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Market Sense

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Endgame

Wed, Sep 17 2008, 09:15 GMT
by Yapi Kredi Bank Economic Research Department

UniCredit Group

The Fed has engineered a controlled explosion, stepping in to avoid AIG’s bankruptcy, extending to the insurer a USD85bn 2-year loan and assuming an 80% stake in the company. The loan is at a punitive Libor plus 8.5%, which makes it extremely clear that this is not a subsidy extended to keep the company afloat, but rather a stranglehold that makes AIG unviable while ensuring that its obligations will be met—indeed, the plan implies that AIG will gradually divest assets to repay the loan. This is to all extents and purposes a controlled bankruptcy, with the Fed assuming responsibility for guiding the orderly winding down of AIG’s operations and disposal of its assets. Shareholders are wiped out by de facto nationalisation of the company—once again, this is definitely not a bailout.

This extremely positive development confirms the sense that the endgame has begun, and that US authorities are showing the strategic thinking and composure needed to win. At this stage, solutions have been found for Bear Stearns, Lehman, Merrill Lynch, Fannie and Freddie, and AIG. It becomes easier to imagine that the next likely flashpoints, such as Washington Mutual and Wachovia, will also be handled without triggering a systemic meltdown. The fact that the real economy has so far proved more resilient than expected also justifies a modicum of optimism.

The financial system remains extremely fragile, of course, and the road to recovery remains long. The pace of events has now accelerated dramatically, however, indicating that the endogenous process of consolidation and deleveraging is also likely to pick up momentum— indeed, overnight we also had the news that Barclays would take over Lehman’s US operations. This makes the environment more difficult to navigate, but it also makes a very encouraging change from the depressed and resigned muddling through that had come to characterize the previous phase of the crisis. There will be a lot of blood on the streets, but this is what a revolution feels like.

AIG was deemed of systemic importance: a failure would have had a tremendous impact on the rest of the financial system, but also directly on the household sector, posing a major threat to both financial stability and the growth outlook (see the Fed’s statement at http://www.federalreserve.gov/newsevents/press/other/20080916a.htm).

The decision came a few hours after the FOMC’s decision to keep rates on hold, defying a market that priced in a rate cut with certainty, As I wrote last night, the Fed understood very clearly that the game was not on the Fed funds rate, but on AIG, and that is where it concentrated its effort. The macroeconomic outlook now hinges on how the financial crisis plays out, and the Fed needed to keep all options open and its powder dry.

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Published on  Wed, Sep 17 2008, 09:18 GMT