AIG Collapse - You have to read this!

Posted November 10th, 2008 by Brett Anuik
How AIG's Collapse Began a Global Run on the Banks 
By Porter Stansberry October 4, 2008
 
Something very strange is happening in the financial markets. And I can show you what it is and what it means...  If September didn't give you enough to worry about, consider what will happen to real estate prices as unemployment grows steadily over the next several months. As bad as things are now, they'll get much worse. 
 
They'll get worse for the obvious reason: because more people will default on their mortgages. But they'll also remain depressed for far longer than anyone expects, for a reason most people will never understand.  What follows is one of the real secrets to September's stock market collapse. Once you understand what really happened last month, the events to come will be much clearer to you...  Every great bull market has similar characteristics. The speculation must, at the beginning, start with a reasonably good idea.
 
Using long-term mortgages to pay for homes is a good idea, with a few important caveats.  Some of these limitations are obvious to any intelligent observer... like the need for a substantial down payment, the verification of income, an independent appraisal, etc. But human nature dictates that, given enough time and the right incentives, any endeavor will be corrupted. This is one of the two critical elements of a bubble. What was once a good idea becomes a farce. You already know all the stories of how this happened in the housing market, where loans were eventually given without fixed rates, without income verification, without down payments, and without legitimate appraisals. 
 
As bad as these practices were, they would not have created a global financial panic without the second, more critical element. For things to get really out of control, the farce must evolve further... into fraud.  And this is where AIG comes into the story.  Around the world, banks must comply with what are known as Basel II regulations. These regulations determine how much capital a bank must maintain in reserve.
 
The rules are based on the quality of the bank's loan book. The riskier the loans a bank owns, the more capital it must keep in reserve. Bank managers naturally seek to employ as much leverage as they can, especially when interest rates are low, to maximize profits. AIG appeared to offer banks a way to get around the Basel rules, via unregulated insurance contracts, known as credit default swaps.  Here's how it worked: Say you're a major European bank... You have a surplus of deposits, because in Europe people actually still bother to save money.
 
You're looking for something to maximize the spread between what you must pay for deposits and what you're able to earn lending. You want it to be safe and reliable, but also pay the highest possible annual interest. You know you could buy a portfolio of high-yielding sub prime mortgages. But doing so will limit the amount of leverage you can employ, which will limit returns.  So rather than rule out having any high-yielding securities in your portfolio, you simply call up the friendly AIG broker you met at a conference in London last year.  "What would it cost me to insure this sub prime security?" you inquire. The broker, who is selling a five-year policy (but who will be paid a bonus annually), says, "Not too much." After all, the historical loss rates on American mortgages is close to zilch.  Using incredibly sophisticated computer models, he agrees to guarantee the sub prime security you're buying against default for five years for say, 2% of face value. 
 
Although AIG's credit default swaps were really insurance contracts, they weren't regulated. That meant AIG didn't have to put up any capital as collateral on its swaps, as long as it maintained a triple-A credit rating. There was no real capital cost to selling these swaps; there was no limit. And thanks to what's called "mark-to-market" accounting, AIG could book the profit from a five-year credit default swap as soon as the contract was sold, based on the expected default rate. 
 
Whatever the computer said AIG was likely to make on the deal, the accountants would write down as actual profit. The broker who sold the swap would be paid a bonus at the end of the first year, long before the actual profit on the contract was made.  With this structure in place, the European bank was able to assure its regulators it was holding only triple-A credits, instead of a bunch of sub prime "toxic waste." The bank could leverage itself to the full extent allowable under Basel II. AIG could book hundreds of millions in "profit" each year, without having to pony up billions in collateral.  It was a fraud. AIG never had any capital to back up the insurance it sold. And the profits it booked never materialized.
 
