Another "Too Big To Fail " Bailout

U.S. stocks bounced today during an extremely volatile trading session dominated by hopes and fears about the prospects for insurance giant American International Group (AIG).

The Dow Jones Industrial Average regained 142 points of its 504-point loss yesterday. In a surprise move, Federal Reserve stood pat on interest rates but this barely caused a ripple.

The big story today was AIG. Nobody could take their eyes off the AIG quote on their computer screen. Over 1 billion shares traded today. After plunging at the open to a low of $1.25, shares of AIG reached a high of $5.24 and ended up closing down $1.01, or 21%, to $3.75.

Traders and investment managers were betting that AIG is too big to fail. They were right but shareholders will still lose most of their stake in the company. Late today news broke out that AIG may get an $85 billion U.S. government loan in return for a majority stake:

The agreement keeps New York-based AIG in business, averting a collapse that could have threatened more financial companies and cost them $180 billion in losses, according to RBC Capital Markets. AIG needed the rescue to stave off a collapse after its credit ratings were cut and shares plunged 79 percent since Sept. 11.

"There's a systemic risk if AIG isn't saved,'' Benoit de Broissia, an equity analyst at Richelieu Finance in Paris, said in a Bloomberg Television interview. Richelieu has about $6.2 billion under management.

Fed spokeswoman Michelle Smith declined to comment. Peter Tulupman, a spokesman for AIG, also declined to comment. Terms of the plan were reported earlier by the New York Times.

AIG's fight to stay afloat was the latest tremor to shake the global financial industry, a day after Lehman Brothers Holdings Inc. filed for Chapter 11 bankruptcy protection and Merrill Lynch & Co. sold itself to Bank of America Corp.

"To the extent that a bridge loan or some type of liquidity provision allows AIG time to sell some assets on its balance sheet and time to maintain its investment-grade rating at A or higher, I think it's a good move,'' Bill Gross, co-chief investment officer of Newport Beach, California-based Pacific Investment Management Co., said in a Bloomberg TV interview before the announcement.

Gross, who netted $1.7 billion in profit after the U.S. government bailed out mortgage giants Fannie Mae and Freddie Mac, stands to lose a lot as his Pimco Total Return Fund guaranteed $760 million of debt issued by AIG:

Pimco Total Return Fund, which oversees $132 billion in assets, backed the bonds by selling credit default swaps to investors that pay off if AIG defaults, according to a filing with the U.S. Securities and Exchange Commission last month. The fund had sold insurance on $7.7 billion of bonds, including $4.8 billion issued by financial-services companies, as of the end of June.

The swaps are part of a larger bet by Gross that some beaten-down corporate bonds will recover because they are too important for the U.S. government to let fail, analysts said. That theory was tested yesterday as Lehman Brothers Holdings Inc. filed for bankruptcy protection and AIG's request for $40 billion in loans was rebuffed by the Federal Reserve.

"It's conceivable that Lehman being allowed to fail will have Pimco rethinking which firms meet their standards and which firms don't,'' said Lawrence Jones, associate director of fund analysis at Morningstar Inc., a Chicago-based stock and mutual- fund research firm. "The financials they are looking for generally are ones they feel are going to be backstopped by the government if anything were to really go wrong.''

...

Credit default swaps can boost Pimco Total Return's performance because the contracts generate annual income without requiring any cash upfront. The fund can take advantage of exaggerated fears in the marketplace that companies will default to boost returns.

"Essentially what you are doing is taking a much more levered bet on whether the company will go into default,'' said Kelly at Tradition Asiel Securities. "If they are fairly comfortable those companies aren't going to go into bankruptcy, it seems a pretty shrewd strategy.''

Are you confused? Don't worry, it's the Wild West out there, but let me try to explain what I think went on today.

First, the Fed engineered this government bailout. They confirmed it late this evening:

"The Board determined that, in current circumstances, a disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth and materially weaker economic performance"

The stock market caught on to a possible bailout, which is why you saw shares initially fall after the Fed's announcement and then bounce back to close higher.

Second, even though they did not want to step in, the U.S. government couldn't allow AIG to fail:

After establishing a supposed hard line against bailouts over the weekend with Lehman Bros., the government was on the verge of abruptly abandoning it Tuesday and extending a $85-billion Federal Reserve loan to insurance giant AIG. The explanation: AIG was deemed too huge (its assets top $1 trillion), too global, and too interconnected to fail.

That, and the fact that unlike with Lehman — where the possibility of failure was openly discussed for months and to a certain extent planned for — federal officials and market participants don't seem to have really focused on AIG's problems until this week.

As with all U.S. insurers, the company is regulated not by the Feds but by a state regulator, in this case New York insurance superintendent Eric Dinallo. Plus, it was awfully hard for outsiders — and even insiders — to understand the gravity of the company's problems.

