Wednesday, September 17, 2008

The Peoples Republic of the U.S. - the AIG Bailout

The 'Helicopter Economics Investing Guide' is meant to help educate people on how to make profitable investing choices in the current economic environment. In addition to the term helicopter economics, we have also coined the term, helicopternomics, to describe the current monetary and fiscal policies of the U.S. government and to update the old-fashioned term wheelbarrow economics.

In a socialist state, the government decides what a company is worth, not the market. The Federal Reserve clearly demonstrated this concept by purchasing almost 80% of the insurance giant AIG on Tuesday night, September 16th. The Fed paid over 10 times what the market said its stake in AIG was worth. It is not clear what U.S. laws allow for the nationalization of part of the insurance industry, nor what companies will be bought next now that this precedent has been set.

The final phase of AIG's death spiral began on Monday evening when the major credit agencies downgraded it. This credit downgrade required AIG to post billions of dollars of additional collateral for its mortgage derivative contracts - capital that AIG simple didn't have. The implications were far more serous than the public realized, since AIG is a central player in the CDS (credit default swaps) market and does business with almost every financial institution in the world. If AIG went under it would have been unable to pay off its CDS obligations and its counter parties would have unable to collect on its trades. It was estimated that a large number of hedge funds, and possibly some banks, would have gone under along with AIG.

Over the weekend AIG attempted to borrow $40 billion form the Federal Reserve. The Fed, originally set up to lend just to commercial banks, had no legal authority to lend to insurance companies. And even though it had extended its lending to broker-dealers in March and to mortgage giants Fannie Mae and Freddie Mac in July, it was reluctant to add insurance companies to the list. Then on Tuesday evening, the Fed (with support from the Treasury and President Bush) decided to extend its legal authority way beyond anything ever intended by agreeing to pump $85 billion into AIG. The media described this $85 billion as a 'loan' even though a 79.9% equity stake in AIG was being given in exchange (note to media: this is a stock purchase, not a loan). This is not for already existing AIG stock, but for newly issued AIG stock, so AIG will have to increase its outstanding amount of stock to five times its current level. This is a better deal for stockholders than usual, since they will be left with something, instead of being completely wiped out.

Based on Tuesday's closing price, AIG had a market cap of just over $10 billion dollars. In order to buy 80% of the company (which was worth $8 billion according to the market), the U.S. paid $85 billion or over 10 times the market price. Socialism leads to just such economic absurdities. Unless this is stopped, expect more of this in the future - and the permanently ruined economy that always follows.

NEXT: The Mega Move Up in Gold and Silver

Daryl Montgomery
Organizer, New York Investing

This posting is editorial opinion. Like all other postings for this blog, there is no intention to endorse the purchase or sale of any security.

No comments: