AIG's Rotten Investments Could Bring the House Down

For the first time in this unfolding financial crisis, I felt personally scared by the news. Not about my money, but about the potential for catastrophe. The Federal Reserve's lightning rescue of AIG has the smell of systemic fear. The house of global finance is on fire and everyone is running for the exits, no sure way to turn them around. What's next? The question itself is ominous, because there are no good answers.

The US central bank and other nations acted with speed, and good that they did--an emergency loan of $85 billion to prop up the failing insurance giant, plus another $75 billion in liquidity pumped into the banking system to calm nervous bankers worldwide who abruptly stopped lending. The international rate for overnight lending among banks has doubled, an expression of fear that describes the potential danger of a sudden freeze in lending, more or less everywhere. That would deliver a deep shock to real economic activity, not just in the United States but worldwide. This feels ominously parallel to the financial chaos that followed the crash of 1929 and led to global economic collapse.

Government is much better equipped this time with various safeguards to defend the system against an implosion--including Fed Chairman Ben Bernanke's personal willingness to act swiftly with unorthodox measures. But the case of AIG suggests the present unwinding has a malignant dynamic to it that might even overwhelm the authorities' capacity to put out fires. That's scary. I hope I'm wrong.

The reason the Fed was compelled to save an American insurance company in order to save the global financial system goes to the source of the rot--the "new financial architecture" developed during the last generation. These innovations allowed banking and finance to expand their leverage explosively, borrowing and lending far beyond the traditional limits defined as prudent risk-taking. One gimmick that supposedly made this okay was the creation of esoteric insurance derivatives--the so-called "credit default swaps" that supposedly protected investors and firms against losses in mortgage securities and other debt paper.

Critics repeatedly warned that these derivatives were a time bomb--trillions of dollars in risk insurance that would be exposed as meaningless if financial markets ever experienced a sharp fall in asset values. Politicians and regulators from both parties brushed aside the critics and led cheers for Wall Street's fancy new ways of guaranteeing risk.

AIG sold those guarantees in huge volume. It assumed potential liabilities far beyond the firm's capacity to make good on the deals if something went terribly wrong. The problem is global because AIG--an imperious promoter of globalized finance--sold this rotten paper all around the world to big investors and leading banks. If AIG is suddenly insolvent, the pain and loss are spread instantly to thousands of balance sheets in Asia and Europe--banks and corporations that must suddenly write down their own assets. That's why the Fed could not wait to find out what would happen if AIG was allowed to fail.

But the system is not free of these troubles. AIG was not the only high flier peddling false hope to supposedly sophisticated financiers and bankers. Some of the largest, most respectable banks--led by JPMorgan Chase--did the same thing. It was a highly profitable line of business. The gimmick insurance was widely admired by financial economists and approved by the supposedly objective rating agencies. It is not clear to me how government intervention can unwind this feature of our corrupted financial system--short of making good on the trillions in these essentially fraudulent contracts. Not even the Federal Reserve has the assets to swallow all of Wall Street's folly and deception.

If my fears are right, a more fundamental reckoning may lie ahead and Washington will have to take far more decisive action. At some point, the new president might have to do what FDR did in the wreckage of early 1933--declare a "bank holiday" and announce emergency rules to govern banking and finance until the crisis is broken. For the country's sake, I think this a better approach than buying up junked banks and failed financial firms, one by one. People have the right to ask: what exactly are the rest of us getting for our money?

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