On 16 Sep 2008, AIG had to borrow US$85billion worth of loans from the Federal Reserve as its attempts to obtain loans from other financial institutions and raising cash through stock sales failed.
How could AIG face such liquidity crunch? The answer, is mainly the credit-default swaps that AIG is liable to make payouts for. ("Fed Agrees to Lend A.I.G. $85 Billion to Head Off Crisis", by Edmund L. Andrews, The New York Times, 17 Sep 2008)
What could have been done to avoid such liabilities concerning these Over-The-Counter derivatives? These OTC should not be OTC in the first place. They should be traded in an exchange where the buyers and sellers are the market makers. There should not be brokers in the market acting as the market-makers. Yes it might reduce the potential trading liquidity for these OTC swaps, but there will be reduced risk as brokers do not have to take an extended position for 1 side of the OTC swaps.
Brokers if they are market-makers of OTC swaps, could be in AIG shoes, taking on too much of 1 position that would cause huge liabilities to themselves. These liabilities would become too much to bear that a crisis would occur.
The present scenario would be for the Securities Exchange Commission to take an immediate stance and create an exchange for derivative instruments that have been trading as OTC. This would reduce counterparty risk for buyers and sellers as they would be dealing with themselves. Should they deal with just 1 financial institution, they would face the default risk of the financial institution, aka AIG in this case.
Wednesday, September 17, 2008
More challenges ahead
During these last few days, the US financial market was in turmoil again.
15th Sep 2008, Monday, saw fall of 2 world-reknown financial institutions. The 101 year old Merrill Lynch announced it was being bought over by Bank of America and the 164 year old Lehman Brothers Holdings Inc formally filed Chapter 11, declaration of bankruptcy. ("Lehman Files for Bankruptcy; Merrill Is Sold" by Andrew Ross Sorkin, The New York Times, 14 Sep 2008)
16 Sep 2008, Tuesday, AIG announced it was receiving US$85 billion worth of loans from the Federal Reserve as it could not raise the amount in the capital markets. It was facing rating downgrades from Moodys and Standard & Poor due to its falling stock price. With its stock price losing 94% of its value, it could not raise the cash needed through a sale of stock. ("Fed in an $85 Billion Rescue of an Insurer Near Failure" by Edmund L. Andrews, The New York Times, 17 Sep 2008)
What does this show about the financial situation in the US now, petaining to the subprime crisis incident. As I had mentioned previously in my previous post, "Possible Spillover of Sub-prime Mortgage Crisis" on 2 Sep 2007, it seems that situation 2 is being acted out in the financial market:
15th Sep 2008, Monday, saw fall of 2 world-reknown financial institutions. The 101 year old Merrill Lynch announced it was being bought over by Bank of America and the 164 year old Lehman Brothers Holdings Inc formally filed Chapter 11, declaration of bankruptcy. ("Lehman Files for Bankruptcy; Merrill Is Sold" by Andrew Ross Sorkin, The New York Times, 14 Sep 2008)
16 Sep 2008, Tuesday, AIG announced it was receiving US$85 billion worth of loans from the Federal Reserve as it could not raise the amount in the capital markets. It was facing rating downgrades from Moodys and Standard & Poor due to its falling stock price. With its stock price losing 94% of its value, it could not raise the cash needed through a sale of stock. ("Fed in an $85 Billion Rescue of an Insurer Near Failure" by Edmund L. Andrews, The New York Times, 17 Sep 2008)
What does this show about the financial situation in the US now, petaining to the subprime crisis incident. As I had mentioned previously in my previous post, "Possible Spillover of Sub-prime Mortgage Crisis" on 2 Sep 2007, it seems that situation 2 is being acted out in the financial market:
"2) Subprime Crisis > Mortgage borrowers fail to pay up > CDOs worthless > Balance sheets of financial institutions get impacted (depending on impact, some may close, others face a huge profit write off) > Markets may get shocked > Investors seek liquidity > Pull of from markets > Markets fall, herd behaviour occurs > Market falls further > Investors lose confidence > Govts step in > Stability may occur slow or fast depending on the speed and actions taken by govts."
The Federal Reserve and the US Treasury have been quick to enter the financial market and make the critical decision on which companies to help and which companies should not be. It will be years of discussion on whether the actions of the 2 have been proper and just. But at the present moment in time, the fire has not been put out.
The financial market is still in turmoil. With the folding of Merrill Lynch and Lehman Brothers; the falling share prices of AIG and various other companies, financial institutions and other companies which are holding these stocks in their portfolio will be facing unrealized revaluation losses. Being the month of Sep, companies are reporting their earnings for the earlier quarter. However, as the failures of Lehman Brothers, Merrill Lynch and AIG are occurring in the month of Sep, the financial results being reported for the quarter should be considered as over-valuing the company at this point in time.
It means that the financial reports are too historical, even though they are being mark-to-market. Companies should provide interim financial results that indicate the impact of Merrill Lynch, Lehman Brothers and AIG. At least investors would be well informed as to the contagion effect and this should prevent another shock to the market when another quarterly reporting occurs.
