That didn't last long

Two days after the US authorities made much of standing firm against calls for a bailout of Lehman, the Fed has announced an $85 billion rescue of insurance company (and large-scale counterparty in all kinds of derivative markets) AIG. There’s none of the ambiguity surrounding Fannie and Freddie in this deal. AIG is not a federally regulated entity, and the insurance subsidiaries are regulated at the state level to ensure their ability to pay out on claims. This is, purely and simply, a case of a speculative financial enterprise that’s too big to fail.

Having reached this point, it’s hard to see how the US can turn back from a massive extension of financial regulation, starting with the derivative markets where AIG got into so much trouble, notably those for credit default swaps (CDS). Along with winding up the affairs of AIG, Lehman and others, the authorities will need to oversee an orderly unwinding of the transactions in these markets which they are now effectively guaranteeing. More generally, it’s time for a partial or complete reversal of the financialisation of the economy that took place after the breakdown of the Bretton Woods system back in the 1970s.

BTW, if you happen to have cash parked in a US money market fund, you might want to read this. (Insert disclaimer about financial advice)

UpdateBrad Setser has the same reaction.

47 thoughts on “That didn't last long

  1. Everyone should read (or reread) JK Galbraith ‘The Great Crash’. It describes clearly all the lessons of 1928-1940 that have since been forgotten by our ‘leaders’. Rescue of the Thundering Herd by Bank of America would not have been possible before the repeal of the . What will actually happen in future will be worse as a result of that repeal, and the many other ‘modernisations’ of the last 20 years.

  2. “This is just crazy! I can’t believe we’re going to bail out another company. Privatized profits, nationalize risk”

    Can I point out, yet again, that “The Fed” is a cartel of private sector banks.

    A Fed bail-out is not a public bail-out. The US Treasury will probably lend money to the Fed – which will be secured against the assets of Fed member banks.

    At a quick first estimation. losses and bail-outs to date in the current crisis probably amount to around $200 billion.

    That’s a very big number.

    The US economy is worth approximately $14 trillion and has a long-term average growth rate of around 2% or $280 billion per year.

    Those are even bigger numbers.

  3. “A Fed bail-out is not a public bail-out. The US Treasury will probably lend money to the Fed – which will be secured against the assets of Fed member banks.”

    Or, more shortly, a Fed bailout is a Treasury bailout is a public bailout.

    “At a quick first estimation. losses and bail-outs to date in the current crisis probably amount to around $200 billion.”

    Losses are already much larger than this – at least $500 billion written off by banks and others, all of whom are ultimately backed by the state.

    As regards bailouts, there’s
    Bear $30 billion
    AIG $85 billion
    Liquidity injections since mid-2007, no idea but certainly more than $100 billion, secured against assets of steadily diminishing quality
    Liquidity associated with Lehman non-bailout $80 billion
    Fannie & Freddie – no estimate, bounded above at $5 trillion

    It’s useful to keep perspective on the size of the shocks relative to the economy, but these are seriously large numbers, enough to knock out years of growth if the current rescues turn out as badly as all the previous ones.

  4. “Or, more shortly, a Fed bailout is a Treasury bailout is a public bailout.”

    Only if the losses on the bail-out exceed the capital base and borrowing capacity of the Fed members.

  5. Ian, in any bailout, the bailor only has to pay if the losses are more than the bailee can pay.

    But in any case, I’m pretty sure you’re wrong about the way the Federal Reserve works. Although it’s nominally owned by private banks, actually they are like bondholders, getting a 6 per cent return on their “shares” while the US Treasury is the true owner (that is, the residual income recipient exposed to profits and losses). So, short of the unthinkable possibility of the Fed being allowed to go bankrupt, and wiping out its capital, a loan from the Fed is exactly the same as a loan from the Treasury.

  6. I hope I don;t come accross as blindly optimistic here.

    I think the US is heading into a recession. I think there’s about a 50-50 chance Australia is also heading into a recession.

    In neither case do I see much reason to assume the recession will be unusually prolonged or severe.

    The worst case scenario for the US seems ot me to be not a repeat of the Great Depression but a repeat of the Japanese deflationary spiral of the 1900’s. The US now has strongly negative real interest rates; falling demand; falling asset prices and the exogenous inflationary shock from the oil price seems to be fading.

    US unemployment will probably rise – from a historically low base and probably to less than the level of 1970’s and 1980’s. Living standards will be constrained by the recession and growth in living standards is likely to be restrained for several years thereafter.

    Americans in 2010 will probably have similar levels of real income to what they had in 2007.

