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AIG Insurer Nationalization Analysis

Companies / Nationalization Sep 19, 2008 - 06:26 AM GMT

By: Christopher_Laird

Companies

Diamond Rated - Best Financial Markets Analysis ArticleNow that we got past the latest mega financial storm, I was thinking about what caused the mess. And if there is anything anyone can do about it. After all, my site is called the PrudentSquirrel.

They key problem in this ongoing credit crisis


First, let's define the key problem. The entire financial and productive economy of the world is leveraged roughly 60 to 1. In my article Credit Crisis II, we talked about how that developed as a gigantic world economic and financial bubble beginning about the end of WW2.

If you follow the economic reports of the latest victims of the credit crisis, Bear, Lehman, AIG, Fannie Freddie, and who knows who is next, the key reason for these firms demise is their 60 to 1 leverage. Maybe in some cases it's only 40 to 1 but it's still the same situation. Fannie Freddie have 60 to 1.

Technical advances and falling commissions

How in the hell did the entire financial world get leveraged like that? Well for one thing, the combination of deregulation and cheap money, plus the internet and the drastic fall of stock brokerage commissions created a situation where the financial cowboys could not make any money, except on ever bigger deals. The securitization of all manner of credit made it extremely profitable for every financial institution to pile up the debt and leverage. As long as the party continued, no one questioned the danger (mostly no one).

Computers and the Internet (I was an Oracle Systems engineer) made it possible to create fantastically complex financial instruments and asset backed securities and derivatives. This made immense amounts of money available for credit. Then, the internet made it possible for brokerages to get millions of people trading online, for next to nothing. So all this money came into the banks and brokerages, and with the power of computers, was securitized into what is now turning out to be disastrously complicated and illiquid financial derivatives.

I know I'm bringing up lots of topics but I am just trying to broad brush this.

No incentives in traditional brokerage business

Since there was very little or no incentive for stock brokers and financial geniuses to gain an income stream from commissions that dropped to pennies a trade, they naturally applied their financial genius to creating the biggest piles of money, securitized credit, which even at ridiculously low commissions, generated hundreds of billions of dollars in commissions a year for brokers and the financial cowboys.

Then, these geniuses figured out that they could make more money by creating a Credit Default Swap. This is merely an insurance policy that is bought against someone's bonds, and for a very modest fee, someone like AIG would guarantee it against a default.

And, why did AIG not get any private money to bail them out this week? Because, they had issued an unfathomable $440 billion of these guarantees in recent years, and made lots of money signing all this up….

But then, we all know that asset backed securities, derivatives, and bonds are all turning to garbage now, and so, AIG is sitting on one hell of a big pile of financial liabilities as all their CDS are now coming due for payment. So, in a short time, AIG becomes insolvent. And that is what happened in this particular credit storm this mid Sept 08.

And Lehman too had the same problems. And, most banks, insurance companies, and brokers, worldwide, are into these kinds of complex securitized financial derivatives, to the tune of an estimated $1000 Trillion as of now! (One Quadrillion). These numbers are derived from the Bank of International Settlements, the BIS. If just 5% of these go bad, the world has a loss of an entire year of GDP!

So, in this huge credit party, basically the entire wealth of the world is leveraged something like 20 times the entire worlds GDP of 60 trillion. Uhm, we have a serious problem here folks!

Throwing hundreds of billions a day out

Considering that the Fed just this week put out about roughly $80 billion Monday, $65 billion Tuesday providing market liquidity (really taking the worthless bonds and such as collateral from the now bankrupt financial world), and $85 billion late Tuesday trying to save AIG (which will fail anyway) that comes to a cool $230 billion of losses out there that the US taxpayer just assumed, and in only 2 days!

Then, of course we know the ECB and the BOJ and every other central bank put out another roughly $100 billion of liquidity themselves in that two days…Russia just loaned its 3 biggest banks $44 billion…

And, we can say that cumulatively, since August of 07, the world central banks have put out roughly $2 trillion and counting if you add up everything they are doing, in essentially bailout out all this bad paper. There is only one problem. There is $1000 Trillion of it out there. And it's going bad very fast. And, the central banks realize there is NOTHING they can do to stop this.

Why do you think the Fed was resisting bailing out AIG so much, till they realized it's either do that, or see a cascade of massive financial bankruptcies worldwide?

This is all called deleveraging by the way.

Insoluble interlinkages

Now, another insoluble problem that presents itself, aside from $1000 Trillion of deleveraging, is the fact that these financial derivatives are all interlinked. That means that, unless one major player is bailed out, everyone else goes bankrupt, just like pulling on a big ball of string.

Just to show you an example of these complex interlinkages, consider the Credit Default Swaps. First, the financial industry creates lots of securitized debt and financial instruments. These are the derivatives. Then they create the CDS to ‘insure' against the derivatives failure. The only problem is, for someone like AIG, since they greedily issued $440 billion of CDS to every financial institution imaginable.

The other institutions were thinking they ‘hedged' their risk on their side, but then when AIG goes under, now all those people lost their ‘insurance'. That's the end of our financial world because AIG put out so much of those CDS. And, they are indeed too big to fail. So, the Fed inevitably had to bail AIG out.

