Our little market battled bravely yesterday to recoup half its losses by the close, but New York is where the action is, and it's a subprime steeplechase over there: the hessian screen has gone up around Lehman Brothers, Merrill Lynch has been scratched and led back to the serving barn, and for American International Group, the water jump looms.
This crisis has been consistently surprising for the size of the problems it has thrown up but, on any standard, AIG is a python-choker, and the attempt to rescue it a hugely important moment.
It's facing losses of tens of billions of dollars on complicated derivatives that it created during the market boom after having its debt ratings downgraded on Monday night by the three main credit ratings agencies, and its boasts the debt crisis trifecta: awesome size, with assets of more than $US1 trillion ($1.3 billion) that have not been marked to market value (US insurance groups aren't required to, unlike the US banks) awesome complexity (it began diversifying away from vanilla life and general insurance in the mid-'60s and now has major exposure to two of the markets at the heart of this crisis, credit default swaps and mortgages) and a mainline connection into the arteries of the US economy.
It is the world's largest insurer by premium income, with a franchise that includes the best China exposure owns the world's biggest aircraft leasing company with a fleet worth almost $US50 billion is a crucial debt market insurer and is a significant US general insurer, with major market share in workers compensation and car insurance.
There is next to no chance that it can survive in its present form the challenge is to give it the time it needs to break itself up.
After allowing Lehman to go to the wall, the US Treasury Secretary, Hank Paulson, has effectively declared that US taxpayer money will not be used to save AIG and the US Federal Reserve has rejected AIG's request for $US40 billion of bridging funding.
AIG is headquartered in New York, and insurance regulators in that state have agreed to turn a blind eye while AIG swings capital up from subsidiaries into the head company, providing a $US20 billion buffer.
But three-quarters of that will go straight out into what are affectively margin call payments on its credit default exposure, following the credit rating downgrade.
Disturbingly, it appears to have assets on the books at unrealistic prices: The New York Times reported yesterday that, at June 30, AIG had $US20 billion of subprime mortgages marked at 69c in the dollar and $US24 billion in Alt-A mortgages (the next step up from subprime), valued at 67c in the dollar. Days before its holding company filed for bankruptcy on Monday, Lehman told its shareholders that it was valuing similar subprime and Alt-A exposure at 34c and 29c in the dollar respectively. The gap between AIG's valuations and Lehman's is worth almost $US14 billion to AIG, and collateralised debt obligation (CDO) assets that AIG values at $US58 billion are also being queried.
There's some great businesses inside AIG. Insurers like Axa would love to get their hands on the group's China franchise, for example, QBE would look at reinsurance, and the aircraft leasing business is already being dressed up for auction. The immediate challenge, however, is to keep AIG alive long enough for an orderly auction to occur.
One possibility is that the funding AIG sought from the Fed might still find its way to the insurer indirectly. AIG's petition to the Fed was rank desperation, because it does not regulate insurers, and cannot fund them.
But banks that do have access to the Fed could raise the dough and pass it on to AIG, and there were unconfirmed reports yesterday that JP Morgan and Goldman Sachs, which was due to announce its latest earnings last night, could swing $US75 billion across.
Where this leads in the short term is anyone's guess, frankly. Citigroup told its clients in the US yesterday that it expected the US Fed to cut its key interest rate by half a percentage point overnight, and said its own financial defences were solid - but acknowledged also that the end-game for the markets was unclear.
Goldman Sachs told its clients that it expected zero economic growth in the US over the next 12 months as the credit crisis and housing market slump weighed on demand.
But Goldman also said it was "actively considering a potential higher allocation to equities given what we believe may be a reasonable risk/reward profile for clients with a long time horizon". An interesting development, given Goldman has so far distinguished itself in this debacle as the investment bank that sold earliest and thus limited the damage.
Our market did better than expected, climbing from a 132.2-point loss at one stage to be only 66.9 points, or 1.4 per cent, down. The recovery was centred on the resources sector, and reflected the fact commodity-exposed shares were a safe haven in a stormy sea, particularly after China on Monday responded to slowing growth by cutting interest rates by 0.27 per cent - the first rate cut since 2002 - and expanding bank lending quotas.
The glass half-full view, reflected in yesterday's fall in the oil price below $US100 a barrel for the first time in six months to $US95.71(34 per cent below its July high of $US145.29), is that a shock of the magnitude that markets are absorbing must also shock global growth. Beijing's pump-priming will therefore not be totally successful - and resource shares are consequently not immune.
Frequently Asked Questions about this Article…
What exactly is happening with AIG and why should everyday investors care?
AIG is facing tens of billions of dollars of losses tied to complex derivatives and mortgage exposures after being downgraded by the three main credit ratings agencies. Because it is one of the world’s biggest insurers with more than US$1 trillion of reported assets and deep links into credit markets, trouble at AIG can ripple through banks, markets and the broader economy — which matters to everyday investors watching portfolio values and market stability.
Why can’t AIG survive in its present form according to the article?
The article says AIG’s combination of huge size, complex businesses (including big exposure to credit default swaps and mortgages) and questionable asset valuations make it unlikely to survive unchanged. Rating downgrades have triggered margin calls and funding pressures that the company can’t absorb without being restructured or broken up.
What rescue options were being discussed for AIG and who might provide funding?
The piece notes the US Treasury (Hank Paulson) effectively ruled out direct taxpayer bailouts and the Federal Reserve rejected a US$40 billion bridging request. New York insurance regulators allowed AIG to move about US$20 billion of capital from subsidiaries to the parent, but most of that would cover margin calls. The article also mentions the possibility that banks with Fed access could raise funds and pass them on to AIG, and that parts of AIG could be sold to insurers or other buyers.
How do AIG’s asset valuations create additional risk?
Reports cited in the article show AIG marked US$20 billion of subprime mortgages at 69 cents on the dollar and US$24 billion of Alt‑A at 67 cents, while Lehman valued similar holdings much lower (around 34c and 29c). That valuation gap — plus questioned CDO assets (about US$58 billion by AIG’s numbers) — suggests AIG may be understating losses, increasing the funding and solvency risk.
Which parts of AIG could still be valuable to buyers and why is that relevant for investors?
The article highlights several attractive pieces inside AIG: a strong China insurance franchise, reinsurance businesses, and a large aircraft‑leasing business being prepared for auction. For investors, orderly sale of these units could preserve value and limit systemic fallout compared with a chaotic collapse.
What short‑term market effects did the article link to the AIG/credit crisis?
The article links the crisis to heightened market uncertainty, expectations of Fed rate cuts (Citigroup expected a 0.5 percentage point cut), and weak near‑term growth forecasts (Goldman expected zero US growth over 12 months). It also notes that some banks might step in to provide funding, which would influence market sentiment and liquidity.
How did this situation affect Australian and commodity‑exposed shares, according to the article?
The article says the local (Australian) market recovered some losses, with the resources sector leading the bounce as commodity‑exposed shares were seen as a relative safe haven. It also points out China’s policy response — a 0.27% rate cut and expanded lending quotas — supported commodity demand, while the oil price fell below US$100 a barrel, showing how global stress can shift sector dynamics at home.
What should everyday investors watch next for updates on AIG and the credit crisis?
Investors should monitor credit rating actions, official moves by the US Treasury and the Federal Reserve, any reports of bank funding or consortium support for AIG, asset revaluations or margin‑call disclosures, and developments on sales or auctions of AIG businesses. Broader indicators to watch include central bank policy moves (including China), oil and commodity prices, and market liquidity signals.
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