The default rate on mortgage securities underwritten in 2005, 2006, and 2007 turned out to be multiples higher than expected. And they continue to increase. In some cases, the securities the banks claimed were triple A have ended up being worth less than $0.15 on the dollar. Even so, it all worked for years. Banks leveraged deposits to the hilt. Wall Street packaged and sold dumb mortgages as securities. And AIG sold credit default swaps without bothering to collateralize the risk.
 
An enormous amount of capital was created out of thin air and tossed into global real estate markets.  On September 15, all of the major credit-rating agencies downgraded AIG, the world's largest insurance company. At issue were the soaring losses in its credit default swaps. The first big write off came in the fourth quarter of 2007, when AIG reported an $11 billion charge. It was able to raise capital once, to repair the damage. But the losses kept growing.
 
The moment the downgrade came, AIG was forced to come up with tens of billions of additional collateral, immediately. This was on top of the billions it owed to its trading partners. It didn't have the money. The world's largest insurance company was bankrupt.  The dominoes fell over immediately. Lehman Brothers failed on the same day. Merrill was sold to Bank of America. The Fed stepped in and agreed to lend AIG $85 billion to facilitate an orderly sell off of its assets in exchange for essentially all the company's equity.  Most people never understood how AIG was the linchpin to the entire system. And there's one more secret yet to come out...  AIG's largest trading partner wasn't a nameless European bank. It was Goldman Sachs. 
 
I'd wondered for years how Goldman avoided the kind of huge mortgage-related write downs that plagued all the other investment banks. And now we know: Goldman hedged its exposure via credit default swaps with AIG. Sources inside Goldman say the company's exposure to AIG exceeded $20 billion, meaning the moment AIG was downgraded, Goldman had to begin marking down the value of its assets. And the moment AIG went bankrupt, Goldman lost $20 billion. Goldman immediately sought out Warren Buffett to raise $5 billion of additional capital, which also helped it raise another $5 billion via a public offering. 
 
The collapse of the credit default swap market also meant the investment banks all of them had no way to borrow money, because no one would insure their obligations. To fund their daily operations, they've become totally reliant on the Federal Reserve, which has allowed them to formally become commercial banks. To date, banks, insurance firms, and investment banks have borrowed $348 billion from the Federal Reserve, nearly all of this lending took place following AIG's failure.
 
Things are so bad at the investment banks, the Fed had to change the rules to allow Merrill, Morgan Stanley, and Goldman the ability to use equities as collateral for these loans, an unprecedented step.  The mainstream press hasn't reported this either: A provision in the $700 billion bailout bill permits the Fed to pay interest on the collateral it's holding, which is simply a way to funnel taxpayer dollars directly into the investment banks. 
 
Why do you need to know all of these details? First, you must understand that without the government's actions, the collapse of AIG could have caused every major bank in the world to fail.  Second, without the credit default swap market, there's no way banks can report the true state of their assets they'd all be in default of Basel II. That's why the government will push through a measure that requires the suspension of mark-to-market accounting. Essentially, banks will be allowed to pretend they have far higher-quality loans than they actually do. AIG can't cover for them anymore.  And third, and most importantly, without the huge fraud perpetrated by AIG, the mortgage bubble could have never grown as large as it did.
 
Yes, other factors contributed, like the role of Fannie and Freddie in particular. But the key to enabling the huge global growth in credit during the last decade can be tied directly to AIG's sale of credit default swaps without collateral. That was the barn door. And it was left open for nearly a decade.  There's no way to replace this massive credit-building machine, which makes me very skeptical of the government's bailout plan. Quite simply, we can't replace the credit that existed in the world before September 15 because it didn't deserve to be there in the first place. While the government can, and certainly will, paper over the gaping holes left by this enormous credit collapse, it can't actually replace the trust and credit that existed... because it was a fraud.  And that leads me to believe the coming economic contraction will be longer and deeper than most people understand.
 

Job well done!

