CHAN AKYA Waiter, there's a banker in my soup
By Chan Akya
... And a broker. And an insurer. With the American financial giants falling
like flies, Asian bankers and investors must be left wondering not just about
how bad things are but also about the next source of trouble.
In my article last weekend (see
Pareto's bazooka, Asia Times Online, September 13, 2008), I left open
the fates of three firms - Lehman Brothers, AIG and Washington Mutual;
respectively a broker, insurer and bank. The article concluded with the
question of which of these three the US government would choose to rescue
because it doesn't have the financial muscle to muster a rescue of all three.
The dramatic events of the last few days put paid to any notions
that some in the equity markets were nursing that the worst of the credit
crisis was behind us. If anything, things will get a whole lot worse from here,
even as the seeds for reconstruction and a new wave of wealth creation are
being sown. We are however getting ahead of ourselves, so lets first look at
the story so far.
Double whammy
A news item on September 16 highlighted the plight of a UK real estate company,
Songbird, that had a particularly bad run of luck. This company, through a
subsidiary called Canary Wharf Group PLC, owns and leases commercial properties
in the heart of London's new financial district - and London is the world's
largest financial center, according to most statistics.
Over the weekend, one of the biggest tenants, leasing about 100,000 square
meters, went bust - Lehman Brothers declared bankruptcy. Eager to downplay the
impact on its financial position, Songbird announced quickly that its leases
were insured - by a highly respected insurance company, namely AIG. Oops and
twice so - AIG itself was being buffeted in the stock markets with a stock that
had fallen some 90% in a matter of a few days.
Late on Tuesday night, the American government (acting through the Fed) stepped
in to rescue AIG, just a day or so after rejecting any public financial support
for the prestigious firm of Lehman Brothers. My Asia Times Online colleagues
Spengler and Julian Delasantellis have already described the events leading to
the downfall of Lehman, so perhaps it is moot to dwell on that topic again (see
Lehman and the end of the era of leverage and
Silences say it all, Asia Times Online, both September 16, 2008). I
look below at the reasons for the Fed to intervene in the case of AIG.
AIG as a large insurance company isn't in the league of names that financial
analysts would consider to be at risk when looking at the domino effect of the
subprime crisis. However, this is to ignore the structural problems of
long-term investors that my colleague Spengler referred to in his article
above.
When the US Federal Reserve cut interest rates aggressively after the dotcom
bubble burst, thereby ushering in a housing bubble, it also materially changed
the returns against risk of all financial instruments. Simply put, the return
on "risk free" money, that is lending to the government, fell so far that all
investors needing that source of income (pensioners and the like) suddenly
found themselves short-changed. Insurance companies had come to depend on bond
market returns, and therefore felt the heat more than any other player in the
financial industry.
The decline of stock prices in the post-dotcom period also hurt insurance
companies, forcing them (and their regulators) to increase the purchases of
bonds instead; as noted above, this was exactly at the time when bond returns
were being pushed down by the Fed, thereby forcing a greater decline in yields.
Eventually, this was to produce the "Greenspan conundrum" - long-term bond
yields refused to rise much even as the Fed raised interest rates. That
conundrum should have been the biggest warning to regulatory authorities in the
US, but what with all the consulting contracts going around, there wasn't
enough attention or alarm raised about the matter.
Anyway, this forced insurance companies to go looking for other "risk free"
alternatives, which is where the whole triple-A malarkey of structured credit
assets (CDOs, ABS, MBS and so on) came about. These securities, offering the
same credit rating as the US government, came with higher yields and so were
perfect for insurance companies and other ratings-constrained investors.
The other development was in the area of credit default swaps (CDS), which are
really insurance contracts on the likelihood of defaults. If as a banker, you
worried that there was simply too much exposure to large companies in your
portfolio (and this cost you a lot of capital), you bought protection
(insurance) through a CDS from another financial institution, say a foreign
bank or an insurer.
