Y(Ike)s! The Financial Tsunami Has Arrived!

I'll tell you where I would not want to be this weekend. I would not want to be anywhere near the Texas coast as Hurricane Ike picks up steam and I would not want to be in Fed Chairman Bernanke's shoes as this credit crisis enters a critical stage:

With the share prices of Lehman Brothers Holdings Inc., Merrill Lynch & Co. and other financial firms on a roller coaster, the crisis could be entering a critical stage.

The Federal Reserve has already slashed interest rates to counteract a deepening credit freeze and instituted its broadest expansion of lending facilities since the Great Depression to keep financial markets functioning. Over the weekend, the nation's two main mortgage finance firms -- Fannie Mae and Freddie Mac -- were placed under government control.

Federal officials and market players are struggling with the same issues: Why haven't the steps taken so far calmed the system? What can policy makers do next? Should the U.S. government let a big institution fail rather than stage another potentially costly bailout?

Interestingly, Chairman Bernanke's predecessor, Alan Greenspan, aka the "Maestro", was out today stating that loss of investor confidence in Lehman Brothers Holdings Inc. would best be resolved by Wall Street firms acting without federal financial aid:

"If that can be done, that's the ideal solution,'' Greenspan said in an interview with Bloomberg Television when asked if regulators should pressure private financial institutions to work out the problems at Lehman. He declined to estimate the chances of such an outcome.

The Fed and Treasury Department are helping Lehman find a buyer after investor concerns about the firm's capital prompted more than a 75 percent decline in its market value this week. Treasury Secretary Henry Paulson is adamant that no government funds will be used in a Lehman resolution, a person close to the matter said today.

Unfortunately, the Fed's hands are tied and I wouldn't be surprised if they are holding emergency meetings this weekend to try and find solutions to calm financial markets.

Yesterday I wrote about how counterparty credit risk is rising. Today, the news is only getting worse. As Lehman scrambles to secure a buyer, American International Group's (AIG) shares plunged by over 30% to reach a 20 year low and close at $12.14 (no wonder AIG was on MFFAIS's global top 10 dumped stocks)

Folks, this isn't just any insurer; it is one of the largest insurers in the world and it exposed to a ton of credit default swaps:

The stock has fallen more than 70.0% since American International Group (nyse: AIG - news - people ) warned investors earlier this year that it could be hit by significant, unrealized losses on credit-default swaps it wrote to guarantee securities linked to subprime mortgages.

I have already written extensively on why AIG's bad news could spell trouble for pension funds. AIG has significant investments in hedge funds, private equity, real estate and infrastructure, which it might now have to liquidate to shore up its balance sheet (can you spell R-E-D-E-M-P-T-I-O-N-S?).

This couldn't come at a worse time for hedge funds and other alternative investments as they struggle to survive in what increasingly looks like the Mother of all financial tsunamis.

And what about pension funds who are exposed to all sorts of alternative investments? I wish them good luck as they get whacked too.

Even worse, some pension funds like PSP Investments, also have exposure to the credit markets through investments in collateralized debt obligations (CDOs), which Diane Urquhart later pointed out were mislabeled as CDOs when in reality they were credit default swaps (CDS), or insurance on CDOs.

Let's go back to PSP Investments' 2008 Annual Report and quote from Gordon Fyfe's President's Report (pages 6 to 9):

In significant short-term market downturns, it is easy for investors to lose the long-term perspective. PSP Investments is in the enviable position of having positive net cash flows for the next 22 years.

With such a distant investment horizon, we are patient investors able both to commit during volatile markets and weather the storms as well as invest in long term projects that will generate healthy returns over the long-term.

And a little further on in regards to the credit crisis:

Fear of exposure to the U.S. sub-prime situation spread to Canada, affecting the asset backed commercial paper market. As holders of non-bank sponsored asset backed commercial paper (ABCP), we actively participated in the restructuring process designed to increase the long-term value of ABCP and to significantly reduce the risk of realized losses.