Posted November 10th, 2008 by Brett Anuik
Good Morning Brett,
 
Thank you for the info.
I think all of our questions have been covered for now, you did a great job the other evening, very professional and you made it a pleasure talking with you.
 
Regards, Anne

What is all this talk about sub prime mortgages and Credit Crunch?

Posted October 17th, 2008 by Brett Anuik

Sub prime mortgages can be traced back to Jimmy Carters presidency when his administration relaxed lending qualifications for big business. Post presidential adminstrations have little by little relaxed these lending qualifications to a point where the current Bush administration ordered Fannie Mae and Freddie Mac to give mortgages to consumers who would normally be considered high risk. By doing this Fannie & Freddie were forced to increase their high risk lending exposure from 6% to 20% over a 1-2 year period.

To compound matters in an attempt to spur on economic growth the US federal bank lowered interest rates to record lows. This created high levels of cash in the economy or "easy money" and generous lending situations for borrowers began to occur. These generous lending conditons also favoured consumers who would normally be considered high rish lenders.

High risk mortgages were then given to consumers who normally would not qualify and included incentives such as teaser rates. Teaser rates are not uncommon and can be compared to credit card balance transfer offers, where a consumer would get a discounted interest rate for a limited  time at which point the rate would be significantly increased.

Once the loans were made banks contracted with other financial institutions, who bought up the loans at a discount and packaged them with higher quality loans in an attempt to make the high interest loans more attractive. This created a promising higher yield product, which were in turn then sold to institutional investors and secondary lenders.The creators and consumers of the sub prime mortgages never anticipated a decline in the real estate market. They  always believed the value of real estate would increase, so if times got bad they could at least break even if forced to sell. Unfortunately, the bubble had to burst and real estate prices began to crumble.

It was at this point mortgages became more than what consumers could afford due to the expiring low introductory rates and mortgage values becoming greator than property values. The only option left for the consumer was give up their homes and drop the keys off at the bank. This happened in such great numbers that banks were forced to take heavy losses, which has created uncertainty among banks and consumers. Banks won't even lend to each other never mind lending to consumers creating to what has been called the current "Credit Crunch"

Canadian Market Update

Posted April 16th, 2008 by Brett Anuik

Despite a dramatic sell-off to end the week, the S&P/TSX Composite index managed a slim gain of 0.1% on the week.  The benchmark index has now risen three straight weeks, prompting the late-week profit-taking bout.  The slide was sparked by a poor earnings announcement from bellwether U.S. conglomerate General Electric that sent stock markets tumbling around the world on hightened recession worries.  Canadian equities were not immune to the selling, with the benchmark index plunging over 225 points on Friday alone.  Overall, three of the 10 sectors the index ended in positive territory. Among the winning groups were the Energy and the Materials sectors, which rose 3.1% and 1.0% respectively on the week.  Resource stocks have rallied for three straight weeks and were the lone bright spots amidst all the selling.  The largest contributors within the Energy sector were heavyweights Canadian Natural Resources (+8.3%), EnCana (+3.4%) and Suncor (+3.7%).  Potash Corp. of Saskatchewan stood out within the Materials sector, gaining a strong 5.9%.  Investors continued their love affair with the fertilizer producer which is already up over 27% this year.  The Utilities sector also stayed above water, but underperformed the index.  On the downside, the Information Technology sector led the fall, shedding 3.1% to break its four-week winning streak.  Within the sector, MacDonald Dettwiler and Associates (MDA) contributed to the losing week after seeing its share price fall 7.5%.  MDA’s stock price tumbled on news that Ottawa had blocked the sale of its satellite unit to Minnesota-based Alliant Technologies.  The proposed US$1.325 billion deal was vetoed because of the firm’s satellite imaging technology that was deemed critical to national defense.  This was the first time ever that the Canadian government has stepped in to block the purchase of a domestic firm by a foreign buyer.

How good is mortgage insurance? Really?

