The Art Of The Deal

Like I alluded to earlier, AIG got a nice little going-away present.

Fearing a financial crisis worldwide, the Federal Reserve reversed course on Tuesday and agreed to an $85 billion bailout that would give the government control of the troubled insurance giant American International Group.

The decision, only two weeks after the Treasury took over the federally chartered mortgage finance companies Fannie Mae and Freddie Mac, is the most radical intervention in private business in the central bank’s history.

With time running out after A.I.G. failed to get a bank loan to avoid bankruptcy, Treasury Secretary Henry M. Paulson Jr. and the Fed chairman, Ben S. Bernanke, convened a meeting with House and Senate leaders on Capitol Hill about 6:30 p.m. Tuesday to explain the rescue plan. They emerged just after 7:30 p.m. with Mr. Paulson and Mr. Bernanke looking grim, but with top lawmakers initially expressing support for the plan. But the bailout is likely to prove controversial, because it effectively puts taxpayer money at risk while protecting bad investments made by A.I.G. and other institutions it does business with.

What frightened Fed and Treasury officials was not simply the prospect of another giant corporate bankruptcy, but A.I.G.’s role as an enormous provider of esoteric financial insurance contracts to investors who bought complex debt securities. They effectively required A.I.G. to cover losses suffered by the buyers in the event the securities defaulted. It meant A.I.G. was potentially on the hook for billions of dollars’ worth of risky securities that were once considered safe.

If A.I.G. had collapsed — and been unable to pay all of its insurance claims — institutional investors around the world would have been instantly forced to reappraise the value of those securities, and that in turn would have reduced their own capital and the value of their own debt. Small investors, including anyone who owned money market funds with A.I.G. securities, could have been hurt, too. And some insurance policy holders were worried, even though they have some protections.

“It would have been a chain reaction,” said Uwe Reinhardt, a professor of economics at Princeton University. “The spillover effects could have been incredible.”

My question is what has fundamentally changed here?

Not much. The underlying cause of the the problem, the housing depression, is still rampant. That hasn't changed, nor has it been even remotely addressed. It will remain with us through at least next year if not well into 2010.

The Fed policy of Too Big To Fail? Hasn't changed at all. Lehman just didn't qualify as systemic enough. You can bet that the next wave of mergers and acquisitions in the financial sector will be hotly contested.

Everyone will want to get to the Too Big Too Fail stage. Everyone in the financial sector will now think they are Too Big To Fail, or be bought out by somebody who thinks they are. That's how the industry works now.

Come to think of it, that's how the airline, auto, and a bunch of other sectors of our economy work now. Everyone's going to try to get to that magical Too Big To Fail level...which means thanks to the wonders of Moral Hazard we will now have companies taking even more risk, not less, than they were before in order to try to make it big. The Fed's actions show you will get a bailout only if your actions are egregious enough to qualify as a systemic risk if you are allowed to fail.

There's no downside now. You'll see this happening across not just the financial industry but all of them. Why not? There's again, no downside to making yourself Too Big To Fail now.

So that's what we'll see. Unless strict new regulations are imposed (and you can bet with both McSame and Obama in the pocket of Wall Street, meaningful new regulations simply will not happen.) we'll continue to be in this mess. The pressure will be there to do something, but we'll hear the same excuses that we're hearing now: "There are already been too much Federal intervention in the markets, less is needed, not more." The GOP surely will say that, including McSame. Obama? He'll be made to get with the program.

Only eventually something systemic will have to go. The Fed is running out of money it can give away. It pumped $155 billion into the financial sector in just the last few days. How long can this keep up?

As long as the Fed can keep printing billions. As long as China and India and the EU decide that the US is Too Big To Fail. As long as the game of Deal Or No Deal comes up with new deals to make and new suckers to exploit.

But when the music stops, the bill that comes due will wreck the country. And the longer we refuse to face it, the worse it will be.

The Fed is hawking T-Bills this morning to raise $85 billion it does not have right now. Once again Asia is paying for our bailout. When they stop buying T-Bills, the game ends.

And the new one begins.