Soon enough, the selling of insurance on defaults became a major business for
these counterparties. Much like the losses of European banks have been bigger
than those of US banks in the American subprime crisis due to their
participation in such contracts, insurance companies also suffered similar
losses. However, unlike banks they are not required to mark their books to
market, and therefore could hide the problems for longer than the banks could,
which is why the troubles of AIG are coming to light now, rather than a year
ago.
Ultimately, this is the reason for the Fed to step in and rescue AIG. Banks
that reported that they are fully hedged on their various exposures to US
subprime, problem assets, and corporate defaults all had bought protection
using CDS from companies like AIG, which itself is estimated to have sold some
$500 billion in credit protection overall.
If the value of that protection evaporates because the person selling it to you
has defaulted (as in the case of Lehman), then your "original" exposure is back
on your books, needing a capital increase. Given that many global banks are
already reporting tangible equity against assets of far less than 5%, the AIG
hit would have been a bit too much for the system. I am satisfied that the
collapse of AIG would have been a systemic event, and hence it warranted an
intervention (this was certainly not the case for Bear Stearns, where the Fed
wasted $30 billion in an unnecessary rescue).
The $85 billion facility has been priced punitively at London Interbank Offer
Rate (Libor) +8.5%, which makes it imperative for AIG to repay as quickly as
possible by selling off its core assets. Various buyers including life
insurance and other companies have lined up to buy, and will offer to pay rock
bottom prices for these assets - and AIG will simply have to agree to those
terms. The US government does own nearly 80% of the equity after last night's
rescue though, making it more likely that they would get a profitable outcome.
The impact on AIG businesses across Asia has been less than salutary, as
expected. Panic-stricken policyholders have lined up all day in Singapore to
surrender their policies to secure redemption value. China's insurance
regulator declared that AIG businesses in the country were sound, echoing
statements from the rest of the region. This is however a big concern going
forward given the large market share that AIG commands in many Asian markets,
and the sheer volume of domestic securities that it holds across the region.
Distressed asset sales will create very large jumps in domestic assets such as
in government bond yields, Asian shares and the like for the short-term.
Bagehot lives, and that is good
Overall, and quite unlike the Bear Stearns experience, events of last weekend
meet the principles of Walter Bagehot, the 19th century British businessman,
essayist, and journalist, concerning a banking crisis: Make money available in
plenty, only accept good collateral and charge a punitive rate. I am in
agreement with the Fed for not cutting rates on Tuesday as was being demanded
by a large section of the market on the collapse of Lehman. This was
courageous, and correct decision to make.
Looking ahead, there are a number of firms still at risk: Washington Mutual,
which is reportedly being looked at by another US bank; two brokers, Morgan
Stanley and Goldman Sachs, whose own CDS are trading at far too wide a spread
to be seen as sustainable; and a host of US regional banks which are all
looking for saviors.
Away from the US, banks are
falling like flies across the world including in
the UK, where one of the largest, HBOS, has been
suspended after falling
over 60% in two days. (Lloyds TBS Group Plc, the UK's biggest provider of
checking accounts, was in talks Wednesday to buy HBOS, Bloomberg reported, citing two people
familiar with the situation.) Similarly, the decline in emerging markets have only
accelerated of late, while Russian shares are being "punished" for the Georgia
misadventure. Other stock markets in China, Brazil and elsewhere haven't done a
whole lot better. Chinese authorities cut interest rates and reserve
requirements this week to provide a boost to the economy, while the Russian
central bank is mulling the creation of a wealth fund to invest in its domestic
stock market. The notion of "every man for himself" will soon be reality.
When the history of the markets is written though, the Fed's timely courage in
avoiding a bailout of Lehman, pushing through a punitive takeover of AIG and
forcing a marriage of declining banks with their larger and better-capitalized
peers could all be seen as the steps that helped to stem the crisis. It
certainly doesn't feel like a turning point as I write this though; but that,
ultimately, is the way emotions differ from fundamentals.
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