While we have not escaped completely unscathed, we remain confident that over 95% of the underlying assets supporting the ABCP we currently own are of high credit quality.

PSP Investments also has exposure to the credit markets through investments in collateralized debt obligations (CDOs). Due to the turbulence in credit markets, the market for these types of investments has become illiquid. Although there are little, if any, credit losses with these investments, the distressed market conditions have had a negative impact on their fair value.

PSP Investments expects, over time, to recover the unrealized losses related to these investments if they are held to maturity.

Well if you ask me, PSP Investments and their stakeholders are going to have to be awfully patient to weather this financial tsunami and they can forget about recovering any "unrealized losses" any time soon. To think otherwise is simply a pipe dream.

To be fair to PSP Investments, they are not the only pension fund that grossly underestimated the impact of the U.S. subprime crisis and its global reach. In fact, most pension funds underestimated the severity of this credit crisis.

Importantly, billions of dollars were invested in all sorts of risky assets over the last few years and most pension funds completely underestimated systemic risk - the risk that all asset classes crumble at the same time due to one credit event that initially looked "contained" only to later spread its tentacles all over global credit markets.

Now asset managers are scrambling to control counterparty risk:

More than half of U.S. asset managers have tightened their risk management in an effort to guard against the possibility that a counterparty on the other side of a derivatives trade fails, a new report says.

One very senior pension fund manager was kind enough to call me late this afternoon to discuss counterparty risk. He was telling me that many pension funds have counterparty exposures in all sorts of derivatives, not just index swaps.

He told me that there are basically two ways to limit counterparty exposure: (1) diversify it through many banks and (2) sign CSAs to limit the credit exposure you are willing to accept from other counterparties.

But he was candid enough to tell me that you cannot diversify away systemic risk - "nobody can".

The problem is that the global financial system is so inter-connected that it doesn't take much for a major credit event to quickly spiral into full blown disaster.

I also asked this individual if he was surprised by the ferocity of the market downturn. He told me that "liquidity spreads are irrational given current default rates". So I asked him if this is a buying opportunity, to which he replied: "there were two other buying opportunities and investors got burned after each of those." He basically agreed with Keynes that "markets can stay irrational longer than you can stay solvent."

Before concluding, I wanted to mention that the Canadian ABCP saga is far from over:

A group of companies led by Jean Coutu Group (TSX:PJC.A) insists that it's of national importance for Canada's highest court to hear their case and block a controversial plan to rescue about $32 billion of ABCP.

The Montreal-based pharmacy chain and its allies, about a dozen other companies with stranded ABCP, responded Monday to opponents who don't want the case to be heard by the Supreme Court of Canada - which is deciding whether to grant an appeal requested last week.

Supporters of a rescue plan for the ABCP argued last week in a legal brief that decisions by Ontario's courts should stand and that the appellants haven't "raised any issue of national importance" that would warrant review by the Supreme Court.

But lawyers representing the dissident group returned fire on Monday, filing a brief that pointed out that the affected companies are based in several provinces and represented by law firms from across the country.

...

One of this group's biggest complaints is that the rescue plan would all but remove their ability to seek compensation from their financial advisers or others involved with the sale of the ABCP to them - except in cases of fraud.

The asset-backed commercial paper was supposed to be a low-risk, short-term investment that would mature within a year but investors with so-called third-party Canadian ABCP have been unable to redeem their notes since about August 2007.

The commercial paper was considered to be low-risk because the ABCP notes were backed by assets ranging from credit card and car-payment receivables to more esoteric financial derivatives.

About $32 billion of ABCP issued by special non-bank trusts has been frozen for about a year - much of it held by Canadian pension plans. Smaller amounts are held by companies and individuals.

While I feel for the individual investors who lost their life savings with these crooks that sold them these "safe" investments, I believe that Jean Coutu et al. are right to argue for blocking this plan.

You can watch CBC Newsworld's coverage of non-bank ABCP this Sunday, September 14th, at 10:00 a.m. (9:00 a.m. ET) and again at 10:00 p.m. (9:00 p.m. ET).