I wrote most of this post before it was announced that the Federal Reserve was directly bailing out AIG.
This is real schizophrenic/bipolar behavior by the Federal Reserve. Lehman Brothers was allowed to fail. AIG and Bear Stearns qualified for bailouts.
Insiders knew that Bear Stearns and AIG would be bailed out, but Lehman Brothers would be forced into bankruptcy. These insiders made a fortune. Pre-bailout, Bear Stearns bonds and AIG bonds were trading for a substantial discount. Post-bailout, they were worth their face amount. Someone could have made a fortune buying Bear Stearns and AIG bonds before the bailout announcement. Someone who knew that the bailout offer would be sweetened from $2/share to $10/share for Bear Stearns would also have made a fortune. Someone could have made a fortune shorting Lehman Brothers bonds before the bankruptcy filing. Politically connected insiders always profit.
The shareholders of AIG will probably receive almost nothing. The terms of the Federal Reserve bailout are unclear. Here's what I read. The Federal Reserve provided a $85 billion loan. The government gets 80% ownership of AIG, which is the same terms as the FRE and FNM bailout. The interest rate is LIBOR plus 8.5%, which is currently approximately 11.3%. That isn't as lucrative as borrowing at the Fed Funds Rate or Discount Rate, but it's still a negative real interest rate and it's better than being forced into bankruptcy.
Someone pointed out this was the first time a Dow component was forced into bankruptcy. AIG isn't literally bankrupt, but it's the functional equivalent. I always thought that GM was the Dow component that was closest to bankruptcy.
The Federal Reserve is taking zero risk by bailing out AIG. The Federal Reserve is literally printing $85 billion in new money to finance the bailout. The Bear Stearns bailout was "only" $30 billion. This is nearly 3 times bigger than the Bear Stearns bailout!
AIG currently has a market capitalization under $10 billion, but it needs a $85 billion bailout.
Ben Bernanke isn't spending his own personal money to bailout AIG, although State employees treat State resources as their own personal assets. The cost of the AIG bailout is paid by everyone else as inflation.
I previously calculated the cost of the Bear Stearns bailout. That bailout caused 0.38% money supply inflation. For every $10,000 you had in your checking account, you personally paid $38 to finance the bailout.
I repeat this calculation for the AIG bailout. Raw M2 was $7713 billion in August 2008. The cost of the AIG bailout was $85 billion. $85 divided by $7713 is 1.1%. For every $10,000 you had in your checking account, you personally paid $110 to finance the AIG bailout.
The AIG bailout is not free. Everyone pays the cost in the form of money supply inflation.
The bailout is hyped as "It won't cost taxpayers a dime." That shows a complete lack of economic understanding. A lot of wealth was destroyed/stolen by the financial industry. It has to come from somewhere, either directly via State payment or indirectly via inflation. Inflation is a tax.
The CEO of AIG has no obligation to repay his huge salary and bonuses in the past few years. AIG spent a lot of money on stock repurchases, so that AIG's stock price would not decline when executives cashed in their options and sold the stock. Senior management at AIG will probably get cushy jobs at another large corporation.
AIG was holding a substantial amount of subprime mortgage bonds. When these bonds were devalued, AIG lost a lot of money.
AIG is not a bank. AIG does not get the perk of borrowing from the Federal Reserve at the Fed Funds Rate or Discount Rate. However, AIG does borrow from policyholders, at a rate comparable to the Fed Funds Rate. AIG was borrowing from policyholders and then investing the proceeds in mortgage bonds and elsewhere. AIG has the same extensive leverage problem as a large bank.
Federal Reserve insiders were pressuring large banks to finance a bailout/loan for AIG. The terms of the loan probably would have been very favorable for the banks issuing the debt. It probably would have been convertible senior debt, paying a nice interest rate and convertible to stock when/if AIG recovers. Apparently, AIG and the banks were unable to reach a deal, or the banks were unwilling to accept the risk. Now, the Federal Reserve is directly bailing out AIG. The bailout deal means that no bank was willing to lend AIG money, even at an 11% interest rate and in exchange for 80% of the corporation's equity.
