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1946dodge received this article and posted it over on PA.

Here is a link to a copy of the original article on the web.
How AIG's Collapse Began a Global Run on the Banks

Caveat: There is a "stock hypester" named Frank Porter Stansberry who has made at least a few enemies.

FBI Began Investigating AIG in March
Washington Post Staff Writers
Thursday, September 25, 2008; Page A12

Dodge and I would love to see a serious critique of this article. To my ears it has the smell of truth.



How AIG's Collapse Began a Global Run on the Banks
By Porter Stansberry
October 4, 2008

Something very strange is happening in the financial markets. And I can show you what it is and what it means...

If September didn't give you enough to worry about, consider what will happen to real estate prices as unemployment grows steadily over the next several months. As bad as things are now, they'll get much worse.

They'll get worse for the obvious reason: because more people will default on their mortgages. But they'll also remain depressed for far longer than anyone expects, for a reason most people will never understand.

What follows is one of the real secrets to September's stock market collapse. Once you understand what really happened last month, the events to come will be much clearer to you...

Every great bull market has similar characteristics. The speculation must – at the beginning – start with a reasonably good idea. Using long-term mortgages to pay for homes is a good idea, with a few important caveats.

Some of these limitations are obvious to any intelligent observer... like the need for a substantial down payment, the verification of income, an independent appraisal, etc. But human nature dictates that, given enough time and the right incentives, any endeavor will be corrupted. This is one of the two critical elements of a bubble. What was once a good idea becomes a farce. You already know all the stories of how this happened in the housing market, where loans were eventually given without fixed rates, without income verification, without down payments, and without legitimate appraisals.

As bad as these practices were, they would not have created a global financial panic without the second, more critical element. For things to get really out of control, the farce must evolve further... into fraud.

And this is where AIG comes into the story.

Around the world, banks must comply with what are known as Basel II regulations. These regulations determine how much capital a bank must maintain in reserve. The rules are based on the quality of the bank's loan book. The riskier the loans a bank owns, the more capital it must keep in reserve. Bank managers naturally seek to employ as much leverage as they can, especially when interest rates are low, to maximize profits. AIG appeared to offer banks a way to get around the Basel rules, via unregulated insurance contracts, known as credit default swaps.

Here's how it worked: Say you're a major European bank... You have a surplus of deposits, because in Europe people actually still bother to save money. You're looking for something to maximize the spread between what you must pay for deposits and what you're able to earn lending. You want it to be safe and reliable, but also pay the highest possible annual interest. You know you could buy a portfolio of high-yielding subprime mortgages. But doing so will limit the amount of leverage you can employ, which will limit returns.

So rather than rule out having any high-yielding securities in your portfolio, you simply call up the friendly AIG broker you met at a conference in London last year.

"What would it cost me to insure this subprime security?" you inquire. The broker, who is selling a five-year policy (but who will be paid a bonus annually), says, "Not too much." After all, the historical loss rates on American mortgages is close to zilch.

Using incredibly sophisticated computer models, he agrees to guarantee the subprime security you're buying against default for five years for say, 2% of face value.

Although AIG's credit default swaps were really insurance contracts, they weren't regulated. That meant AIG didn't have to put up any capital as collateral on its swaps, as long as it maintained a triple-A credit rating. There was no real capital cost to selling these swaps; there was no limit. And thanks to what's called "mark-to-market" accounting, AIG could book the profit from a five-year credit default swap as soon as the contract was sold, based on the expected default rate.

Whatever the computer said AIG was likely to make on the deal, the accountants would write down as actual profit. The broker who sold the swap would be paid a bonus at the end of the first year – long before the actual profit on the contract was made.

With this structure in place, the European bank was able to assure its regulators it was holding only triple-A credits, instead of a bunch of subprime "toxic waste." The bank could leverage itself to the full extent allowable under Basel II. AIG could book hundreds of millions in "profit" each year, without having to pony up billions in collateral.

It was a fraud. AIG never any capital to back up the insurance it sold. And the profits it booked never materialized. The default rate on mortgage securities underwritten in 2005, 2006, and 2007 turned out to be multiples higher than expected. And they continue to increase. In some cases, the securities the banks claimed were triple A have ended up being worth less than $0.15 on the dollar.

