Tuesday, September 16, 2008

Dow drops 500 points on Lehman bankruptcy, AIG worries

This is from BusinessWeek.com:

On Monday, the Dow Jones industrial average tumbled 504.48 points, or 4.42%, to finish the session at 10,917.51, ending below the psychologically significant 11,000 level. The broader S&P 500 index plunged 57.98 points, or 4.63%, to 1.193.72, breaking below its July lows. The tech-heavy Nasdaq composite index sank 81.36 points, or 3.60%, to 2,179.91.

Market breadth was overwhelmingly negative. On the New York Stock Exchange, 30 stocks declined in price for every one that advanced. The ratio on the Nasdaq was 24-3 negative. Trading was active, reports S&P MarketScope.

European markets stumbled, though they finished above session lows. London stocks were off 3.87%, Frankfurt was off 2.74% and Paris was down 3.78%. Asian markets were closed for holidays.

The rout capped a global sell-off after a cataclysmic chain of events for major Wall Street firms over the weekend, raising concerns about the health of financial markets. Investment bank Lehman Brothers (LEH) filed for bankruptcy protection, while rival Merrill Lynch (MER) agreed to be taken over by Bank of America (BAC) and the Federal Reserve threw a lifeline to the battered financial industry. Shares of troubled insurer American International Group (AIG) plummeted as the firm asked for financial help from the Fed.

According to a Wall Street Journal report late Monday afternoon, the government obliged -- sort of -- by asking Goldman Sachs (GS) and J.P. Morgan Chase (JPM) to lead a $70 billion-$75 billion lending facility for AIG.

I was thinking that the DOW would be dropping around 300-400 points, after traders learned the news of Lehman's bankruptcy, late Sunday night. By around 8am Monday morning, I woke up to hear that the Dow had already fallen past 300 points. It was not a happy day for Wall Street. For today, the Dow dropped another 150 points, before erasing much of those losses, to stand at +15 points to 10,925. The S&P 500 gained 4.34 points to 1,197.04, and the Nasdaq 100 rose 5.54 points to 2,185.45. The market is still trading now, but I'm thinking that the bottom feeders are picking up whatever bargains they can find, and that traders are not as jittery, after receiving the news that the Fed asked Goldman Sachs and J.P Morgan to lend $70 billion to AIG.

Now let us look at what happened with AIG. According to the New York Times, AIG's troubles started when the companies dealings in "complex debt securities and derivatives" threatened to drain cash faster than the financing package could be assembled. I suspect that these "complex debt securities and derivatives" involved subprime mortgages. AIG's write-offs may reach around $60-$70 billion. Shares of AIG tumbled more than 60 percent on Monday, as traders worried that AIG may not be able to "withstand cuts to its debt rating," and that AIG's request for a $40 billion bridge loan from the Fed was rejected. Talks continued Monday night between AIG executives, New York state and federal regulators, private equity firms and Wall Street banks on how to resolve AIG's inability to honor its derivative contracts. Today, New York Gov. David A. Paterson announced that the state would allow AIG to borrow $20 billion from its own subsidiaries in order to help bolster its capital in the face of these credit downgrades. According to the New York Times:

A.I.G. is the parent of dozens of major insurance companies, and Mr. Paterson said it was possible for them to lend money to their corporate parent without putting their policyholders at risk, because the subsidiaries would receive some form of collateral. He said the collateral would consist of “illiquid assets,” but did not describe them.

Insurance sources said some of the money could be produced by exchanging assets between the holdings of A.I.G.’s life insurance subsidiaries and its property and casualty subsidiaries, which have different capital requirements. For instance, an A.I.G. property insurer might buy stock from an A.I.G. life insurer’s portfolio, paying for them with high-quality bonds from its own portfolio.

Life insurers have tighter capital requirements than property insurers, so replacing stock with bonds would strengthen the life insurer’s capital structure, allowing it to send the surplus to the holding company.

Such a transfer would leave the life insurance company with investment assets that would produce less income, so the insurer would probably have to make up the difference by charging more for its life insurance policies, annuities and other products.