Inevitable deleveraging

Now, I don't want to scare you, but the entire point here is that this deleveraging problem is insoluble. At some point, the end comes, and the Fed and ECB and BOJ and everyone else knows it. The party is about done. The only question is when.

The ONLY solution is to wipe out all debts worldwide and start over. And we know that lots of financial interests don't want that to happen.

Imagine a new world

Now, I want you to imagine a new world. In this world, everyone in debt, GM, AIG, you, the nations with big national debts – imagine if all that is zeroed out.

Would not economic activity start screaming? Would not the world enter a period of unprecedented economic prosperity, for probably another 65 year prosperity boom?

Now, of course, some of you are laughing at this proposition. But that is exactly what happens in a Great Depression. Everyone goes insolvent, often currencies collapse, and national debts effectively wiped out. After all the economic carnage, a new era begins.

So, we are right on the cusp of this. But first there is a little ‘work' to be done.

When do they finally give up?

Now then. Since I believe it is impossible to stop this deleveraging (debt destruction effectively) then I am quite sure the world's central banks are going to finally let go. It's just this time, the Fed blinked on AIG. But this is gonna happen.

If continuing efforts are made to prevent this deleveraging, the entire population of the world will be turned into debt slaves. Hell, they already are anyway, which is why economic activity is falling as we speak, and tax receipts are falling. The end of our 63 year post WW2 prosperity boom is here.

Tax deferred accounts?

IF the world central banks insist on bailing out the bad capital, they will run gigantic deficits. They will eventually be forced to raise taxes. It's impossible. This is one reason we have been talking about the idea to subscribers that maybe tax deferred savings are not quite what they are cracked up to be.

Basically, when the central banks and each nation realize they are going insolvent too, they will raise taxes on those ‘tax deferred' accounts by the time you want to pull out the money. So, I'm fairly sure that you're going to pay a lot more taxes on that pile of money than you think. If the world economy was not collapsing, then that would not be the case. But it is the case.
Now, what are we supposed to do?

Why gold is falling

Before we get into that, let's discuss why gold is falling. In a very basic sense, the world is experiencing debt deflation. Deflation causes the value of money to go up (everybody wants' cash right?) Prices fall, and since gold is money, then, naturally its value goes up compared to other prices that are falling too. So, even if the nominal price of gold falls, then it still keeps its value because price of everything else is collapsing.

And, if you want to talk about paper currency, sure, the value of that rises too at first in debt deflation, because everybody is fleeing into cash.

So, at the moment gold is falling, and the USD, for instance, is rising. But, I am not bothered by this. Ultimately, the USD will fall in value again, maybe even collapse, and if you have some gold, you will at least have some money – whatever that price turns out to be. And wise economies will bail out on this world deflation and not let their currencies collapse. But, there will be pain associated with that. But some nations will certainly see their currencies collapse, and just suffer worse pain anyway. The end is the same.

Now, getting back to what we might do. We could gather cash and spread it around, not all in one account. We might buy some gold when the price drops (or silver). We might buy gold stocks, but in a great depression, mining companies might have a hard time operating profitably, so I consider gold stocks to be second best, but not ruled out.

We might buy a place and pay it off to live in. Store some wealth there. Sure, the price of the home drops, but the home still has a use, and is valuable, even if the prices at the moment are falling. A home never should have been looked at as an ‘investment' anyway. It's shelter.
I don't like the idea of having a loan on the house to benefit from an eventual currency collapse because you may lose your income before the currency collapses, and then the house.
Then, if you survive the depression, living very frugally, when the currency ultimately does collapse, and a new one is created, you could sell the home for the new currency, or any real thing you managed to keep in the depression. A lot of people got wealthy in the Great Depression as they found great deals on everything, and bought the stuff at 10 cents on the dollar, and just waited the mess out.

The trick is surviving with some real things paid off. Now, I can already hear someone saying, yeah Chris, but they will raise property taxes. That's right. But, unless you plan on emerging from the coming depression with NOTHING, you better plan on dealing with some taxation as the governments panic.

Another thing you can do is maybe have some variety of currencies in modest savings accounts. If they all don't collapse, then you at least have that money. But, one problem here is that in these economic emergencies, foreign exchange restrictions are put in and your money is frozen where it is. And maybe they allow you to take a modest about out each month. But you ain't moving no $100 K overseas in the midst of that emergency….The government does not want all the money fleeing the country in these crises. So, they sort of lock down accounts.

So, these are just some thoughts on the latest Credit Crisis this week, The credit crisis seems to be heading to the Credit Crisis II scenario that I wrote about.

By Christopher Laird
PrudentSquirrel.com

Copyright © 2008 Christopher Laird

Chris Laird has been an Oracle systems engineer, database administrator, and math teacher. He has a BS in mathematics from UCLA and is a certified Oracle database administrator. He has been an avid follower of financial news since childhood. His father is Jere Laird, former business editor of KNX news AM 1070, Los Angeles (ret). He has grown up immersed in financial news. His Grandmother was Alice Widener, publisher of USA magazine in the 60's to 80's, a newsletter that covered many of the topics you find today at the preeminent gold sites. Chris is the publisher of the Prudent Squirrel newsletter, an economic and gold commentary.

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