Skip to main content

Nothin' but an AIG thing

Not a good day for US shares. As we head into the close of Wednesday's US trading session, the Dow Industrials are down around 400 points (-3.7 percent), and the S&P 500 index is down around 50 points, or -4.2 percent.

North American stocks suffered today, while gold rallied sharply, despite the government's $85 billion bailout loan to troubled insurer and financial-engineering firm AIG.

Meanwhile, Bloomberg reports that bank lending has seized up, treasury bill yields plunged to a 54-year low on a rush to perceived safety, and global shares have lost about $2.8 trillion in market value this week. Major share indexes in Russia, Hong Kong, and the US have fallen to new multi-year lows.

But the main focus of the markets has been on AIG, which leads a basket of 13 "unlucky" US stocks that have lost $1 trillion in market value this year.

The Wall Street Journal reported today that the US will take over AIG in an $85 billion bailout. In a quick turnaround of the anti-bailout sentiment that allowed investment bank Lehman Brothers to file for bankruptcy earlier in the week, the government has stepped in to loan money to AIG, claiming the company was too big to fail.

Terms of the bailout package from the Journal:

"The U.S. negotiators drove a hard bargain. Under terms hammered out Tuesday night, the Fed will lend up to $85 billion to AIG, and the U.S. government will effectively get a 79.9% equity stake in the insurer in the form of warrants called equity participation notes. The two-year loan will carry an interest rate of Libor plus 8.5 percentage points. (Libor, the London interbank offered rate, is a common short-term lending benchmark.)

The loan is secured by AIG's assets, including its profitable insurance businesses, giving the Fed some protection even if markets continue to sink. And if AIG rebounds, taxpayers could reap a big profit through the government's equity stake.

"This loan will facilitate a process under which AIG will sell certain of its businesses in an orderly manner, with the least possible disruption to the overall economy," the Fed said in a statement. "

Note that the Journal sees AIG's profitable insurance business as protection for the Fed and US taxpayers. FT Lex has some contrasting opinions on that point:

"A patched-up AIG could stagger on, with the Fed’s assistance. Institutions could be strong-armed into providing the huge infusions of capital needed to tide it over.

However, its brand – motto: ”the strength to be there” – may already be damaged beyond repair. Buyers of insurance tend to accept that a provider generally knows what its assets are worth but can make only an educated guess as to its liabilities (the direct opposite of a bank). AIG clearly does not have a good handle on either. The group’s murky book of CDS on collateralised debt obligations has contributed to losses of about $13bn this year, and is probably deteriorating daily."

Reading the details of the crisis at AIG, it's interesting to find that the root of the company's failure (and the impending damage to its counterparties) can be found in its decision to branch out from its main insurance business and into the derivatives and swaps business.

"As American International Group fights for survival, the question on everyone’s lips is how could what was once the world’s biggest insurer get itself into such a mess?

The answer has its roots in a decision in the late 1980s to hire a group of derivatives specialists from Drexel Burnham Lambert.

These formed the basis of AIG Financial Products, which wrote billions of dollars of derivatives, which are now at the heart of AIG’s woes and are a long way from the mainstream insurance business that continues to lie at AIG’s core."

Is AIG too big to fail? Are its numerous counterparties too big and important to suffer write-downs or losses? Read through the following related articles for more details and decide for yourself.

Related articles and posts:

1. "US to take over AIG in $85 billion bailout" - Wall Street Journal.

2. "Non-core blows to AIG's heart" - Financial Times.

3. "The boring is biting with a vengeance" - Financial Times.

4. "Say goodbye to the old America..." - Fabius Maximus.

Popular posts from this blog

Seth Klarman: Margin of Safety (pdf)

Welcome, readers! Signup for free email updates at the Finance Trends Newsletter . Update: PDF links removed due to DMCA notice. Please see our extensive Klarman book notes below. New visitors, please check the Finance Trends home page for all new posts. Here's something for anyone who has been trying to get a look at Seth Klarman's now famous, and out of print, 1991 investment book, Margin of Safety .  My knowledge of value investing is pretty much limited to what I've read in Ben Graham's The Intelligent Investor (the book which originally popularized the investment concept of a "Margin of Safety"), so check out the wisdom from Seth Klarman and other investing greats in our related posts below. You can also go straight to Ronald Redfield's Margin of Safety book notes .    Related posts: 1. Seth Klarman interviews and Margin of Safety notes     2. Seth Klarman: Lessons from 2008 3. Investing Lessons from Sir John Templeton 4.

Slate profiles Victor Niederhoffer

Slate's recent profile of writer/speculator, Vic Niederhoffer has been getting some attention from traders and finance types in recent days. I thought we'd take a look at it here too, to offer up some possible educational value from Vic's experiences with trading and loss. Here's an excerpt from Slate's profile of Victor Niederhoffer : " I've enjoyed getting your e-mails. It sounds like you've thought a lot about being wrong. Well, the reason you contacted me, to call a spade a spade, is that I'm sort of infamous for having made a big, notorious, terrible error not once but twice in my market career. Let's talk about those errors. The first was your investment in the Thai baht, which pretty much wiped you out when the Thai stock market crashed in 1997. I made so many errors there it's pathetic. I made one of my favorite errors: "The mouse with one hole is quickly cornered." That is key. There are certain decisions you make in li

Moneyball: How the Red Sox Win Championships

Welcome, readers . T o get the first look at brand new posts (like the following piece) and to receive our exclusive email list updates, please subscribe to the Finance Trends Newsletter .   The Boston Red Sox won their fourth World Series title of t he 21st century this we ek. Having won their first Se ries in 86 years back in 200 4, the last decade-plus has marked a very strong return to form for one of baseball's oldest big league clubs. So how did they do it? Quick background: in late 2002, team own er and hedge fund manager, John W. Henry (with his partners ) bought the Boston Red Sox and its historic Fenway Park for a reported sum of $ 695 million. Henry and Co. quickly set out to find their ideal General Manager (GM) to help turn around their newly acquired, ailing ship. This brings us to one of my fav orite scenes from the 2011 film , Moneyball , in which John W. Henry (played by Ar liss Howard) attempts to woo Oakland A's GM Billy Beane (Brad Pi