Systemic risk of life insurance company failure

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From AIG's website, a whitepaper on the Systemic Risk in the insurance industry. Certainly, AIG is wrapping themselves in the cover of their industry by speaking of the industry's Systemic Risk. But whether it is the entire industry at risk or just AIG and some others, the acknowledgment of systemic risk in such a direct way is striking:

"A significant rise in surrender rates – inspired by consumers’ needs for cash or because of rumored or real failure of insurance companies – could be disastrous. Because of widespread loss of liquidity, the industry would struggle to raise adequate cash to meet surrender requests. A “run on the bank” in the life and retirement business would have sweeping impacts across the economy in the U.S. In countries around the world with higher savings rates than the U.S., the failure of insurance companies like AIG would be a catastrophe."

Read the full March 6 Draft whitepaper titled: AIG: Is the Risk Systemic?

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Who benefited by US support of AIG

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Barclays $7.0
Deutsche Bank 6.4
BNP Paribas $4.9
Goldman Sachs $4.8
Bank of America $4.5
HSBC $3.3
Citigroup $2.3
Dresdner Kleinwort $2.2
Merrill Lynch $1.9
UBS $1.7
ING $1.5
Morgan Stanley $1.0
Societe Generale $0.9
AIG International Inc. $0.6
Credit Suisse $0.4
Paloma Securities $0.2
Citadel $0.2
Total $43.7

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AIG reveals who we are bailing out

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Confused? We all are. Read this to learn what Financial Derivatives are.

Severe valuation losses on the super senior multi-sector credit default swap portfolio of AIG Financial Products Corp. (AIGFP) triggered collateral provisions in the swap contracts, creating a liquidity crisis for AIG in September 2008. The Federal Reserve Bank of New York (FRBNY) provided an emergency $85 billion loan to AIG to meet short-term cash needs. The aid received by AIG helped avoid severe financial disruptions by providing liquidity to important financial institutions and municipalities.

Using funds from the emergency loan, financial counterparties listed on Attachment A (all attachments are posted online at http://www.aig.com/Related-Resources_385_136430.html ) received a total of $22.4 billion in collateral relating to CDS transactions from AIGFP between September 16, 2008 and December 31, 2008. This amount represents funds provided to such counterparties after the date on which AIG began receiving government assistance. The counterparties received additional collateral from AIG prior to September 16, 2008.

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AIG CEO Letter to Geithner

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Letter from AIG's government appointed Chairman and CEO Edward Liddy to US Secretary of the Treasury Geithner:

In the first quarter of 2008, prior management took significant retention steps at AIG Financial Products. These arrangements were designed at a time when AIG Financial Products was expected to have a significant, ongoing role at AIG, and guaranteed a minimum level of pay for both 2008 and 2009. (Due to losses at AIG Financial Products, a senior manager will receive about 43% of his 2007 expected level for 2008.) Some of these payments are coming due on March 15, and, quite frankly, AIG’s hands are tied. Outside counsel has advised thatthese are legal, binding obligations of AIG, and there are serious legal, as well as business, consequences for not paying. Given the trillion-dollar portfolio at AIG Financial Products, retaining key traders and risk managers is critical to our goal of repayment. This is all discussed in more detail in the attached “white paper.”

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Late Change in Geithner's Bank Plan

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Late Change in Course Hobbled Rollout of Geithner's Bank Plan - washingtonpost.com: "Just days before Treasury Secretary Timothy F. Geithner was scheduled to lay out his much-anticipated plan to deal with the toxic assets imperiling the financial system, he and his team made a sudden about-face.

According to several sources involved in the deliberations, Geithner had come to the conclusion that the strategies he and his team had spent weeks working on were too expensive, too complex and too risky for taxpayers.

They needed an alternative and found it in a previously considered initiative to pair private investments and public loans to try to buy the risky assets and take them off the books of banks. There was one problem: They didn't have enough time to work out many details or consult with others before the plan was supposed to be unveiled.

The sharp course change was one of the key reasons why Geithner's plan -- his first major policy initiative as Treasury secretary -- landed with such a thud last Tuesday."

