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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.

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