Market Epicurean


The Month I Could Never Forget: A Not-So Happy Anniversary - PART FOUR

Pipe

Bailout Bombs Begin

The first article in our series replaying the horrific events of September 2008 (Getting Your Fannie Whipped) portrayed a government intervention, but it was an intervention into two companies (Fannie Mae and Freddie Mac) that most people viewed as quasi-government entities, to begin with. The second piece (Ground Zero: The Fall of the House of Lehman) looking at Lehman Brothers involved no government intrusion, and that is actually a controversy all its own there (the lack of a bailout). The third piece (Mother Merrill Gets Adopted) featured a “bailout” of sorts, though it was not the government bailing out Merrill Lynch, but rather Bank of America. So, we now get to September 16, 2008, the economy in total free fall, the feeling of global credit market collapse in the air, and thus far, the government has not actually become the central player they would eventually become.

But that would not be true by the end of September 16.

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Like Merrill Lynch, AIG had been founded in the early part of the 20th century, rich in history, heritage, and brand. A leading life insurance and annuity company, AIG was a respected financial products innovator, known for respectable cost management practices, and a true U.S. success story. When regular folks on Main Street thought about Wall Street, the stock market, securities trading, corporate finance, and the mortgage market, none would have affiliated such terms with AIG. A host of other Wall Street brand names from Merrill Lynch to Bear Stearns would have come to mind, but not old line insurance company, AIG. For most people, AIG just wasn’t at the heart of Wall Street, let alone the U.S. mortgage market.

That disconnect apparently had existed at the Federal Reserve and Treasury Department as well.

I took my son, Mitchell, then three years old, to Disneyland, the afternoon of the 16th. I had promised him and his mother all Summer long I would take an afternoon off to do so, and I had been working 20-hour days for a week straight as this crisis was fomenting. Leaving the office near the end of the market day on this Tuesday was not easy. The Dow had actually gained back 1.3% (from its 4.4% loss the day before) as naïve traders began to wonder in the aftermath of the Lehman deal if things weren’t getting a little cheap. But nothing felt stable and the unknowns were overwhelming. I kept my word and went to Disneyland with my wife and son, with a work-issued Blackberry in one pocket and a personal iPhone in the other (the 1.0).

Space Mountain was not as wild as the afternoon of emails, texts, alerts, and news cycle drama would prove to be.

The Federal Reserve waited until the market closed to announce that they were injecting $85 billion into AIG, firing management, and effectively taking over the company. AIG had been asking for a “government loan” of $40 billion on Sunday night, and the government had told them to pound sand. Less than 48 hours later, the government was singing a different tune.

At the heart of this decision was the reason AIG needed the assistance, to begin with – they were the guarantor of risk for financial institutions all over the globe via the credit default swap market. Effectively, AIG had been the counter-party in an insurance contract on so many of these mortgage instruments that various financial firms had been writing. For an insurance premium, AIG became an insurer of the securities. These premiums were unfathomably profitable for AIG during the boom years, as defaults on these instruments were 0%, payouts were 0%, and the expression “there is no free money” appeared to be laughably untrue. But now with the mortgage market in pandemonium, AIG’s liabilities on the other side of these trades were far, far in excess of their total capital. Their own solvency was not only blown away but the fact that counter-parties all over Wall Street (and across the pond) assumed they had “hedged” certain positions meant everyone else’s solvency was called into question.

To make it as simple as possible, financial firms like Goldman Sachs may have had a $1 billion exposure on a Certain Mortgage Derivative or CDO, but if they sold credit default swaps with AIG on that, they may have figured they had a net exposure of, let’s say, $250 million. But if AIG could not pay, not only was AIG out all of their capital, but Goldman was out the $250 million they thought they had at risk, and the $750 million they thought they had insured. The collateral damage (no pun intended) to each other company around AIG’s insolvency was staggering. If Goldman’s marks on their books were impaired, that meant everyone else’s was, and everyone else traded with each other, too, all based on certain presumptions of financial wherewithal. The domino effect was incomprehensible, not merely because it was hard to measure, but because what could be measured was stupefying.

So just like that, the Republican Bush administration and the Federal Reserve were throwing in the towel on the idea of a financial contraction that would not involve the heavy hand of government. The Fed injected $85 billion (to start), at a very high coupon of 8%, and took warrants for 80% of the equity of the company. In most countries, we call this nationalization. It was not a bailout of AIG, other than in the literal sense that it obviously was, but rather a bailout of the counter-parties of AIG. This was never adequately explained to the American people, in my opinion. All focus had now charged to limiting contagion risk.

And as we will see in the days ahead, this contagion was no longer hypothetical. All hell was breaking loose. Money markets were falling. Commercial credit was non-existent. AAA-rated companies were having a hard time rolling over the debt. And trust in the financial system was at the lowest it had been since the Great Depression.

“Your first bailout will never be your last.”

Disneyland may have been the happiest place on earth that day. They didn’t have any credit default swaps.

David L. Bahnsen
Chief Investment Officer, Managing Partner
dbahnsen@thebahnsengroup.com

The Bahnsen Group
www.thebahnsengroup.com

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