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PIMCO - IO Feb 2009 Gross Beep Beep

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PIMCO - IO Feb 2009 Gross Beep Beep: "The simplicity of the solution, however, is not easily achieved once deflationary momentum takes hold. Animal spirits, once dampened, are hard to reignite; “fear of fear itself” dominates greed. Under such circumstances, the benevolent hand of government is required and Keynes is reincarnated in an attempt to plug the dike via fiscal spending and imaginative monetary policies that support asset prices. PIMCO has recently been contracted to assist in several publically announced programs which have helped in that effort: the CPFF, which has benefitted commercial paper yields, and the Federal Reserve’s purchase program for agency-backed mortgage loans, which has lowered 30-year mortgage rates to 4.5% and fostered the affordability of new and secondary housing prices. These two programs, in our opinion, have been the major policy successes to date – not because of our involvement – but because they have supported and increased asset prices whose decline has been the major deflationary thrust behind the real economy. Stop asset prices from going down and with a 12-month lag, unemployment will stop going up, and President Obama’s targeted three million new jobs will have a fighting chance of being achieved."

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PIMCO - IO Feb 2009 Gross Beep Beep

PIMCO - IO Feb 2009 Gross Beep Beep: "But stopping the decline of asset prices can be and has been attempted in numerous, seemingly uncoordinated ways. Recapitalization of the banks has been the major thrust, in the hopes that banks would extend credit which would reinvigorate asset pricing. Those who argue strongly for a recapitalization of the banking system, however, may be missing the distinction between the banking system as we once knew it, and the “shadow banking” system that superseded it. Jim Bianco, who heads up the research tank bearing his own name, brought the difference to mind in a recently produced piece entitled, “When Will The Banks Start Lending?” His conclusion was that banks already were – lending – but it was the “shadow system” (my words) that was holding up the parade. According to his analysis, shown in Chart 1, securitization has for several years exceeded bank loans as a percentage of private credit market debt. In contrast to recent headlines, however, banks have been picking up their lending, but it has been the “shadow banks” that have faltered. That makes sense. While banks may have tightened their lending standards, fresh capital from the TARP has made it possible to make new loans. The shadow banks, however – hedge funds, investment banks, and str"

PIMCO - IO Feb 2009 Gross Beep Beep

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PIMCO - IO Feb 2009 Gross Beep Beep: "PIMCO’s advice to policymakers is as follows: you can’t bail out everyone, yet economic recovery is not possible unless certain critical asset sectors are not only reliquefied, but rejuvenated in price. The prior Administration’s focus on the banks has been critical but unidimensional. The shadow banking system with its leverage and financial innovation, powered a near 25-year global economic expansion, but it is the delevering of those hidden quasi-banks that is now threatening its petrification. Policymakers should not focus entirely on one-off bailouts of large real estate developers, municipalities, or even credit card issuers like they have with Citi, BofA, and AIG. Rather, they should recognize that supporting critical asset prices such as municipal bonds, CMBS, and even investment grade corporate bonds is a necessary step towards eventual economic revival. Capitalism at its philosophical and practical center depends on credit, and while new loans can be and are being advanced via the banking system, it’s a much more difficult task to force shadow banks to lend. That lending depends on securitization which in turn depends on stable and eventually higher asset prices than currently exist. The original focus of the TARP was on asset prices, but the prior Administration quickly lost its way or perhaps its"

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Zero Hedge

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Zero Hedge: "So does the upcoming bailout have the makings of actually fixing the structural problems in the economy? Some thoughts on the various approaches, from BAC:

Aggregator Bank

This is an off balance sheet vehicle that pools multiple bank’s bad assets into one “Bad Bank” or “Aggregator Bank” that can both manage and dispose of the bad assets it buys from banks. To alleviate the pricing problem, the bad bank could focus on trading account securities and loans that have been most heavily marked down. By either taking these at the latest mark, or standardizing these marks across banks of the (relatively) more price transparent assets, the pricing issue – setting the correct price to protect taxpayers – could be avoided. The impact of this move would remove further downside uncertainty for the banks, freeing them up from those assets (while at the same time transferring all future upside to the government as well). However, that pool would be limited to those deemed sufficiently marked down to be able to avoid both price uncertainty and the potential that by setting too low of a price, further capital inadequacy issues would be exacerbated. These were the core problems of the first TARP program.

