Just in case you have been stranded on an island these last few days, I would like to take a moment to review the cataclysmic events that have happened in our financial system. Lehman Brothers, one of the big investment banks, officially became the largest bankruptcy in US history. The shockwaves sent the global markets down nearly 5% on Monday, as the financial system feared losses in the tens of billions. Lehman dropped 95% in one day. To make things more interesting, AIG- the world’s largest insurance company- also revealed on Monday that it was on the brink of total collapse. AIG dropped nearly 60% in one day. Bank of America made an unusual bid for Merrill Lynch that was a 70% premium to the closing price. The only logical explanation was that it was a shotgun wedding arranged by Paulson and co. during the weekend to instill confidence in the value of other financial companies. On Monday night after the market carnage, it became widely known that AIG would required at least 40 billion dollars in the short-term to stay afloat. Today AIG shares were down as much as 75% before closing down 20%, although as I write this AIG is down 30% after hours. The interbank rate doubled today, reflecting the largest jump since 2007, and a deep freeze in the credit markets. Banks simply will not lend to each other even despite their dire need for liquidity. Today the Fed decided to stand pat on interest rates, and the market rallied, perhaps because the absence of a rate cut signalled confidence that things will settle down.

Analysis

The government has been under fire for nationalizing Fannie Mae and Freddie Mac which will cost taxpayers a large amount of money, and double the national debt. To counter this criticism they decided to make an example out of Lehman Brothers and let it fail to prevent the markets from believing that every bank will be bailed out. Lehman was not as connected to the financial system in the form of swaps and other derivatives as Bear Stearns as most of their bad assets were in the form of bad mortgage-backed securities. The Fed decided that the system could handle the impact of their collapse, although the fallout would still be severe. In contrast AIG is large and heavily interconnected with the financial system. AIG guarantees insurance policies on hundreds of different financial instruments with the most critical being default insurance on deals between two financial parties. It is estimated that AIG could cost the system as much as 200-400 billion dollars if it were to be allowed to fail. Personally I think that this is a lowball estimate. Essentially if AIG fails, the financial system will have to endure a new series of writedowns equivalent to or exceeding the subprime losses. This would of course be catastrophic, and would continue to exacerbate the deadly dominoe effect of bankruptcies within the system. At this rate, the financial system as we know it will completely change. Investment banks will disappear and become absorbed into the larger commercial banks. The environment will be more similar to the Canadian banking system with a handful of large banks that also engage in traditional investment banking activities. The environment will be less competitive and the banks will be more conservative. Regulators will severely curtail the use of derivatives and other complicated financing schemes. Proprietary trading will largely disappear, and most of this type of trading will be replaced by the growing hedge fund industry. For consumers, borrowing will be extremely difficult, and banking and advisory fees will go up for both individuals and corporations. When the dust settles, the financial system will have shrunk to a small fraction of its former size, and the average salary will decline drastically.