$85B is serious money, even by 21st century standards. So, why are taxpayers coughing up that sum for a (formerly) private insurance company? Because of some thing I wrote about last February and am still more than a little hazy on: credit default swaps (CDS).
Credit default swaps are insurance-like contracts that promise to cover losses on certain securities in the event of a default. They typically apply to municipal bonds, corporate debt and mortgage securities and are sold by banks, hedge funds and others. The buyer of the credit default insurance pays premiums over a period of time in return for peace of mind, knowing that losses will be covered if a default happens. It's supposed to work similarly to someone taking out home insurance to protect against losses from fire and theft.
Except that it doesn't. Banks and insurance companies are regulated; the credit swaps market is not. As a result, contracts can be traded — or swapped — from investor to investor without anyone overseeing the trades to ensure the buyer has the resources to cover the losses if the security defaults. The instruments can be bought and sold from both ends — the insured and the insurer. [More]
So how big is "too big to fail"? Apparently somewhere around $62,000,000,000,000.
More or less.
If A.I.G. had collapsed — and been unable to pay all of its insurance claims — institutional investors around the world would have been instantly forced to reappraise the value of those securities, and that in turn would have reduced their own capital and the value of their own debt. Small investors, including anyone who owned money market funds with A.I.G. securities, could have been hurt, too. And some insurance policy holders were worried, even though they have some protections.
“It would have been a chain reaction,” said Uwe Reinhardt, a professor of economics at Princeton University. “The spillover effects could have been incredible.” [More]
The scope of the intervention should make clear how deeply shaken is our financial system. And while we marvel at the strange things happening around us, we are often unaware this is what truly historic times look like in realtime. Like many Big Moments in History, this one is not about good things happening, I fear.
I'm not sure why I think this, but I have waning confidence in our ability to avoid these oft mentioned catastrophes. It seems like we're simply slowing the chain of events down to allow a stately sinking of our economic ship. Oddly enough, some people at the very top are not much more confident.
"Ben, you are playing a very unique role in world economic history," Hale recalled telling Bernanke, an expert in the Great Depression. "You are the first central bank governor of the United States to preside over a recession with no decline in commodity prices."
Bernanke could hypothetically limit inflation in commodities by raising interest rates, a policy that would restrict the flow of money but potentially lead to an avalanche of bank failures. At a financial conference in Florida on Tuesday, Hale, a Chicago-based economist for investment managers, hedge funds and multinational companies, paraphrased the Fed chairman's response.
"We have lost control," said Hale, quoting Bernanke. "We cannot stabilize the dollar. We cannot control commodity prices."
If efforts to stop a recession sent commodities to record levels through July, then the realization that a recession could be imminent has sunk oil prices by almost 40 percent during the past two months. For all the debate about foreign demand and financial speculators, one overlooked aspect of commodity prices is the health of the American economy. [More]
All bets are off. And I think that's what the stock market is trying to tell us. So what's my strategy? Well, first I reserve the right to panic. It's a perfectly good instinct that has served us well for for about 2 million years, so let's not throw away all that adrenaline thoughtlessly. Besides, I'm tired of all talking heads saying "This is no time to panic". OK, when is a good time?
Second, I'm going to catch my breath and clear my desk and finish my plate. What is coming needs my full attention, and I'm too unfocused right now. Third, I going to see what I can do for friends and family. No real reason, except I can imagine unlooked-for assistance of any kind right now would be doubly welcome.
Finally, I'm going to keep all my partners up and down my production chain informed - starting now with the news I have no idea what is happening but plan to fulfill my commitments absolutely. Updates will follow as I know more.
You realize I consider all of you my partners, right?