    That’s a pretty poor outcome and stands as an indictment of the Bush administration and the Fed Board (dating back to the Greenspan era). But its unlikely to be anything like the Great Depression (double digit falls in living standards and double digit unemployment.)

  7. I’m still trying to get my head around it…80% ownership of AIG? A trillion-plus USD asset base world-wide (according to the ex-CEO it was at least a trillion, but under firesale conditions who is to say) with tentacles reaching far and wide into the so-called ‘real’ economy, this must make the US government the most unfreemarket capitalist government in history. [hyperbole off].

    How can the US government seriously say it is a free market believer when it owns so much of global insurance (and other items like financial institutions, real estate, CDOs, etc). In any case, what happens to the government’s committed position with respect to AIG once the assessors can reach the hurricane Ike affected areas? That hit to AIG’s books has yet to seep in…

  8. ian, japan was a net creditor in the 1990’s with a large amount of national savings,
    and so was the US in the great depression,

    neither situation is realistic as a comparison

    also in my opinion the falling asset prices are temporary, and like oil i reckon will be on the way up again by christmas

    all in all, i think your prognosis is wildly optimistic

  9. Yep, I think a prolonged period of slow growth is the most likely outcome for the US. And I wouldn’t be at all surprised if it marks the end of the USD as the world’s reserve currency as they try to get out of it by debauching their currency (US long bond rates are, IMO, ridiculously low at the moment – in the short run the threat is deflation, but the long run one is inflation)

    Nasty, but not Great Depression stuff. That is, unless the world’s economic authorities really stuff up on the scale they did in the 30s. I think that’s unlikely, but unfortunately not impossible.

  10. What about the private equity financial innovation thing?

    An implosion in this area would hit operating firms directly (ie is the problem of corporate borrowing excesses in the spirit of the 1980s an embedded problem?)

    If AIG type private debt for government equity swaps were to be used in the event then the US and other governmens might end up owning much more than a middle of the road mixed economy looks like.

  11. In discussing the pros and cons of government bail-outs, people tend to talk as though the private shareholders somehow end up ahead.

    A couple of months ago, AIG was valued at $80 billion, the shareholders have now probably lost $60 billion +.

    That has to hurt.

  12. As for the Fed Reserve System – the twelve Federal Reserve Banks spread across the United States are “owned” by the country’s private banks. The private banks have to invest a set percentage of assets in Reserve Bank shares. The shares are nontransferable and pay a 6% dividend.

    The Federal banks have cumulative assets of $880 billion and cumulative liabilities of $840 billion. Net assets are therefore a relatively modest $40 billion.

    However most of the “liabilities” are the US notes issued by the Fed and theoretically redeemable.

    Oh the FEd also has $22 billion worth of gold on its balance sheet – valued at US$42 billion an ounce. The market value is – somewhat larger.

    In the event the Fed found itself in a liquidity crisis, it would probably get the Treasury to extend the term on its debt and increase the required shareholding from its member banks, effectively recapitalising itself over a period of years.

  13. And apparently last year AIG was valued at, $170 billion, so its shareholders are out of pocket roughly $150 billion.

  14. One is tempted to think that all the “lost” billions were false billions. They never existed in the first place; not in the sense of being backed by current tangible assets of any kind nor in the sense of representing any real potential for the generation of future assets.

  15. I am having trouble reconciling market forces, socialism, mercantalism and the current crisis. At the same time I am hoping that what is being done will stablise markets, whilst thinking that the market which rewarded individuals handsomely for creating debt, will not expect those same individuals to have any personal responsibility for their actions.

  16. Forget predictions the US economy just flew into a flock of black swan events. The neo-cons just conducted the biggest bank nationalisation in history, the US government just bought the US insurance business sector, the Obama and the democrats sound like republicans and the republicans are playing make believe reformist democrats. OR did are we simply seeing the republican inspired administration just simply loot the US treasury before doing a runner? Go figure? Must be about time for the classic political ploy of a foreign military diversion somewhere. No coincidence that the tipping point came with peak oil a couple of years back so when the first blast of the reality of diminished fossil fuels ripped through the oil markets to a chorus of climate changing weather pattern events that the wheels wobble and fell off. Welcome to the future, chaos and uncertainty from here on in.

