Wednesday, September 17, 2008

Venturing into the undiscovered country

We've now entered into the early phases of the grand liquidation of financial derivatives I wrote about last June. The most stunning—indeed flabbergasting—event so far has been the “rescue”, or more precisely effective takeover, of AIG, the largest insurance and financial services company in the United States by the Federal Reserve, which granted a two year credit line of US$85 billion secured by all of the assets of AIG. In return, the U.S. government receives a 79.9% share of AIG's equity, diluting existing shareholders' stake in the company by 4/5.

To my knowledge, nothing like this has ever happened before in U.S. financial history, at least not in the last century (you always wonder about railroad deals in the 19th century, but I don't know if precedent exists there; in any case that was before the Federal Reserve was founded, and the financial system worked very differently in that era). Certainly there have been bailouts before, such as that of Chrysler in 1980, but even that deal, controversial as it was at the time, was, in inflation-adjusted dollars, less than one twentieth the size of the credit line provided to AIG and was a pure government loan guarantee: the government took no equity stake in Chrysler at all. In the case of AIG, the U.S. now has effectively nationalised the largest insurance company in the country, with not just a controlling interest but an overwhelming ownership stake of around 80%, and the whole deal was done overnight without, as was the case of the Chrysler loan guarantee, extensive debate in the Congress and the enactment of a bill explicitly granting the guarantee.

That's part of John Walker's take on the AIG "bailout". (You should read the entire thing.)

I won't predict that this is the first domino. However, the precedent is now set--the Federal Reserve can now acquire a controlling stake in a troubled company at will, simply by declaring that the "disorderly failure" of a given firm will "add to already significant levels of financial market fragility". (Yes, those are the words of the Fed, reported by Bloomberg in this article.) No formal government action required--just the Fed cutting a deal with the desperate.

Watch carefully. One occurrence may be what we should hope--one occurrence too many. (I believe AIG should have been allowed to fail, as happened with Lehman Brothers. Better to get the pain over with quickly, than sink into a decade long slump like Japan (You may need BugMeNot for that link)). Multiple occurrences, well, let's just say I would exit the equities markets very quickly, before the already beaten value of my stock was diluted by 4/5.

Or I would exit if I were still there. If you aren't out now, leave while there's still time. I'm expecting a long fall and a cold winter--and praying for spring.

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