Tuesday, October 7, 2008

AIG and Other Insurance Companies in this Bailout

I agree with Porter Stansberry's take on AIG's near-collapse, and its financial ramifications worldwide. Here is my take, with my own edits:

There's 3 things I learned that we need to understand before we figure out what we have to do going forward:

1) Without the government's actions, the collapse of AIG could have caused every major bank in the world to fail.

2) Without the credit default swap market, there's no way banks can report the true value of their assets - they'd all be in default. That's why the government will enact laws that require the suspension of mark-to-market accounting. Essentially, banks will be allowed to pretend they have far higher-quality loans than they actually do. AIG can't cover for them anymore. Our "recovery" plan includes false accounting.

3) Without the huge fraud perpetrated by AIG, the mortgage bubble could have never grown as large as it did. Yes, other factors contributed, like the role of Fannie and Freddie in particular. But the key to enabling the huge global growth in credit during the last decade can be tied directly to AIG's sale of credit default swaps without collateral. This went on for a decade, exacerbating the problem.

I agree with allocating at least 10% of assets toward gold. But a flight to quality means not only gold, but also to well-capitalized market share leaders who are being undeservedly punished. I have my targets, but every individual needs to find their own comfort level.


  1. Do you have a Private mortgage insurance (PMI) policy? If you do have one your PMI insurer passes their risk to others by bundling 100 policies together and then they sell them as a credit default swaps (CDS). In doing this they can take 1.7% of the annual policy. They also do this in order to protect themselves from making large cash payments to mortgage providers in the event your home is repossessed. In the mortgage industry this has been the case for decades. If you bought a PMI policy to protect your lender then you are building the CDS market. To avoid this put at least 20% down on your home or pay what it takes now to get rid of the PMI policy. http://nomedals.blogspot.com

  2. For properties when I've paid 20% or more down, yes, I've avoided PMI. However, based on Missed Fortune strategies, we look to optimizing our rate of return, along with increasing liquidity and safety of principal. Hence, we aim to pay as little down as possible, increasing the rate of return--even if it means we have to pay PMI. Ideally, we pay 0% down, as any gains now have an infinite rate of return, as there is no opportunity cost penalty. In today's environment, that is increasingly difficult, unless we go the sales contract route. The caveat with a lower down payment is that the borrower has to be disciplined to earn a higher rate of return than the borrowing costs. Two factors give the borrower this advantage: 1) the borrowing cost is tax-deductible, and is either amortized or better yet, simple interest, and 2) the interest earned is compounding, and if possible, accumulates tax-free. Those two components coupled together create a very powerful positive arbitrage--and dwarfs any negative impact from the PMI.