Ring fencing

This approach has two attractions. First, it avoids having to deal with the pricing issue. This is important for loans with no ready price an"

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B of A to defer some bonuses over three years

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Bloomberg.com: Worldwide: "Bank of America Corp. is deferring payment of 2008 bonuses of $50,000 or more at its capital markets and investment banking units over three years, according to people familiar with the matter.

Employees who had expected a bonus this month based on their 2008 work will instead get most of it in three annual installments, starting in February 2010, said the people, who declined to be identified because the plan isn’t public."

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How to not let this happen again

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Allowing Lehman Brothers to collapse had such severe systemic effects that the global financial system went into cardiac arrest and is still dealing with the aftermath.

How do we set up a sytem to eliminate the risk of (another) global financial meltdown? In their FT.com article 'A proposal to prevent wholesale financial failure', NYU Stern students Lasse Pedersen and Nouriel Roubini have devised a way to avoid the "worst financial crisis since the Great Depression."

Bail-outs of major financial institutions are based on a fear that their collapse would cause havoc, with collateral damage to the real economy. Examples include the Bear Stearns, Fannie, Freddie, AIG, and Citi­group.

The current system is "vulnerable to financial contagion when big banks (or many small ones) go bust. This is the systemic risk. The root of this problem is that "banks have little incentive to take into account the costs they impose on the wider economy" if their failure prompts a liquidity crisis.

"This is akin to when a company pollutes as part of its production without incurring the full costs of this pollution. To prevent this, pollution is regulated and taxed."

How do we reduce both the moral hazard and the cost of bail-outs in the event of a liquidity crisis? Impose a new systemic capital requirement and systemic insurance program. Once systemic risk can be measured, it can be managed.

Banks already use standard risk-management techniques internally to weigh how much each trading desk or division contributes to the overall risk of a bank. But the authors suggest that these same ideas should be used to evaluate the banks themselves. They set out their ideas in an NYU Stern project on restoring financial stability.

"First, the regulator would assess each bank’s systemic risk. The higher it is, the more capital the bank should hold. This would seek to ensure that the banking system as a whole had sufficient capital relative to the system-wide risk. This is just like the headquarters of a bank charging each trading desk or division for use of economic capital measured by its contribution to overall firm risk.

Second, each institution would be required to buy insurance against its systemic risk – that is, against its own losses in a scenario in which the whole financial sector is doing poorly. In the event of a pay-off on the insurance, the payment should not go to the company, but to the regulator in charge of stabilising the financial sector."

What happens then? A market-based estimate of the risk the develops (the amount of theinsurance premiums). Second, each bank would have an incentive to limit systemic risk (via lower insurance premiums). Finally, it would reduce the fiscal costs and the moral hazard of government bail-outs (because the company does not get the insurance pay-off).

Since the private sector may not be able to put aside enough capital for all the systemic risk insurance, government could provide part of it. Government already provides such partnership on insurance with the private sector in terrorism insurance.

"Unfortunately bank regulation, such as the Basel accord, ignores systemic risk since it analyses the risk of failure of each bank in isolation. It seeks to limit the probability of failure by each bank, treating isolated failures and systemic ones in the same way (and also ignoring how much a bank loses if it fails). However the move by many large banks to lever their balance sheets with similar mortgage-backed securities is more dangerous than if they had made loans to diverse borrowers."

More broadly, a systemic crisis that feeds on itself is more dangerous than the isolated failure of smaller banks. A small bank will probably be taken over with a smooth transition of operations – it does not bring down the economy.

"We believe our proposal offers several advantages by explicitly addressing systemic risk based on tools already in use by private companies to manage internal risks. Our proposal is a better way to deal with the trade-off between letting a large institution go bust (Lehman, for example) and causing a global cardiac arrest of the financial system or being forced to spend trillions of dollars of taxpayers’ money to bail out such systemically critical institutions."

The writers are professors at NYU Stern School of Business and the proposed regulation of systemic risk is part of the NYU Stern project Restoring Financial Stability: How to Repair a Failed System (John Wiley & Sons, 2009)

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Banks on Life Support

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The coming tidal wave of consumers falling behind on their credit cards and other debt will keep banks in sorry shape for the next year or more, Oppenheimer analyst Meredith Whitney told CNBC Wednesday.

