Wednesday, September 17, 2008

Marc Faber on Economy, Lehman and AIG

AIG bigger problem than Lehman; emergency rate cut possible, says Marc Faber

16 Sept, 2008

INTERNATIONAL. The Federal Reserve could make an emergency move and cut the federal funds rate by half a point during trading Monday, investment advisor Marc Faber told CNBC.

"Whether there will be a follow up on the downside is not sure, we could have kind of a reversal, simply because central banks will flood the system with liquidity, and I wouldn't rule out, in America, an emergency rate cut, say by half a percent in the trading session and also interventions into the market."

"I would expect markets to temporarily bottom out between now and the middle of October and then have a fairly strong rebound, but of course, no new highs," Faber said.

"The takeover of Bank of America of Merrill Lynch is, of course, an exchange of bad paper for even worse paper," he added.

"In other words, the one-eyed bank buys the blind bank. Bank of America, having already bought a terrible asset, which is Countrywide Financial, is buying another asset about which they have little idea about the value of its securities."

"I'm not so sure than even a rate cut will lead to a strong recovery in financial stocks," he said.

"Personally, I shake my head: why would Bank of America pay a 70% premium for Merrill Lynch?"

Meanwhile, Faber told Bloomberg Television that AIG could be a "much bigger problem" than Lehman Brothers Holdings, the securities firm that filed for bankruptcy protection Monday.

AIG shares plummeted Tuesday after the insurer's credit ratings were cut, heightening concerns it might file for bankruptcy and further upset the global financial system.

In late-morning trading, AIG shares were down US$2.29, or 48.1%, at US$2.47 on the New York Stock Exchange, after earlier falling as low as US$1.25. The shares had fallen 60.8% on Monday.

The shares recovered much of their early losses after CNBC television said government money might be used in a bailout of AIG. But the shares later fell back after the network said U.S. Treasury Secretary Henry Paulson opposed using government money and that a private sector solution wasn't likely.

How to protect yourself from the Lehman collapse

By Deputy Editor John Stepek

Sep 16, 2008

Lehman Brothers headquarters. Copyright: Bloomberg

Chancellor Alistair Darling might permit himself a rueful little chuckle this morning.

A mere couple of weeks after the pundits lined up to shoot him down over his claim that Britain was facing the worst economic conditions in 60 years, the papers are now full of comparisons to 1929.

Of course, he won’t be laughing for long. After all, the collapse of Lehman will just leave him with yet more headaches, and doubtless there’s still plenty of drama to come on both sides of the Atlantic.

But forget him – how does all of this affect you?

There will be a whole new round of disruption to interbank lending

Stock markets around the world took a hammering yesterday, unsurprisingly. The Dow Jones ended below 10,000, slumping 504 points. The FTSE 100 was off 212 points at 5,204.

This isn’t over. Lehman Brothers is gone, Merrill Lynch has been sold off, but the impact will be felt throughout the markets for a long time. No one is entirely sure what will happen as Lehman’s liabilities are unwound. That means a whole new round of disruption to interbank lending as banks become more afraid to lend to each other again. So forget about mortgages getting any cheaper any time soon.

As Philip Aldrick points out in The Telegraph, there’s the debt that Lehman actually has outstanding (around $150bn, about five times that of telecoms group WorldCom, which was until now the biggest debt default in history). The debt is still worth something – Lehman itself clearly has some valuable assets – so we’re not talking about a loss of that entire $150bn. But whatever it’s worth, it’ll be a lot less than its face value.

Then there’s the credit default swaps (CDS) issue to worry about. CDSs are basically a type of insurance written on corporate debt, guaranteeing payment of the debt in the event of a company going bankrupt. Sandy Chen at Panmure Gordon reckons there was about $350bn in CDSs written on Lehman debt. Again, because the debt is worth something, we’re not looking at an entire $350bn – but using an “optimistic” 60 cents in the dollar, that’s still $140bn the banks writing the insurance will have to pay out.

Then of course, as Lehman sells off its dodgy assets, the market price of these will fall further, which will also mean that other banks have to take further writedowns on their own dodgy portfolios. All in all, it looks a bit like the subprime meltdown all over again.

Then there’s the small matter of insurance giant AIG, which is struggling to raise emergency funds as I write this. As Kenneth Lewis, chief executive of Bank of America told CNBC, “I don’t know of a major bank that doesn’t have some significant exposure to AIG.” A collapse would “be a much bigger problem than most that we’ve looked at.” We’ll have more on this story on the website later today.

So what does all this mean for you?

Unsurprisingly, the main losers in the UK amid the sea of red – the only risers were utility stocks – were the banks. HBOS was the top faller, down 17.5%, with Royal Bank of Scotland and Barclays close behind. As the three British banks most exposed to ‘toxic’ assets, they’ve been hit hardest.

