AIG Armageddon

   

AIG Armageddon

For the first time during the current financial crisis, I found myself lost for words.  After the market closed yesterday, the rating agencies announced that they were cutting the ratings on American International Group, Inc. (AIG).

Of course this was expected news that many thought would come earlier in the day.  The very threat thereof on Friday had put in place a series of events that sent the company scrambling for capital. At issue, is the number of derivative transactions that risk entering into default should AIG’s rating drop too far.  With the current ratings cut, the company is that much closer to that default line.

In default means that the company must have the capital to fulfill its obligations under such a scenario.  AIG does not carry such cash or readily liquid investments that it can use for these purposes. Their only option is to raise capital and to do so quickly.  Thus, over the weekend, the company started its quest by approaching private equity shops and large money center banks in hopes of securing some $40 billion in immediate capital that could be used to satisfy the ratings agencies.

With all of the attention on Lehman Brothers (LEH) and a veritable freeze in the banking system, the odds of raising that kind of money in such a short amount of time were not good.  As such, the only alternative for AIG was the highly unusual request for a bridge loan from the Federal Reserve.

Watching the drama unfold, it seems like AIG was marching to oblivion (see also, “World’s Largest Insurer Dangles By a Thread“). The request to the Federal Reserve was a desperate move and signaled to the market that AIG was in trouble. And in this market, that is all it took for the vultures to circle. 

Shares of AIG fell dramatically when stocks began trading yesterday.  Given the result of the LEH negotiations, it was unlikely that the government would step in with a bridge loan. Needless to say, the line in the sand was drawn.

As the company held its breath during the day, the rating agencies apparently offered a lifeline by withholding the expected rate cuts.  That gave the company more time to find the needed capital, but to no avail.

What Does Failure Mean for Investors?

The problem for AIG is the complexity of its business.  While it is true that the company has many outstanding assets that can be liquidated over time, the great unknown remains how much must be raised.

Do they need $40 billion?  Is the number $70 billion?  Or, will $100 billion do the trick? Only those sitting at the table seem to know… the answer and even then, one must wonder if they have any clue as to what is really going on here.

It is all very disconcerting.  Here we have a Dow Jones Industrial Average component stock on the verge of collapse.  Not only that, but AIG’s tentacles spread across the entire global financial system (see also, “AIG’s House of Falling Cards“). The government is in a bind here.  It has already stated that a solution for AIG needs to be private.  Unfortunately, the private market does not seem to be capable to finding a solution either. That means failure.

According to all of the speculation last night, investors may be facing financial Armageddon should AIG fail.  That’s right, if AIG fails, we can expect a world financial calamity not seen since the Wall Street Crash in 1929.

As a Rational Investor, I tend to take such fear-mongering in stride.  Heck, I’ve heard about financial calamity many times over the last 20 years and the fear turns out to be all smoke.  In fact, it is out of that fear that market-beating returns can be generated (to see how, read, “Don’t Jump Ship!“).

However, this time may be different. 

Of course this doesn’t mean I’m going out and selling everything.  That’s simply not how I operate.

Instead, I am sitting back and watching the show.  There really is not much you, nor I, can do about AIG and the implications of bankruptcy.  But you can position your portfolio in the long term belief of capitalism and corporate growth.

That’s my conviction, and it has not changed.  The good news is that I am relatively well positioned for a market like this.  I am outperforming the market, and one of my positions, the ultrashort oil ETF, is making big bucks as crude oil prices fall.

I have about 25% of the portfolio in cash, thus even if stocks drop hard I will be well-positioned for some serious buying.  It is interesting to note that in late 2007 I wrote that the next great buying opportunity in the market would present itself in October of 2008.

If AIG fails, I may be more correct with that prognostication than I ever have been.

This article was written by Jamie Dlugosch, contributor to InvestorPlace.com. For more actionable insight likes this, go to: www.InvestorPlace.com.


Article printed from InvestorPlace Media, http://investorplace.com/2008/09/aig-armageddon/.

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