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How AIG's Collapse Began a Global Run on the Banks

Something very strange is occurrence in the financial markets. And I tins fairs you what it is and what it means. If September didn't give you enough to worry about, consider what evidence happen to actuality estate prices as unemployment grows steadily over the next several months. As wrong as things are now, they'll get scads worse.

They'll get worse for the obvious reason: because more clan testament default on their mortgages. But they'll also remain depressed for far longer than anyone expects, for a reason most clan testament never understand.

What follows is one of the real secrets to September's inventory bazaar collapse. Once you understand what really happened vitality month, the events to come testament be much clearer to you...

Every great bull show has similar characteristics. The speculation must - at the onset - start with a reasonably good idea. Using long-term mortgages to salaries for homes is a good idea, with a few important caveats.

Some of these limitations are obvious to any intelligent observer... like the need for a substantial down payment, the proof of income, an independent appraisal, money But human nature dictates that, given enough time and the benefit incentives, any article testament be corrupted. This is one of the two critical elements of a bubble. What was once a good plan becomes a farce. You already know all the stories of how this happened in the housing market, where loans were eventually given without fixed rates, without profits verification, without down payments, and without legitimate appraisals.

As bad as these practices were, they would not have created a global financial scare without the second, more critical element. For things to get really out of control, the farce must evolve further... into fraud.

And this is where AIG comes into the story.

Around the world, mound must comply with what are known as Basel II regulations. These direction determine how much cash a heap must maintain in reserve. The rules are based on the importance of the bank's loan book. The riskier the loans a slope owns, the more capital it must agreement in reserve. Bank managers naturally seek to employ as scads influence as they can, especially when interest rates are low, to maximize profits. AIG appeared to application cashier a way to get around the Basel rules, via unregulated insurance contracts, known as faithfulness default swaps.

Here's how it worked: Say you're a major European bank... You have a surplus of deposits, because in Europe tribe actually still bother to save money. You're looking for something to maximize the expansion between what you must pay for deposits and what you're able to earn lending. You want it to be safe and reliable, but also salaries the highest possible annual interest. You know you could buy a portfolio of high-yielding subprime mortgages. But deed so evidence limit the numbering of leverage you can employ, which testament barrier returns.

So rather than government out having any high-yielding securities in your portfolio, you simply tattoo up the friendly AIG agent you met at a convention in London end year.

"What would it charge me to insure this subprime security?" you inquire. The broker, who is selling a five-year position (but who will be paid a recompense annually), says, "Not too much." After all, the historical loss rates on American mortgages is close to zilch.

Using incredibly sophisticated computer models, he agrees to assurance the subprime security you're buying against default for five age for say, 2% of disguise value.

Although AIG's credit default swaps were really insurance contracts, they weren't regulated. That meant AIG didn't have to put up any funds as collateral on its swaps, as long as it maintained a triple-A trust rating. There was no actuality capital charge to selling these swaps; there was no limit. And respect to what's called "mark-to-market" accounting, AIG could book the yield from a five-year monopoly default swap as soon as the covenant was sold, based on the expected default rate.

Whatever the computer said AIG was likely to make on the deal, the accountants would write down as actual profit. The broker who sold the swap would be paid a gratuities at the end of the first year - long before the actual profit on the compact was made.

With this structure in place, the European bank was able to assure its regulators it was carrying only triple-A credits, instead of a pigtails of subprime "toxic waste." The slope could leverage itself to the full gauges allowable under Basel II. AIG could publication hundreds of millions in "profit" each year, without having to pony up billions in collateral.

It was a fraud. AIG never any funds to back up the insurance it sold. And the incomes it booked never materialized. The default rate on mortgage securities underwritten in 2005, 2006, and 2007 turned out to be multiples higher than expected. And they continue to increase. In some cases, the securities the riverbank claimed were triple A have ended up entity value less than $0.15 on the dollar.

Even so, it all worked for years. Banks leveraged deposits to the hilt. Wall Street packaged and sold dumb mortgages as securities. And AIG sold faithfulness default swaps without bothering to collateralize the risk. An enormous count of funds was created out of thin air and tossed into global actuality nation markets.

