David R. Kotok co-founded Cumberland Advisors in 1973 and has been its Chief Investment Officer since inception. He holds a B.S. in Economics from The Wharton School of the University of Pennsylvania, an M.S. in Organizational Dynamics from The School of Arts and Sciences at the University of Pennsylvania, and a Masters in Philosophy from the University of Pennsylvania. Mr. Kotok’s articles and financial market commentary have appeared in The New York Times, The Wall Street Journal, Barron’s, and other publications. He is a frequent contributor to CNBC programs. Mr. Kotok is also a member of the National Business Economics Issues Council (NBEIC), the National Association for Business Economics (NABE), the Philadelphia Council for Business Economics (PCBE), and the Philadelphia Financial Economists Group (PFEG).

~~~~~

AIG: What It Means?
March 2, 2009

The news on AIG of additional federal funds and a change in the structure of the preferred stock and its implications have rattled the securities markets. We are scheduled to discuss this tonight on National Public Radio (NPR), “All Things Considered” and on CNBC in the 8:10 p.m. segment and, subsequently, in the 8:45 p.m. segment.

It appears that the change in terms of the federal support for AIG were triggered by requirements that the “AAA” rating be maintained on AIG’s counterparty risk-based instruments. The policy behind this federal support seems clearly focused on avoiding a second Lehman-type failure and, subsequent, market meltdown. The devastation caused by Lehman’s failure was in the counterparty risk arena. This is the complex structure in which opposing parties of derivative instruments are dependent upon the credit worthiness of each other. If the instrument requires a “AAA” credit rating, loss of the credit rating can become an element of default.

Whether we like it or not, America’s federal policy is now driven by the need to avoid another “Lehman.” Thus, we see increasing federal monies applied to support AIG. And, we see this elsewhere as my colleague, Bob Eisenbeis, noted about Citi in his comments today.

We can spend hours debating whether or not this is a good or bad policy. We can spend more time arguing about whether or not Countrywide should have been permitted to fail rather than to be saved via a merger. We could examine the decisions about Bear Stearns or Fannie Mae or others. Those are the exercises that will occupy historians and academics for the next several decades. But those are not the relevant questions for portfolio managers today.

The decisions made today and tomorrow come down to a very fundamental question. Will, (1) massive federal intervention like preferreds and equity ownership, (2) huge expansion of the Federal Reserve’s balance sheet, (3) trillions of federal contingent guarantees combine to avoid a deflationary prolonged depression?

History says the answer is yes. There are no limits to the amount of federal credit that can be extended in support of this new policy. The Federal government is now committed to do whatever it takes, in whatever amount is necessary and with whatever tools are needed. If you believe as I do, that the economy will find some bottoming in 2009 or early 2010, then one has to view the future risk several years from now as inflation, not deflation.

For today, inflation is not the risk, deflation is the threat and enormous new federal credit is the weapon used to confront it. That’s what the AIG bailout is all about.

Category: Bailouts, BP Cafe, Derivatives

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

19 Responses to “AIG: What It Means?”

  1. johnhaskell says:

    people get paid for this?

    “Hey guys, policy is being driven by fear of another Lehman. Look out for deflation near term, inflation long term. Eat more fruits and vegetables. Exercise caution as items may have shifted during flight.”

  2. or, differently, AIG is a direct conduit from the UST to (AIG’s) their derivative counter-parties, and noone, who has the grease on their hands, dare ruin that bountiful daisy-chain..

    DK,

    try that on the NPR crowd, the reality-shock might do them some good, or, at least, one can hope that it would.

  3. ClarkAspen says:

    Why is it that statements like “[t]here are no limits to the amount of federal credit that can be extended in support of this new policy ” scare the bejeezus out of me?

  4. GeorgeNYC says:

    “History says the answer is yes.”

    What history? Is there a time period when such policies actually succeeded? Or is the “history” you are talking about is the analysis of what “should have been done” to stop some prior recession? That is just second-guessing. That is not “history.” Of course this does not mean that such analysis is not important. Just that it is not “history” proving anything.

