AIG bailout: Where does financial crisis lead next?
Other large firms may be close to the brink.
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That doesn't mean that Citi is headed toward collapse, or that Merrill couldn't have survived on its own. But these are extraordinary times. AIG's current situation seemed unthinkable two weeks ago.
The pace of failures is hard to forecast because it is inextricably tied to the uncertainties in the real estate market as well as to the ties so many firms have to that market.
"[There are] two hallmarks of this credit cycle," says Max Bublitz, chief investment strategist at SCM Advisors in San Francisco. "The first is the incredible amount of leverage," with firms making investments using borrowed money, often at high ratios of 20 or 30 times their underlying capital base.
"Second, the leverage was created around a bubble in housing," he says. Home prices soared far beyond traditional relationships to rental prices or household incomes in many metro areas.
In many cases, firms hold securities based on mortgages that are now seeing rising rates of default and foreclosure. And the risk is that, as firms try to unload their bad assets, the price of those assets will keep falling. Merrill Lynch recently sold one large pool of real estate investments at 22 cents on its original dollar.
A recent commentary on the market by William Gross, a bond fund manager at Pimco, was sobering: "Delevering slows/stops when assets have been liquidated and/or sufficient capital has been raised to produce an equilibrium," he wrote. "The raising of sufficient capital now depends on the entrance of new balance sheets. Absent that, prices of almost all assets will go down."
For AIG, the Fed was a new balance sheet. The company's troubles mounted as credit rating firm Standard & Poor's downgraded AIG's debt rating this week.
That meant an instant jump, effectively, in AIG's capital needs. What had been a request for a $40 billion loan last weekend quickly doubled.
In effect, AIG was a "good" company and a "bad" investment firm rolled together. The same was true with Lehman, which hoped to sell or partition its bad real estate investments to survive.
But it could find no buyer. That doesn't mean the real estate investments are worthless, but they're hard to value in the current environment.
Eventually, such assets may recover in value, some Wall Street analysts say. But for now, what matters a lot is their current market value.
When one firm sells assets at low prices, other firms must mark down the value of similar assets on their books, even if they have no need to sell. That's because of "mark to market" accounting rules.
Suddenly, in this manner, balance sheets weaken across the board. Thus, one current debate is whether part of the fix to the downward credit spiral is some revision of mark-to-market accounting.
Another controversial question involves the role in recent collapses played by "short sellers" – investors who make money when stocks fall in price.
Some investors say that they are playing an outsized and unscrupulous part. Feiger is in another camp. "You have a huge amount of short selling," he says. But "most of the times, the market valuations are pretty good guides" to a company's underlying health.