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How banks depend on AIG

• Robert Peston
• 16 Sep 08, 04:40 PM

, the chief executive of Bank of America, said yesterday that "I don't know of a major bank that doesn't have some significant exposure to AIG".

So 's need to raise billions in new capital to shore itself up has sent shockwaves through global markets and helped to undermined the share prices of many banks.

But how exactly are banks "exposed" to AIG?

Light is shed by an insightful bit of research by Sandy Chen of .

He has found the following paragraph in AIG's US regulatory filing:

"Approximately $307bn (consisting of corporate loans and prime residential mortgages) of the $441bn in notional exposure of AIGFP's super senior credit default swap portfolio as of June 30, 2008 represented derivatives written for financial institutions, principally in Europe, for the purpose of providing regulatory capital relief rather than risk mitigation. In exchange for a minimum guaranteed fee, the counterparties receive credit protection with respect to diversified loan portfolios they own, thus improving their regulatory capital position."

If you managed to read to the end of that, your reaction is probably "you what?"

Well, I'll tell you what.

AIG is saying here that it has insured $307bn of corporate loans and prime residential mortgages that are on the balance sheets of banks, mostly European banks.

The banks have bought this insurance to protect themselves against the risk that these loans would go bad, that borrowers would default.

Their motive for doing so was to reassure their respective regulators - such as the for UK banks - that these loans are of minimal risk.

And the benefit of doing that was that they could lend considerably more relative to their capital resources.

But if AIG is in trouble, then doubts arise about whether it would be able to honour the financial commitments it has made through these insurance contracts (which, for those of you who like to learn the lingo, are called super senior credit default swaps).

In fact, in a wholly mechanistic way, the downgrades of AIG's credit rating that we saw last night automatically increased the perceived riskiness of loans made by banks that have insured credit with AIG.

Which means those banks' balance sheets become weaker - and that could mean that they'll be forced by their regulators to raise additional capital.

So there's a widespread view among bankers that the and the simply can't allow AIG to fail, in the way that they felt that they could allow to collapse into insolvency.

If AIG went down, a number of banks' balance sheets would be mullered - there would a dangerous risk to the stability of the global financial system.

Or to put it another way, AIG is so pivotal in the global financial system, it can't be consigned to the dustbin of history in a precipitous way.

PS. For those of you who currently have the willies about , its exposure to AIG is not life threatening.

What's currently doing for HBOS's share price is blindingly obvious: it provides 20% of all UK residential mortgages; the UK housing market is the major vulnerability of the UK economy; if there's a sharp rise in the number of homeowners defaulting on their mortgages, HBOS would incur significant losses, especially on self-cert, buy-to-let and loans with a high loan-to-value ratio.

But HBOS has recently raised 拢4bn of new capital to cushion itself against the impact of just such a debacle.

So there is more fear than reason underlying the success of the short-sellers in driving down HBOS's share price - although the short-sellers will claim a modest victory in the decision by to lower HBOS's credit ratings by a smidgeon.

But HBOS's ratings remain pretty strong. And the rating cuts shouldn't lead to a sharp increase in the cost of its finance or to an exodus of those who provide that finance.

UPDATE 19:25

I suspect that Sandy Chen has found only a part of AIG's credit protection business, since I am told that US banks are more exposed to AIG than are European banks (which is not what the regulatory filing spotted by Chen shows).

And here's a compelling wrinkle. AIG writes its credit default swaps contracts (its loan insurance business) through a French banking subsidiary.

Even so, the possible collapse of AIG isn't a French problem. What AIG needs to obtain is financial support from the American taxpayer at the top holding company level in the US - and it would then use these funds to recapitalise the French bank it owns.

What this shows is the fearful complexity of AIG's corporate structure, which just adds to the difficulty in negotiating a rescue.

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Profiting from fear

• Robert Peston
• 16 Sep 08, 09:10 AM

Alistair Darling has just signalled on the that he is profoundly uncomfortable with the widespread practice of profiting from the woes of companies perceived as vulnerable through short-selling their shares.

This is highly relevant right now, in that shares in - our largest mortgage lender - fell by more than 30% at one stage yesterday, which would have been unthinkable a few months ago. And they've fallen again this morning.

If you are running a huge deposit-taker like HBOS you can't dismiss that kind of share-price fall as just one of those things, a stock-market phenomenon that'll pass.

There's always a risk of contagion from equity markets to credit markets.

Or to put it another way, the HBOS chief exec would be anxious (to put it mildly) that those who fund his bank - who lend to it - would get the heeby-jeebies from what he would see as an over-reaction on the stock market to the demise of .

If you have your savings with HBOS, if you're a money manager that has lent HBOS many tens of millions of pounds, it's hard to shrug off what looks like investors screaming that there's a fire at HBOS.

Those investors may be hysterical, alarmist and misguided. But how can HBOS's creditors be absolutely sure of that?

And if these creditors decided not to hang around to find out, and simply withdrew their credit from HBOS, well that could turn stock-market rumour and speculation into a reality - as no bank can survive as and when it loses the confidence of its creditors.

Which is why the Chancellor was unambiguous this morning that something should be done about speculative short selling, or the practice by hedge funds and others of selling shares that they don't own (shares they've borrowed) with a view to buying them back at a lower price and pocketing the difference.

However he neatly passed the buck to the regulator, the , saying that it was looking at how and whether to restrict short-selling in these febrile conditions.

And it won't be easy for the FSA to sort this.

First, short-selling (as I've said many times) is not evil, in and of itself. In fact, short-sellers perform a public service when they take a risk to puncture the over-valuation of assets, as they routinely do.

Second, in global markets it's hard for any single national regulator to take a stand against a practice like short-selling, when investors can simply move their activities offshore.

But it would probably be foolish for the authorities to plead impotence - because the consequence might be a much bigger mess for them to clean up, as and when the short-sellers spark a fully fledged banking crisis.

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Barclays wants Lehman rump

• Robert Peston
• 16 Sep 08, 08:09 AM

Barclays has decided to try to "buy" the core of Lehman, its US broker-dealer business and its mergers-and-acquisitions team.

The best way of seeing this is not as a purchase of assets. Barclays does not want either Lehman's toxic investments in the residential and commercial property markets, nor does it want to unwind its extant, unsettled transactions.

What it wants is the 8,000 to 10,000 US employees which it sees as formidable profit generators.

But the value of these employees' relationships with clients is withering by the hour.

So if Barclays is to pick them up out of insolvency, it has to move fast.

If a deal is done, it'll be completed in hours.

As for the 5,000 Lehman staff in London, the outlook for them remains gloomy - since, as of now, it's unlikely Barclays will hire them (though that could change).

The big question for Barclays' shareholders is whether the bank will need to raise new capital to fund this deal. I wouldn't rule it out.

But history shows that the biggest investment gains are made by those who buy when all around are panicking that the end is nigh, when markets are close to bottom.

So if Barclays picks up the rump of Lehman, it may look very smart a few years from now.

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