The Government has nationalised AIG

September 17, 2008

That in order to calm the markets the Fed now needs to bailout a couple of financial firms, instead of only cutting rates, demonstrates that we’re in a new stage of this crisis.


From Fed’s statement:


“The Federal Reserve Board … to lend up to $85 billion to the American International Group under section 13(3) of the Federal Reserve Act.


The Board determined that … a disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth, and materially weaker economic performance.” 


“The AIG facility has a 24-month term. Interest will accrue on the outstanding balance at a rate of three-month Libor plus 850 basis points.


The loan is collateralized by all the assets of AIG, and of its primary non-regulated subsidiaries.  These assets include the stock of substantially all of the regulated subsidiaries.  The loan is expected to be repaid from the proceeds of the sale of the firm’s assets. The U.S. government … has the right to veto the payment of dividends to common and preferred shareholders.”


AIG will relinquish a 79.9 percent stake to the government and senior managers will leave their posts. The shares will not be eliminated, but it’s unlikely that the company will survive in its present shape, as it will be forced to unwind assets and sell its parts and subsidiaries to pay the government back. In the meantime, the Fed’s balance sheet keeps getting worse and worse, with stocks, asset backed securities, failed companies, and just about anything problematic on Wall Street finding its way there when there are tensions.


It’s clear that the private sector is out of solutions to this crisis. The Fed had attempted to convince JPMorgan, and Goldman Sachs to loan 70 billion to AIG, but as it has been the custom, the attempt failed. It’s not for no reason that these large firms refuse to take part in saving their peers. Having resigned themselves to expect that the government will continue to assume their responsibilities, along with their bad paper and troubled assets, they have even less incentive to bear the burden of the trouble that they created. The government has created the expectation that it will bail out everyone that is too big to fail; that if someone fails abruptly, the Fed and the Treasury will take its losses on their own balance sheet. It is all very well, but one should ask the question, where will this money come from? That it’s only the treasury secretary, and the Fed chief who want to assume these risks has only one reason – the funds that they risk are not their own.


But what else can the government do? The mortgage borrower who expects government aid, the lender who expects a bailout, the speculator who demands rate cuts, the banker who wants guarantees are all collectively responsible for this situation. Just yesterday, Bill Gross was commenting “But we don’t plan to sell our MBS at these low prices, since the government has announced a buy back plan, why will we sell our paper at these distressed prices, when we can sell them to the government, later, for more?” Very well, but it’s this bailout culture of the past decades that is facing bankruptcy today. The financial sector has no responsibility, how can one expect them to apply proper risk controls?


Another problem with this bailout is the freeze in financial markets. The situation is likely to get quite worse from here, as we’re nowhere near the end of this crisis; banks will fail, corporates will fall, consumers will have to save instead of spending. So how will the government actually dispose of all these bad assets that it has on its books? That it can’t sell them in the US is obvious – if they could be disposed of in the foreseeable future, JPM, and Goldman would have undertaken this task, and in the meanwhile acquired control of the largest insurance company in the US. But they do not, because they know how difficult the market is.


The US government is already running a 500 billion deficit, if anything, it needs lenders. Only international action, essentially a bridge loan to the US government itself will save the US economy. It’s crucial to observe the treasury’s data on capital flows. These past months have shown a significant decrease, but we need more than a few months to speak about a loss of appetite for government paper in the rest of the world.


Nonetheless, it must be remembered that foreigners, especially exporters are likely to receive less revenues from taxes and business as the global economy, and possibly global trade contract. So even if they wanted to, there will not be sufficient excess cash to justify continued exuberance toward dollar denominated assets.


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