Tuesday, September 16, 2008

Short selling, credit default contracts, and illiquid assets: a deadly combination for AIG; who's next? The financial Domino Theory


Larry Cramer has a valuable post on TheStreet today that explains how short sellers helped bring about the crisis at AIG. He says that the SEC had placed a “bottom” on short selling on July 15, and then removed it. He claims that their removing it precipitated the attack on AIG and perhaps the demise of Lehman and forced sale.

He is quite critical of the Bush administration and the SEC’s behavior, which he seems to think was negligent. It’s also obvious, however, that the reckless exposure in credit default insurance contracts by AIG and many other companies is what attracted the short sellers.

The problem is that the “disease” is contagious and could quickly spread to other companies that are viewed as sound now, but who may have hidden “liquidity problems”. This is the financial version of the Johnson era "Domino Theory" regarding national security. The end result could be other bankruptcies, or at least a line of people coming to the Fed for loans. Pensions could be lost and some retirees could be thrown into poverty by the “greed” of others, perhaps (remember Michael Douglas – “Greed is good” from the movie “Wall Street’) but really because of inconsistent oversight and carelessness by regulators.

Neither John McCain nor Barack Obama have discussed this problem properly (neither have the vice presidential candidates) or displayed much of an intellectual understanding of the problems. This is really not a partisan issue, unless the idea is to encourage the recklessness that encourages some people to get rich by impoverishing others.

Of course, short selling can be “fun”!

Larry Cramer’article today is titled “SEC Played a Big Role” link here.

The latest late Tuesday is that the Fed may make a bridge loan to AIG. Still unclear. Whatever it does, it sets an example. I would say, what happened to "moral hazard", except that the real problem seems to be a sleepy SEC.

Update: Yup, the Fed is bailing out the world's largest insurance company (AIG) and taking 80% control, after massive "private mismanagement" and targeting by short sellers -- but, after all, the government was partly to blame. Here's the CNBC story.

The Federal Reserve Bank has issued a formal press release regarding this action, here.

Update: Sept. 17

The SEC has tightened the rules on short sellers again, with respect to delivery. The SEC says it is prohibiting "abusive short selling" with zero-tolerance. Conservatives are calling for reinstating the "uptick rule" and changing some accounting rules. Bloomberg's report, by Jesse Westbrook and Edgar Ortega, is here.

Sept. 18

Various sources report that the Securities and Exchange Commission plans a temporary ban on short selling against around 800 financial institutions. CNBC link is here.

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