Posts Tagged ‘AIG’

Central banks helping to increase your insurance premium

Wednesday, April 15th, 2009

Insurance is one of the easiest businesses to understand. Basically, it earns money this way:

  1. Collect insurance premiums
  2. Invest the collected premiums (in insurance jargon, this invested money is known as floats)
  3. Pay out insurance claims

Where are the areas that can go wrong with this kind of business?

One possibility is that it may miscalculate the probability of mishaps and mispriced the insurance premiums charged to customers. As a result, claims on the insurance company overwhelms its ability to pay. The Australian government’s guarantee of bank deposits and funding is akin to providing insurance to the Australian financial system. But as we said before in Australian government?s contingent liability to exceed AU$1 trillion, if the mishaps in the financial system are correlated with each other, the Australian government may find that it has burned a big hole in its pocket. For insurance companies, at least they can buy re-insurance to insure itself from such fiascos. The Australian government, on the other hand, have no re-insurance to insure itself other than the monetary printing press.

The other possibility of what can go wrong can occur when it suffer severe losses in its investment endeavours. That can happen when the investment divisions of insurance companies decide to become cowboys and get involved in sexy derivatives, as in the case of AIG. The more prudent ones keep a substantial portion of its investment portfolio in safe bonds and other fixed interest securities. That’s where central bankers are not helping. By cutting interest rates to below price inflation rate, the investment returns of insurance companies get eroded. Along with rising value of claims due to price inflation (e.g. rising health care costs for health insurance), their profit margins get squeezed, sometimes so severely that they can suffer losses.

So, guess what insurance companies will do in that case? They raise the premiums that all of us pay. Cutting interest rates may be good for borrowers, but as everything else in life, there is no such thing as a free lunch.

Is this the beginning of the loss of confidence in fiat money?

Sunday, September 21st, 2008

Events from the past week are tumultuous. It started from the nationalisation of Freddie and Fannie (we were mulling about the implication of nationalisation 2 months ago in How do we all pay for the bailout of Fannie Mae and Freddie Mac?). Then came the bankruptcy of Lehman Brothers and takeover of Merrill Lynch. Then we have the nationalisation of AIG. Gold prices surged by more than US$100 in two days (it had declined since), which was the most rapid surge in 26 years. At the same time, the Dow plunged by more than 400 points. It looked as if there was a panic from stocks straight to gold, which meant even cash was distrusted.

Then we have another massive rally in stocks for the past two days when there was hope that the US government, in conjunction with the Federal Reserve are doing something to solve the root of the rot in the financial system. Reports come out that they are planning to use taxpayers’ money to buy up bad assets at sale price. As always the case, the devil is in the details. At this point in time, there is no definitive figure on the cost. Make no mistake about this: this is no trivial task. As this New York Times article reported, Ben Bernanke warned the Congressional leaders,

As Senator Christopher J. Dodd, Democrat of Connecticut and chairman of the Banking, Housing and Urban Affairs Committee, put it Friday morning on the ABC program ?Good Morning America,? the congressional leaders were told ?that we?re literally maybe days away from a complete meltdown of our financial system, with all the implications here at home and globally.?

Mr. Schumer added, ?History was sort of hanging over it, like this was a moment.?

When Mr. Schumer described the meeting as ?somber,? Mr. Dodd cut in. ?Somber doesn?t begin to justify the words,? he said. ?We have never heard language like this.?

By now, it should be clear that this global financial disaster has the potential of even surpassing the Great Depression of the 1930s!

Is this crisis a surprise? If you listen to the mainstream economic schools of thought, central bankers, mainstream financial media, captains of the financial industry and so on, it looked as if this looming financial disaster is something that no one can see coming. The common underlying excuse (that was un-said, un-written but implied) goes something like this: “No one could ever foresee this! It’s impossible! Only hindsight can tell!”

