Wednesday, September 17, 2008

Understanding the Credit Crisis and AIG

I found Michael Lewitt's "Wall Street's Next Big Problem" helpful in understanding how the continued stability of AIG (American International Group, FYI) is important for the financial system. Lewitt is president of a money management firm. Here is an excerpt.

Its collapse would be as close to an extinction-level event as the financial markets have seen since the Great Depression. A.I.G. does business with virtually every financial institution in the world. Most important, it is a central player in the unregulated, Brobdingnagian credit default swap market that is reported to be at least $60 trillion in size.

Nobody knows this market’s real size, or who owes what to whom, because there is no central clearinghouse or regulator for it. Credit default swaps are a type of credit insurance contract in which one party pays another party to protect it from the risk of default on a particular debt instrument. If that debt instrument (a bond, a bank loan, a mortgage) defaults, the insurer compensates the insured for his loss. The insurer (which could be a bank, an investment bank or a hedge fund) is required to post collateral to support its payment obligation, but in the insane credit environment that preceded the credit crisis, this collateral deposit was generally too small.

As a result, the credit default market is best described as an insurance market where many of the individual trades are undercapitalized. But even worse, many of the insurers are grossly undercapitalized. In one case in the New York courts, the Swiss banking giant UBS is suing a hedge fund that said it would insure nearly $1.5 billion in bonds but was unable to do so. No wonder — the hedge fund had only $200 million in assets.

If A.I.G. collapsed, its hundreds of billions of dollars of mortgage-related assets would be added to those being sold by other financial institutions. This would just depress values further. The counterparties around the world to A.I.G.’s credit default swaps may be unable to collect on their trades. As a large hedge-fund investor, A.I.G. would suddenly become a large redeemer from hedge funds, forcing fund managers to sell positions and probably driving down prices in the world’s financial markets. More failures, particularly of hedge funds, could follow.Regulators knew that if Lehman went down, the world wouldn’t end. But Wall Street isn’t remotely prepared for the inestimable damage the financial system would suffer if A.I.G. collapsed.

As far as I can figure it out, this whole crisis stems from interest rates being so low for so long. (Read Alan Greenspan's warning in 2005 concerning this, though he was Federal Reserve Chairman at the time: "Alan Greenspan, chairman of the Federal Reserve, warned Monday night that the baffling persistence of low long-term interest rates was driving investors to hunt for higher returns by plowing money into hedge funds that will not be able to deliver on their promises." -- NYT, June 7, 2005) That made money cheap to borrow. So lots of people did. They bought houses.

With so much money flowing into the housing market so freely, prices inflated. With home values rising so quickly, financial institutions eager for profit (nothing wrong with that unless it's unmoderated by prudence) developed ever more generous means of letting people into the market, such as adjustable rate mortgages and interest only mortgages. These are fine as long as home values keep rising. But they cannot rise indefinitely. This seems something like a Ponzi scheme without the scheming.

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