Shiv139

Federal Reserve Buys AIG

United States stepped up with an $85 billion loan in exchange for a 79.9% equity stake in AIG.

When BSC was bailed out the question of a moral hazard arose. Yet a LEH buy out was not forth coming. A few days prior, FRE & FNM were rescued. A day later we have AIG rescued. Why?

Now that solvency has become a major issue and is a great danger to both Wall Street & the real economy, how should this be tackled? A central back serves an important function as a lender of the last resort; should the government also act as an investor of the last resort?

The problem, has spread from mere sub-prime to other debt and on to liquidity & now solvency. The de-leveraging of the system is causing all asset classes to contract as positions are wound down. This is probably one major reason why oil stays down despite production costs & Ike (whose impact was limited but certainly not welcome news).

I think a trend is emerging. United States will act as a "lender of the last resort" to prevent damage from liquidity related issues through the Fed's monetary policy including rate cuts as necessary & most importantly the window.

In addressing a crisis arising from solvency related problems - United States will protect Main Street, acting as an "investor of the last resort"; which is not dis-similar to a sovereign wealth fund. So FMN, FRE and AIG are saved but LEH is not. In all cases the moral hazard is avoided simply because the existing owners effectively lose all; this is unlike the first bail out of BSC where the existing shareholders were protected.

My own view is that for a nation to act as a sovereign wealth fund in times of crisis is not desireable; particularly for a nation with spectacular deficits. However in times of unprecedented crisis it might be perceived that such an action is required.

Ultimately, a view might form that if Wall Street institutions (not their shareholders) are saved; in most situations, the administration will secure a good long term return on its investment. And that too with no moral hazard. The entity failing is racked by a confidence crisis, the United States administration can provide the lacking confidence; the synergy from provision of the confidence intangible has an immediate positive impact on the acquired entities valuation and to an extent makes a profitable exit once the crisis is over likely. This avoids getting into a self perpetuating cycle of crises of liquidity-write downs-capital required-confidence-so...

The big risk is that these investments will cause a rising deficit, inflation and interest rate increases. Today foreign investors question the risk of United States financial institutions; tomorrow, if the credibility of the United States as a debtor nation comes into question, there will be hell to pay for the globe.

Had the United States been in a surplus position, the governments acting as an "investor of the last resort" is a no brainer; in the present situation of record deficits, it is a huge risk. In the long run, it might be better to allow the solvency issues to work their way through the system and allow the economy to restore its own health and well being.