Stocks tumbled the second day this week after the US government extended AIG an $85 billion emergency loan to prevent a bankruptcy filing. The Federal Reserve agreed to provide an $85 billion two-year loan in exchange for a 79.9% stake in the insurance giant.
The bailout did little to ease the turmoil in the credit markets. The higher spread indicates increased fears of credit risk and reluctance of banks to lend to each other.
During the mortgage boom, Merrill Lynch had billions worth of dubious collateralized debt obligations, those troublesome bonds backed by pools of risky subprime mortgages. In order to reduce its own risk, Merrill bought insurance contracts from AIG called credit default swaps, which pay off if the mortgages blow up.
Merrill holds $5 billion worth of guarantees from AIG alone. AIG insures $441 billion of Collateralized Debt Obligation (CDO), including $58 billion with subprime alone. It is not clear which firms bought those guarantees; it seems AIG sold many to big European banks.
When AIG couldn’t hold any longer, those contracts couldn’t be trusted to make good. If the insurer had remained in jeopardy, Merrill and others would have faced another round of losses. Given that possibility, that’s why the Fed had to step in.
The signs are still not very encouraging. Even though the Fed’s dramatic bailout of AIG prevented a global panic that might have happened with the collapse of the largest insurer. AIG’s sudden lurch toward bankruptcy also showed how dangerously fragile the whole financial system can be.
For many years that interconnecting financial system covers enormous underlying risks, only until now it is amplified. As each new thread unfolds itself during the 13 month financial crisis, it adds up to a fresh problem. How bad the situations can get from here will depend on how the rotten firms and the toxic investments can be cleanly extracted from the rest.
As each day passes, the task seems to grow more difficult. The total losses are now at about $500 billion and by the time the financial crisis is over, the losses could reach a staggering $2 trillion, according to some financial analysts.
“It’s hard to find ideas that aren’t picked over and harder to get real returns and differentiate yourself. We are entering a new environment. The days of big returns are gone” – Steven Cohen, Founder of Hedge Fund SAC Capital Advisors
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