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Generational Dynamics Web Log for 11-Feb-08
AIG announcement puts money market funds at risk

Web Log - February, 2008

AIG announcement puts money market funds at risk

American International Group disclosed that inadequate internal controls, as determined by its outside auditing firm PricewaterhouseCoopers, had led to "material weakness" in financial reporting relating to the fair valuation of credit default swap (CDS) portfolio obligations of its subsidiary AIG Financial Products Corp.

CNBC has been reporting that writedowns are expected to total around $6.2 billion.

AIG had previously claimed that it had managed to escape the major problems that other financial institutions had encountered, forcing them to write down tens or hundreds of billions of dollars CDOs and securities. Monday's news throws this claim into doubt.

To understand the importance of this story, you have to understand the relationship between AIG and its subsidiary, AIG Financial Products Corp., and that's best explained on the AIG web site as follows:

"AIG Financial Products Corp. (AIG-FP) is a wholly-owned subsidiary of American International Group, Inc., world leaders in insurance and financial services. Founded in 1987, AIG-FP was one of the first companies focused principally on the derivatives markets in the United States. AIG-FP is active in a full spectrum of OTC derivative and structured products markets, including commodities, credit, energy, equities, foreign exchange, and rates. ...

As leading participants in the capital and derivatives markets, we provide clients with corporate finance, investment, and financial risk management solutions.

Unlike many financial institutions, we act as principal in nearly all of our transactions, including acting as a principal investor in the energy and infrastructure sectors. All of AIG-FP's payment obligations are guaranteed by our parent, American International Group, Inc.

Our clients include many of the world's top corporations, investment managers, pension funds, banks, investment banks, sovereigns, hedge funds, foundations and endowments, as well as select high-net-worth individuals."

And now, according to AIG's Monday announcement:

"American International Group Inc. said Monday that it has decided to clarify and expand its disclosures relating to the methodology and data inputs used to determine the fair values of the super senior credit default swap portfolio related to the multi-sector collateralized debt obligations of its AIG Financial Products and AIG Trading Group units."

Putting these statements together, you can see that the AAA rated "super senior CDS portfolio" has been feeding into the AAA rated "multi-sector CDOs," providing funding to "investment managers, pension funds, banks, investment banks, sovereigns, hedge funds, foundations and endowments, as well as select high-net-worth individuals."

(For those interested in the math behind the creation of CDOs from CDSs, see "A primer on financial engineering and structured finance.")

Peter Yastro, market strategist at MF Global <font face=Arial size=-2>(Source: CNBC)</font>

Peter Yastro, market strategist at MF Global (Source: CNBC)

According to Peter Yastrow, market strategist at MF Global, speaking on CNBC:

"What's scary about today -- and I think that people need to understand this -- a lot of people have money in cash, and on the sidelines in money markets, and we all assume that those investments are 100% safe, and I'm afraid that there's going to be more than hand-wringing if people find out that the money they have in cash is actually at risk."

From the point of view of Generational Dynamics, this kind of news, far from being surprising, MUST continue, as the humongous credit bubble deflates.

As I explained in "Will hyper-inflation make the dollar worthless (like the Weimar republic)?", and in "Questions and answers about the 'credit crunch,'" we're entering a harsh deflationary spiral, as the amount of money in the world contracts. The reason that it contracts is because the leveraged use of credit during the creation of the bubble created hundreds of trillions of dollars in credit derivatives in new securities. These securities, which are massively interlocked in many obscure ways, are newly created money, in the sense that they could be used as collateral or to make investments.

It's worth remembering that the world GDP is $45 trillion, and all the world's stock markets hold about $60 trillion in assets. This is small compared to the $700 trillion is credit derivatives.

Now that these securities transactions are unwinding, the amount of money in the world is decreasing. This AIG announcement is part of that, and will reduce the amount of money in the world by $6.4 billion -- not counting the effects on other funds.

As the markdown process continues, the writedowns will affect mutual funds, investment trusts, hedge funds, savings banks, pension funds, college endowments, money market funds, insurance companies, and any other institution with money -- possibly including institutions that hold YOUR money.

It's getting harder and harder to identify places where it's safe to keep money, as discussed last week in "Readers comment: Gold prices and where you should put your money." I've seen some reports, though I can't verify their credibility, that hundreds of regional bank failures are expected in the last half of this year, thanks to follow-on effects of the "subprime" crisis.

