Financial Meltdown: Day 2

Everyone make it through yesterday's massacre? Good. Welcome to Day Two: It's as big of a clown show as yesterday.

Mama said there'd be days like this ...
Investors' fears came true Monday night, as insurance giant AIG  (NYSE: AIG  ) had its debt downgraded, sending it frighteningly closer to the brink of bankruptcy. Credit downgrades for insurance companies can trigger calls that require additional capital to be put up. In AIG's case, this means it needs an additional $14.5 billion it doesn't exactly have lying around. With the company already scrambling for cash as is, the need to post more money could prove too onerous for AIG, effectively forcing it into failure.

The implications here could be massive. AIG's balance sheet holds far more than $1 trillion in assets -- about $400 billion more than Lehman Brothers  (NYSE: LEH  ) -- so unwinding all of its contracts, policies, derivatives, and other random financial positions could be stupidly chaotic. One of the big issues here is systemic risk, or the possibility that AIG and Lehman's liquidations could force others to start selling assets in droves, creating a tsunami of pressure on global financial markets.

There could be a solution to this, though: Lend AIG money. A lot of it. Most estimates suggest the company needs something in the neighborhood of $75 billion to stave off a looming bankruptcy. The bad news? It needs that money A.S.A.P., and where it'll come from is anyone's guess. To be blunt, there's little chance of AIG making it through the week unless it finds someone with enough bravado to lend it tens of billions of dollars.

So what now?
Two possibilities arise: Either the Federal Reserve can make an emergency loan, or AIG can borrow from other banks. The first option is a long shot; just hours after the Feds let Lehman fail, it seems mad that AIG would suddenly be entitled to a bailout.

Besides, opening up government coffers to an insurance company like AIG would create a whole new chapter in the credit crunch. If insurance companies get the privilege, who else should? Hedge funds? Pension funds? General Motors (NYSE: GM  ) and Ford (NYSE: F  ) ? At some point, the Fed has to put its foot down and say "Too bad."

The second option (borrowing from other banks) is also a shot in the dark, but it seems like the only option. The Wall Street Journal reports that the Fed has asked Goldman Sachs  (NYSE: GS  ) and JPMorgan Chase  (NYSE: JPM  ) to put together a loan package for AIG totaling as much as $75 billion. This seems like a sensible (and perhaps the only) solution, but it still comes with several admonitions. For one, it could shift risk to two of Wall Street's only remaining healthy banks, akin to putting your strongest fighters on the front line of the battlefield. Stay tuned, Fools -- AIG's fate should become clearer as the day goes on.

The bad news isn't over
In other news, Washington Mutual  (NYSE: WM  ) had its debt downgraded by Standard & Poor's to essentially the same levels to which two other rating agencies lowered it last week, making its ongoing problems just that much worse. As it did last week, WaMu defended itself after the downgrade, but the trend is clear: Investors aren't in the mood to kick the tires and give banks the strength-test they deserve. When fear looms over the market, capital-raising isn't these companies' only concern. Bank runs become an ever-present danger, too, as customer confidence plunges.

At any rate, the latest developments make a few things clear: The Federal Reserve is pretty much over the bailout business, essentially telling Wall Street, "Sorry, this is your problem." What that means for AIG and WaMu should shape how the market pans out in the coming weeks.

For related Foolishness:

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this articleJPMorgan Chase is a Motley Fool Income Investor recommendation. The Fool has a disclosure policy.


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  • Report this Comment On September 16, 2008, at 8:33 PM, dhobe1 wrote:

    "Two possibilities arise: Either the Federal Reserve can make an emergency loan, or AIG can borrow from other banks. The first option is a long shot; just hours after the Feds let Lehman fail, it seems mad that AIG would suddenly be entitled to a bailout.

    Besides, opening up government coffers to an insurance company like AIG would create a whole new chapter in the credit crunch. If insurance companies get the privilege, who else should? Hedge funds? Pension funds?" I'm speechless, I really am. Where will this madness end?

  • Report this Comment On September 17, 2008, at 12:25 PM, intxicated wrote:

    Ha! Fed over the bailout business? Looks like we the people are holding the bag once again - to the tune of $85 billion! I.O.U.S.A. indeed.

  • Report this Comment On September 17, 2008, at 12:50 PM, temp2290 wrote:

    The real failure here is the Bush Administration's hypocrisy. I can just see their meeting rooms: "Hey let's be all for the free market to help out our business buds... unless it doesn't, in which case we'll have to bail them out with taxpayer money. We'll just make up some BS about helping the average American."

    If you're going to scream about privatization and free market constantly, at least stick to your ideals, however stupid they are.

  • Report this Comment On September 17, 2008, at 4:06 PM, NightBengal wrote:

    temp2290,

    The Fed does not report to the President, and the President does not control the economy; his only semi-direct influence is through Congress. I have a very strong feeling that much of this would have happened (except maybe the rebate checks) no matter who was in the Oval Office.

  • Report this Comment On September 17, 2008, at 4:54 PM, p1at0 wrote:

    Investors should take a deep breath, realize that this is going to be a tumultuous few weeks (or possibly even months), and prepare to ride it out. If you watch the breathless commentary on CNBC, you'd think that financial Armageddon is upon us. It isn't. There's no single thing happening in the market right now; there's a combination of things happening simultaneously:

    - Fear-based selling. Some folks are selling everything, packing up the candles and canned goods, buying gold, and heading for the mountains.

    - Bear raids. There is no doubt in my mind that predatory hedge funds are intentionally trying to bring about the next death spiral so they can profit from short-selling. Morgan Stanley and Goldman Sachs are clearly targets, as are other financial firms. Both of these companies are fundamentally strong (yes, they have problems, but not of the fatal variety), but if market manipulators can create enough fear and doubt, they can set in motion an unstoppable series of events (including ratings downgrades) that will result in these companies' demise.

    - Deleveraging / unwinding of positions. This has been overdue for some time. Hedge funds and financial firms have built up enormous positions in assets and derivatives of all kinds, using extreme leverage. Now that those assets are falling in value, they're having to unwind those positions and sell to repay their debts or satisfy their counterparty obligations. This process is going to take some time and it will result in continuing downward pressure on the markets.

    - Cash is on the sidelines. There's plenty of money out there -- trillions of it -- watching and waiting for the right time to get back in. Not many investors are in the mood for falling-knife-catching at the moment, but once we get to a consensus that the bloodletting is over, that cash is going to be put to work. In fact, that day may be sooner rather than later. The sheer level of panic, hysteria, and towel-throwing-in leads me to suspect that we could be right in the middle of a classic capitulation, setting the stage for a solid recovery.

    They great untold story of the last few days is the fall in the price of commodities, particularly oil. This is going to act as a massive stimulus to consumer spending, allowing people all over the country to resume their latte addictions and buy nifty gadgets at Best Buy. The last time I checked, consumer spending accounts for the lion's share of economic activity in the U.S., so this is going to help get the real economy (the one *outside* of Manhattan) back on track. Not much talk about that on Power Lunch these days, what with all the hysterical hand-waving hyperbole and Great Depression comparisons, but declining commodities is the real story to watch if you plan to be in the market beyond the next couple of weeks.

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