Now, we would like to make it clear that this is completely false. Please note that we are not accusing individuals of lying. Instead, our point is that this excuse is a sign of collective mass delusion. If you look at the 6000 years worth of the history of human civilisation, you will find that humanity is repeatedly capable of mass delusions. Always, only the minority could see through the lie. In this case, students and practitioners of the non-mainstream Austrian School of economic thought SAW IT COMING. Some of them sounded the alarm as early as 2004! To press our point further, let’s us show you the chronicle of our warnings in this blog since 2006…

  1. In May 2008, when the world was in denial about the precarious state of the global financial system, Satyajit Das warned that the credit crisis was just the end of the beginning (see Is the credit crisis the end of the beginning?).
  2. Back in November 2007, if you look at the list of major US financial institutions that was compiled by Nouriel Roubini at How solvent are some of the major US financial institutions?, only half of them are left standing. Interestingly, Merrill Lynch was the safest among the insolvents and today, it failed to live. If Merrill Lynch was insolvent, what about the remaining ones today (i.e. Goldman Sachs, Morgan Stanley, Citigroup)?
  3. In June 2007, in Epic, unprecedented inflation, we warned that

    How much longer will the roaring global economy fly? We do not know the answer, for this boom may last longer than what we anticipated. However, please note that in the entire history of humanity, all bubbles (and we repeat, ALL) burst in the end. Thus, a global painful hangover will ensue?the greater the boom, the more painful the eventual bust. This is the theme that we had repeated many times.

    Thus, do not be surprised if a second Great Depression were to strike.

  4. In the same month, the Bank for International Settlements (BIS) warned that the world was in danger of another Great Depression (see Bank for International Settlements warns of another Great Depression).
  5. Back in January 2007, in Spectre of deflation, we wrote that

    But we smell danger.

    It is a danger in which many in the finance industry failed to fully appreciate?deflation. Such complacency is beyond our belief. In the 1990s, Japan experienced it, with dire consequences for their economy. At least, the ordinary Japanese had their savings to fall back on. For many Americans, with their negative savings rate, what can they fall back on? Have they not learned from the mistakes of others in the past?

  6. In the same month, Trichet, the president of EU central bank warned of a coming asset re-pricing (see Prepare for asset repricing, warns Trichet).
  7. Back in November 2006, in How will asset-driven ?growth? eventually harm the economy?, when the global economy was still booming in apparent ‘prosperity’, we quoted the late Ludwig von Mises (the in which the Mises Institute of the libertarian Austrian School of economic thought is named after) and warned that

    That collective error in judgement resulted in the economy misallocating scarce resources into housing sector?in the case of the US, a significant proportion of the jobs created during the asset-driven ?growth? was related (both directly and indirectly) to the housing boom. Since economic resources are always scarce, any misallocation of it implies an opportunity cost on the other sectors of the economy. The result is a structural damage to the economy that can only be corrected through a recession.

    This is the reason why we believe a recession is on its way.

  8. In October 2006, we quoted the late Dr. Kurt Richeb├Ącher (an Austrian School economist) and questioned in The Bubble Economy,
  9. These are some of the serious questions we would like to ask:

    1. As the US spends its way into economic ruin, its economy is being damaged structurally. How much longer can the US sustain its colossal debt?
    2. Right now, the US housing bubble is deflating. Will it eventually burst and wreck havoc on the rest of the economy?

Other contrarians who sounded the alarm long ago (and we quoted often) include Marc Faber, Jimmy Rogers, Robert Shiller, Peter Bernstein, Nouriel Roubini and our local Aussie economist, Professor Steve Keen.

Our readers should, by now, appreciate the colossal magnitude of this financial crisis. When you listen the media, the phrase “since the Great Depression” is often mentioned. Make no mistake about this, this has the potential to be worse than the Great Depression (note: we are NOT predicting that it will happen).

The world’s stock market is rallying in the hope that the US government’s plan to nationalise the financial industry will be successful in stopping the core of the rot. New legislations has to be rushed through Congress by the end of next week to change the rules to make the plan legal. As in everything done in haste, we believe there will not be enough thought put into them to understand the long-term ramifications. It is probable that once the changes are in place, they will not be revisited again.