One issue with fund managers like Fidelity and Merrill is that their accounts are not insured. The funds may be worthless if Fidelity and Merrill themselves go under.

If your money is in a 401K held by one of these funds managers, one solution might be to transfer your money out of the funds and into specific assets -- Treasuries and bank CDs (certificates of deposit) -- that the fund managers are merely holding for you. You would own the actual assets, and you'd be protected.

One web site reader recently wrote to me as follows:

" Regarding holding treasury bonds and bills in Fidelity retirement accounts: I do this myself and it is a relatively straightforward process. Go to your Fidelity account online, choose "Trade Fixed Income", choose "Search Inventory", then choose "US Treasury, Auction." You'll see the list of treasury instruments being auctioned this week. (I do this on a Sunday for the upcoming week. The instruments shown depend on the day of the week.) Click the "Trade" link next to the maturity of instrument you are interested in, and enter the number of $1000 units you want to purchase.

Then when the auction occurs, Fidelity buys the instrument for you - with no fee charged - and you are then holding the actual Treasury instrument in your account rather than only a Fidelity treasury money market fund.

As I read somewhere recently, in the upcoming financial debacle if you can simply hold onto your money you will win. Yes, the Treasuries pay less than the inflation rate. But in these very dangerous and uncertain times, I am willing to pay that penalty in order to have my money in one of the relatively safe investment vehicles. I think that those who insist on chasing some yield at this time will simply lose principal."

That's very good advice. These are excellent philosophies if you want to survive what's coming.

This same reader indicated that he disagrees with me about buying gold:

"I am also a believer in a much higher gold price. Gold is not simply a commodity like other commodities, and in times of financial catastrophe people are going to be desperate for safe havens. The value of the dollar will be destroyed by a Congress with no sense of fiscal responsibility at all. And arguments that the dollar has been stable for two centuries hold no weight because the dollar was good as gold then, and hasn't been since 1971. We've had 36 years of a pure fiat currency regime and it's about due to collapse. Gold and other real assets will be the only viable way to protect your savings. That's why I'm currently 50/50 treasuries and gold and am prepared to go entirely to gold as circumstances demand. I don't know how high gold may go, but I do feel I know that Congress will show no restraint whatsoever when people start to demand relief. They will destroy the value of the dollar before they exercise financial restraint, because that is what the increasingly desperate electorate will demand of them."

Here I must strongly disagree with the writer. The dollar will NOT be destroyed, except in world war scenarios where the US itself is effectively destroyed. In any likely scenario, the dollar will remain the strongest and most valuable currency on the planet.

The writer refers to the "a Congress with no sense of fiscal responsiblity at all." Even if that were true, it would make no difference at all.

Congress today is talking about a $150 billion "stimulus package." That's peanuts. We've already had hundreds of billions of dollars taken out of the economy through CDO writedowns, so this "stimulus package" won't even compensate for the CDO writedowns. And that leaves the trillions of dollars in deleveraging knock-on effects completely untouched.

I have to repeat that we're being hit with a 10-mile high tsunami, and the only tools that the Fed and Congress have are one-foot high flood walls. The tsunami is going to wash over everything, and nothing else is relevant. The only thing that you can do is prepare by running to higher ground.

With regard to gold, here is my opinion on what's going to happen:

Gold has been surging to $1000/oz as part of the commodities bubble. As long as the commodities bubble keeps growing, gold will increase.

The "real" value of gold is around $500/oz. As soon as the bubble bursts, gold will fall, and will probably overshoot, going down to the $300-400/oz range.

Gold may spike up higher in the case of a major war scenario, but even here the price may fall sharply a little while later, when it becomes clear that the US dollar is still valuable. Betting that gold will go up and stay up is a VERY HIGH RISK strategy, only for risk-seeking people with plenty of money to invest.

It's very hard for me to see any justification buying gold at the current bubble prices. When the bubble bursts, and gold falls below $500, then gold may again be a worthwhile investment.

However, if you DO buy gold, make sure that you take possession of the actual metal. Gold-backed funds may become as worthless as other funds. (11-Feb-08) Permanent Link
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Generational Dynamics Web Log for 11-Feb-08 AIG announcement puts money market funds at risk

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Generational Dynamics Web Log for 11-Feb-08
AIG announcement puts money market funds at risk