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Tottering Financial Firms

September 16th, 2008 - At the time of writing, the fate of AIG hangs in the balance.  The authorities have been saying that they are not willing to commit public funds to save the company.  Having allowed Lehman to fail, earlier in the week, this was sufficient to make the markets very nervous.

But the size of the firm and its interconnections with the financial system, not just in the US but also globally, makes it unlikely that the authorities will allow it to go under.  There are rumours that the Fed is willing to consider a loan package.  The management at AIG, which has shown considerable incompetence in the past and got the company into the present mess, appears to be counting on government aid.

Private equity firms were willing to throw it a lifeline, but it was rejected by AIG on the grounds that the offer was too low.  Essentially, they took the same stance that Lehman had adopted earlier, refusing to value their assets at knockdown prices.  But in current conditions you can’t be too choosy, particularly when you are not in a good bargaining position.

Contrary to what the powers that be are saying, they have already become involved in helping AIG.  The New York authorities, where the insurer is principally regulated, allowed them to dip into funds that are normally out of bounds.  But this was intended as a way to tide the company over temporary liquidity problems until they can raise sufficient capital.

AIG has a pile of fairly toxic mortgage-related securities and also a large book of credit default swaps that they had written in happier times.  An earlier credit downgrade has increased the need for more funds to meet collateral calls and early termination payments, even as the credit-rating cut makes it more difficult to raise capital.

The US Treasury appears to have finally recognised the dangers of exacerbating the moral hazard problem, when it refused to bail out Lehman.  This came as something of a surprise to the markets, which were counting on virtually unlimited government largesse.  Barclays wanted the same deal as JPM got in taking over Bear, namely for the government to take up the toxic debt.  But the Treasury said nyet and that was the end of Lehman.

There is no need to shed any tears over the investment bank’s demise.  The top managers and traders made piles of money in the good years and won’t be asked to pay any of it back.  Long-term shareholders are the losers, along with the unfortunate employees who are being sacked.  Thankfully, the payer-of-last-resort, also known as the taxpayer, isn’t being mugged this time round.

However, the final bill for the ongoing process of deleveraging is still mounting.  The earlier rescue of Fannie and Freddie was inevitable, given the potentially disastrous impact of their failure on the economy and the financial system.  There was fulsome praise for the government action from the authorities in China and Japan, as well as PIMCO’s Bill Gross.  Naturally, all stood to gain from the rescue.

Out of the five major American investment banks, three have disappeared.  Lehman has been allowed to fail and its carcass will be picked over by various vultures in the bankruptcy process.  The other two, Bear Stearns and Merrill, have been absorbed into large deposit-taking banks.

Some observers see this as the end of an era.  They do not think that the investment-banking model that functioned so well in the go-go years can survive in the coming period of tighter risk control and increased regulation.  The thinking is that investment banks may need the stability provided by large banks with an extensive deposit base.

Maybe so, but investment bankers are a fleet-footed and creative bunch.  Certainly, right now the survivors are hurting in many places.  Deal-making and brokerage activity is down and their prop desks may have made some wrong bets.  They may yet meet their demise in the ongoing deleveraging process. But if they survive, we will have to wait awhile to see what shape the new regulatory framework will take before we can hold funeral services for the remaining investment banks.