  17. I wonder if John’s point about the “reversal of the financialisation of the economy” is what is going on. I remember an ABC Big Ideas dialog by Paul Woolley in February titled “Capital Market Dysfunctionality”. (The pod cast may still be available from the ABC web site.) He stated that currently some 40% of enterprise returns are being absorbed by financial services. Financial services only absorbed 10% of returns 30 years ago and this was probably an appropriate amount for the services provided. Thus, the 40% figure represents some sort of market failure.
    Is the current crisis a collapse of a financial services bubble?
    If so given that the 40% figures is world wide, not just local to the USA capital markets, will we see a contraction of the share of the economic cake going to financial services wind back in other markets as dramatically as they have in the US?

  18. I must read ‘Greenspans Bubbles’ by the sounds of the advertising preamble, although perhaps the preamble sys it all-

    ‘There is a certain sense of deja vu watching US Federal Reserve chairman Ben Bernanke pump more liquidity into the US market to try and keep it afloat.

    In his damning book, Greenspan’s Bubbles, William Fleckenstein accuses his predecessor of blowing two asset bubbles. He says that the subprime mortgage crisis is Greenspan’s legacy.

    “Greenspan bailed out the world’s largest equity bubble with the world’s largest real estate bubble. That combination easily equates to the biggest orgy of speculation and debt creation in the United States (and the world) has ever seen. Unfortunately, Greenspan’s legacy will not just be those two bubbles, their attendant busts, and the trillions of dollars of debt left in their wake. Operation Enduring Bubble – what I call Greenspan’s monetary and interest rate decisions that created the real estate bubble also exacted a heavy toll on the dollar.”

    Greenspan, according to Fleckenstein, routinely suppressed the forces of creative destruction that come with every market. By slashing interest rates and keeping them low for too long, and by pumping in money, he ensured there was a loss of fear which meant that the normal risk reduction response that most business people have to periodic pain never occurred. It left the US swimming in an ocean of debt that has been ratcheting higher.

    According to Fleckenstein, Greenspan couldn’t see the tech bubble because he was mesmerized by the facade of a technology-driven productivity boom, resulting in a continual cheerleading that encouraged others to make wrong-headed economic and investment decisions.

    And, according to Fleckenstein, he championed the technology and financial innovations in the form of derivatives, asset-backed securities, collateralized loan obligations and collateralized mortgage obligations that allowed lending institutions to offer products to people who couldn’t get loans before, providing home owners with more money than they could afford to repay.

    In this book, Greenspan comes across as someone who is absolutely fixated on his economic theories, and completely blind to his mistakes.

    Fleckenstein does not pull his punches. Consider this: “It is oddly ironic that a small group like the Federal Open Market Committee (FOMC), similar to those found at all levels of any former communist regime, would be in charge of the world’s largest and most successful capitalist country – that is the United States of America and its $13 trillion economy. Given that human being are not omniscient – and historically central planning committees have been notoriously prone to error – it’s easy to imagine that such a group would be far more likely to pick the wrong interest rate than they would be to choose the right one to run an economy. Yet, when these central planners decide they’ve chosen the wrong rate, for whatever reason, they use the very same process when selecting a new one. It’s an impossible job but they seem happy to do it.”

    No doubt Greenspan’s supporters will pick the eyes out of this book, and jump on various claims and assertions. Still, the book does give some perspective as we watch Bernanke come to the rescue of entities that took on excessive risk with the US falling further down the dark tunnel into what many predict could be a long and nasty recession.’

  19. If I ever here a white collar whining about welfare ( dependency ) for poor people again, I’ll clobber them on the spot…

  20. SO lets deal with your logic.

    On one hand
    You are upset with computer models that got the real world wrong when trying to simulate risk.

    one the other.
    You believe that climate models do in fact represent the real world, and you want a brand new financial instrument based on computer models to be implemented to cut CO2 emissions.

    So in summary, you are all in favour of one giant mess up, but have no problems with another one in the offing?

    Here is a tip, give Nassim Nicholas Taleb book on Black Swans a read and you might understand why computer models can never represent the real world and will always fail.

  21. Sorry, the unexpected happened and I made a mistake.

    “So in summary, you are against one giant mess up, but have no problems with another one in the offing?

  22. Just a few titbits I have to point out.

    1, Greenspan was never in favour of the fiat currency system that he run, the only person who has been consistent on this issue is Rep. Ron Paul

    2 Fiat currency is political in nature, it is based upon trust, when trust goes the currency eventually goes too.

    3, F May and West was not a Nationalisation in the ture sense,their debt went from being implicitly backed by the Fed, to explicitly backed by the fed.

    4, In 2003 GWB tried to reform May and West.

    In 2006 a certain john McCain, was ringing the alarm bells.

    5, Its ok to so on about new regulation, but what kind of regulation, and what kind of unforeseen consequences might arise?