Even so, it all worked for years. Banks leveraged deposits to the hilt. Wall Street packaged and sold dumb mortgages as securities. And AIG sold credit default swaps without bothering to collateralize the risk. An enormous amount of capital was created out of thin air and tossed into global real estate markets.

On September 15, all of the major credit-rating agencies downgraded AIG – the world's largest insurance company. At issue were the soaring losses in its credit default swaps. The first big writeoff came in the fourth quarter of 2007, when AIG reported an $11 billion charge. It was able to raise capital once, to repair the damage. But the losses kept growing. The moment the downgrade came, AIG was forced to come up with tens of billions of additional collateral, immediately. This was on top of the billions it owed to its trading partners. It didn't have the money. The world's largest insurance company was bankrupt.

The dominoes fell over immediately. Lehman Brothers failed on the same day. Merrill was sold to Bank of America. The Fed stepped in and agreed to lend AIG $85 billion to facilitate an orderly sell off of its assets in exchange for essentially all the company's equity.

Most people never understood how AIG was the linchpin to the entire system. And there's one more secret yet to come out...

AIG's largest trading partner wasn't a nameless European bank. It was Goldman Sachs.

I'd wondered for years how Goldman avoided the kind of huge mortgage-related writedowns that plagued all the other investment banks. And now we know: Goldman hedged its exposure via credit default swaps with AIG. Sources inside Goldman say the company's exposure to AIG exceeded $20 billion, meaning the moment AIG was downgraded, Goldman had to begin marking down the value of its assets. And the moment AIG went bankrupt, Goldman lost $20 billion. Goldman immediately sought out Warren Buffett to raise $5 billion of additional capital, which also helped it raise another $5 billion via a public offering.

The collapse of the credit default swap market also meant the investment banks – all of them – had no way to borrow money, because no one would insure their obligations.

To fund their daily operations, they've become totally reliant on the Federal Reserve, which has allowed them to formally become commercial banks. To date, banks, insurance firms, and investment banks have borrowed $348 billion from the Federal Reserve – nearly all of this lending took place following AIG's failure. Things are so bad at the investment banks, the Fed had to change the rules to allow Merrill, Morgan Stanley, and Goldman the ability to use equities as collateral for these loans, an unprecedented step.

The mainstream press hasn't reported this either: A provision in the $700 billion bailout bill permits the Fed to pay interest on the collateral it's holding, which is simply a way to funnel taxpayer dollars directly into the investment banks.

Why do you need to know all of these details? First, you must understand that without the government's actions, the collapse of AIG could have caused every major bank in the world to fail.

Second, without the credit default swap market, there's no way banks can report the true state of their assets – they'd all be in default of Basel II. That's why the government will push through a measure that requires the suspension of mark-to-market accounting. Essentially, banks will be allowed to pretend they have far higher-quality loans than they actually do. AIG can't cover for them anymore.

And third, and most importantly, without the huge fraud perpetrated by AIG, the mortgage bubble could have never grown as large as it did. Yes, other factors contributed, like the role of Fannie and Freddie in particular. But the key to enabling the huge global growth in credit during the last decade can be tied directly to AIG's sale of credit default swaps without collateral. That was the barn door. And it was left open for nearly a decade.

There's no way to replace this massive credit-building machine, which makes me very skeptical of the government's bailout plan. Quite simply, we can't replace the credit that existed in the world before September 15 because it didn't deserve to be there in the first place. While the government can, and certainly will, paper over the gaping holes left by this enormous credit collapse, it can't actually replace the trust and credit that existed... because it was a fraud.

And that leads me to believe the coming economic contraction will be longer and deeper than most people understand.

You might find this strange... but this is great news for those who understand what's going on. Knowing why the economy is shrinking and knowing it's not going to rebound quickly gives you a huge advantage over most investors, who don't understand what's happening and can't plan to take advantage of it.

How can you take advantage? First, make sure you have at least 10% of your net worth in precious metals. I prefer gold bullion. World governments' gigantic liabilities will vastly decrease the value of paper currencies.