Thursday, September 11, 2008
Shareholders' Woes
The infamous phase of the year if not for years or decades, "If you’ve got a bazooka and people know you’ve got it, you may not have to take it out.” ("As Crisis Grew, a Few Options Shrank to One" by Charles Duhigg, Stephen Labaton and Andrew Ross Sorkin, 07 Sep 2008, New York Times) In the end, he still had to use it. Who is he? Treasury Secretary Henry M. Paulson Jr. is him.
At the time of implementation of the bazooka, which is simply to give officials the power to inject billions of dollars into the Freddie Mac and Fannie Mae through investments and loans("Scramble Led to Rescue Plan on Mortgages", Stephen Labaton, 15 Jul 2008, New York Times), Treasury Secretary Paulson only wanted an instrument to calm the market. He was able to calm the markets with the bazooka. But it was only for a short duration.
The market became even more jittery after that, which can be seen from the stock prices of Fannie Mae and Freddie Mac. With each passing day, the market was worried. Should the bazooka be used, who would be the ones affected? Would it be the shareholders, bondholders or both? What would be the repercussion for any of them?
Shareholders would lose the worth of the shares. Bondholders would lose not only their interest paydowns but their principals as well. But who is the group that the Treasury Department is willing to bear the losses? The shareholders or the bondholders? Note that most bondholders are foreign central banks, financial institutions and others ("In Rescue to Stabilize Lending, U.S. Takes Over Mortgage Finance Titans", Stephen Labaton and Edmund L. Andrews, 7 Sep 2008, New York Times) and if the bonds are defaulted, it would mean that the US has defaulted payments. No country would want this, not especially the United States of America. As such, the only logical group to bear the cost would be the shareholders.
Finally the bazooka was fired. Mainly due to Freddic Mac being unable to rise the USD5.5billion which was needed. Fannie Mae was considered as being too close with Freddie Mac and since Freddie needed help, Fannie should be helped too. ("As Crisis Grew, a Few Options Shrank to One" by Charles Duhigg, Stephen Labaton and Andrew Ross Sorkin, 07 Sep 2008, New York Times)
However, with shareholders bearing the blunt of this explosion. One will begin to wonder who are the shareholders of these GSEs? Are they the financial institutions who are facing the sub-prime crisis, like Citigroup, Lehman Brothers, Morgan Stanleyand UBS just to name a few. If the closing stock price of Fannie and Freddie being USD 0.99 and USD 0.8834 respectively as of 09 Sep 2008, what would this mean to the books of these financial institutions who are holders of these 2 GSEs? Surely, there is a need to mark-to-market. Further losses from financial institutions can be expected due to this conservatorship done by the Treasury Department.
There is one consolation prize from all of this. The market seems to be reacting well to the usage of the bazooka with the Dow Jones and Nasdaq rising. However, only time will tell if this is just a short term bullrun based on feel good sentiment from the bazooka.
At the time of implementation of the bazooka, which is simply to give officials the power to inject billions of dollars into the Freddie Mac and Fannie Mae through investments and loans("Scramble Led to Rescue Plan on Mortgages", Stephen Labaton, 15 Jul 2008, New York Times), Treasury Secretary Paulson only wanted an instrument to calm the market. He was able to calm the markets with the bazooka. But it was only for a short duration.
The market became even more jittery after that, which can be seen from the stock prices of Fannie Mae and Freddie Mac. With each passing day, the market was worried. Should the bazooka be used, who would be the ones affected? Would it be the shareholders, bondholders or both? What would be the repercussion for any of them?
Shareholders would lose the worth of the shares. Bondholders would lose not only their interest paydowns but their principals as well. But who is the group that the Treasury Department is willing to bear the losses? The shareholders or the bondholders? Note that most bondholders are foreign central banks, financial institutions and others ("In Rescue to Stabilize Lending, U.S. Takes Over Mortgage Finance Titans", Stephen Labaton and Edmund L. Andrews, 7 Sep 2008, New York Times) and if the bonds are defaulted, it would mean that the US has defaulted payments. No country would want this, not especially the United States of America. As such, the only logical group to bear the cost would be the shareholders.
Finally the bazooka was fired. Mainly due to Freddic Mac being unable to rise the USD5.5billion which was needed. Fannie Mae was considered as being too close with Freddie Mac and since Freddie needed help, Fannie should be helped too. ("As Crisis Grew, a Few Options Shrank to One" by Charles Duhigg, Stephen Labaton and Andrew Ross Sorkin, 07 Sep 2008, New York Times)
However, with shareholders bearing the blunt of this explosion. One will begin to wonder who are the shareholders of these GSEs? Are they the financial institutions who are facing the sub-prime crisis, like Citigroup, Lehman Brothers, Morgan Stanleyand UBS just to name a few. If the closing stock price of Fannie and Freddie being USD 0.99 and USD 0.8834 respectively as of 09 Sep 2008, what would this mean to the books of these financial institutions who are holders of these 2 GSEs? Surely, there is a need to mark-to-market. Further losses from financial institutions can be expected due to this conservatorship done by the Treasury Department.
There is one consolation prize from all of this. The market seems to be reacting well to the usage of the bazooka with the Dow Jones and Nasdaq rising. However, only time will tell if this is just a short term bullrun based on feel good sentiment from the bazooka.
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