How Financial Madness Overtook Wall Street

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Uncle Sam Steps Back In
The market lost faith in AIG too, but the government was forced to save it. A major reason is that AIG is one of the creators of the aforementioned credit-default swaps. What are those, you ask? They're pixie-dust securities that supposedly offer insurance against a company defaulting on its obligations. If you buy $10 million of GM bonds, for instance, you might hedge your bet by buying a $10 million CDS from AIG. In return for that premium — which changes day to day — AIG agrees to give you $10 million should GM have an "event of default" on its obligations.

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But as a way to make sure that swap meisters can make good on their obligations, they have to post collateral. If their credit is downgraded — as was the case with AIG — they have to post more collateral. What put AIG on the brink was that it had to post $14 billion overnight, which of course it didn't have lying around. Next week, the looming downgrades might have forced it to come up with $250 billion. (No, that's not a typographical mistake; it's a real number.) Hence the action. If AIG croaked, all the players who thought they had their bets hedged would suddenly have "unbalanced books." That could lead to firms other than AIG failing, which could lead to still more firms failing, which could lead to what economists call "systemic failure." Or, in plain terms, a financial death spiral in which firms suck one another into the abyss.

AIG, like Lehman, was ultimately done in by credit-rating agencies, of all things. The main credit raters — Moody's and Standard & Poor's — had blithely assigned top-drawer AAA and AA ratings to all sorts of hinky mortgage securities and other financial esoterica without understanding the risks involved. Would you know how to rate a collateralized loan obligation? Or commercial-mortgage-backed securities? Sophisticated investors took Moody's and S&P's word for it, and it turned out that the agencies didn't know what they were doing. Credit raters, who claim to offer only opinions, are party to Wall Street's cycles too. At the beginning, they're far too lenient with borrowers, who are the ones who pay their rating fees. Then, after a couple of embarrassments — remember Enron and WorldCom? — the raters tighten up, maybe too much. Then memory fades, and the cycle repeats.

What doomed AIG was the rating agencies' decision — they had suddenly awakened to AIG's problems — to sharply downgrade the firm's securities. That gave AIG no time to react, no time to raise more capital, no more time to do anything else but beg for help. Because AIG is in a much scarier situation than Lehman — the insurer has assets of $1 trillion, more than 70 million customers and intimate back-and-forth dealings with many of the world's biggest and most important financial firms — Uncle Sam felt that it had no choice but to intervene.

Right before the markets began to unravel last year, Lloyd Blankfein, chief executive of Goldman Sachs, presciently quipped that he hadn't "felt this good since 1998," referring to the Wall Street wipeout precipitated that year by Russia's defaulting on its ruble debt. Blankfein argued that confidence in global markets had built up to a dangerously giddy level and that investors weren't being compensated for assuming outsize risk in securities like esoteric bonds and Chinese stocks. Blankfein was right, of course, but even he wasn't paranoid enough. Though Goldman stands, along with Morgan Stanley, as one of the last two giant U.S. investment banks not to collapse (as Lehman and Bear Stearns have) or be sold (à la Merrill Lynch), Goldman too has been pummeled. The firm's quarterly profit plunged 70% — results considered to be relatively good. While analysts generally believe that Goldman and Morgan Stanley will survive the meltdown, that view is not unanimous. Says doomster New York University economics professor Nouriel Roubini: "They will be gone in a matter of months as well. It's better if Goldman or Morgan Stanley find a buyer, because their business model is fundamentally flawed." Both firms would beg to disagree, but their stock prices have been hammered.

All of us are now paying the price for Wall Street's excesses. Some of the cost is being paid by prudent people, like retirees who have saved all their life. They're now getting ridiculously low rates of 2% or so on their savings because the Federal Reserve has cut short-term rates in an attempt to goose the economy and reassure financial markets. Taxpayers are going to get stuck too. By the estimate of William Poole, former head of the St. Louis Fed, bailing out the creditors of the two big mortgage firms, Fannie Mae and Freddie Mac, could cost taxpayers $300 billion. Think of that as about a year and a half in Iraq.