Second, I can tell you we're either at or approaching a moment of maximum pessimism in the markets. These kinds of panics give you the chance to buy world-class businesses incredibly cheaply. A few worth mentioning are ExxonMobil, Intel, and Microsoft. I have several stocks like these in the portfolio of my Investment Advisory.

Third, if you're comfortable short selling stocks (betting they'll fall in price), now is the time to be doing it... simply as a hedge against further declines.

Keep the fraud of AIG in mind when you form your investment plan for the coming years. By following these three strategies, you'll survive and prosper while most investors sit back and wonder what the hell is going on.
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I think the freerepublic link sums it up quite well.

However, I think it is likely that world-wide bank failures will continue.

It is very hard to put an end to this kind of spiral, since one downgrade and loss leads to the next downgrade and loss.
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Comment from:

"AIG's largest trading partner wasn't a nameless European bank. It was Goldman Sachs.>>>>>>>>>>>>>>>>.

Now what was the name of the firm that Paulsen just retired from???? "
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I am no expert but this question is an important one that requires answering.

Yes little or no collateral is required to issue a credit default swap (CDS) and since there is no clearing house for the trades it is probably impossible for we investors to learn who is exposed to what. I suggest that banks fear lending to each other because of the opacity of the CDS situation.

Here is an exerpt from an article published by Morningstar:

"In the case of credit default swaps, the protection buyer expects to pay a recurring fee, but the protection seller may not need to pay anything beyond an initial margin collateral requirement--or a margin call driven by a price drop--unless the reference entity (a specific bond issue) goes into default; then the seller may have to cough up defaulted bonds or an equivalent value in cash. Even though the two parties are effectively "swapping" with each other, it's usually a financial firm acting as the go-between, assuming risks from both parties, and theoretically policing their ability to pay. Generally, the firm standing in the middle becomes each side's "counterparty."

"That last part is the killer. For one thing, firms acting as go-betweens get to set their own margin requirements, and the whole appeal of the swap structure is that margin requirements are typically very low. In effect, that allows swap parties to take on market exposures without putting up much capital--the basic definition of leverage. When you can do that in the swaps market, you can do it over and over again. So even if you're a manager who has only $100 million in actual cash, you might be able to control many times that amount of market exposure via swaps."

The Bank for International Settlements sets rules/guidelines regarding capital adequacy rations and methods of assessing risk. Its 55 member countries tend to implement the standards developed by the BIS. The BIS is in Basel, Switzerland hence the reference to Basel II.

I retrieved this article from their website
Testimony of Mr Ben S Bernanke, Chairman of the Board of Governors of the US Federal Reserve System, before the Joint Economic Committee, US Congress, Washington DC, 24 September 2008.

"In the case of AIG, the Federal Reserve, with the support of the Treasury, provided an emergency credit line to facilitate an orderly resolution. The Federal Reserve took this action because it judged that, in light of the prevailing market conditions and the size and composition of AIG's obligations, a disorderly failure of AIG would have severely threatened global financial stability and, consequently, the performance of the U.S. economy."

Returning to the earlier mentioned Morningstar report:

"It's true that many key concerns around the failures and weakness at Bear Stearns, Lehman Brothers, and AIG (AIG
) have related directly to the counterparty risk they represented to trading partners, and to the system as a whole. Each of those firms was a counterparty to untold numbers of contracts, to say nothing of AIG's massive global insurance presence. In effect, they each were acting as substitutes for the role of an exchange. Had a more disorderly collapse of any of them or other firms been allowed to occur, it's unclear just how badly and how far the damage would have stretched."

Is AIG the de-facto international clearing house for CDS's? Is that why Bernanke claimed AIG's failure would have severely threatened global financial stability?

I realize this does not address the question: are CDS's recognized by the BIS as legitimate means of mitigating the risks associated with securities. Since CDS's aren't regulated and are inherently risky are they a reliable form of insurance against other financial risks?

I come away from this little exercise wondering just how much money is at risk and how great the risk is. There is no question in my mind that this and other derivatives markets require regulation. We do not know the extent to which other opaque factors are affecting the riskiness of our investments. The SEC is there to give us the information we need to know to make informed decisions.
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