Tuesday, September 16, 2008

Is AIG Too Big to Fail?

From Bloomberg:

A collapse of American International Group Inc., the insurer seeking to raise as much as $80 billion, would have consequences for financial firms around the globe, analysts and investors said.

Wall Street's top firms, and the biggest companies in Europe and Asia, have bought protection on $441 billion of fixed-income assets from AIG to guard their investments against potential bankruptcies. A failure by New York-based AIG may cause those protections to vanish. AIG also insures some of the largest assets in the world, doing business in more than 100 countries.

``They have tentacles into everything, and they are certainly critical to the ongoing health of the financial markets, or lack of health,'' Anton Schutz, president of Mendon Capital Advisors Corp. in Rochester, New York, said in an interview today with Bloomberg Television.

Wall Street's largest firms met at the New York Federal Reserve for a fifth day today, discussing ways to save AIG, said a spokesman for the New York Fed. AIG, with $1 trillion in assets, piled up net losses totaling $18.5 billion in the past three quarters on writedowns tied to the collapse of the U.S. subprime mortgage market.

``If AIG goes under, there could be a domino effect,'' said Andrea Cicione, a credit strategist at BNP Paribas SA in London. ``AIG is very connected to the financial system and it is very connected to the real economy.''


Let's back-up a bit and look at this situation in a bit more detail.

Wall Street's top firms, and the biggest companies in Europe and Asia, have bought protection on $441 billion of fixed-income assets from AIG to guard their investments against potential bankruptcies.

These are "credit default swaps". While they sound exotic they aren't. They are essentially insurance on corporate bonds. Suppose you manage a bond portfolio and you want to hedge your risk. If you were an equity trader you would sell an out of the money put.

Options are financial instruments that convey the right, but not the obligation, to engage in a future transaction on some underlying security, or in a futures contract. In other words, the holder does not have to exercise this right, unlike a forward or future.

For example, buying a call option provides the right to buy a specified quantity of a security at a set strike price at some time on or before expiration, while buying a put option provides the right to sell. Upon the option holder's choice to exercise the option, the party who sold, or wrote, the option must fulfill the terms of the contract.[1][2]


But no such option exists for bond managers. This led to the rise of the "credit default swap" (CDS) market. These are simply options on bonds, or an option to sell x amount of bonds at a certain price at a certain time. They are a great development because they allow fixed income managers to hedge downside risk. But (and here's the big but) the market is off balance sheet and unregulated. Because the market is private there is no way to limit it's size to an appropriate size. Put another way, suppose you had $10,000,000 in bonds that you wanted to insure. There is no reason for there to be numerous contracts on this bond position -- one will do. But because this is a private market there is no way to know if there are multiple options on the same bonds. This is one of the reasons why the CDS market is currently dangerous. Because AIG is so intimately involved with this market they have essentially become "too big to fail".

``They have tentacles into everything, and they are certainly critical to the ongoing health of the financial markets, or lack of health,'' Anton Schutz, president of Mendon Capital Advisors Corp. in Rochester, New York, said in an interview today with Bloomberg Television.


Barry over at the Big Picture noted one of the reasons why the Fed bailed out Bear Stearns is because the firm got so large it was too vital to the economy. That's essentially the case right now with AIG. It's too big to fail. This wasn't a deliberate strategy, but it is the result of a company getting really really big in an economy that is incredibly dependent on finance.

Wall Street's largest firms met at the New York Federal Reserve for a fifth day today, discussing ways to save AIG, said a spokesman for the New York Fed. AIG, with $1 trillion in assets, piled up net losses totaling $18.5 billion in the past three quarters on writedowns tied to the collapse of the U.S. subprime mortgage market.


Mish described this situation as "Fed Sponsored Poker Party Morphs Into "Old Maid"". That's exactly what is happening. All the parties are deciding who will be stuck with the check for this thing.