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AIG Stock Plummets On Bailout News

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Why is a bailout bad news for AIG?

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Where will it end? Even as you are reading this, the stock price of American International Group (AIG) is plummeting, down more than 40%, that despite news of an apparent "bailout" by the Federal Reserve. What gives?

The answer is actually relatively simple, but first we need to lay out the terms of the deal. The Fed is going to loan AIG $85 billion dollars, assuming nearly an 80% stake in the company, but the interest rate on the loan is Libor+850 basis points and it appears the loan is fully collateralized by AIG's assets. The losers in this deal are common and preferred shareholders.

That is why AIG stock is down so much today. It essentially was seized on near pawnbroker terms and there is very little chance given the Libor +850 basis points it is paying on the loan terms it can do anything but liquidate many of its assets over time.

But, in a sense, that is what this is all about. It is not about "saving" AIG as it formally existed, nor, as some economists are misunderstanding, is it about "creating additional credit out of thin air."

The Fannie Mae (FNM) and Freddie Mac (FRE) bailouts will cost taxpayers billions, but in the case of AIG the probability that the loan gets paid back is quite good since all of the company's assets are pledged against it. In effect, rather than creating credit out of thin air, the Federal Reserve is embracing debt deflation by insisting that the assets be liquidated over time to satisfy the loan terms. In effect, there is no credit expansion taking place; liquidation and risk reduction is taking place. This is deflationary.

Under ordinary circumstances, the market's role is to direct capital toward the most productive businesses at the expense of the weakest and least productive.

As it stands, virtually every action being taken by authorities to intervene in the market's determination of what constitutes a productive business enterprise is serving the purported goal of extending the process so that an orderly liquidation can ensue. This is having the unintended consequence of making capital for productive businesses very expensive or, in some cases, non-existent. In some respects the cure is worse than the disease.

The argument was no doubt made in the corridors of the New York Federal Reserve last night that allowing AIG to fail, as the market was demanding at the time, would cause irreparable harm to the global financial structure. I suspect that may be true. But the choice being made is ultimately to extend the tear-down process so that it occurs in an orderly manner. In Las Vegas, some buildings you detonate so they implode inwards, others you dismantle over time. This one is being dismantled over time.

The proper question to ask is, Where will it end? What is the line between protecting this barely functioning system and allowing the market to do its work? Treasury Secretary Hank Paulson was asked that question yesterday and had no answer. So, apparently no one knows where the line is, which is equal parts terrifying and astonishing. In the meantime, the order of the day is debt destruction and asset deflation.

Yesterday in Five Things You Need to Know we outlined the Macroeconomic Holy Grail according to Fed Chairman Ben Bernanke. Today we have taken yet another step closer to discovering it.

No positions in stocks mentioned.

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