AIG Is Toast

How dangerous is AIG? Michael Lewitt tells us, in today’s NYT:

There is a substantial possibility that A.I.G. will be unable to meet its obligations and be forced into liquidation. A side effect: Its collapse would be as close to an extinction-level event as the financial markets have seen since the Great Depression…

Regulators knew that if Lehman went down, the world wouldn’t end. But Wall Street isn’t remotely prepared for the inestimable damage the financial system would suffer if A.I.G. collapsed.

Paul Jackson is on the same page; he also notes that AIG, which is a huge player in the P&C business, will have a substantial amount of exposure to the damage caused by hurricane Ike — damage estimated at between $6 billion and $18 billion.

AIG stock is now trading on option value only, which means that we can no longer look to its share price as an indication of what the market thinks is going to happen. But we can certainly look to the bond market, and if you thought the share price was ugly, just wait until you see this:

AIG’s $2.5 billion of 5.85 percent notes due in 2018 plunged 19.5 cents to 33 cents on the dollar as of 9:55 a.m. in New York, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

33 cents on the dollar? The message is loud and clear: AIG is toast. This is the massive counterparty failure everybody’s been scared of, and frankly I’m astonished that the broader stock market isn’t plunging as a result. No one is prepared for the repercussions here: the failure of AIG is likely to be an order of magnitude more harmful than the failure of LTCM would have been. And it’s not even happening on a Friday, where we could have yet another Emergency Weekend to try to work things out.

Here’s my favorite comment on my stock-market round-up yesterday:

That’s right, Felix. FEEL the fear, sweat openly, swallow hard, stammer, piss your pants. You pathetic weasel. Go back inside until you get a grip.

I’m not ashamed to admit it: I’m having a really hard time being sanguine right now. Of course I hope that the global financial system will be able to get through this somehow. But Hank Paulson’s new hard-line no-bailouts policy isn’t helping: it was justifiable with Lehman, but the unintended consequence is that no one now expects a bailout for AIG, and that’s just making things worse.

My one hope is that someone will essentially find a way for AIG’s bondholders to suffer all the losses, while AIG’s counterparties suffer very little if at all. (That also seems to be the idea behind Barclays buying Lehman’s brokerage operations.) So long as counterparty risk is minimized, we should be able to get through this. But will that happen? I have no idea.