AIG: What It Means?

David R. Kotok co-founded Cumberland Advisors in 1973 and has been its Chief Investment Officer since inception. He holds a B.S. in Economics from The Wharton School of the University of Pennsylvania, an M.S. in Organizational Dynamics from The School of Arts and Sciences at the University of Pennsylvania, and a Masters in Philosophy from the University of Pennsylvania. Mr. Kotok’s articles and financial market commentary have appeared in The New York Times, The Wall Street Journal, Barron’s, and other publications. He is a frequent contributor to CNBC programs. Mr. Kotok is also a member of the National Business Economics Issues Council (NBEIC), the National Association for Business Economics (NABE), the Philadelphia Council for Business Economics (PCBE), and the Philadelphia Financial Economists Group (PFEG).

~~~~~

AIG: What It Means?
March 2, 2009

The news on AIG of additional federal funds and a change in the structure of the preferred stock and its implications have rattled the securities markets. We are scheduled to discuss this tonight on National Public Radio (NPR), “All Things Considered” and on CNBC in the 8:10 p.m. segment and, subsequently, in the 8:45 p.m. segment.

It appears that the change in terms of the federal support for AIG were triggered by requirements that the “AAA” rating be maintained on AIG’s counterparty risk-based instruments. The policy behind this federal support seems clearly focused on avoiding a second Lehman-type failure and, subsequent, market meltdown. The devastation caused by Lehman’s failure was in the counterparty risk arena. This is the complex structure in which opposing parties of derivative instruments are dependent upon the credit worthiness of each other. If the instrument requires a “AAA” credit rating, loss of the credit rating can become an element of default.

Whether we like it or not, America’s federal policy is now driven by the need to avoid another “Lehman.” Thus, we see increasing federal monies applied to support AIG. And, we see this elsewhere as my colleague, Bob Eisenbeis, noted about Citi in his comments today.

We can spend hours debating whether or not this is a good or bad policy. We can spend more time arguing about whether or not Countrywide should have been permitted to fail rather than to be saved via a merger. We could examine the decisions about Bear Stearns or Fannie Mae or others. Those are the exercises that will occupy historians and academics for the next several decades. But those are not the relevant questions for portfolio managers today.

The decisions made today and tomorrow come down to a very fundamental question. Will, (1) massive federal intervention like preferreds and equity ownership, (2) huge expansion of the Federal Reserve’s balance sheet, (3) trillions of federal contingent guarantees combine to avoid a deflationary prolonged depression?

History says the answer is yes. There are no limits to the amount of federal credit that can be extended in support of this new policy. The Federal government is now committed to do whatever it takes, in whatever amount is necessary and with whatever tools are needed. If you believe as I do, that the economy will find some bottoming in 2009 or early 2010, then one has to view the future risk several years from now as inflation, not deflation.

For today, inflation is not the risk, deflation is the threat and enormous new federal credit is the weapon used to confront it. That’s what the AIG bailout is all about.