As we warned in Recipe for hyperinflation,

There is no way any politician can sell the message that America needs a severe recession (or even a depression) to cleanse the economy from the gross excesses, imbalances, blunders and mal-investments. Thus, it is very likely that they will have to fight deflation till the very bitter end, till the last drop of blood from their last soldier. Since the current structure of ?rules? will be too restrictive in such a war against deflation, there will be popular momentum towards the bending and rolling back of these ?rules.? If they press on relentlessly till the final end, there can only be one outcome: the US dollar will be joining the long list of failed fiat paper money in the annals of human civilisation.

Chained together, for better for worse

Wednesday, September 17th, 2008

As the drama unfolds in Wall Street over the past week, you may wonder what the big deal is. So what if Lehamn Brothers collapses? So what if AIG and Washinton Mutual go down the grave too. Why are the financial markets, central bankers and governments all over the world so jumpy about all these failures?

One word to explain it: contagion.

As we explained back in Financial system?messy, tangled ball of yarn,

All these ?wonders? of the modern financial system, namely debt and derivatives, enabled the creation of a complex tangled mess of linkages between participants (e.g. financial institutions, funds, investors, banks, etc). The former (debt) allows the use of leverage while the latter (derivatives) allows risks to be transferred like a hot potato from one hand to the other. That sounds good, does it? But what if the derivative that you used to hedge your risks become useless because the counter-party of that derivative could not honour its obligation? In that case, you may not be able to honour your obligation against another party. Imagine repeating this scenario countless times over, forming a yarn of complex entanglements. What if a small section of the yarn catches fire? What will happen to the yarn as a whole?

To give you a more concrete idea of what’s going on in the financial system, consider this hypothetical scenario from this excellent article, The Ultimate Wall Street Nightmare:

Here’s the great dilemma: The tangled web of bets and debts linking each of these giant players to the other is so complex and so difficult to unravel, it may be impossible for the Fed to protect the financial system from paralysis if just one major player defaults. And if Lehman is not that player, the next one will be.

To understand why, put yourself in the shoes of a senior derivatives trader at a big firm like Morgan Stanley (which has $7.1 trillion in derivatives on its books and about $10 billion in capital).

Let’s say you’re personally responsible for $500 billion in derivatives contracts with Bank A, essentially betting that interest rates will decline.

By itself, that would be a huge risk. But you’re not worried because you have a similar bet with Bank B that interest rates will go up.

It’s like playing roulette, betting on both black and red at the same time. One bet cancels the other, and you figure you can’t lose.
Here’s what happens next …

  • Interest rates go up, reflecting a 2% decline in bond prices.
  • You lose your bet with Bank A.
  • But, simultaneously, you win your bet with Bank B.
    So, in normal circumstances, you’d just take the winnings from one to pay off the losses with the other ? a non-event.

But here’s where the whole scheme blows up and the drama begins: Bank B suffers large mortgage-related losses. It runs out of capital. It can’t raise additional capital from investors. So it can’t pay off its bet. Suddenly and unexpectedly …

You’re on the hook for your losing bet.
But you can’t collect on your winning bet.

You grab a calculator to estimate the damage. But you don’t need one ? 2% of $500 billion is $10 billion. Simple.

Bottom line: In what appeared to be an everyday, supposedly “normal” set of transactions … in a market that has moved by a meager 2% … you’ve just suffered a loss of ten billion dollars, wiping out all of your firm’s capital. Now, you can’t pay off your bet with Bank A ? or any other losing bet, for that matter.

Bank A, thrown into a similar predicament, defaults on its bets with Bank C, which, in turn, defaults on bets with Bank D. Bank D has bets with you as well … it defaults on every single one … and it throws your firm even deeper into
the hole.

During the 2nd century AD, just before the official end of the Han Dynasty, China was broken up into warlord’s fiefdoms. One warlord, Cao Cao, was amassing a large navy to defeat the combined forces of Liu Bei and Sun Quan. Cao Cao, used a misguided strategy to protect his navy from being scattered by chaining the ships together. His enemies launched an incendiary attack. Because his ships were chained together, fire spread from one ship to another and none of them could scatter to escape. The result: a massive defeat that paved the way for China to be split into 3 kingdoms.

This is the same for today’s financial system. They are chained together by derivatives.