    The question is what is going to happen when the government intervenes in the market and exchanges private debt for public obligations. What happens? I mean, does this encourage new investment? Does this keep productive capacity operating in the market?

    This whole “inflation/deflation” argument seems just so facile. The government pumps up the money supply and we get inflation! Therefore if we are facing deflation, just pump up the money supply!

    Wow. It is just so easy! I think not.

    What exactly are we “saving” by keeping these organizations going? What exactly are we “guaranteeing?”

    It strikes me that at some point all of this was linked to the real world. I am sure when most of these instruments were created there was a tangible risk or “insurable interest”. However, at some point these instruments became just pure bets. However, unlike casino there were no limits. Although it frankly seems more like the casinos started playing the games themselves.

    It would be as if three of us started a “market” making bets between ourselves. We each bet $10 million and then $10 billion and then $10 trillion. We start borrowing money from real people based on the “assets” created by these “bets.” Then one of us goes under and the government says that it will bail us out. Suddenly, out of nothing, we are worth $10 trillion!

    I doubt it is so simple but there is something fundamentally awry here. People do not lose this kind of money betting on real events. This kind of money is lost based upon fiction.

  5. formershrink says:

    One big problem nowadays is that pieces like this one are thought to be explanations. Mr. Kotok’s explanation is two steps above “because:” it’s because of systemic risk because of derivatives. I realize that he dumbed this down for NPR but I’m getting very frustrated that nobody, and certainly not Geithner or Obama, ever goes into any more depth than that. I want to learn about who the counterparties are and what the amounts are. How many are foreign banks? What are the dynamics of the dreaded systemic meltdown? Are there other ways to minimize the risk of it? And, most of all, why does it seem to be all-or-nothing? Is there no alternative to spending gazillions to make the counterparties whole, or having meltdown and depression?

    Sorry, but this is “bailout for dummies.”

  6. Lunch Meat says:

    Yeah, yeah, yeah. Me I’m expecting at least a bit more of what we’ve already seen from bailout bums.

  7. @ClarkAspen Says:March 2nd, 2009 at 4:50 pm

    Why is it that statements like “[t]here are no limits to the amount of federal credit that can be extended in support of this new policy ” scare the bejeezus out of me?

    It shouldn’t. It’s been like that since they closed the gold window in the ’70′s which would probably make it the majority of the adult lifetimes of anybody reading this blog.

    I’ve been saying for years that they have always had this tool at their disposal. They just haven’t chosen to use it. THAT is why I call Bernanke the emperor. It is at his discretion as to whether the economy lives or dies because he controls the money flow in and out of the economy. That is the number one reason I dislike central banking. Your life is rich or poor based on the whim of the one at the Fed helm and God help us if a sadist is chosen for the job some day.

    *As long as* people still have the confidence in the dollars being printed the economy is at the whim of the members that control monetary policy at the federal reserve. If people decide that dollars are no longer worth their goods and labor then the game changes. Until then Bernanke is your defacto emperor. That is also why the media seldom mentions this. They seldom bite the hand that feeds

  8. larry says:

    Don’t remember the source, but AIG will continue to be bailed out not only because it’s another Lehman, but because its failure will directly lead to the collapse of Western European banks.

    For the bailouts of Fannie, Freddie, AIG and Citi, there’s a significant foreign policy component to it.

  9. d4winds says:

    re, “Whether we like it or not, America’s federal policy is now driven by the need to avoid another “Lehman.’ ”

    That is the current problem. Allowing Lehman to fail was the first–only–policy success in this crisis. The policy fiasco with Lehman was leading markets to believe that there would be a bail-out. For that reason, counterparties and Lehman debt holders did not appropriately protect themselves over the 6 month period of the unfolding, obviously upcoming bankruptcy by backing out of deals and writing down debt values over time to expected recovery levels.