    6, This whole thing could and should have been avoided with a simple directive given by politicos to the central bankers, when the economy grows make sure that credit growth does not outstrip economic growth.

    7, why did they not give this instruction? could it be that stuffing peoples pockets with cash especially poor peoples pockets is seriously good politics? for both the left and the right?

    8, History does not repeat itself, circumstances are never exactly the same, Historicism is one of the most universal discredited theories of the 20th century. The 1930s crash was a very different thing altogether, except of course it involved banks going bust as well.

  23. It certainly didn’t last long and hot on the heels of HBOS and AIG comes Morgan Stanley-

    MORGAN Stanley, which saw its stock pummeled overnight on worries it may not survive the credit crunch as a broker-dealer, is considering merging with Wachovia, or another commercial bank, according to reports.
    Morgan Stanley chief executive John Mack received a call on Wednesday from Wachovia, the fourth-largest US bank, expressing interest in a deal with the Wall Street investment bank, the New York Times reported on its website, citing sources.

    Morgan Stanley, the second largest US investment bank, is considering other options, as other banks also have expressed interest, the Wall Street Journal reported.

    Both Wachovia and Morgan Stanley declined to comment on whether it was having takeover talks, but said it was doing everything it could to help its stock price.

    “The smartest people at this firm are focused on solutions,” said a company spokeswoman.

    The Wachovia talks are in the early stages and no deal may be completed, according to the reports that cited unidentified sources.

    A number of analysts and investors, though, questioned the wisdom of combining two banks that have been burned by the spreading credit crisis that began with plunging mortgage prices and spread to commercial real estate.

    “Two wrongs don’t make a right,” said James Ellman, a fund manager and president of SeaCliff Capital. “Hasn’t Mr. Market been saying both companies possibly are going to fail? If you put them together, how does that make a better company?”

    I guess the answer to the last question is that-
    “The smartest people at this firm are focused on solutions,”
    No doubt Morgan Stanley people, having watched Lehman Bros staff clear their desks, while some are not allowed to fail, have recognised it’s time to join the latter. There’s a fallacy of composition here somewhere, but I guess when you’re up to your tits in moral hazard it’s time to seek higher moral ground from the Creator.

  24. If you want a government bailout, you have to be “too big to fail.” That is why the smartest people at the firm are looking to merge with anyone, anybody, as fast as possible. Due diligence be damned :-0

  25. Standard & Poor (S&P), one of the crucial members of the ‘financialised economy’, has made a noise (“negative”) about the MacBank on the grounds of its assessment of the MacBank business model.

    S&P had about 10 years time to examine the MacBank business model. They offered their piece of wisdom after the share price halved during the past year. Have these high-charging glorified private sector second-guessers been sound asleep behind the wheel for all this time?

    Nevertheless, ‘the market’ (short-sellers?) still seems to take notice of these second-guessers noise makers. This morning (about 20 minutes before this post), the share price fell by over $6 to just under A$27.

    If there is something ‘wrong’ with the MacBank business model then this should come out in the wash through the ‘root and branch’ review of the regulatory framework of the international financial system. Hopefully such a review leads to the conclusio that S&P and ‘core players’ in the ‘financialised economy’ have unhelpful business models.

    Disclosure: I have NO financial interest in the MacBank and I am not associated with any of its employees.

  26. AIG wasn’t “too big to fail” it was “too critical to be allowed to fail”.

    AIG “inusred” $300 billion worth of European bank loans – guaranteeing thre lender agaisnt any default.

    This was sheer economic engineering – it allowed the banks to remove the loans from their balance sheets are therefore loan more.

    An AIG bankrupcy would have resulted in credit down grades for many of those banks and could have caused another wave of defaults and forced sales.

  27. #33 That’s true but it just raises again the question of how the authorities could allow an essentially unregulate firm such a critical role in the system. In particular, why were regulated banks allowed to fiddle their books in this way?

  28. ahh McCain, you’ve done it again.
    McCain Embraces Regulation After Many Years of Opposition

    …Three years earlier, McCain had joined with other Republicans to push through landmark legislation sponsored by then-Sen. Phil Gramm (Tex.), who is now an economic adviser to his campaign. The Gramm-Leach-Bliley Act aimed to make the country’s financial institutions competitive by removing the Depression-era walls between banking, investment and insurance companies.

    That bill allowed AIG to participate in the gold rush of a rapidly expanding global banking and investment market. But the legislation also helped pave the way for companies such as AIG and Lehman Brothers to become behemoths laden with bad loans and investments.

