Tuesday, September 30, 2008

humpty dumpty goes to wall street.

I recently received one of those chain emails. It started out, “I'm against the $85,000,000,000.00 bailout of AIG. Instead, I'm in favor of giving $85,000,000,000 to America in a We Deserve It Dividend.” It went on to claim that that would give over $400,000 to every American over 18. Sound good? Why bailout the fat cats? What about the common people who are really struggling? Wouldn’t that do more for the economy?

OK. Before we go on, let me ask a few questions.

#1. Do you know what a “credit default swap” is? (Also known as a CDS.) Did you know that there is 62 trillion dollars worth of these special financial contracts out there? Do you have any idea how much $62 trillion is? There are over 31 million seconds in a year. A trillion is a million million. So 62 trillion is how many ticks of a clock there are in 2 million years.

That is a big number.

The value of credit swaps is 15 times larger that the total stock market value of all U.S. corporations. If you added up all the incomes of the over 300 million Americans for a year, it would still be well less than a fourth of $62 trillion. If you added up all the incomes for a year of all the nearly 7 billion people on the planet earth, it would still be less than $62 trillion.

#2. Do you have any idea as to the consequences of a major failure in this market? What would happen if people lose confidence in the value of the credit swap contracts?

#3. Do you know what the so-called “bail out" of AIG really involved? Do you know what the money was going for or what was trying to be accomplished? What would have happened if AIG went into bankruptcy?

I doubt if one out of a hundred Americans could answer the above questions. I also doubt if very many members of Congress have a clue. I must admit, my own understanding of these questions is not the greatest.

Credit Swap?
A credit swap is essentially an insurance contract protecting owners of debt against default. If someone owes you money, this is like you paying someone to guarantee the debt will be paid. You pay someone a little to assume the risk of default or nonpayment. Credit swaps are generally between corporations. For example, Home Depot wants to borrow $10 million for 90 days. IBM loans them the money. However, IBM may pay a little to AIG to guarantee that Home Depot will pay. If Home Depot defaults, doesn’t pay IBM, then AIG will pay $10 million to IBM and then try to collect from Home Depot.

AIG was a fairly big player in the swaps market. They guaranteed a lot of bonds, including a good chunk of debt backed by home mortgages. AIG was losing a lot of money on the mortgage backed debt. The fear was if AIG went into bankruptcy, the insurance on debt would disappear, for all debt, not just the housing-backed stuff. The debt would become riskier and worth less to firms.

Cut to the Chase. I won’t try to explain the following in any detail. Two weeks ago credit markets were starting to seize up; not working at all. Firms were trying to sell the debt, the IOUs they were holding, no one was buying. Prices dropped, losses mounted. Other firms, even healthy strong companies, were finding it hard to borrow. No one was lending. It looked like the beginning of a world-wide financial meltdown the like of which has never been seen before. One participant in the Lehman Bros. and AIG negotiations that week said we were “at the edge of the abyss.”

You might be thinking, “Poor babies. Why should I care about the fat cats? What does it have to do with me?” To go back to our example, what if Home Depot can’t borrow money to pay workers or suppliers? What if companies supplying Home Depot are having trouble getting paid? Do you really think they will just keep on making shipments, keep on producing, keep on hiring people? What if this is a general problem not limited to Home Depot? A financial market breakdown will lead to a severe economic breakdown. Layoffs, declines in income, a big fat hairy recession that could last a long time. These results are guaranteed with a financial meltdown.

The bail-out was to keep AIG in business, not to rescue AIG stockholders. The bailout’s conditions, the conditions on the loan to AIG, were so severe that the U.S. government actually had a good chanced of ultimately making a profit on the deal. AIG accepted because had no choice if they wanted to avoid bankruptcy.

AIG needed to stay in business because the alternative was an extremely high chance of international financial collapse, a fall into the abyss. The breakdown of the credit swaps market would lead to a breakdown of credit markets in general. Once you get the meltdown, the collapse, it is really difficult to put things back. Humpty Dumpty goes to Wall Street.

Is this the We Deserve It America Dividend you want?

Now put out your thumb and index finger. Have them separated by about an inch.

This is how big a piece of the current financial crisis AIG represents. It is far more complicated than what I described. The AIG story is just one little piece of a much, much bigger puzzle. We’re not even getting close to the cause, but merely one of the many possible results of a much bigger problem.

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