Now we’ve been warning readers away from investing in banks for a long time, so hopefully most MoneyWeek readers will have avoided taking a hit from their share prices collapsing. As for concerns about another Northern Rock - on this point, we’ve already suggested, along with every other newspaper, that it’s a good idea to make sure you only have a maximum of £35,000 saved with each individual bank. That’s the limit covered by the Financial Services Compensation Scheme.

That’s not to say that anything is going to happen to any of the high street banks that would imperil people’s savings. If Northern Rock was deemed too big to fail, the government can hardly pull a Lehman Brothers on a genuinely important bank like HBOS, for example. But it’s always better to be safe than sorry.

As for the rest of your portfolio - something interesting happened yesterday amid all the carnage. The oil price took a dive. This could be put down to Hurricane Ike being less disruptive than feared, or to increased fears about the state of global growth. But I’d argue that it’s yet more proof that much of the recent surge above $100 a barrel was due to a flood of speculative money, which is now being yanked out of the markets. We suggested selling out of oil at the start of August and I wouldn’t be looking to buy back in again yet.

The real value of gold – insurance against financial disaster

At the same time, the gold price moved higher. Gold – as my colleague Dominic Frisby has pointed out – has had an awful time recently, partly down to the dollar rally and some thoroughly misplaced optimism about the US economy. But events like yesterday’s demonstrate the key reason for holding gold – as insurance against financial disaster.

In a recent edition of his Gloom, Boom and Doom newsletter, Marc Faber argued: “I am not a great believer in insurance policies, but since I think that sooner or later the entire financial system will blow up I want to make sure that… I shall still be left with some assets that are mine (physical gold in a safe deposit box – not in the US).”

Now that’s a very downbeat way to look at things. But the point is that the more that things like the Lehman collapse happen, the more people start to wonder if Mr Faber is right. That’ll drive demand for gold higher, regardless of whether a total financial collapse happens or not. And if it does, well, there are worse things to be holding than gold.

So I’d suggest you keep holding on to your gold. You can find out more in our current issue, where Dominic has more on why physical demand has been rocketing. If you’re not already a subscriber, you can get your first three issues free by clicking here.

Our recommended article for today

Where now for oil and gold?
There's a saying that bull markets 'are born on pessimism, grow on scepticism, mature on optimism and die on euphoria'. Given all that's happened lately, are the bull markets in gold and oil over - and are they now primary bear markets?

AIG approaches Fed as shares plummet amid scramble to raise capital
September 16, 2008

Shares in American International Group (AIG), the largest US insurer by assets, fell by half in early trading yesterday as the company failed to present a plan to raise capital and stave off credit downgrades.

AIG, seeking to raise $20 billion (R160 billion) in capital and sell $20 billion in assets, had rejected investments from buyout firms Kohlberg Kravis Roberts, TPG and JC Flowers & Co, according to people familiar with the talks. AIG instead sought a $40 billion bridge loan from the Federal Reserve, the New York Times reported, citing an unnamed person. The shares plunged by $6.25 to $5.89 at 9.42am in New York.

Business news channel CNBC said AIG was seeking funds from the Fed as a temporary measure and planned to repay the Fed with proceeds from asset sales.

Warren Buffett, the chairman of Berkshire Hathaway, "is thought to be in talks" with AIG about a possible investment, the Insurance Insider reported, citing unidentified sources.

No comment could be obtained from representatives of Berkshire or AIG.

"People are afraid of what they are not hearing," Robert Bolton, the managing director at Mendon Capital Advisors, told Bloomberg Television. "The only thing people have to trade on right now are the rumours."

Chief executive Robert Willumstad is under pressure to raise capital and sell units after three quarterly losses totalling $18.5 billion. Investors are concerned that the insurer cannot raise enough cash to withstand further write-downs from credit-default swaps.

AIG might report write-downs of $30 billion, resulting in its "worst quarter yet", if Lehman's bankruptcy led to distressed sales of mortgage assets, said Citigroup analyst Joshua Shanker. He downgraded AIG to hold from buy.

Downgrades could hurt AIG's insurance business, since some policies carry clauses that nullify a contract in the event of downgrades below a certain level.

Marc Faber, the managing director of Marc Faber Limited, told Bloomberg Television that AIG could be a "much bigger problem" than Lehman Brothers Holdings, the securities firm that filed for bankruptcy protection yesterday.

Standard & Poor's said on Friday that it might downgrade AIG's credit ratings because the share declines could crimp the insurer's access to capital. The shares had fallen 79 percent this year before yesterday.

JC Flowers had offered $8 billion for a stake that would have given the firm an option to buy the rest of AIG, the Times said.

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