Questions Answered: September 17, 2008
By Jim Oelschlager
I will try to answer a few questions I am receiving from people concerned about what is occurring in the financial markets.
First of all, it is not the end of the world. People are still growing crops. People are still making widgets. People are still having surgery. This is confined, basically, to the financial markets. There is a bigger overview; then, there is the triggering of events of the last few days.
From the bigger picture: A lot of the financial institutions were irresponsible in the manner in which they made loans. Not only did they give loans to people they should not have given to, they then leveraged those loans, which only exacerbated the problem on the downside. They probably would have been in reasonably good shape if they hadn’t been lured into the leverage game. Leverage can work great on the upside, but it is a killer on the downside. Some of the lenders, particularly to the sub-prime group, were leveraged as much as thirty to one and the collateral on these loans, the homes, were depreciating in value. People were missing their payments, becoming delinquent and, in the extreme, undergoing foreclosure.
Last weekend, the Fed Reserve (“the Fed”) said it wasn’t going to intervene on behalf of American International Group, Inc. (“AIG”) and then abruptly changed its mind on Tuesday evening. The US Treasury Department will provide the funds that AIG needs to continue to operate, up to $85 billion. You can almost think of it in terms of a bridge loan; however, it doesn’t come cheap. The government is going to take approximately 80% of the company’s stock going forward. AIG still has a lot of assets. It was basically in a cash bind. It may well turn out that the government makes money on this investment as they did with the 1979 Chrysler bail-out. I was opposed to the bail-out years ago; but, obviously the government did it and took equity, again, and actually made a rather handsome profit on their investment. AIG does have a lot of assets which can’t be moved between subsidiaries to cover problems in other subsidiaries, but they still do have a lot of assets.
So what happened? What was the triggering event for AIG? AIG sold bonds to raise money for different projects within the company. Rating agencies downgraded the debt of AIG amid concerns about the company’s exposure to subprime securities. When the debt was downgraded, it triggered certain clauses in derivative contracts, requiring the borrower, (in this case, AIG), to put up additional collateral. AIG had to come up with a substantial amount of cash, which they couldn’t do. It is not unlike a run on a bank. If there is a run, the bank has to liquidate all their assets instantly and pay the people in cash, even though their assets may be very sound. That’s not to say that AIGs assets are/were all sound. Clearly, some are/were not.
So, are the taxpayers going to pay for this? Probably not. Where will the money come from? The government will get money from the same place they get money when they finance the deficit. They borrow it. The U.S. has run in deficits many times over the years. To make up for this deficit, they sell bonds around the world as well as in the United States. The loan which will be provided to AIG, while it seems huge, will be rather miniscule compared to the total financing needs of the federal government. If there are no buyers out there for U.S. government bonds (“treasuries”), we would have a real problem; but, there clearly is still a market out there for selling the treasuries. In fact, in a time of financial stress such as we are currently going through, people usually seek safety in U.S. Treasury bonds. As a result of the increased demand, the yield on bonds goes down and their prices go up. What this means is the U.S. government is likely to be able to sell debt at a more attractive rate than it was three weeks ago. Earlier this week, in response to this “flight to quality” investments, the rate on treasuries dropped 25 basis points in one day, which is a humongous drop.
So, the U.S. should be able to finance the investment, or bridge loan, or whatever you want to call it, in AIG. Hopefully, when the assets have liquidated-over a period of time as opposed to being forced out in a short period of time - the government will have more money available from the assets and the initial debt, and the stock will have meaningful value. If this plays out, the government will have, once again, come to the rescue and also made some money for the government and the taxpayers.
Unfortunately, in situations like this, there is an inclination to look for a scapegoat. There is also an inclination, on the part of Congress, to enact new regulations and rules. House Speaker Nancy Pelosi has already said that she thinks we ought to tighten up the regulations in the banking industry. This is a case of addressing things after the fact. I don’t think tightening the regulations would have avoided this financial trauma, which we are currently going through, had they been done a year or two ago.
It is hard to legislate against people doing stupid things. Unfortunately, man has an inalienable right to do stupid things, and he often does, particularly when greed becomes involved.
So, turn off the business channel and rest in comfort knowing that we will get through this financial trauma as we have with every other one in the past. The key at this point, for the general public, is not to panic. The ten-year Treasury was down again today in yield. The yield is down 6 basis points today, September 17, to 3.37%, an extremely low rate relative to recent history, which will enable the government to finance – at a very attractive rate - any additional funds needed.
Just as an example of how the rest of the economy is doing just fine and should continue to do just fine: Cisco, just coincidentally yesterday, had an analyst meeting in which they said they expect sales to continue to grow between 12 and 17 percent in the foreseeable future. So, here is an example of a corporation that expects to do quite well despite the financial trauma which is occurring on Wall Street.
So, once again, as before, my advice is to take a walk in the park and don’t panic.
Best regards,
Jim
This manager commentary represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice.