AIG rescue fails to boost investor confidence

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The government’s rescue of insurance giant AIG prevented a deeper financial catastrophe but failed to restore confidence Wednesday as investors continued to flee the stock market.

Part of the reason is that the unprecedented move late Tuesday is only a stopgap measure in the ongoing unwinding of a credit bubble that continues to weigh on the financial markets and the economy.

The Fed's decision to extend an $85 billion lifeline to AIG was intended to prevent the insurance giant's cash squeeze from spreading to the hundreds of institutions, investors and governments it does business with.

The immediate concern Wednesday was whether the Federal Reserve’s $85 billion loan to AIG would be enough to stop the company's bleeding. Continued uncertainty about the value of AIG’s holdings left some on Wall Street wondering if the capital infusion is big enough to turn the company around.

Investors began selling at the opening bell Wednesday, and losses accelerated in the final hour of trading, when the Dow, of which AIG is a component lost over 300 points. AIG lost another 45 percent Wednesday to close at $1.70 a share, compared with more than $20 last week and nearly $50 as recently as June.

The blue-chip index already is down 7 percent this week.

AIG’s problem stemmed from uncertainty about the value of a class of investment known as credit default swaps — a kind of insurance against a debt going bad.

The explosion of this paper — some $60 trillion of these swaps are held by banks, brokerages, hedge funds and other financial institutions — is clogging the credit markets and lies at the core of the crisis now engulfing the entire financial system.

“If the markets turn against them and those assets lose value, they’ll have to post additional collateral,” said Carlos Mendez, senior managing director with ICP Capital, referring to AIG. “The majority of that $85 billion will go out the door for collateral calls and other more immediate needs for cash.”

Officials involved in the the rescue said it’s unlikely AIG will need more cash.

“There could be a greater need for capital, but the valuations that were done assumed a lot of worst-case scenarios. Some of the holding companies and the noncore insurance companies were given very, very low valuations,” said Eric Dinallo, superintendent of the New York state Insurance Department.

“So I think that while it is possible and there may be continued degradation and it would require more capital, the federal government has put into place enough to handle those transactions,” he said.

Dinallo added that, with breathing room to sell parts of its business in a more orderly fashion, AIG can get a better price for those assets than if it had to sell under pressure. Other insurance companies already have expressed interest in buying pieces of AIG, he said.

While the clock has stopped ticking on AIG, it appeared to have little impact on the loss of confidence in the financial markets. Several major financial companies remained under pressure due to widespread uncertainty about the value of assets. Morgan Stanley was reportedly looking for a merger partner, and a buyer was being sought for Washington Mutual.

The growing uncertainty over the value of assets raised the cost of short-term borrowing, putting further pressure on companies that need to cover short-term debts.

“If your business is based upon having to walk in every morning and borrow billions of dollars to keep your business going, you got a real problem right now,” said Stephen Massocca, a partner at the investment firm Pacific Growth Equities. “So many of these (companies) — be it hedge  funds or investment banks or whatever — are dependent on the ability to borrow money on a day-to-day basis. That drives their business plan, and that's a big issue right now.”

One strong indication that the credit crunch continues to weigh on the financial system was the announcement Wednesday that the Treasury Department plans to issue fresh bonds to help shore up the capital base of the Federal Reserve system.

It’s not clear how the government will respond to future financial meltdowns. The refusal by Fed and Treasury officials last weekend to backstop the failed investment bank Lehman Bros.  was seen by many as a “line in the sand” — a signal that the government would not put taxpayer dollars at risk to rescue companies that made bad financial decisions and took on too much risk. Just days later, the government has apparently reversed course in its rescue of AIG.

The ad hoc nature of the government’s approach has prompted calls for a broader government response to the crisis in the financial sector. Rep. Barney Frank, D-Mass., chairman of the House Financial Services Committee, has called a hearing to consider setting up a separate government agency to oversee the bailout of failed financial institutions.

"The issue is are we now in a situation where there's so much bad paper out there, at least temporarily devalued, that it's clogging the system and somebody has to step in and take it off (the books)," Frank told CNBC.

Proponents of a new agency to deal with the crisis say it would go a long way to restoring confidence in the financial system.

“Right now we're dealing with it on an ad hoc basis -- but only during times of crisis,” said Bernard McSherry, senior vice president with institutional brokerage Cuttone & Co. “If we can set up a vehicle to take some of those assets off the books of banks that are not in crisis earlier in the process, we might get a more orderly disposition of some of those assets.”

Much of the uncertainty over the value of assets in the financial system is due to the declining value of housing — the asset backing much of the most problematic debt. The housing market continues to grind through its biggest downturn since the Great Depression. Fresh evidence came Wednesday with data showing that housing construction hit a 17-year low last month.

While home sales have begun to show signs of stabilizing, prices are still falling in many areas of the country. That suggests that a larger portion of those sales may be coming from foreclosures, according to John Ryding, chief economist at RDQ Economics.

“With a large overhang of unsold homes in relation to sales, and prices continuing to decline, it is too soon to look for stabilization in housing construction,” he said.

There are also concerns that the credit crisis in the financial system is spilling over to the broader economy. While the economy continues to post growth, the rising pace of job losses is a troubling sign that growth may be faltering. The slowdown in the global economy and the rising value of the dollar will likely dampen the recent demand for U.S. exports. Despite low interest rates, credit is harder to come by as lenders have tightened their standards, and consumer spending is slowing.

"Major downside risks to the economy, with diminishing inflation risks, are plain for anyone who has eyes to see," said Brian Bethune, an economist with Global Insight.