| Something very strange is happening in the financial | | | | insurance company. At issue were the soaring losses |
| markets. And I can show you what it is and what it | | | | in its credit default swaps. The first big writeoff came |
| means. If September didn't give you enough to worry | | | | in the fourth quarter of 2007, when AIG reported an |
| about, consider what will happen to real estate prices | | | | $11 billion charge. It was able to raise capital once, to |
| as unemployment grows steadily over the next | | | | repair the damage. But the losses kept growing. The |
| several months. As bad as things are now, they'll get | | | | moment the downgrade came, AIG was forced to |
| much worse. | | | | come up with tens of billions of additional collateral, |
| They'll get worse for the obvious reason: because | | | | immediately. This was on top of the billions it owed to |
| more people will default on their mortgages. But they'll | | | | its trading partners. It didn't have the money. The |
| also remain depressed for far longer than anyone | | | | world's largest insurance company was bankrupt. |
| expects, for a reason most people will never | | | | The dominoes fell over immediately. Lehman Brothers |
| understand. | | | | failed on the same day. Merrill was sold to Bank of |
| What follows is one of the real secrets to | | | | America. The Fed stepped in and agreed to lend AIG |
| September's stock market collapse. Once you | | | | $85 billion to facilitate an orderly sell off of its assets in |
| understand what really happened last month, the | | | | exchange for essentially all the company's equity. |
| events to come will be much clearer to you... | | | | Most people never understood how AIG was the |
| Every great bull market has similar characteristics. The | | | | linchpin to the entire system. And there's one more |
| speculation must - at the beginning - start with a | | | | secret yet to come out... |
| reasonably good idea. Using long-term mortgages to | | | | AIG's largest trading partner wasn't a nameless |
| pay for homes is a good idea, with a few important | | | | European bank. It was Goldman Sachs. |
| caveats. | | | | I'd wondered for years how Goldman avoided the kind |
| Some of these limitations are obvious to any intelligent | | | | of huge mortgage-related writedowns that plagued all |
| observer... like the need for a substantial down | | | | the other investment banks. And now we know: |
| payment, the verification of income, an independent | | | | Goldman hedged its exposure via credit default swaps |
| appraisal, etc. But human nature dictates that, given | | | | with AIG. Sources inside Goldman say the company's |
| enough time and the right incentives, any endeavor will | | | | exposure to AIG exceeded $20 billion, meaning the |
| be corrupted. This is one of the two critical elements | | | | moment AIG was downgraded, Goldman had to begin |
| of a bubble. What was once a good idea becomes a | | | | marking down the value of its assets. And the |
| farce. You already know all the stories of how this | | | | moment AIG went bankrupt, Goldman lost $20 billion. |
| happened in the housing market, where loans were | | | | Goldman immediately sought out Warren Buffett to |
| eventually given without fixed rates, without income | | | | raise $5 billion of additional capital, which also helped it |
| verification, without down payments, and without | | | | raise another $5 billion via a public offering. |
| legitimate appraisals. | | | | The collapse of the credit default swap market also |
| As bad as these practices were, they would not have | | | | meant the investment banks - all of them - had no |
| created a global financial panic without the second, | | | | way to borrow money, because no one would insure |
| more critical element. For things to get really out of | | | | their obligations. |
| control, the farce must evolve further... into fraud. | | | | To fund their daily operations, they've become totally |
| And this is where AIG comes into the story. | | | | reliant on the Federal Reserve, which has allowed |
| Around the world, banks must comply with what are | | | | them to formally become commercial banks. To date, |
| known as Basel II regulations. These regulations | | | | banks, insurance firms, and investment banks have |
| determine how much capital a bank must maintain in | | | | borrowed $348 billion from the Federal Reserve - |
| reserve. The rules are based on the quality of the | | | | nearly all of this lending took place following AIG's |
| bank's loan book. The riskier the loans a bank owns, | | | | failure. Things are so bad at the investment banks, the |
| the more capital it must keep in reserve. Bank | | | | Fed had to change the rules to allow Merrill, Morgan |
| managers naturally seek to employ as much leverage | | | | Stanley, and Goldman the ability to use equities as |
| as they can, especially when interest rates are low, to | | | | collateral for these loans, an unprecedented step. |
| maximize profits. AIG appeared to offer banks a way | | | | The mainstream press hasn't reported this either: A |
| to get around the Basel rules, via unregulated insurance | | | | provision in the $700 billion bailout bill permits the Fed to |
| contracts, known as credit default swaps. | | | | pay interest on the collateral it's holding, which is simply |
| Here's how it worked: Say you're a major European | | | | a way to funnel taxpayer dollars directly into the |
| bank... You have a surplus of deposits, because in | | | | investment banks. |
| Europe people actually still bother to save money. | | | | Why do you need to know all of these details? First, |
| You're looking for something to maximize the spread | | | | you must understand that without the government's |
| between what you must pay for deposits and what | | | | actions, the collapse of AIG could have caused every |
| you're able to earn lending. You want it to be safe and | | | | major bank in the world to fail. |
