The rescue of American International Group might have settled the future of that organisation but it has done little to settle the market.
Last night was another very bad session on Wall Street. The last two remaining investment banks, Morgan Stanley and Goldman Sachs, saw their share prices fall 25 per cent and 15 per cent respectively, and credit markets went into an absolute funk, or rather fell further into the one they were already in.
Bailout rallies just ain’t what they used to be: the positive effect of the Bear Stearns bailout lasted a few months; the Fannie/Freddie bailout lasted a few days; the AIG bailout, just a few hours.
That’s probably because there is a growing sense that either:
a) Fed chairman Ben Bernanke and US Treasury Secretary Hank Paulson have lost the plot and are just making it up as they go along like everybody else, or;
b) if there is a plot, it’s more Terminator than Superman.
Maybe this isn’t a happy-ending movie where the heroes save the day after all; maybe it’s one of those art-house shows where you don’t know who’s a good guy and who’s a bad guy.
Five institutions have now bitten the dust, not counting the sale of Merrill Lynch. Four have been bailed out in various ways and one was left to file for bankruptcy.
And then, perhaps most important of all, the Fed callously and stubbornly refused to cut interest rates this week.
Commentators and markets have been left lurching from one opinion to another, from euphoria to gloom.
When Bear Stearns’ sale to JPMorgan was supported by the Federal Reserve, the markets rallied 20 per cent in the belief that the US authorities would clearly do “whatever it takes” to bail out the system.
The post-Fannie and Freddie bailout rally was overtaken by the run on Lehman Brothers. When that firm went into Chapter 11, markets were severely crunched around the world.
They then paused pensively this week when the Fed left interest rates on hold, not knowing whether it was bad that rates weren’t cut or good that the Fed thought it unnecessary (hint: it was bad).
Then they rallied briefly following the amazing AIG “bailout” and now they’re sinking again as the shorts listen for the next death rattle and debate rages about the bailouts. Everyone has a different view about what’s going on.
Mine is that AIG wasn’t a bailout at all — it was a nationalisation for zero compensation following a regulatory failure, as was the effective nationalisation of Freddie Mac and Fannie Mae.
That’s not what the Fed called the AIG action, of course. The press release called it a “liquidity facility” and said that AIG would be allowed to borrow up to $US85 billion for two years at 850 basis points above Libor, which is 13.5 per cent or more than five times the discount rate at which the Fed officially lends money.
In return for this two-year loan at the usurious rate of 13.5 per cent, the Fed gets a fixed charge over all of AIG’s assets and its subsidiaries. And then, almost as an afterthought, the statement finishes by saying the Fed would get 79.9 per cent of AIG’s equity and the right to stop dividends on the rest.
There was no price put on the transfer of equity to state ownership, and why would there be? Any firm that has to give security over all of its assets to borrow a small amount of money at 13.5 per cent must have negative equity.
One minute the firm is owned by private funds and individuals, the next it is owned by the state. This was not some sort of liquidity facility to tide AIG over, but the emergency nationalisation, for nothing, of an insolvent institution.
American insurance companies are regulated by the states to protect policyholders, and as a result the regulation is a mess. In the case of AIG it has manifestly failed and the federal government has had to step in via the central bank.
So the Federal Reserve now owns the world’s largest insurance company. Will it run the business, or liquidate? Is there actually any choice, since there is no market for the assets?
Fannie Mae and Freddie Mac were also effectively nationalised following manifest regulatory failure.
The Office of Federal Housing Enterprise Oversight (OFHEO) was specifically set up in 1992 to promote “a strong national housing finance system by ensuring the safety and soundness of Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation).”
Its act requires the OFHEO to stress-test Fannie Mae and Freddie Mac for a variety of market conditions but in the end it was as surprised as everyone else when they went broke.
Given this failure, the Government had little choice but to do with taxpayers money what wasn’t done by the OFHEO — protect investors’ money and the system from their collapse.
Lehman Brothers was allowed to fail for fear of moral hazard, and because after Bear Stearns Hank Paulson had drawn a line in the sand. Phooey. Lehman failed because it was insolvent – nothing to do with the Government.
Bear Stearns had $US30 billion of its assets nationalised (the worst ones), so that JPMorgan could acquire the rest, because it was a major clearer.
According to the authoritative blogger Ken Houghton, if Bear Stearns had declared bankruptcy “about 30 per cent of the hedge funds in the country would not have been able to execute virtually any transaction for the following thirty days. Not a payment. Not a redemption. Not a trade on a listed exchange. Not a receipt. Not a de-leveraging. Not a swap payment, not a CDS payment, not fulfilling an option exercised against them. There’s just not a “maybe” about financial collapse in such a scenario.”
If this analysis is correct (and there is really no way of knowing), then it is not simply a matter of the US authorities running a general bailout strategy and drawing the line on moral hazard somewhere or other.
There is no line; there is no strategy. And there was no rate cut.