Global No-Confidence Vote: Deal Or No Deal Part 2

September 15, 2008...Black Monday...was just the beginning, folks. The Dow may have lost 500 points, but the S&P lost 4.71%, an even worse day on the broader markets. And once again, I cannot stress enough that Lehman Bros. was not the real problem.

It was just one more domino in the chain, one more player in the great game of Deal Or No Deal. Lehman Bros. got No Deal...and the global markets are in freefall as a result.

But today could be worse. Today's Deal or No Deal contestant is the largest insurance company in the world, American International Group or AIG. It's time to play the game.

And AIG is in serious, serious trouble.

American International Group Inc. fell 38 percent in early New York trading after the insurer's credit ratings were cut, threatening efforts to raise funds to keep the company afloat and roiling global financial markets.

S&P lowered AIG's long-term counterparty rating three grades to A- because of ``reduced flexibility in meeting additional collateral needs and concerns over increasing residential mortgage-related losses,'' the rating company said yesterday. Moody's cut AIG's senior unsecured debt two grades to A2. Fitch Ratings lowered its assessment to A from AA-.

The downgrade of AIG is the latest tremor to shake the global financial industry, less than a day after Lehman Brothers Holdings Inc. filed for Chapter 11 bankruptcy protection and Merrill Lynch & Co. sold itself to Bank of America Corp. for about $50 billion. Stock markets from Tokyo to London tumbled as investors weighed the impact of a potential collapse of the largest U.S. insurer by assets.

``There's a systemic risk if AIG isn't saved,'' Benoit de Broissia, an equity analyst at Richelieu Finance in Paris, said in a Bloomberg Television interview. Richelieu has about $6.2 billion under management.

I've been talking about systemic risk in the Global No-Confidence Vote series for months now. Systemic risk is just that: a risk that threatens the entire system. Fannie and Freddie going under was the ultimate systemic risk. The Fed had no choice but to save it. But AIG poses a large systemic risk as well. What do I mean by systemic?

Take a look at the aftermath of Hurricane Ike as an example. Millions of Americans got a harsh lesson in systemic risk this weekend, including myself. Recovery efforts are needed from Houston to Detroit, power outages, gas shortages, food and water interruptions, critical supply problems. Here in the Cincy area there are still hundreds of thousands without power, even with power crews being called in from other states.

Now imagine a hurricane so bad that the entire lower 48 was hit with 75 MPH+ winds that caused damage, power outages, and supply interruptions across the entire country at the same time. All states would need their power crews. All power companies would be facing angry customers. Getting supplies into areas would be nearly impossible because they would be needed everywhere. All Governors would be scrambling for Federal emergency assistance. FEMA would be overloaded.

Supplies of food, water, and gas would dwindle to nothing. There would be no easy way to get supplies back in. Tens of millions of Americans would have to fend for themselves. The system would break down. The threat would be systemic. We would degenerate into riots, martial law, and chaos after only a few weeks. It would take months to get the system back up again...if it was even able to come back up at all.

That is the level of risk an AIG collapse would pose to the entire global financial system. How bad would it be?

This bad.

When Lehman Brothers filed for bankruptcy on Monday, it became the latest but surely not the last victim of the subprime mortgage collapse. Lehman owned more than $600 billion in assets. Financial institutions around the world have already reported more than half a trillion dollars of mortgage-related losses and that figure will most likely double or triple before the crisis exhausts itself.

But there is a bigger potential failure lurking: the American International Group, the insurance giant. It poses a much larger threat to the financial system than Lehman Brothers ever did because it plays an integral role in several key markets: credit derivatives, mortgages, corporate loans and hedge funds.

Late Monday, A.I.G. was downgraded by the major credit rating agencies (which inexplicably still retain an enormous amount of power in the marketplace despite having gutted their credibility with unreliable ratings for mortgage-backed securities during the housing boom). This credit downgrade could require A.I.G. to post billions of dollars of additional collateral for its mortgage derivative contracts.

Fat chance. That's collateral A.I.G. does not have. There is therefore a substantial possibility that A.I.G. will be unable to meet its obligations and be forced into liquidation. A side effect: Its collapse would be as close to an extinction-level event as the financial markets have seen since the Great Depression.

A.I.G. does business with virtually every financial institution in the world. Most important, it is a central player in the unregulated, Brobdingnagian credit default swap market that is reported to be at least $60 trillion in size.

Nobody knows this market's real size, or who owes what to whom, because there is no central clearinghouse or regulator for it. Credit default swaps are a type of credit insurance contract in which one party pays another party to protect it from the risk of default on a particular debt instrument. If that debt instrument (a bond, a bank loan, a mortgage) defaults, the insurer compensates the insured for his loss. The insurer (which could be a bank, an investment bank or a hedge fund) is required to post collateral to support its payment obligation, but in the insane credit environment that preceded the credit crisis, this collateral deposit was generally too small.

As a result, the credit default market is best described as an insurance market where many of the individual trades are undercapitalized. But even worse, many of the insurers are grossly undercapitalized. In one case in the New York courts, the Swiss banking giant UBS is suing a hedge fund that said it would insure nearly $1.5 billion in bonds but was unable to do so. No wonder -- the hedge fund had only $200 million in assets.

If A.I.G. collapsed, its hundreds of billions of dollars of mortgage-related assets would be added to those being sold by other financial institutions. This would just depress values further. The counterparties around the world to A.I.G.'s credit default swaps may be unable to collect on their trades. As a large hedge-fund investor, A.I.G. would suddenly become a large redeemer from hedge funds, forcing fund managers to sell positions and probably driving down prices in the world's financial markets. More failures, particularly of hedge funds, could follow.

Regulators knew that if Lehman went down, the world wouldn't end. But Wall Street isn't remotely prepared for the inestimable damage the financial system would suffer if A.I.G. collapsed.

AIG's collapse could very well be a systemic risk problem...a problem that risks the end of the current global financial system. If there's No Deal, there could be far worse consequences than a 500 point Dow loss.

The real problem is that there are dozens of companies that could be the systemic risk that blows a hole in the entire global financial system. If AIG does survive, there will be another company that's in trouble...and another...and another.

There will eventually be a No Deal large enough to take out the system sooner or later. Either the Fed will draw a line, or they won't have the money to save them. That possibility is looking to be sooner...MUCH sooner.

Even if it's not AIG, there will be more contestants on Deal or No Deal, Wall Street Edition. Many, many more.

Which one will break the global derivative market and with it plunge America and the world into a financial nightmare?

Be prepared.

Cross-posted at the Frog Pond.