“The big banks are going to be on life support for at least 18 months, if not 36 months,” she said. “The big banks will not fail, but the big banks will not grow, in my opinion, for at least another two years.”

Her remarks underscore recent comments by the nation’s top bankers. Bank of America CEO Ken Lewis says he anticipates the credit card industry will experience record losses. Lewis’ predecessor Hugh McColl recently told the San Francisco Business Times that it will take time for the economy to work its way through unwinding the credit bubble. And when he says time, he’s talking years, not months.

“Individuals are over-leveraged,” he said, adding that he’s speaking as an industry observer and not on behalf of BofA (NYSE: BAC).

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Fed Has Already Adopted Quantitative Easing

Image via WikipediaPer the latest Market Watch from Barclays Capital:

"In recent weeks, there has been a rather odd debate over whether the Fed will adopt Japanese-style quantitative easing: that is, flood the banking system with reserves to induce more lending. In our minds, the Fed has already gone well beyond anything the Japanese ever did. It has already dramatically expanded bank reserves, and unlike the Japanese, it has used these funds to intervene aggressively in many parts of the capital markets. This is quantitative easing on steroids.

If our baseline forecast is correct, it could mean a broad-based shift in the capital markets as a variety of risk aversion trades unwind. Once the markets believe policy-makers are succeeding in containing the capital markets and economic crisis, we would expect a rally in risky assets such as credit spreads and equities; a bear steepener in the treasury market, as the Fed holds down the short end and budget deficit concerns push up the long end; a weakening of the dollar as safe-haven inflows ease; and a rally in commodity markets as investors price in an eventual recovery in global demand."

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Bloomberg.com: Exclusive

Image via WikipediaBarclays Dickers on Loan Waivers as European Banks Fight More Writedowns: Royal Bank of Scotland Group Plc and Barclays Capital are staving off writedowns by propping up European companies with plummeting loan values."

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Citi's 'slow, grudging nationalization

Image via WikipediaCan Citigroup survive? - Nov. 24, 2008: "Citi's 'slow, grudging nationalization'

Monday's massive rescue package hasn't solved Citigroup's problems, says bank analyst Christopher Whalen.

(from Fortune Magazine) -- In just a few days Citigroup went from trouble to trauma as its stock price plunged amid sweeping layoffs and deep losses on some of its more esoteric assets. When news reports swirled that the megabank was considering a sale of part or all of the company, it was clear that Citi was singing from the same hymnbook as firms like Lehman Brothers, Wachovia and AIG had before they fell. The public's only question: What would the end game look like?

Now we have our answer - a government agreement to shoulder hundreds of billions of dollars in possible losses and inject billions of dollars into the bank. FORTUNE checked in with bank analyst Christopher Whalen, co-founder of Institutional Risk Analytics and a prescient critic of Citigroup (C, Fortune 500) since 2003, when he said its riskier, higher-return strategy made it more vulnerable than its banking peers.

Here are some excerpts. This one is well worth a read of the full article.

Fortune:

Does this plan solve Citi's problems?

Whalen: This does nothing more than temper the problem, but, no, it hasn't solved anything.

Fortune:

How does this rescue plan differ from the other bailouts we've seen in the past few months?

Whalen: The accurate term for what the government has done is "open bank assistance." It's similar to what the FDIC had to do when it was clear that Wachovia could no longer go on, except there is not a ready buyer in this case. The other big financial institutions have had parties willing to pick up the assets, but you won't see that with Citi. This bailout is more like a resolution. That means that the government essentially has to take control of Citicorp and become more and more involved with its operations until the bank ultimately is nationalized.

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Is Laissez-faire dead?

Image by jetzenpolis via FlickrSome strong words. Read full article here: Are sovereign investment funds the new economic model?

"The Western financial system, as we know it, is dead. Not tarnished or cracked. Dead. With its demise go the Anglo laissez-faire financial mechanisms of the Reagan-Thatcher-Kohl era that have held sway for nearly three decades. The American subset, affectionately referred to as “the cowboy experiment,” run by self-centered eccentrics, is at the root of this collapse. After all, New York, not London, had been the creator of new financial products, strategies and entities. We were the innovators. Leverage was the tool. And greed was the measure of success."