    The second fiasco was the rescue of AIG and again leading markets and management to believe a bail-out might be forthcoming, even for a company like AIG which created a massive insurance fraud with its uncollateralized CDS book. This case was especially odious. Over a weekend, the AIG board rejected a private buy-out for $40bn, expecting a better deal from Paulson even though their credit would down-graded on Mon. The down-grade took place, bumping collateral requirements so that now AIG needed $80bn to stay afloat, not $40bn. They got it from Paulson on that Tuesday. So, AIG effectively black-mailed the US Treasury. Note that again there was nothing unexpected about AIG’s financial condition, since it had been widely assessed for 6 months. The markets got the memo: moral hazard is good if it’s big enough–the bigger the better; black-mail is the best policy.

    Now we have a vicious cycle of bail-outs reinforcing expectations of further bail-outs, thus increasing the perceived cost of not bailing out, and increasing yet further the fear level. The only gainers are the bonus pool/deferred comp. recipients, current management and boards, debtholders/stockholders of the failed institutions, and the counterparties whose incompetence in dealing with an insolvent enterprise has been fully underwritten by the USG.

  10. How the Common Man Sees It Says:

    “*As long as* people still have the confidence in the dollars being printed the economy is at the whim of the members that control monetary policy at the federal reserve. If people decide that dollars are no longer worth their goods and labor then the game changes. Until then Bernanke is your defacto emperor. That is also why the media seldom mentions this. They seldom bite the hand that feeds..”

    yes, the true beauty, so neatly distilled, of our, long-running, current scene.

    that we are complicit in our own capitivity is a Reality that puts pale any comparison to any stories we’ve heard of the Stockholm variety..

    HTCMSI,

    I only wish that your nom de Blog was, in fact, descriptive of the common weal..

    til’ then,

  11. Greg0658 says:

    “since they closed the gold window in the ’70’s ….. the number one reason I dislike central banking ….. Your life is rich or poor based on the whim of the one at the Fed helm and God help us if a sadist”

    lighten up on the sadist angle .. all it takes is an insider protecting his kind .. which is why we have central bankers to protect his country (I thought)(before globalization I guess)

    On gold .. a gold standard replaces the central banker with miners being in control (with slave labor most likely) …. I was getting caught up on newspapers yesterday (I spend alot of time reading yo’all) (I like the interactivity) and saw a full page ad a couple times .. the headline “buy gold get a free safe to put it in” .. made me think of the confiscation days and how safe are we from any which way

    and from Kotoks remarks “History says the answer is yes. There are no limits to the amount of federal credit that can be extended” …. when we must pay property taxes and are disallowed to run a yard like a farm and barter for external needs that mankind has invented to make our lives finer / easier / more productive .. then yes we are slaves to the currency and the bankers running it (by design – some people just hated the plow 1000s of years ago)

  12. Greg0658 says:

    before yo’all make me .. the banker pushin (pullin) plow slam … I take it back abit
    someone has to collect taxes to pay armies to protect the farm from the neighbors who over populated or just don’t have it as nice on their side of the fence

  13. VangelV says:

    “For today, inflation is not the risk, deflation is the threat and enormous new federal credit is the weapon used to confront it. That’s what the AIG bailout is all about.”

    What we have is a collapse in confidence and a massive bout of deleveraging even as the central banks are flooding the system with liquidity. Most paper currencies are already in big trouble and once the Yen and USD carry trades are done both currencies will be heading down. What AIG means is that if you want to protect your assets you better own real gold, silver, agricultural commodities and energy. While all could have trouble in the short term there is little doubt that a year or two down the road we will be looking at much higher prices.

  14. Greg0658 says:

    to the big guy and the kid on CNBC this moment in time … I yelled at the screen and changed the channel
    “we are trying to claw back our jobs not protect the dollar to no end” on the stimulus package filled with building America back up and the world ain’t gonna go for buying bonds on that premise .. like whats been going down for 8+ years .. ya he’s probably right .. F**k bread and butter jobs but ya gotta fund the army .. thats your new roll for the world America (man we’re slow at gettin some things) (must be the drugs) (and the tv) (cue Garth as Chris Gaines “Right Now”)

  15. Greg0658 says:

    a story I grew up with …

    “The Illinois knew that in order to survive they had to leave the area. They decided to seek refuge on top of the rock. They climbed up to the summit of the rock hoping that the Potawatomi and Fox would by-pass them on their way southward. Unfortunately, the plan backfired and the Potawatomi and Fox surrounded the base. As the Illinois tried to get water by lowering buckets with rope the Potawatomi and Fox would cut the ropes or shatter the buckets with their arrows. They also climbed up on top of Devil’s Nose and showered them with arrows. As the Illinois grew more desperate, some tried sneaking down, but they were murdered. The rest that were left on top starved.”

