Save AIG, save the world?

US Federal Reserve bails out insurance giant to stabilise global fiancial markets


By Zhen Ming


YOU could see it in their afraid-to-lose-out faces: fear, anxiety and confusion.

Better safe than sorry, I suppose.

This was the sentiment on Tuesday when hundreds of policyholders of AIA Singapore - a subsidiary of the American International Group (AIG) - lined up outside its Shenton Way office to terminate their policies. This, despite assurances from the Monetary Authority of Singapore that AIA has 'sufficient assets' to meet its liabilities to policyholders.

A knee-jerk reaction, no doubt. It was triggered soon after news that AIG would be allowed to access US$20 billion ($29b) of capital from its own subsidiaries to help it out of its difficulties.

The US Federal Reserve announced yesterday that it would lend AIG up to US$85 billion in emergency funds in return for a government stake of 79.9 per cent in the company.

It was an extraordinary step meant to stave off the collapse of the giant insurer that plays a crucial role in the global financial system.

To be sure, most of AIG's businesses are still healthy.

But AIG was saved to save the world - because of its links to many of the world's financial institutions and the major role it plays in the largely-unregulated credit default swaps (CDS) market.

On Monday, for instance, the Dow Jones industrial average lost more than 500 points, its steepest point drop since the day the stock market reopened after the 11 Sep 2001 attacks. This wiped out some US$700b from retirement plans, government pension funds and other investment portfolios.

The carnage was, by far, the most stomach-churning in a single day since a financial crisis began to bubble up from billions of dollars in rotten mortgage loans.

Loans that have crippled the balance sheets of one bank after another, and that have landed mortgage giants Fannie Mae and Freddie Mac under the control of the US federal government.

Meanwhile, Merrill Lynch, the world's largest retail brokerage, had fled into the awaiting arms of Bank of America (BofA), in an all-stock deal worth US$50b.

BofA agreed to pay 0.8595 shares of its common stock for each Merrill share. The price, which comes to about US$29 per share at the time of the announcement, represents a 70 per cent premium to Merrill's share price last Friday.

On paper, Temasek Holdings - as Merrill's biggest shareholder - could stand to reap ballpark gains of US$1.5b from this sale. But this would have to depend on the value of BofA shares when the transaction closes in the first quarter of next year.

Meanwhile, it's getting lonely at the top of Wall Street's investment bank pyramid - with only two major players, Goldman Sachs and Morgan Stanley, still standing. Will they suffer a similar fate as their ex-rivals?

And the other question: What went wrong for the others? In one simple word: complexity.

Columnist Nils Pratley in The Guardian: 'The complexity lies in modern markets' love affair with derivatives - the financial contracts sold to the world as a way to reduce risk. Got too many mortgages on your balance sheet? No problem, slice them up, package them, sell them on. Worried about your trading partner defaulting? Buy some insurance. The possibilities are almost endless.'

Amazingly, the gross value of outstanding derivatives is now counted in tens of trillions of dollars.
Consequently, what was once a traditional backwater of the investment banking business has now become a principal activity - and a pretty dangerous one, too, as the great investor Warren Buffett figured out years ago.

His 2002 letter to his Berkshire Hathaway shareholders made headlines by condemning derivatives as 'financial weapons of mass destruction'.

They were 'time bombs, both for the parties that deal in them and the economic system'.

Back then, Buffett also made this gloomy prediction: 'The derivatives genie is now well out of the bottle, and these instruments will almost certainly multiply in variety and number until some event makes their toxicity clear. Central banks and governments have so far found no effective way to control, or even monitor, the risks posed by these contracts.'

Who to blame?

At the rate things are going, expect the pace of bank failures in America to pick up.
Who then should we blame for this mess?

Back in 1993, religious institutional investors began making 'eerily prophetic warnings' of an impending subprime mortgage debacle in the US, said Laura Berry, executive director of the Interfaith Center on Corporate Responsibility.

If the warnings had been heeded, the world 'would have avoided the kind of meltdown we are experiencing today,' she said.

Meanwhile, the globalisation of finance and the ability to move money and financial information with great speed through modern communications has perhaps multiplied the dangers from poor and unethical investment decisions.

It's a sure-fire recipe for disaster - with the benefit of hindsight, of course.


Source: The New Paper, Thu 18 Sep 2008