Thursday, September 18, 2008

Sub-prime crisis, continued

Indian cart, the U.N. - 1 star
Prospect St., New Haven, CT

New Haven is currently enjoying its beautiful two-week season of early fall, with crystal-clear skies and temperatures in the low 70s. So for lunch today, Kiel, Tommy, and I took a stroll up Prospect St. to the School of Management, Yale's idiosyncratically-named business school. The object of our quest was an array of pushcart vendors outside the SOM. There are a Thai cart, an Indian cart, a Japanese cart, a Mexican cart, a Middle Eastern cart, and probably others I've forgotten. In Berkeley, there's a food court on Durant that my friend Nancy dubbed the U.N., because all of the developing world countries were represented (there was an Afghan place that I particularly liked), so I'm going to call this place the U.N., too.

You can get a rice plate with up to four things on top, for just $4.50 (vegetarian, at least); I had channa masala (chickpeas), which was pretty bland, and a good spicy potato dish, as well as a samosa. Kiel also got Indian, including a big, chewy piece of naan, and Tommy got Thai noodles. We sat on the patio of the SOM and talked about capitalism. Ah, to be young again.

Today in procedure class, while the conflagration in the financial system continued to swirl around all of us, we learned about the distinction between personal jurisdiction and venue. In short, if you are a citizen of Connecticut who was harmed by an operation performed in New York by a doctor who lives in New York, and you sue him in federal court in Connecticut, that court will probably have personal jurisdiction (depending on the extent of that doctor's connections to Connecticut) but will not have venue; but if instead you sue the hospital where you got the operation, you will almost certainly have personal jurisdiction and you will have venue. At the end, the professor said there was no coherent theory that could explain that difference, and we just moved on.

One other person in my small group independently noted that there is a stunning silence at Yale over this week's events, which people will be studying for the next hundred years. I don't have any particuar insights, but I thought I would take a stab at explaining some of the mechanics that are usually glossed over in the newspapers, either because the financial reporters take them for granted, or (more often) because the financial reporters don't understand them.

Last time I wrapped things up by talking about how high leverage can cause banks to have negative capital even if there's only a moderate fall in the value of their assets. That's basically what happened to Lehman Brothers; their assets were over 30 times their capital, meaning just a 3% fall would have wiped them out, and no one believed their assets were properly valued anyway, meaning most people thought they were already underwater. In that situation, no one wanted to do business with them, and if you are an investment bank and no one will loan you money, you are dead. (Lehman had liabilities of over $600 billion to support all those assets; as the loans came due, no one was willing to roll them over or make new loans to Lehman, so they were about to simply run out of cash.)

AIG was a bit more complicated. Like Lehman, AIG was highly leveraged and owned big piles of securities that were plummeting in value. In addition to mortgage-backed securities, AIG in particular was engaged in perhaps hundreds of billions of dollars worth of credit-default swaps; under the terms of these swaps, AIG was essentially insuring payment on bonds, including mortgage-backed securities. So as those mortgage-backed securities became more and more risky (see the earlier post), the chances that AIG would have to pay out on insurance claims went up, and the value of their swap holdings plummeted. So they were stuck with real debts on the one hand, and on the other hand they had a pile of assets that were falling in value and that no one wanted to buy, and it looked like they were going to run out of cash this week, because no one wanted to lend them money. In particular, as they looked more and more risky, the ratings agencies lowered their ratings for AIG; and the way loans to big companies are often structured, if the ratings fall past a certain point, the company has to "put up more collateral," which means they have to pledge more cash or assets to the lenders. (It's as if, as the price of your house falls, your bank says that you need to pledge another house to secure your mortgage ... but you don't have another house.) In this case, ratings downgrades on Monday forced AIG to come up with over $13 billion in cash or collateral, and they just didn't have it.

On Friday AIG was asking for a $20 billion loan, but by Sunday it was $40 billion, by Monday it was $75 billion, and by Tuesday the eventual federal bailout was $85 billion. This is a very worrying sign; it probably means that according to AIG's books they needed $20 billion, but when the other investment bankers looked at the actual securities holdings and swap positions they decided they were worth a lot less than AIG had assumed they were worth, and hence the need for more cash. The problem is that many people are now assuming that every bank has similarly optimistic assumptions about its assets, and if that's true then we are in big trouble.

There is some talk that the government will get its $85 billion back, at 12% interest, and this is certainly possible. But it rests on the assumption that AIG's assets are somehow worth more than the investment bankers think they are, and that once the market settles down they will be able to sell those assets at a better price. If they could get that price now, they would just sell them and they wouldn't need a loan. So the government is betting that prices of these assets, colloquially known as "toxic waste," will go up. After the last twelve months, I wouldn't bet on it.


Ben said...

Nice summary.

For the $85B, wouldn't the government (a.k.a., "us") end up responsible for some significant share of it anyway? Seems like some of it would just fall out at the bottom of the chain with individually insured accounts and the like?

James said...

Do you mean that even without the $85B loan the government might have been on the hook for some of it? If so, I'm not sure. I doubt any of AIG's losses would have been in the form of FDIC-insured deposits, which the government is on the hook for. As far as AIG's insurance businesses go, I believe some of them are insured by states (primarily personal lines and workers' comp) and some are not insured by anyone (primarily commercial lines). In this case, I'm not sure any of those insurance operations would have gone bankrupt, since they are separate entities and the holding company is limited in its ability to take capital from the subsidiaries (although New York decided to let AIG take $20 billion from its subsidiaries).