In the last part we saw why the banks were rather reckless in their lending, why certain investment banks started failing and why all this got AIG into trouble. We also saw what CDSs were and how banks made money from mortgages. Continuing from the point where Lehman Brothers failed:

The Government now refused to lend a helping hand to the ailing ibank and dismissing the case as a one off case of reckless Wall Street decisions. The public at large, hailed this decision of the government to penalize the irresponsibility of Wall Street which led to the fall of their comrade. However what they failed to consider was the extent of ties they had with the giant insurer. They had failed to estimate the invisible roots the investment bank had with the economy at large. Since a good portion of the Lehman investments were covered by the AIG, they had no choice but to pay up for the defaults. And so came the fall of the Goliath. The government, now recognizing the deep roots of AIG across the globe, rushed a $80bn USD bailout thereby recapitalizing the ailing insurance major, the terms of which was rather careless, which is probably why we now hear about the AIG’s bonus scandal.

A few days later, a massive bailout program was organized called as the TARP or the Troubled Assets Relief Program- A program in which government would recapitalize institutions running on the verge of bankruptcy. TARP was originally provided by the government hoping to infuse more money into the markets and the banks so that the ongoing foreclosures would cease and more people would get to stay in their homes. But due to lack of oversight a lot of these institutions often used this money to pay bonuses or hire expensive foreign staff and take no steps to meet the original objectives of the TARP. The biggest problem here was that the Government protected them from failing but not incompetence.

Until recently, it was a widely held belief that AIG was too big to fail. But slowly economists have started questioning that line of thought. Why should AIG not fail? After all, this institution has been at the centre of the rescue plan, has been a zombie company which constantly guzzles taxpayer money and the end doesn’t seem to be in sight. The real reason why government did not let AIG fail in the first place was due to the fact that AIG held a huge number of credit default swaps (CDS) which the government felt were too many in number. But now, it is a widely held belief that AIG must settle those CDS and move on. There are many instances where the insurance major has insured or executed multiple swaps on same set of mortgages which essentially means that AIG would have done multiple deals on a single house and since the house is only one in number and if it faces foreclosure, the insurer would have to dole out multiple compensations for instruments on that single house.

Geithner’s plan to cleanse the bank balance sheets is much like running a junkyard sale. There could be a few useful items but you would never know when you end up picking up the scrap. The plan quite simply aims to rid the banks of the toxic assets by making them look better to buyers who know what they’re getting themselves into. This way, the gamblers have their way and the banks can carry on with business as usual.

 Finally, the credit markets need to be unfrozen by introducing more liquidity in the system so that the needy get the money to carry on with their business. Empowering small business seems to be a good idea right now. While the nation doesn’t need all the banks to survive, it needs most. The trick is in knowing which ones and offer them help. In the end, money has to move and change hands as it did in the good old days!

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