s target rate. The Fed’s response was an injection of 70 billions. In both Europe and the US there is great difficulty in pricing everything from short term liquidity, to corporate debt.

In the rest of the world, Bank of Indonesia and People’s Bank of China have both reduced rates this week. More are expected to follow, but the wisdom of this choice is not entirely clear. What happened to Korea’s won recently is a good reminder that confidence in emerging markets is fading rapidly, as general risk aversion is extracting liquidity and threatening financial stability. Lower interest rates will probably lead to an acceleration of investors’ and speculators’ flight from these markets.

Taiwan’s government instructed its four major funds and state-owned banks to buy shares to help reverse the stock market’s 9 percent slump following Lehman Brothers Holdings Inc.’s bankruptcy filing yesterday, effectively nationalising a part of the economy. This is similar to Asian government response during the 1998 Russian and Asian financial crisis.

The Bank of Japan added a total of 2.5 trillion yen ($24 billion) to the financial system. Both the ECB and BoE will hold a second round of exceptional fine-tuning operations to ease tensions in the short term markets, among many others, from Norway to Australia.

This appears to be the turning point for the markets; the calm and complacency of the last year, the illusions that this issue was limited to financials, that there would be no contagion, seem to have disappeared with the speed of lightning. But this is how markets manage themselves.

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