    the rest of the story:
    http://jove.geol.niu.edu/faculty/fischer/429_info/429trips/starvedrock/history.html

    the spot:
    http://maps.google.com/maps?f=q&source=s_q&hl=en&geocode=&q=starved+rock+utica+il&sll=37.0625,-95.677068&sspn=33.435463,56.25&ie=UTF8&ll=41.322234,-88.99209&spn=0.01547,0.027466&t=p&z=15

  16. @Mark E Hoffer Says:March 3rd, 2009 at 6:38 am

    I only wish that your nom de Blog was, in fact, descriptive of the common weal..

    Maybe I should change my name to how a common man sees it. :)

    I’m lucky (if you could call it luck), finance/economics is a hobby that I like to do. I’ve always been interested in numbers and it turns out that I can also use it to make some money in investments. From that perspective I suppose I’m not a common man. My life was destined for normalcy until it took a quirky turn and forced me into the school of hard knocks from whence I derive my common manness. That is why I have my nose so firmly stuck in economics. I see that as the light at the end of this weary laborer’s tunnel

    @Greg0658 Says: March 3rd, 2009 at 8:15 am

    On gold .. a gold standard replaces the central banker with miners being in control (with slave labor most likely) ….

    That is a pretty common argument but it is a misconception IMO. Gold miners could never produce enough gold to do to Zimbabwe what Mugabe did. Their contribution to total world gold stock is only something like 1% or 2% per year and they would be hard pressed to duplicate the 5% to 14% growth in the money stock that the Fed has produced leading up to the crisis. Also, there would be no putting a trillion dollars in gold on the balance sheet at the fed’s whim.

    I also am not arguing for a gold standard though that would probably be the most stable monetary situation in my mind. I see the fatal flaw and weak link in the banking system being it’s fractional reserve nature and the banker’s ability to lend money into existence. That is the area that is creating the booms and busts in my opinion

  17. bdg123 says:

    “History says the answer is yes” Huh? What history is that? Please do tell. Using Japan as a historical example is a high and center fastball and my swing is pretty accurate. Indeed, history does not say yes. Not only that but the answer doesn’t require history. It can easily be explained by a sound understanding of monetary economics. The answer is more clearly no. The Fed is simply transferring risk. That in itself will never work. In fact, that policy without a major change in economic policy will indeed contribute to a lengthy deflation.

    Your thesis that the government’s balance sheet is limitless is preposterous. You are citing “theoretical” limits without a seeming understanding that reality is substantially less than a theoretical limit. Anything and everything could be theoretically limitless. Including my ability to spend if American Express will only keep extending my credit limit. I’d be more than happy to oblige were they willing to do so. I hope you know what those “reality” limits are. Were this not the case, we could just let the government run the economy. Oh, I forgot. That’s exactly what caused this crisis.

  18. Greg0658 says:

    Mark “could never produce enough gold to do to Zimbabwe what Mugabe did” … but could he store a proper equivalent gold standard in his safe against the armies of the world? With tusk tipped spears? :-|

  19. HTCMSI,

    as you already know, when you’re keeping “your nose to the grindstone”, you need “eyes in the back of your head” ~~

    Greg,

    this, with which I agree,: “Gold miners could never produce enough gold to do to Zimbabwe what Mugabe did. Their contribution to total world gold stock is only something like 1% or 2% per year and they would be hard pressed to duplicate the 5% to 14% growth in the money stock that the Fed has produced leading up to the crisis. Also, there would be no putting a trillion dollars in gold on the balance sheet at the fed’s whim.” –was from HTCMSI, above..

    though, those tusk-tipped spears might rile up the WWF, and with the attention they can bring to the fore, maybe some understanding of Zimbabwe’s true plight could be had..

    http://www.worldwildlife.org/