"You can read through every financial statement in the world and have absolutely no clue as to the risks they are taking," says Leo Tilman, a former Bear Stearns strategist who now runs the advisory firm L.M.Tilman & Co.

...

"Its collapse would be as close to an extinction-level event as the financial markets have seen since the Great Depression," wrote money manager Michael Lewitt in Tuesday morning's New York Times. There's also the fact that through its insurance policies AIG touches far more regular Americans (and consumers around the world) than Lehman Bros. did. Plus, AIG's insurance businesses make so much money that they could conceivably pay off the cost of the bailout within a few years.

I think by now investors understand that AIG was at the brink of collapse and its failure would have led to global chaos:

"AIG poses a systemic risk because it's a large counterparty in the financial system,'' said Prasad Patkar, who helps manage the equivalent of $1.8 billion at Platypus Asset Management in Sydney. "It's too big to be allowed to fail.''

But will this bailout calm the markets or just make things worse? That remains to be seen. Since last week, the health of the global banking system significantly deteriorated as Libor rates soared:

In London, overnight sterling Libor, having jumped to well over 6% late last year in the early stages of the credit crunch, had been back very close to 5% - the normal high street rate - for the past few months.

But yesterday morning, at its daily fixing by the British Bankers' Association, it leapt spectacularly to 6.8%. The Bank of England added £20bn in liquidity to London markets as its contribution, adding to a £5bn operation on Monday.

There was little sign, though, that that was sufficient, because the offer of liquidity was three times over-subscribed.

All of these rates mark exceptional times for highly stressed money markets and show the degree of strain that Lehman's collapse and the woes at AIG have caused.

"The banking crisis is not over and we have potentially a difficult few months to get through right to the end of this year," said Padhraic Garvey, strategist at ING Financial Markets.

A spike in Libor rates would also wreak havoc on the U.S. mortgage market:

Many Libor-linked U.S. mortgages don't limit the size of a loan's first adjustment, with caps of 2 percent on subsequent changes. That means a monthly mortgage bill could double or even triple when it first resets.

"If the Libor market seizes up and stays that way, it's going to complicate everything,'' said Bill Fleckenstein, president of Fleckenstein Capital in Seattle. "What you are seeing is the unwinding of the financial system as we know it.''

What we are also witnessing is unprecedented government intervention to stave off global financial chaos. For now, it looks like markets are breathing easier as Asian stocks advance on the news.

But I warn you, this financial crisis is far from over. In fact, it will take a long time to clean up this mess. It looks like contagion is spreading despite the Fed's strongest medecine:

Perhaps this optimistic assessment will work out in practice. Panic tends to overshoot in the same way that greed does.

But the lesson from the last year is that people have been too eager to say the worst is over. There's certainly no good reason to be confident any improvement is imminent -- as opposed to a very long, slow process of gradual recovery at best. And that's actually the good news.

There is a very rational fear that the unravelling of the now tainted Lehman empire will force other banks to make more large write-offs.

That will, in turn, further depress prices and confidence, accelerating the spiral down, and the impact on the real economy.

No one wants to lend; only the truly desperate want to borrow. As to where that could all end, who knows?

No wonder trust is in short supply. The more expert the advice and the better remunerated the financial advisers and investment bankers, it seems, the less likely they are to be correct in how life will turn out.

All those CDO products and CDS trades obviously seemed so very clever at the time -- the more esoteric the better.

Now the impact is all horribly real. And there is no safe haven.

Nor is there any obvious catalyst for the market to stop falling. All sorts of assets are now worth considerably less than their supposed value, not to mention their very real levels of debt, but no one wants to actually admit it. Not yet.

In the end, that will be the only way to get out of the mess. But it will cause all sorts of destruction, much of it undeserved, all of it devastating to confidence. The uncertain fate of the large insurer, American International Group, only demonstrates how much worse it can become for everyone.

Finally, please take the time to watch yesterday's Charlie Rose interview with Lawrence Summers, Charles Gasparino, Andrew Ross Sorkin, Nouriel Roubini and Josh Rosner. It is priceless and you need to have paper and pen handy to jot down some notes (pay close attention to Roubini's and Rosner's comments).

As I conclude tonight, I wonder which other financial institution will make Uncle Sam's "too big to fail" list? Also, at what point will "too big to fail" become "too big to bail"?

***Update (17-09-08): It looks like stocks will open lower this morning as investors digest what this bailout means for the financial system. Meanwhile, the Libor rate jumped the most in nine years as banks continue to hoard cash and the Russian market was halted (again) as emergency funding fails to halt rout.

In the U.K., Prime Minister Gordon Brown personally intervened to secure HBOS, Britain’s biggest savings bank, which is in talks to be acquired by Lloyds TSB.

It's getting U-G-L-Y out there.