US Subprime: History of the Credit Crunch and Credit Crisis, Part 2
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Geneva, 29 Oct 2008. In this multi-part series, we uncover the events that led to the subprime credit crunch, and analyze future financial prospects.
Part 2: BURSTING THE BUBBLE
Collapse of AIG
Geneva, 29 Oct 2008. In this multi-part series, we uncover the events that led to the subprime credit crunch, and analyze future financial prospects.
Part 2: BURSTING THE BUBBLE
Collapse of AIG
On September 15 2008, all of the major credit-rating agencies downgraded AIG – the world’s largest insurance company because of the soaring losses in its credit default swaps. The first big write-off came in the fourth quarter of 2007, when AIG reported an $11 billion charge. It was able to raise capital once, to repair the damage. However, the losses kept growing. The moment the downgrade came; AIG was forced to come up with tens of billions of additional collateral, immediately. This was on top of the billions it owed to its trading partners. It didn’t have the money. The world’s largest insurance company was bankrupt.
Collapse of Lehman Bros
The dominoes fell over immediately. Suddenly the banks were forced to downgrade the securities they were holding, which meant their capital requirements had to be raised. Worse, if AIG was bankrupt, the banks had no credit insurance and had to write down their CDOs. Lehman Brothers failed on the same day. Merrill was sold to Bank of America. The Fed stepped in and agreed to lend AIG $85 billion to facilitate an orderly sell off of its assets in exchange for essentially all the company’s equity. That is how AIG became the linchpin to the entire system. However, the Fed decided not to rescue Lehman Brothers, America’s 5th biggest investment bank, and that was their big mistake as it immediately undermined confidence in the banks. If a major bank was allowed to go bust, then in the present circumstances, no bank could be trusted. Confidence in banks collapsed overnight.
AIG’s largest trading partner wasn’t a nameless European bank. It was Goldman Sachs. Goldman had avoided the huge mortgage-related write-downs that plagued all the other investment banks by hedging its exposure using credit default swaps with AIG. Sources inside Goldman say the company’s exposure to AIG exceeded $20 billion, meaning the moment AIG was downgraded, Goldman had to begin marking down the value of its assets. The moment AIG went bankrupt, Goldman lost $20 billion. Warren Buffet stepped in and invested $5 billion, which also helped it raise another $5 billion via a public offering.
The collapse of the credit default swap market also meant the investment banks had no way to borrow money, because no one would insure their obligations. To fund their daily operations, they’ve become totally reliant on the Federal Reserve, which has allowed them to formally become commercial banks. As at last week, banks, insurance firms, and investment banks have borrowed $348 billion from the Federal Reserve – nearly all of this lending took place following AIG’s failure.
Why the rescue?
I have gone into this detail because:
1. Without the government’s actions, the collapse of AIG could have caused every major bank in the USA and Europe to fail, which would in turn bring down most banks in the world as they all lend to each other. However, letting Lehman Brothers go bankrupt was not such a good move and has been severely criticised.
2. Without the credit default swap market, there’s no way banks can report the true state of their assets – they’d all be in default of Basel II. That’s why the government will push through a measure that requires the suspension of mark-to-market accounting. Essentially, banks will be allowed to pretend they have far higher-quality loans than they actually do. The credit default swap market cannot provide cover anymore.
3. Most importantly, without the massive credit swap market initiated by AIG, the mortgage bubble could have never grown as large as it did. Other factors contributed, such as the role of Fannie Mae and Freddie Mac in buying subprime mortgages without questioning their quality, but the key to enabling the huge global growth in credit during the last decade can be tied directly to the sale of credit default swaps without underlying collateral. That was the stable door. And it was left open for nearly a decade.
There’s no way to replace this massive credit-building machine; the credit that existed in the world before September 15th should not have been there in the first place. The numbers are massive, as we have seen by the scale of the government bailout schemes announced by the US and UK governments followed by other major national governments.
Clive Ward, Guest Contributor for EconomyWatch.com
Sources: Financial Times, The Times, Steve Sjuggerud Daily Wealth, International Monetary Fund website, Time Magazine
Clive Ward is a director of Affinity Consulting Group Ltd (ACG) and of Ganoz Asset Managment Ltd (GAM). ACG provides investment advice
