Bailouts And AIG's Dangerous Collapse

Two articles caught my attention this morning.

Published on CNN money, Yet another bailout - Taxpayer tally. The following passage is most interesting, for it represents a reality check on the size of the total bailouts so far.

• The Federal Reserve has backstopped the purchase of Bear Stearns to the tune of $29 billion. It will loan $85 billion to insurer AIG. It's letting banks borrow up to $150 billion using risky mortgage-backed securities as collateral. And it's letting investment banks, which it doesn't regulate, get short-term loans using the central bank's discount window.
  
  The Treasury, meanwhile, has pledged to backstop Fannie and Freddie up to $200 billion. Lawmakers passed legislation allowing the Federal Housing Administration to insure up to $300 billion in loans for troubled borrowers. They're likely to loan $25 billion to the auto industry.
  
  And the government might not be finished. Some Democrats on Capitol Hill are arguing for an expansion of the FHA program for troubled borrowers. And talk is building that the government might have to set up a fund - similar to efforts in the 1930s and 1980s - to buy bad securities clogging up the financial system.
  
  If you add up how much the Treasury and Fed have pledged or made available for loans so far, it's close to $800 billion.
  
  So what's the real cost to taxpayers for all these interventions? No one can say for sure, and probably won't be able to for some time. The Savings & Loan crisis of the early 1990s cost taxpayers a net of $124 billion in 1999 dollars, according to the FDIC - more than initially estimated but below projections made during the height of the crisis.
  
  But one thing is certain: The price tags on today's bailouts bear "no direct translation to the taxpayer cost," said Lyle Gramley, a former Fed governor now with the Stanford Group, a Washington policy research firm.
  
  Indeed, he said, "None of us knows yet if there'll be any cost to the taxpayer at all."
  
  Here's why: The bailouts are, in one form or another, loans or investments. How much they end up costing (or making) depends on a number of factors including how the economy holds up and when the real estate market recovers.
  
  "A lot depends on whether or not we get in a severe recession and how quickly we turn things around in housing," Gramley said.
  
  In exchange for their stepping in, the Fed and Treasury are getting assets as collateral (in some cases, income-producing assets and saleable assets) as well as majority ownership stakes in AIG, Fannie and Freddie. They've also claimed veto power for corporate decisions and a No. 1 spot among stakeholders who get paid first.
  
  In the case of the Fed's $85 billion loan to AIG, the central bank is charging what are essentially double-digit interest rates: specifically, the 3-month Libor (around 2.88% currently) plus 850 basis points.
  
  So what gains or losses the Treasury and Fed realize will depend on the performance of those assets and stocks, and the companies' ability to pay back their loans. Ultimately those performances rest on how soon confidence is restored to the markets and how the economy fares.

And the following editorial posed on FSU is most wworth reading, AIG’s Dangerous Collapse & A Credit Derivatives Risk Primer. It is written by Daniel R. Amerman, CFA September 17, 2008

• What is driving the fall of AIG – and potential government losses that may far, far exceed the $85 billion bailout announced late on September 16th - is not mortgages or real estate (directly), but fears that AIG’s huge, global credit-default swap positions will unravel. The $62 trillion dollar credit derivatives market is 50 times the size of the subprime mortgage derivatives market, and is indeed larger than the entire global economy.

Sometimes a simple chart makes things so simple and clear and Daniel has included the following chart.

WOW!!!!!!!

And the following passage explains the clear and precise danger.

• Where Assumptions Meet Reality
  
  Now here's the thing. The subprime mortgage market is tiny compared to the overall corporate market. A corporate market which has credit derivatives interwoven throughout. Let’s say in this day of highly leveraged companies, that a real recession does hit and it takes down something like $2 or $5 trillion worth of book value along with it. Those would be real losses. Staggering losses that dwarf what we have seen with subprime mortgages.
  
  Where is the money going to come from to pay for those losses? In theory, the way this works from an academic economics perspective is that you have all these hordes of incredibly intelligent people, each of whom is working for well-capitalized institutions, and they all backstop each other. They do so first by using that supposedly awesome collective intelligence to keep mistakes from being made in the first place. Next, the theory is that there will be multiple layers of protection available if there's a problem, to absorb any damage.
  
  Unfortunately what we saw actually happen in the real world with mortgage derivatives was just the reverse of the theory. The multiple layers of the so-called “smartest person in the room” became multiple layers of people making steadily worse (and more obvious) mistakes in the pursuit of short-term profits until the situation not just predictably – but inevitably – collapsed upon them.
  
  On top of that, far from the firms backstopping each other, in the real world we have a cascading series of credit losses that spread from one firm to another, as tens of billions of dollars in actual subprime losses multiplied out to become much larger hits to values of securities portfolios, nearly bringing down the industry together.
  
  Which again brings up the question of what happens if a real recession hits the $62 trillion credit derivatives market?

Do read the rest of his editorial here