AIG was also in the business of insuring debt and bonds. These are "credit default swaps". As the risk of insolvency elsewhere increases, these insurance contracts have a greater risk of making a payout. AIG must come up with more cash to set aside for a potential claim.
AIG is dependent on its own AAA credit rating. If you buy an insurance contract from AIG, there is an implicit assumption that AIG itself is not at risk for bankruptcy. If AIG loses its AAA credit rating, then nobody would be willing to do business with AIG at a reasonable price. The risk of an AIG bankruptcy must be factored into any insurance contract with AIG, which limits prices that AIG may charge. Why buy insurance from AIG when you can buy insurance from Berkshire Hathaway, where there is currently no bankruptcy risk?
Further, many of AIG's insurance contracts contained a clause that said "The insured may demand immediate payment if AIG's credit rating is downgraded." When AIG had its credit rating downgraded, then AIG is subject to immediate huge payouts. Similarly, many of Enron's contracts had a clause that demanded immediate payment if the credit rating is downgraded, leading to an accelerated bankruptcy spiral.
This places credit rating agencies in a conflicted position. If they downgrade AIG's debt, then they are directly contributing to AIG's bankruptcy. If they don't downgrade AIG, then they're neglecting their fiduciary responsibility to lenders. Typically, credit rating agencies don't downgrade debt until after a default has occurred. Very often, the market price for debt is totally out of line with what the credit rating agencies say.
AIG is in trouble due to extensive use of leverage. After a credit rating downgrade, AIG must make immediate cash payments to many customers. Nobody would do business with an insurance company that is at risk for insolvency.
The financial industry is a con game. Rumors of insolvency are sufficient to cause insolvency! In a true free market, that is never an issue. "Confidence in the system matters" is a symptom of widespread corruption.
I'm writing about financial industry turmoil a lot lately! The financial industry is one big scam. Nobody in the financial industry does any real work, yet they collect huge salaries. If someone gets paid without doing any real work, that means somewhere else, someone is doing an equal amount of work without getting paid.
The only way to fully protect yourself from financial industry shenanigans is agorism. You have to boycott the Federal Reserve and income tax. You have to use sound money to prevent your savings from being eroded by inflation. If agorists trade with sound money, then they should be mostly protected from the money supply inflation/deflation cycles that wreck the rest of the economy.
In other news, Barclays bought out most of Lehman Brothers for $1.75 billion. They were merely buying the profitable components of the business. All the bad loans remain in bankruptcy court.
A money market fund lowered its Net Asset Value below $1/share. This is called "breaking the buck". The fund had invested heavily in Lehman Brothers debt. This is the worst sort of disaster that can happen to a money market fund, because it means investors lost their principal. Typically, the corporation managing the fund will take a loss to preserve the $1 share price. This loss was by a corporation that only ran money market funds, so it could not absorb the loss, instead passing the loss on to investors.
"Breaking the buck" is the functional equivalent of announcing "I don't want to run a money market fund." All the investors will sell the fund after its "net asset value" falls below $1.
1 comment:
Golly Neds! your post really scared the crap out of me.
But I have a question. Assuming that treasury just printed dollars to pay for that bailout, what did they base the amount printed on?
Was it the perceived value of the share of those companies bought?
So.. putting it in terms most of us could understand, isnt it like the government was bulldozing a ditch on Fort Knox and uncovered a pile of bullion that wasnt on the books?
Once that gold was weighed, what would Treasury do, after they moved it?
Wouldnt they print additional currency to equal the market value of that gold?
Seems to me, the inflationary effect would come from the difference between the value printed and the actual proceeds from the sale of that gold.
What I'm saying is that AIG and Bear Stearns 'arent worth nothing'. The inflationary aspect is the difference in what Treasury printed to cover the bail-outs and what the assets purchased bring on the market.
And we dont know that, yet.
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