If we let A.I.G. fail, said Seamus P. McMahon, a banking expert at Booz & Company, other institutions, including pension funds and American and European banks “will face their own capital and liquidity crisis, and we could have a domino effect.” A bailout of A.I.G. is really a bailout of its trading partners — which essentially constitutes the entire Western banking system.
No one wants to say it, but essentially the Fed has been bailing out European banks.
The inflation-adjusted cost of the Marshall plan has been estimated at about $115 billion in current dollars. If we end up spending $250 billion on AIG, how much of that sum will go to European financial institutions and might it someday exceed the scope of the Marshall plan? (I do not, by the way, think that central banks ought to treat foreign creditors differently.)
One attempt to formulate a bailout plan for eastern Europe just failed. This is round one in a series of longer negotiations. As the European financial crisis worsens, and Germany asks itself whether it will bail out Ireland and Hungary and maybe others, it will become increasingly clear that major foreign policy crises are afoot.
The best actual marker of the progress of the financial crisis is not stock or real estate prices, but rather how well international cooperation holds up.
Why is the banking crisis so hard to solve? We stood and watched while Hank Paulson and Ben Bernanke fumbled with their response in the fall. Now we are being treated to the distressing spectacle of Tim Geithner struggling as well to articulate a clear policy for dealing with zombie banks. How come these smart and powerful men can’t get a handle on the problem?
The MBS (mortgage backed securities) have been packaged, re-packaged and re-re- packaged, sliced, diced and blended on "vaporize" to the point that know one knows who owns the original paper. I have a friend ( a lawyer) who has a client that just got foreclosure notices from FIVE different entities FIVE! They all think they own the paper for the house! This is clearly insane.
We can throw money from here to eternity at he "zombie banks" and it won't do any good until the toxic assets in these vaporized MBS packages are resolved, and they cannot be "picked out" of the packages that have been "Cusinarted" to death. It is a structural problem - but more about that later...
In the decade 1988-97, net financial investment for households totalled $2.6 trillion, as households accumulated more financial assets than liabilities. In the decade 1998-2007, net financial investment for households totalled negative $3 trillion. This was an enormously significant shift. This was the first decade on record where households took more money out of the financial system than they put in. Who took the place of households as net investors? It was foreign money, pouring into the country in the trillions of dollars. Foreign investors were buying everything from subprime mortgage-backed securities to hedge funds to purchases of shares.
Foreign investors in the U.S. flocked to investments which offered decent returns and high (perceived) safety. This demand for safety showed up in the Fed statistics. Between 1998 and 2007, foreign investors poured roughly $10 trillion into acquiring financial assets in this country. Out of that total, only about $3 trillion went into supposedly-risky equities, mutual funds, and direct investment in U.S. businesses. The rest went into perceived less-risky investments, such as Treasuries and mortgage-backed securities (after all, housing never goes down!).
Wall Street catered to this foreign demand for safety. Many hedge funds, for example, promised “positive absolute returns”, meaning that they would do well even in down markets. That’s one important reason why hedge funds boomed in this decade—they promised safety to foreign money, which were willing to pay big fees to get it. Many hedge funds were pitched directly to foreign investors. When Paulson testified before Congress in November, he said that 80% of his $36 billion in assets came from foreign investors.
And when there wasn’t enough “safe assets” to sell to willing foreigners, the intrepid investment bankers created more. Consider, for example, credit default swaps, which pay off if a bond defaults—in effect, insurance on debt. Wall Street saw this as a ‘two-fer.’ They would sell corporate bonds to foreign investors, and at the same time collect fees on credit default swaps on the bonds in order to reassure those apparently too-nervous investors from another part of the world. This started with A.I.G. (TRILLIONS in CDS and OTC derivatives), and will end with A.I.G.'s Chapter 11 discovery process - after they have burned through half a trillion dollars of YOUR MONEY, young people... your money- when their CDS/derivative exposure is unmasked. Then we will learn that these instruments of the Devil are really worth about 2 - 5% of their book or face value. Then the entire international banking/investment infrastructure will implode, as it should.
Time, September 17, 2008
"On September 1st, few knew that AIG, the largest insurance company in the world with over $1 trillion in assets, was in deep trouble. By September 12th, the rumors about major trouble were everywhere. By September 15th AIG’s corporate life expectancy was being measured in days, and the question was: bankruptcy, buyer or bailout? By the evening of September 16th, the federal government had massively intervened, making an $85 billion loan to AIG in exchange for a controlling 79.9% equity share of the company.
Welcome to the brave new world of credit derivatives driven collapses. A world that is far more dangerous than the world of subprime mortgage derivatives. A complex world that because of its sheer size can potentially cause more damage in a matter of days than the subprime mortgage derivatives caused in their first year in the headlines. In fact the relative size of the credit derivatives and subprime mortgage markets is 66 to 1. That mean the total CDS investment at AIG is 660% larger than the sub-prime mortgage derivative money outstanding!"
But the joke, in the end, was on Wall Street. The foreign investors bought the bonds, but they also bought the protection, credit default swap derivatives—which much to everyone’s surprise was needed. And the U.S. banks and investment banks were left with piles of ‘toxic assets’—the obligation to pay off all sorts of bonds and derivatives. But the "hit" was, these "toxic" assets were not integral - they were inputed through -out the paper chase of contracts, in dribs and drabs, molecules within vast hectares upon hectares of financial goo!
The arithmetic is simple. Foreign investors were the main source of funds during the boom years, when these mortgage-backed securities and credit default swaps were being issued in droves. Since not many of these securities are being sold these days, it’s likely that foreign investors are still on the other side of these securities. Moreover, as companies struggle, more details are revealed of their problem. When Lehman went bust, its bankruptcy filing showed that Lehman’s biggest bank loans came from foreign banks such as Japan’s Mizuho Corporate Bank and Aozora Bank.
Goldman Sachs tops the list of companies that received funds from the government via A.I.G., but that may be misleading. If Goldman marketed its investment funds to foreign investors, these foreign investors are the ultimate beneficiaries of the payments from the government via A.I.G. There is absolutely no transparency.
The international angle is very important. Geithner and Bernanke keep saying that the problem is that no one knows how much the toxic assets are worth. But that’s not the full story. If the counterparties and beneficiaries of the toxic assets held by American banks are also American, it would be relatively easy for Geithner and Bernanke to gather them in a room and make them come to a ‘reasonable’ agreement about how much these securities were worth. After all, even the most powerful hedge funds must ultimately bow to the power of the Fed and Treasury, especially in a crisis.
But with most of the counterparties in other countries, the job becomes much more difficult. There’s no way for Bernanke and Geithner to force European banks, for example, to accept any particular valuation of derivatives or bank bonds—not without the cooperation of the foreign regulators.
In fact, right now we have the worst of both worlds. U.S. banks own securities which may or may not obligate them to pay a large amount of money to foreign investors. And foreign banks have assets on their books which no one trusts are worth what they say. The uncertainty is killing both the borrowers and lenders. Sometime later this year we will have a massive global conference aimed at simultaneously resolving the banking crises in the major developed countries. The goal will be a political negotiation of the value of the toxic assets, and a clearing of the books.
If the conference succeeds, then it will be possible to fix the financial system relatively easily. But if it fails, then things get very dicey. Pack you bags now... just to be sure.
I wish to thank Michael Mandel and Tyler Cowan for conversations related to these topics.
