It's beginning to look like American International Group (NYSE: AIG), the largest U.S. insurer, will file for bankruptcy possibly today or tomorrow. What could keep it from filing is a $75 billion raise in capital from the remaining investment banks. But thanks to a $14 billion margin call on its Credit Default Swaps (CDSs) resulting from S&P's downgrade of its credit rating, this capital raise is unlikely to happen. I know that Ben Bernanke, Federal Reserve Chairman, has been reported to be an expert on the Great Depression. He is certainly going to pull the trigger on an interest rate cut this afternoon -- probably 1% -- which would bring the U.S. interest rate down to 1%. This cut will probably have no effect on stock prices, but it will telegraph to investors the level of panic within the U.S. government. After all, most Asian markets fell 4% to 5% in sympathy with the Dow's 4% decline -- the perpetrators of the 9/11 attacks must be celebrating in their caves over this bracket to Bush's eight year reign. So what seems to be AIG's problem? Despite the New York Department of Insurance freeing up $20 billion of subsidiary capital to the parent, the U.S. decided not to give AIG a $40 billion loan, instead hoping to get a private solution. Barron's reports that "The Federal Reserve was working with JPMorgan Chase (NYSE:JPM) and Goldman Sachs (NYSE: GS) to arrange a massive loan package of up to $75 billion to stave off a severe liquidity crisis at AIG." It will come again to the Credit Default Swap (CDS) market -- popularized by John McCain's chief economic advisor, Phil "Americans are Whiners" Gramm -- to wipe out AIG. The price of AIG's CDS have skyrocketed due to the risk of a bankruptcy and this requires AIG to pay a huge upfront premium to insure its debt. How big of an increase? "The all-in cost virtually doubled, to a 1722 basis points, an increase of 820 basis points, according to Tim Backshall, chief strategist at Credit Derivatives Research. That would normally translate to a cost of $1.722 million annually to insure $10 million of AIG debt for five years. But, because the market fears an accident sooner, AIG CDS require an upfront payment -- some $3.05 million -- plus $500,000 annually," writesBarron's. This is why AIG's CDS counterparties could demand that AIG come up with $14.5 billion in collateral. If JPMorgan and Goldman can somehow take money from the Fed through its Primary Dealer Credit Facility and lend it to AIG, then it will avert a bankruptcy filing. This would create the illusion that taxpayer money is not on the line in a bailout. I cannot imagine why these two banks would want to put their money on the line here. If that doesn't work out, there's always bankruptcy for AIG. That $1 trillion bankruptcy would make it the largest in history -- surpassing Monday's previous record $639 billion bankruptcy from Lehman. But AIG is stuck in a no-win spiral where it needs to raise capital to avert a ratings downgrade. And that makes it harder to raise the capital. The lessons of the Great Depression probably do not pertain to the current situation. This is the Greatest Depression -- about which I posted in March -- and the lessons of this one are likely to exposefive fundamental flaws in our financial architecture. An AIG bankruptcy would be the biggest sneeze ever and it would unleash a Category V storm in financial markets. I doubt that a 100 basis point interest rate cut will stop this. Peter Cohan is President of Peter S. Cohan & Associates. He alsoteaches management at Babson College and edits The Cohan Letter. He owns AIG securities and has no financial interest in the other securities mentioned.Will AIG file $1 trillion bankruptcy today?
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Tuesday, 16 September 2008
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