    McCain now condemns the executives at those companies for pursuing the ambitions that the Gramm-Leach-Bliley Act made possible, saying that “in an endless quest for easy money, they dreamed up investment schemes that they themselves don’t even understand.” …

    so the guy with his name on the law is McCain’s economic advisor. he’s the same guy who recently called Americans ‘whiners’ for not thinking the economy was doing fine.

  29. JQ – the whole Basel II architecture which essentially let banks write their own prudential guidelines (sorry “risk management models”) needs to be revisited.

  30. The think with the Gramm=Leach-Bliley Act is that the barriers between different areas of finance never really applied in the other major capitalist economies (hence the European Bancassurance giants).

    It’s tempting now in retrospect to say the fundamental thrust of the bill was wrong – but other major economies have operated on that basis for decades.

    Clearly something went badly wrong – but simply blaming Gramm (tempting as it is to lefties like me) doesn’t really help us understand exactly what went wrong and how to fix it.

  31. Sept. 16 (Bloomberg) — Merrill Lynch & Co. Chief Executive Officer John Thain and trading-division head Thomas Montag may reap payouts totaling more than $47 million if they leave or are given lesser roles after Bank of America Corp. buys the firm.

    Montag, who joined in August and is a former colleague of Thain’s from Goldman Sachs Group Inc., would get $30 million in accelerated stock awards and at least $6.4 million in options if he’s dismissed or his duties are diminished after a change of control, Crystal said.

    36 million dollars for two months work that involved the failure of the company

    that is what is wrong with this system

  32. so reassuring to learn the system is fundamentally sound, but just needs a bit of tweaking and plucking of bad apples.

    otherwise i would think that a system that periodically boomed and busted, in which clever people made millions and walked away leaving lives ruined, was not a system at all. just a jungle.

    but it seems that only those profiting from the system euphemistically called capitalism are unfussed by periodic convulsions and destruction of savings, so perhaps i won’t take their word for it.

  33. To put a more positive light on the matter.

    The collapse of Lehmans and selling off of Merrill are hugely significant events. They represent the massive reallocation of resources away from failing uses toward more productive uses.

    It clearly demonstrates that no matter how large, entrenched and institution maybe it is suceptible to being annihilated by market forces.

    The cause is the total sum of all the decisions of individual players in the market place trying to get the best deal for themselves.

    These events have happened without any violence, change of government, terrorist attacks, planning committees, government intervention etc..

    In essence, the market, is the great leveler.

    The quicker we liquidate the badly allocated resources the better off we will all be.

  34. Ian Gould says, “Ikonoclast, and in those terms how “realâ€? is the money now being pumped into AIG?”

    That’s a good question and I’m not sure there is an easy answer. This money has or at least arrives with a different kind of backing to the “backing” that the lost billions had in the merry go round pass-the-debt-parcel financial system. However once these new billions are in the system, where do they go and what are they worth? Given the continuing negative reaction of the markets I’d say, “Who knows? and “Not much.”

    And another pundit says I am almost sounding like an Austrian! (Meaning of the “Austrian” Economic School I guess.) LOL. Not quite, but if there is any logic in their system I would be akin to them on those points.

  35. Every day Socialist China becomes more capitalist and capitalist USA becomes more socialist. It’s like the end of Animal Farm. Pigs started looking like men and men started looking like pigs. Puts a new slant on the lipstick on a pig line

    I would suggest a reading of “The Vanity of Human Wishes� by Samuel Johnson. Lines that caught my eye in the first 2 stanzas alone were;

    “How Nations sink, by darling Schemes oppress’d,
    When Vengeance listens to the Fool’s Request.”

    “For Gold his Sword the Hireling Ruffian draws,
    For Gold the hireling Judge distorts the Laws;
    Wealth heap’d on Wealth, nor Truth nor Safety buys,
    The Dangers gather as the Treasures rise.”

    Read the poem at

    Remember, reading good poetry is very economical entertainment and mind improving too!

  36. Being on the ATO email list, it suddenly dawned on me that many of you may be having a lot of trouble working out the value of things at present. Perhaps you sorta know what your thing is worth but need confirmation, or you have a thing and haven’t got a clue what it’s worth right now, then you need to know help is at hand (with appropriate documentation of course)-
    It’s important to remind ourselves that we can always rely on Govt in these troubled and confusing times.

  37. Ernestine. It was just a thought. On a Blog. No offence intended.

    It would be interesting to see if the funds the world banks intend to “save” our economies with are backed by anything at all ?

    If its fiat money then it would be bad money chasing after more bad money .

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