How The Global Credit Crisis Will Affect You

The following was guest blogged by Alex.

The current economic downturn will mean different things to different people. No one really knows the extent of the damage quite yet as it takes time to trickle through the economy. Every time a bank fails, it is one less amplifier in the system creating and distributing money efficiently through the capital markets. If you really think about how fluid money is, then it is not unreasonable to think a new restaurant that would have opened in your neighborhood, may not anymore.

Lehman Brothers’ downfall was extraordinary for it’s speed because it had never reported a quarterly loss since it was spun off by American Express and listed publicly in the early 90s. It went from reporting its first ever quarterly loss to bankruptcy in only 3 months. In the tech world, that would be the equivalent impact of the Research In Motion we know today to it going out of business in 3 months.

AIG’s troubles back in September were even more extraordinary for it’s size. Then Treasury secretary, Henry Paulson, made it very clear the US Government was done bailing out financial institutions and that it was going to leave Lehman Brothers to a private solution (open markets). The fact that they had a change of mind and extended a bridge loan to AIG only 3 days later led many to believe that not even the US Government were completely clued in on the true state of turmoil that was on Wall St.

The general consensus is that the US Treasury made the right decision in throwing a lifeline to AIG for 2 key reasons. AIG’s business spans 130+ countries and a collapse would have accelerated the global economic downturn with mind boggling ramifications. The bigger reason for the bailout, which has been less reported on, is because AIG has a large monoline business (also known as Credit Default Swaps (CDS)). This is the business of insuring bonds (or better known as debt). Just about every mutual fund, hedge fund or institutional investor will use CDS to protect against default from the bonds they hold. If AIG had failed, all the insurance they provided to bond holders around the world would have gone with it. The result? A nuclear meltdown in the global financial markets. Every portfolio manager in the world who had bonds in their portfolio would have had to revalue their bonds lower. If AIG went under, could you still be confident the company issuing you the bond can still make payments to you for the money you lent them? So in that sense, every corporate bond on the market would have had to drop in value to reflect it’s true value (increase the yield) as did the sub-prime CDOs – that is why we hear of the ‘write downs’ from investment banks because the CDOs they continue to hold are worth less and less by the day.

To put this in perspective, the CDS market is estimated to be well over a trillion USD, as much or more than the market of CDOs for all mortgages (including sub-prime), credit cards, auto loans and etc. The reason it is only ‘estimated’ is because CDSs are traded over-the-counter and not on a regulated exchange so there is no traceable record of value or terms of each deal made except for those involved.

Today, AIG is 80% owned by the US Government and effectively nationalized. Next week, it is expected AIG will report the largest US corporate loss ever in history at around $60 billion. To make things worse, they have been selling their assets in the wrong order. AIG’s life insurance businesses globally are still great businesses on their own. Understandably they hesitated to sell them initially, likely hoping things would pass and so instead they tried to sell off their poor performing assets first. Now that there is a need to streamline the business on government pressure, there is a sense that they are desperate to sell off their good businesses. The markets know this and it is partially why they are not getting the high bids for their life insurance units in Asia.

To answer the original question, you will be affected because as less capital is available in the economy, your income is likely to depreciate nominally or intrinsically (true value). If there is one thing you and I can learn from this, which Lehman Brothers, Bear Stearns, Merrill Lynch and AIG did the hard way, it would be that there are many times more debt in the world than there is liquid money (currency). So respect money.