A collapse of American International Group Inc., the insurer seeking to raise as much as $80 billion, would have consequences for financial firms around the globe, analysts and investors said.
Wall Street's top firms, and the biggest companies in Europe and Asia, have bought protection on $441 billion of fixed-income assets from AIG to guard their investments against potential bankruptcies. A failure by New York-based AIG may cause those protections to vanish. AIG also insures some of the largest assets in the world, doing business in more than 100 countries.
``They have tentacles into everything, and they are certainly critical to the ongoing health of the financial markets, or lack of health,'' Anton Schutz, president of Mendon Capital Advisors Corp. in Rochester, New York, said in an interview today with Bloomberg Television.
Wall Street's largest firms met at the New York Federal Reserve for a fifth day today, discussing ways to save AIG, said a spokesman for the New York Fed. AIG, with $1 trillion in assets, piled up net losses totaling $18.5 billion in the past three quarters on writedowns tied to the collapse of the U.S. subprime mortgage market.
``If AIG goes under, there could be a domino effect,'' said Andrea Cicione, a credit strategist at BNP Paribas SA in London. ``AIG is very connected to the financial system and it is very connected to the real economy.''
Let's back-up a bit and look at this situation in a bit more detail.
Wall Street's top firms, and the biggest companies in Europe and Asia, have bought protection on $441 billion of fixed-income assets from AIG to guard their investments against potential bankruptcies.
These are "credit default swaps". While they sound exotic they aren't. They are essentially insurance on corporate bonds. Suppose you manage a bond portfolio and you want to hedge your risk. If you were an equity trader you would sell an out of the money put.
Options are financial instruments that convey the right, but not the obligation, to engage in a future transaction on some underlying security, or in a futures contract. In other words, the holder does not have to exercise this right, unlike a forward or future.
For example, buying a call option provides the right to buy a specified quantity of a security at a set strike price at some time on or before expiration, while buying a put option provides the right to sell. Upon the option holder's choice to exercise the option, the party who sold, or wrote, the option must fulfill the terms of the contract.[1][2]
But no such option exists for bond managers. This led to the rise of the "credit default swap" (CDS) market. These are simply options on bonds, or an option to sell x amount of bonds at a certain price at a certain time. They are a great development because they allow fixed income managers to hedge downside risk. But (and here's the big but) the market is off balance sheet and unregulated. Because the market is private there is no way to limit it's size to an appropriate size. Put another way, suppose you had $10,000,000 in bonds that you wanted to insure. There is no reason for there to be numerous contracts on this bond position -- one will do. But because this is a private market there is no way to know if there are multiple options on the same bonds. This is one of the reasons why the CDS market is currently dangerous. Because AIG is so intimately involved with this market they have essentially become "too big to fail".
``They have tentacles into everything, and they are certainly critical to the ongoing health of the financial markets, or lack of health,'' Anton Schutz, president of Mendon Capital Advisors Corp. in Rochester, New York, said in an interview today with Bloomberg Television.
Barry over at the Big Picture noted one of the reasons why the Fed bailed out Bear Stearns is because the firm got so large it was too vital to the economy. That's essentially the case right now with AIG. It's too big to fail. This wasn't a deliberate strategy, but it is the result of a company getting really really big in an economy that is incredibly dependent on finance.
Wall Street's largest firms met at the New York Federal Reserve for a fifth day today, discussing ways to save AIG, said a spokesman for the New York Fed. AIG, with $1 trillion in assets, piled up net losses totaling $18.5 billion in the past three quarters on writedowns tied to the collapse of the U.S. subprime mortgage market.
Mish described this situation as "Fed Sponsored Poker Party Morphs Into "Old Maid"". That's exactly what is happening. All the parties are deciding who will be stuck with the check for this thing.
9 comments:
If the argument that AIG "is too big to fail" flies, and taxpayers have to bail them out...what does that say about Bank of America? Is it not time to stop BOA now, dead in its tracks?
very minor nit: in the last sentence before your blockquote from wikipedia on stock options, you write "If you were an equity trader you would sell an out of the money put" -- I think you meant to say "...you would BUY an out of the money put," right? (Assuming that you are long the underlying stock, anyway -- by contrast, if you are short you would buy an out-of-the-money call).
As someone who routenly sells out of the money puts, I must say you're almost spot on. The problem was that these idiots didn't hedge in their shorting activities. That's what saved Goldman Sachs, they always figured "what if we're wrong" so they even bet against themselves. Traders who short options, the ones that survive that I know, just do verticals or iron condors. But you have to make sure that those prices are outside standard deviation.
One more thing, these managers had access to futures on Swaps, which traded in a centralized market like the Chicago Board of Trade (now part of the Chicago Mercantile Exchange Group). Yes, it's a derivative on a derivative, but the contract would have served what a future's product was originally meant to be, as a hedge.
So why do taxpayers have to foot the bill? I sure haven't received any divedend checks?
Anonymous 2: we foot the bill so that our neighbors can still get a mortgage or business loan or a student loan -- i.e., get money out of the financial system in order to do something productive that will contribute to our national economy long-term. If this stuff all goes under, you and I are in the tar pit. I have no skin in the game with the big boys, just a small regional bank. But, if the major players fail, they take out that small regional bank in which I hold shares. And that will limit my ability to be more economically active in my own community. It could even wipe out my modest holdings. My small-town bank didn't create this mess, but they are tied to it to a greater or lesser extent like every other bank in this country. They, and we, sink or swim with these sharks. I'm not crazy about it, but that's how this game is being played. The Fed can toss out the life-raft in this storm, and if they do, I hope there's enough room for everyone who needs it.
Noor I hope the life rafts big enough too,--but remember McCain said we do have the best workers in the country and the fundamentals of the economy are sound.(oh, sure)
AIG is different...if the CDS market crumbles, then truly innocent participants (millions of folks relying on pensions) will get burned. Lehman and Bear falling apart is different than this right here.
The market is insane...it's all over the counter...regulation is desperately needed, but before that can happen, if bailing out AIG is what it costs, it's worth it
yeah yeah fed to the rescue,,print more and more money.
you people live in a fantasy world.
The Fed is the root of the problem.If you are in a hole stop digging.
The US has to let these useless corrupt institutions die take the pain and move on if you want a decent future for your kids.
This present US government is the most fucked up corrupt bunch in a century led by a clueless idiot who´s only solution to anything is to bomb the shit out of 3rd world countries.
Wake up people its payback time.
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