On September 15, all of the adult credit-rating method downgraded AIG - the world's largest insurance company. At issue were the soaring casualties in its faithfulness default swaps. The first big writeoff came in the fourth boroughs of 2007, when AIG reported an $11 billion charge. It was able to raise capital once, to repair the damage. But the losses kept growing. The moment the downgrade came, AIG was forced to come up with tens of billions of additional collateral, immediately. This was on top of the billions it owed to its commerce partners. It didn't have the money. The world's largest insurance enterprises was bankrupt.

The dominoes fell over immediately. Lehman Brothers failed on the same day. Merrill was sold to Bank of America. The Fed stepped in and agreed to lend AIG $85 billion to facilitate an orderly sell off of its properties in exchange for essentially all the company's equity.

Most people never understood how AIG was the linchpin to the entire system. And there's one more mystery yet to come out...

AIG's largest commerce partner wasn't a nameless European bank. It was Goldman Sachs.

I'd wondered for years how Goldman avoided the sort of huge mortgage-related writedowns that plagued all the other investment banks. And now we know: Goldman hedged its photograph via faith default swaps with AIG. Sources inside Goldman say the company's abandoning to AIG exceeded $20 billion, definition the importance AIG was downgraded, Goldman had to begin marking down the value of its assets. And the value AIG went bankrupt, Goldman lost $20 billion. Goldman immediately sought out Warren Buffett to raise $5 billion of additional capital, which also helped it raise another $5 billion via a public offering.

The defeat of the faithfulness default swap bazaar also meant the authorization banks - all of them - had no means to borrow money, because no one would insure their obligations.

To fund their daily operations, they've become totally reliant on the Federal Reserve, which has allowed them to formally become commercial banks. To date, banks, insurance firms, and authorization heap have borrowed $348 billion from the Federal Reserve - nearly all of this lending took situation following AIG's failure. Things are so wrong at the siege banks, the Fed had to innovations the rules to allow Merrill, Morgan Stanley, and Goldman the capacity to use equities as collateral for these loans, an unprecedented step.

The mainstream press hasn't reported this either: A food in the $700 billion bailout loop permits the Fed to pay interest on the collateral it's holding, which is simply a funds to funnel citizen dollars directly into the authorization banks.

Why do you necessity to know all of these details? First, you must understand that without the government's actions, the stampede of AIG could have caused every major mound in the land to fail.

Second, without the trust default swap market, there's no medium slope tins description the true countryside of their assets - they'd all be in default of Basel II. That's why the government will push through a measure that requires the delay of mark-to-market accounting. Essentially, heap will be allowed to pretend they have far higher-quality loans than they actually do. AIG can't envelope for them anymore.

And third, and most importantly, without the huge forgery perpetrated by AIG, the mortgage bubble could have never grown as large as it did. Yes, other factors contributed, like the role of Fannie and Freddie in particular. But the key to enabling the huge global growth in custody during the vitality decade can be tied directly to AIG's sale of monopoly default swaps without collateral. That was the barn door. And it was left open for nearly a decade.

There's no medium to replace this massive credit-building machine, which type me very skeptical of the government's bailout plan. Quite simply, we can't replace the credit that existed in the world before September 15 because it didn't deserve to be there in the first place. While the authority can, and certainly will, paper over the gaping gap left by this enormous trust collapse, it can't actually replace the monopoly and faith that existed... because it was a fraud.

And that guide me to believe the entrance economic consumption will be longer and deeper than most clan understand.

You effectiveness discovery this strange... but this is great news for those who understand what's departing on. Knowing why the economy is shrinking and knowing it's not departing to rebound quickly gives you a huge odds over bulk investors, who don't understand what's occurrence and can't layouts to income advantage of it.

How can you income advantage? First, make sure you have at least 10% of your weave importance in precious metals. I prefer gold bullion. World governments' gigantic liabilities testament vastly decrease the importance of paper currencies.

Second, I can tell you we're either at or approaching a moment of maximum pessimism in the markets. These sort of scare give you the chance to buy world-class businesses incredibly cheaply [ https://bankingintel.com/ ]. A few value mentioning are ExxonMobil, Intel, and Microsoft. I have several lineage like these in the portfolio of my Investment Advisory.