Posted April 9th, 2008 by Brett Anuik

Introduction to the concept

  • A mortgage is the single largest debt most Canadians will ever assume. Most consumers will take the time to shop around for good interest rates and terms that suit their needs, but not everyone bothers to do the same for the accompanying mortgage insurance.
  • Many simply accept the coverage that's offered by their lender without investigating other options. That's a pity, because in many cases you can obtain better coverage for a lower price from an independent financial advisor.

What is mortgage insurance for?

  • Mortgage insurance is about protecting your loved ones. If something should happen to you (or your partner), mortgage insurance will pay off your debt. It's a simple concept, but the details in each contract can vary significantly.

What kind of coverage does the bank offer?

  • If you purchase mortgage insurance from your bank or credit union, you are purchasing creditor's group insurance.
  • You are a certificate holder. You do not own the policy. The bank may make changes to the coverage without your consent, and coverage will terminate as soon as the mortgage is paid off.
  • The premium you pay remains the same, but the coverage decreases along with the balance of your mortgage. You are paying a level amount for decreasing coverage.
  • You are not able to name your own beneficiary. If something should happen to you, the bank receives the insurance proceeds directly.
  • If you decide to change banks at a later date, you will have to re-apply for insurance coverage pay rates based on your age at that time, and if your health has changed, you may be declined.
  • In most cases, creditors group is based on "blended rates," meaning that smokers and non-smokers pay the same amount for the same coverage. If you live a healthy lifestyle, you will pay the same amount as someone who is overweight and smokes a pack a day.

What are the advantages of owning my own mortgage insurance policy?

  •  An individual mortgage insurance policy, obtained directly from an insurer, puts you in control of your own coverage.
  • You own the policy. If you decide you want to keep some or all of the insurance after the mortgage is paid off, you may do so.
  • Your insurance is for a fixed amount, based on the original amount of your mortgage. If you purchase a policy for $200,000 and you die when your mortgage is only $100,000, your heirs will still receive the full $200,000.
  • You may name whomever you please as beneficiary — spouse, child, grandchild or friend. They receive the funds directly from the insurance company, meaning they are free to decide whether they want to pay off the mortgage, or invest the funds and use the interest to make the monthly payments.
  • An individually-owned policy is fully portable. When your mortgage renews, you are free to shop around for the best rate. If you decide to change lenders, your individual policy will come with you — completely unchanged from when you first obtained it. You will not have to reapply for coverage, and your premiums will remain unchanged.
  • An individual policy is underwritten based on your individual circumstances. Someone who leads a healthy lifestyle could end up paying a much lower rate for better coverage.

What can I do about my student loans?

Posted April 1st, 2008 by Brett Anuik
After graduating you have six months before you have to start paying back. If you can prove low or no income you may be eligible for interest relief where the gov't will pay the interest on your loans for six months. I believe you can recieve a maximum 2-5 years of relief. After you have exhausted your interest relief you may be eligible for the debt reduction program. This program will relieve you of a percentage of you gov't held debt base on your financial ability to pay.
 
To answer your questions about not paying. You could default on the loan. Because your loan is held by the government and RBC you'll have two different collections coming after you. What will happen to the gov't held portion of the loan depends. They may come after you for it, but it's more likely the gov't will right it off. The privately held portion is another story. If you don't pay the loan it will go into default and they will call it. They'll send you a bunch of nasty letters and finally they'll give you a buy out amount. This is probably your best chance to negiotate with them.  You can find out what the buyout amount is if you call them.
 
 RBC is relentless and will track you down and hound you for it. When I was in school my roomate tried to skip on his and it was a nightmare for him. Somehow they found him and constantly baggered him for it. You have to be nice them when you're talking to them or else you have no chance with them. Try and find a rep that is sympathatic and keep dealing with them. They may tell you the information is on the internet, but I've never been able to find it. One other thing to remember is keep everything you send them and they send you. Keep good notes when talking to them on the phone.
 

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