| reliable, but also pay the highest possible annual | | | | Second, without the credit default swap market, |
| interest. You know you could buy a portfolio of | | | | there's no way banks can report the true state of their |
| high-yielding subprime mortgages. But doing so will limit | | | | assets - they'd all be in default of Basel II. That's why |
| the amount of leverage you can employ, which will limit | | | | the government will push through a measure that |
| returns. | | | | requires the suspension of mark-to-market accounting. |
| So rather than rule out having any high-yielding | | | | Essentially, banks will be allowed to pretend they have |
| securities in your portfolio, you simply call up the friendly | | | | far higher-quality loans than they actually do. AIG can't |
| AIG broker you met at a conference in London last | | | | cover for them anymore. |
| year. | | | | And third, and most importantly, without the huge fraud |
| "What would it cost me to insure this subprime | | | | perpetrated by AIG, the mortgage bubble could have |
| security?" you inquire. The broker, who is selling a | | | | never grown as large as it did. Yes, other factors |
| five-year policy (but who will be paid a bonus annually), | | | | contributed, like the role of Fannie and Freddie in |
| says, "Not too much." After all, the historical loss rates | | | | particular. But the key to enabling the huge global |
| on American mortgages is close to zilch. | | | | growth in credit during the last decade can be tied |
| Using incredibly sophisticated computer models, he | | | | directly to AIG's sale of credit default swaps without |
| agrees to guarantee the subprime security you're | | | | collateral. That was the barn door. And it was left |
| buying against default for five years for say, 2% of | | | | open for nearly a decade. |
| face value. | | | | There's no way to replace this massive credit-building |
| Although AIG's credit default swaps were really | | | | machine, which makes me very skeptical of the |
| insurance contracts, they weren't regulated. That | | | | government's bailout plan. Quite simply, we can't |
| meant AIG didn't have to put up any capital as | | | | replace the credit that existed in the world before |
| collateral on its swaps, as long as it maintained a | | | | September 15 because it didn't deserve to be there in |
| triple-A credit rating. There was no real capital cost to | | | | the first place. While the government can, and certainly |
| selling these swaps; there was no limit. And thanks to | | | | will, paper over the gaping holes left by this enormous |
| what's called "mark-to-market" accounting, AIG could | | | | credit collapse, it can't actually replace the trust and |
| book the profit from a five-year credit default swap | | | | credit that existed... because it was a fraud. |
| as soon as the contract was sold, based on the | | | | And that leads me to believe the coming economic |
| expected default rate. | | | | contraction will be longer and deeper than most people |
| Whatever the computer said AIG was likely to make | | | | understand. |
| on the deal, the accountants would write down as | | | | You might find this strange... but this is great news for |
| actual profit. The broker who sold the swap would be | | | | those who understand what's going on. Knowing why |
| paid a bonus at the end of the first year - long before | | | | the economy is shrinking and knowing it's not going to |
| the actual profit on the contract was made. | | | | rebound quickly gives you a huge advantage over |
| With this structure in place, the European bank was | | | | most investors, who don't understand what's |
| able to assure its regulators it was holding only triple-A | | | | happening and can't plan to take advantage of it. |
| credits, instead of a bunch of subprime "toxic waste." | | | | How can you take advantage? First, make sure you |
| The bank could leverage itself to the full extent | | | | have at least 10% of your net worth in precious |
| allowable under Basel II. AIG could book hundreds of | | | | metals. I prefer gold bullion. World governments' gigantic |
| millions in "profit" each year, without having to pony up | | | | liabilities will vastly decrease the value of paper |
| billions in collateral. | | | | currencies. |
| It was a fraud. AIG never any capital to back up the | | | | Second, I can tell you we're either at or approaching a |
| insurance it sold. And the profits it booked never | | | | moment of maximum pessimism in the markets. These |
| materialized. The default rate on mortgage securities | | | | kinds of panics give you the chance to buy |
| underwritten in 2005, 2006, and 2007 turned out to be | | | | world-class businesses incredibly cheaply. A few |
| multiples higher than expected. And they continue to | | | | worth mentioning are ExxonMobil, Intel, and Microsoft. I |
| increase. In some cases, the securities the banks | | | | have several stocks like these in the portfolio of my |
| claimed were triple A have ended up being worth less | | | | Investment Advisory. |
| than $0.15 on the dollar. | | | | Third, if you're comfortable short selling stocks (betting |
| Even so, it all worked for years. Banks leveraged | | | | they'll fall in price), now is the time to be doing it... simply |
| deposits to the hilt. Wall Street packaged and sold | | | | as a hedge against further declines. |
| dumb mortgages as securities. And AIG sold credit | | | | Keep the fraud of AIG in mind when you form your |
| default swaps without bothering to collateralize the risk. | | | | investment plan for the coming years. By following |
| An enormous amount of capital was created out of | | | | these three strategies, you'll survive and prosper while |
| thin air and tossed into global real estate markets. | | | | most investors sit back and wonder what the hell is |
| On September 15, all of the major credit-rating | | | | going on. |
| agencies downgraded AIG - the world's largest | | | | |