So AIG will borrow money from its insurance holdings to bolster its parent group, in order to pay off its derivative contracts. However, such a transfer would mean that the insurance company will have less investment assets, producing less income. The insurance division of AIG would be forced to charge higher insurance premiums on its customers to make up the difference.

There were also credit agency threats to downgrade AIG's credit rating. According to the NY Times:

Ratings agencies had threatened to downgrade the insurance giant’s credit rating by Monday morning, a step that could allow counterparties to A.I.G.’s swap contracts to require A.I.G. to post collateral of up to $13.3 billion. The urgency of the talks grew by late Monday as A.M. Best Company, a credit rating organization specialized in insurance and health care companies, downgraded the credit of A.I.G. and several of its major subsidiaries. Fitch Ratings also downgraded A.I.G.’s credit Monday evening.

Standard & Poor’s downgraded its long-term and short-term counterparty ratings of A.I.G.. and Moody’s cut its rating of A.I.G.’s senior debt, to levels requiring A.I.G. to post collateral of up to $10.5 billion.

So because of AIG's gambling in the derivatives market, and the subprime mortgage mess, the company found itself facing huge write-downs, and credit agencies demanding larger collateral for the company to honor its derivatives contracts. AIG didn't have the money. So there was this huge worry on Wall Street that AIG may also end up declaring bankruptcy.

This bring us to the Feds asking Goldman Sachs and J.P. Morgan chase to provide AIG with a $70 billion loan package. The Fed had already bailed out Bear Stearns and J.P. Morgan when the subprime mess threatened their companies, and refused to bail out Lehmans, which went bankrupt. The Fed also refused to accept AIG's $40 billion bridge loan. Instead, the Fed is demanding that Wall Street clean up its own mess. Now there was talk of 10 Wall Street banks providing a rainy-day fund of $70 billion to cover such emergencies, as the Lehman failure, but I'm not sure if Wall Street has agreed to such a fund. Currently, the Fed has asked both Goldman and J.P. Morgan to provide AIG with a $70 billion loan. There is no word as to whether the two companies will agree to such a loan, nor is it certain that both Goldman Sachs and J.P. Morgan Chase could raise such an amount in a short period of time in order to cover AIG's derivative contracts. So AIG is still not out of the woods yet.

This brings up an even bigger problem here. It is not just Lehman Brother's bankruptcy, or AIG's teetering into a financial collapse. This is a systematic failure of all financial institutions. These institutions jumped headfirst into the housing bubble, the subprime equity market, bought and sold billions worth of mortgage securities and derivative contracts based on lofty home values that Americans purchased through subprime mortgages and adjustable-rate interest deals. With the subprime mortgage industry collapsing, banks foreclosing on homes they can not sell to cover their loans, and home values dropping, nobody really knows what the true value is on these mortgage-backed securities, or the derivative contracts based on subprime mortgage market. The entire financial service industry has been writing down losses due to this collapse of the housing bubble. Wall Street's $70 billion rainy-day fund by 10 banks isn't enough to cover, not just AIG's financial problems, but also potentially unknown problems lurking from other banks and institutions. The federal government is refusing to bail out Wall Street banks caught up in this cycle of subprime mortgage meltdowns. I don't know what the answer is. I just know it is going to get even worst.

Update: It appears that the talks between the Fed, AIG and Wall Street banks on resolving AIG's financial crisis may be breaking down. From the New York Times:

The prospects of a private market solution to the deterioration of the American International Group appeared to be faltering on Tuesday, as talks involving the Federal Reserve and several banks turned to the possibility of using government money to shore up the ailing insurance giant, people briefed on the negotiations said Tuesday morning.

Fed officials were still meeting with A.I.G., JPMorgan Chase, Goldman Sachs, Morgan Stanley and others at the Federal Reserve Bank of New York Tuesday morning to discuss possible options. It isn’t clear that any solution, including one involving government money, will emerge, this person said.

If a financing solution is not reached, A.I.G. may file for bankruptcy as soon as Wednesday, a person briefed on the matter said Monday night.

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