It's getting bad

AIG, America’s largest insurance company, is down over 21% today. Its losses for the year are impressive: on Sept. 17, 2007, it closed at just under $65 a share. It closed today at $3.75. At one point shares traded at a buck and a quarter a pop.

Because of its exposure to securities (and I use that term only in its most technical sense) based on subprime mortgages, its credit rating has been downgraded: “Standard & Poor's lowered its rating on AIG to A- from AA-, and Moody's Investors Service cut its rating to A2 from Aa3. Fitch Ratings and AM Best also downgraded AIG.”

The downward move in its credit rating will trigger the need to provide an additional $14.5 billion or more in collateral (above already immense collateral obligations) to shore up insurance contracts, including derivatives like credit default swaps. It also may be enough of a slap to their credit worthiness that customers will begin to cancel policies because of fear AIG won’t be able to cover their obligations. The downgrade will also mean that any debt issued by AIG going forward will come at a higher premium and that principle on outstanding debt is going to be worth less than its original face value. If you own bonds issued by AIG, you lost money overnight. Individuals, mutual funds, and financial institutions worldwide own AIG paper. Even if you don’t directly own the company’s bonds, you might be exposed to them. The potential that they might default makes more borrowing more expensive.

This is a downward spiral.

What’s going on?

From the NY Times:

“Most of A.I.G.’s businesses are healthy, but its troubles grew from one unit that dealt in complex debt securities and derivatives and now threatens to drain cash more quickly than the financing package can be assembled.”

I have no idea whether AIG can survive. The necessary cash infusion numbers are astronomical. Up to $75 billion in some reports. The impact on the rest of the financial world is going to be monstrous. AIG has expensive dealings with banks and financial institutions and governments all over the world. One BBC report has it that AIG insures more than $300 billion in mortgages held by European banks. Banks in Hong Kong, Sydney, Seoul, Toronto and Frankfurt will be hurt if the company fails.

Ideas for short term solutions are above my pay grade, to borrow a phrase. Most likely they will involve borrowing more than phrases.

But going forward through the wreckage of this week one thing is abundantly clear. The financial system is in dire need of a way to regulate the derivatives market. We must have a transparent way to assign real value to the financial instruments which are at the heart of this disaster. Private credit ratings companies and government regulators have utterly failed all of us.

Until today, I wasn’t that worried about the severity of this recession. It was bad, to be sure. But I could imagine a way out of the swamp. Now the alligators have moved in among us and the swamp is becoming malarial.