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Good Gracious! - Barrons.com

Image via WikipediaGood Gracious! - Barrons.com: "On Sept. 11, his 91st birthday, Tripp ended a 30-year relationship with his financial advisers at Lehman Brothers' private banking division, Neuberger Berman -- just days before Lehman went under. 'I was verbally assured that my assets were safe,' he recalls, 'but I know when things are falling apart, funny things can happen.' He yanked his money and sent it to another bank.

Plenty of other rich investors are just as dismayed, a result of dismal investment performance and mounting concern about the strength of financial institutions. More than 80% of wealthy investors in one survey said they planned to withdraw at least some of their money from their private bank, and more than half plan to dump their banks altogether.

Many of the respondents probably were venting, rather expressing actual plans. But it's clear that private banks -- outfits that cater to the wealthy and are owned by banks, brokerages and others -- haven't been immune to the turmoil of the past year. Assets under management at the top 40 private banks increased just 4.3% in the year through June 30, versus 20%-plus in each of the previous two years, according to an annual study by Barron's. See nearby table for a ranking of the top 40, based on assets in $1 million-plus accounts."

MetLife Spooks Investors - Forbes.com

MetLife Spooks Investors - Forbes.com: "Insurance stocks plunged Wednesday after MetLife annouced it would be raising capital, cutting jobs and withdrew its 2008 earnings guidance due to the dramatic downturn in the world financial markets.

In an effort to provide some semblance of certainty to nervous investors, MetLife (nyse: MET - news - people ) pre-annouced its third-quarter results, which it said will be hurt by a drop in investment income and fees due to the turmoil in the global financial markets.

In a separate announcement, MetLife said it would sell common stock to bolster its capital amid rising losses on investments. The offering of 75 million shares priced late Wednesday at $26.50, raising nearly $2 billion.

MetLife also promised Wednesday an unspecified number of job cuts by the end of the year.

By the end of Wednesday's highly volatile trading session, MetLife shares fell 26.8%, or $9.87, to $27.00.

"We are in these unprecedented times," Steve Kandarian, MetLife's chief investment officer, said on a call with investors Wednesday, according to the Associated Press. "I think we're as well positioned as anyone in our industry for these times, but we are not immune, nor is any other of our peers."

Those peers fell accordingly. Prudential Financial (nyse: PRU - news - people ) dropped 6.9%, or $3.22, to $43.29, and Lincoln National (nyse: LNC - news - people ) fell 8.5%, or $2.59, to $27.97.

Insurance companies have been among the hardest hit by the recent turmoil in the financial markets. American International Group (nyse: AIG - news - people ) was bailed out by the government, and investment manager and life insurer Hartford Financial Services (nyse: HIG - news - people ) got a much-needed capital infusion from Allianz of Germany. (See "Hartford Recovers With Help From Allianz.")

The mortgage insurance unit of Genworth Financial (nyse: GNW - news - people ) was downgraded recently by Standard & Poor's after its parent company announced that the unit may be on the block. (See "S&P Docks Genworth Mortgage Insurance Unit.")

Over the past month the SPDR KBW Insurance ETF (amex: KIE - news - people ) has fallen 35.9%.

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Bloomberg.com: Exclusive

Bloomberg.com: Exclusive: "`Destroyed the Market'

To be sure, she has angered investors. Some Wachovia shareholders blame her for wiping them out when she helped engineer the sale and warn that other banks will suffer for it.

``That destroyed the market,'' said Peter Kovalski, senior portfolio manager at Alpine Woods Capital Investors LLC. ``Taking over a healthy, well-capitalized bank, the way they did, now investors are not going to be willing to invest in any bank.''"

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Bloomberg.com: Exclusive: "Making a Point

When Bair found herself in control of IndyMac in July, she used the bank to make her point. She suspended foreclosures on $15 billion worth of mortgages and sought to work out deals for the 60,000 borrowers who were behind in payments.

``My hope is that the program for IndyMac Federal Bank will be a catalyst for others across the country to modify their loans more rapidly and systematically,'' she told lawmakers at a hearing last month."

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