Tuesday, March 3, 2009

AIG's Bottomless Pit

Since the majority of the general public, and all of the Financial Media, seem to be constantly asking in bewilderment as to reason AIG keeps requiring additional bail-outs, I decided to try my hands at a simple answer. AIG has exposure to the highest tranches of credit risk. In other words, AIG has insured the highest quality credit in the world. But it did that with gusto. I reckon AIG has risk exposure roughly equal to $1 billion/basis point of investment grade risk*. In other words, every time investment grade credit risk rises by 0.01% AIG books a mark-to-market loss of $1 billion. Why mark-to-market then? The mark-to-market is required by AIG's counterparties and the rating agencies to properly protect against an AIG default. When an adverse mark-to-market takes place, one has to post additional collateral with counterparties or convince rating agencies of reserve adequacy. The inability to do so, causes a total collapse in credit quality and ultimately insolvency. That is why the bail-outs keep coming.

Two years ago investment grade credit spreads where around 30bps. Today they are over 200bps*. This blow-up in credit spreads has happened without any considerable defaults in the investment grade world. What would happen when default start taking place. How much of a bail-out would AIG then need. Go figure!

* A March 3, 2009 article at CNNMoney.com states that the total AIG bailout so far stands at $163 billion. This almost exactly confirms the analysis presented above.

Friday, January 30, 2009

Filling the Crater

As Washington tries to navigate its way through the current economic morass, the general public is repeatedly stunned by the enormity of the figures. The number trillion (one followed by 12 zeros) was thought by many to be an imaginary number, merely a couple of years ago. Nowadays, it seems that every government official will be in charge of dispensing a trillion or two.

What happened? And is inflation upon us?

The big-bang noise you just heard was the sound of the credit bubble blowing up. The federal reserve system of America, and its sisters around the globe, have been creating capital out of thin air for over 25 years. Through the less than sober expansion of credit, the global economy looked exceptionally healthy for the most part of a quarter of a century. A mini 'real estate'/'savings & loans' bubble, followed by a massive 'technology company'/'stock market' bubble, followed by a giant credit/'hedge fund'/'real estate' bubble, followed by a commodities bubble gave us the pleasurable externalities of a wildly vibrant economy.

The bubble popped! It was tens of trillions of dollars big. Now we are left with a crater. The governments of the world are trying to shovel as much cash as possible into the crater.

In all likelihood, they won't be able to fill the whole crater. That means that no matter how much money they print, it is just a partial rationing of the credit they have already issued. As a result it has no inflationary impact. All prices should fall, albeit not at the same rate. For instance, gold may fall less than Florida real estate. To support asset prices, the government will have to inject so much cash that bubbles will pop up in some unexpected places.

Whether this effort will succeed or not is uncertain. One thing is certain, however, a bubble in government has already begun!