Roger Baker : AIG and the ‘Adverse Feedback Loop’

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Bernanke hates to call our current situation a deflationary spiral despite its close resemblance to one. Perhaps because of the association of that term with the Great depression, Bernanke chooses to call our current crisis an ‘adverse feedback loop.’

By Roger Baker / The Rag Blog / March 2, 2009

American International Group (AIG) is in big trouble, its stock having fallen from $50 a few years ago to less than 50 cents today. Why is this so important?

AIG is a sort of deregulated non-bank global securities insurance “group” that has specialized in insuring securities deals, through credit default swaps, etc. This insurance was deemed smart and profitable, unless there is a world economic crisis. Such a crisis was known to be to be theoretically impossible because of readiness of the US treasury and the Fed to do whatever it takes (even dispatching helicopters full of money if needed) to stimulate the US economy enough to pull the USA out of a deflationary spiral.

Bernanke hates to call our current situation a deflationary spiral despite its close resemblance to one. Perhaps because of the association of that term with the Great depression, Bernanke chooses to call our current crisis an “adverse feedback loop.”

The adverse feedback loop and how Ben Bernanke is trying to loosen it

“…On a day when more dismal housing price data and record-low consumer confidence highlighted the continuing plight of the U.S. economy, Mr. Bernanke warned that a full recovery could take more than two to three years and that recent economic forecasts could prove optimistic. “I believe that, over all, the downside risks probably outweigh those on the upside,” the central bank chief said in his semi-annual appearance before lawmakers…”

However, before we blame AIG too harshly for risking the whole global economy by pledging too many trillions of dollars in now-failing security insurance policies, we should recall that these institutions were poorly informed by those who should know better. There were scholarly assurances from brilliant mathematicians who calculated the risk on the credit swaps, which were much of the basis for much of AIG’s business (although AIG knew how to insure anything).

It was mathematically determined that the kind of securities insurance deals that AIG sought to do could, at the same time, be highly profitable and carry a low risk.

Enough retroactive finger pointing. It is now considered vital for the U.S.A to bail out AIG’s securities’ bad insurance deals. If not, a huge amount of supposedly rock solid deals around the globe will go up in smoke, leaving the biggest players in the global economy feeling cheated, suspicious, unwilling to lend, buy treasury debt, etc.

Whether or not to admit that the biggest banks are broke, and then to nationalize them, is something else Bernanke may need to figure out fairly soon. The bank solvency problem is a related issue involving domestic investor confidence.

“…nationalisation is not an end in itself, but a consequence of the policy that most rapidly returns the banking system to health. It is a heavy cost, but there is no alternative. If taxpayers own a bank, pretending that they don’t only exacerbates the harm…”

Meanwhile, the AIG deals need our immediate attention. Bailing out the AIG deals (and perhaps similar assurances spread throughout the “shadow banking system” – see the link above) through a series of emergency cash injections is deemed absolutely necessary, no matter what the cost, as the following article indicates. The main problem is the U.S. treasury funded bailouts needed to paper over the global bad debt shortfalls seem to keep getting bigger and bigger.

AIG failure would still be disastrous for global mkts
By Lilla Zuill and Kristina Cooke / March 1, 2009

NEW YORK — A revised bailout of American International Group Inc (AIG.N) may be just another “band-aid” solution, but more than five months after it was first rescued by the government the option of letting the insurer fail would still be considered too big a shock to already fragile global markets…”The government really does not have the option of letting AIG totally blow up,” said Robert Haines, senior insurance analyst at CreditSights. AIG’s foray into the roughly $28.5 trillion credit default swap market left it heavily exposed to losses on toxic mortgage assets that it had guaranteed against default….

“European banks are about two-third of the problem… it would be a domino effect across the globe. “The ensuing panic would be disastrous,” he said…

Moody’s Investors Service and Standard & Poor’s both have AIG on review for downgrade from the seventh highest investment grade, and have said that only government support was keeping ratings from being cut to “junk” status. “If AIG is allowed to fail — many banks holding CDS paper from AIG could also fail,” said Mark Keenan, insurance partner at law firm Anderson Kill & Olick. “In other words, I don’t think the U.S. government can afford to allow AIG to fail — no matter how many bandaids may be needed,” he added. Over time, however, some analysts say the U.S. government may find that an orderly failure of AIG is the only way to stop the financial bleeding.

“The whole thing is ridiculous. How much longer are we going to do this? This is another bandaid, and we’ll be having this discussion again,” said Christopher Whalen, co-founder of Institutional Risk Analytics, a provider of analysis and ratings for banks…”

Source / Reuters, UK

The dollar value of global securities deals AIG has insured against default is fairly astronomical. The article above mentions $28 trillion. Whatever the dollar amount needed to stabilize the global economy, it apparently could dwarf the few trillion dollars in Obama’s budget and or his stimulus package. Perhaps China will decide that our US treasury bonds have, for some reason, regained their previous appeal.

However, if cutting the interest rate to zero, plus the stimulus package, plus all the bailouts so far all put together can’t seem to do the job, and if all else fails, there are always the US Treasury Department printing presses.

The Rag Blog

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2 Responses to Roger Baker : AIG and the ‘Adverse Feedback Loop’

  1. Anonymous says:

    The proper pronunciation of AIG is now AGH!

  2. Roger Baker has given us an excellent post. I would add that a lot of blame goes to the deregulators, Republicans and some of the New Democratic Coalition types like Bill Clinton. Clinton signed Phil Gramms two major deregulatory bills, but Bill did try unsuccessfully to strengthen the sEC and at least enforce what was on the books.

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