We can’t say we’re surprised. While workers at Lehman (LEH) might feel somewhat aggrieved, it seems the Fed decided that AIG really was too big to fail. “A disorderly failure of AIG could add to already significant levels of financial market fragility.”

So what’s happened – and what does this mean for the wider economy?

The Fed’s decision to bail out AIG after apparently drawing a line under bail-outs with Lehman Brothers shows just how much more important it was to the financial system. The problem with letting AIG collapse is that the group’s tentacles reach everywhere.

An update on the problems with exchange-traded commodities

On that point, before we go any further, one place where AIG exposure has cropped up was in ETF Securities, where yesterday trading was halted in a large number of the company’s exchange traded commodities (ETCs). The ETFs backed by physical assets, including ETFS Physical Gold (LON:PHGP), and ETFS Silver (LON:SLVR) are fine, as are the oil securities backed by Shell. However, the securities based on futures contracts, including short securities such as the Short Oil (SOIL) ETF and agricultural securities are backed by AIG.

ETF Securities says that AIG has continued to fulfil all its obligations to the group. At the time of writing, trading in the affected ETFs is still suspended, though I spoke to the company earlier this morning and it did say that the AIG bail-out was “good news”. In a further update it has now said that it remains in talks with its “market makers and the Exchanges” to “ensure that trading can resume and/or continue in an orderly fashion as soon as possible.” We’ll be bringing you more on this as and when we get it. Some of my own portfolio is in the affected assets, so you can be sure I’ll be keeping a close eye on it.

What does the AIG bail-out mean for the wider economy?

It just goes to show how rapidly the threat to one company can spread in these interconnected markets. So does the Fed bail-out – which involved AIG giving up a near-80% stake to the government, and cost the jobs of many senior managers, including chief executive Robert Willumstad – draw a line under the credit crunch?

It doesn’t seem likely to me. The markets will certainly be relieved that the Fed has stepped in to save AIG.
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Source: The Economy Will Plunge, Despite the AIG Rescue

But it’s not the shareholders who were the problem – it was bond holders. Fannie and Freddie are still responsible for almost 70% of new mortgage loans in the States. They raised cheap money by issuing bonds, and were thus able to fund cheap mortgages for US home buyers.

Now Fannie and Freddie have always inhabited a kind of “nudge, nudge, wink, wink” financial hinterland. The US government didn’t exactly say it was responsible for the two mortgage providers. But everyone knew it was. So that meant that the two companies were able to borrow money at the same rate as the US government.

That’s ended recently as fears for Fannie and Freddie’s future grew. All those foreign governments buying up Fannie and Freddie debt suddenly started to worry – wait a minute, maybe these guys aren’t bluffing. Maybe they really won’t pay back any of the loans that we’ve got here. And that sent them rushing for the hills. That increased the cost of borrowing for Fannie and Freddie, which in turn made US mortgages more expensive.

So now the US government has been forced to turn around and explicitly back Fannie and Freddie. How much is this going to cost? Well, just like Northern Rock, the answer is that nobody really knows.

The US Government is crossing its fingers and hoping that things go well enough so that it might even turn a profit at a later date as it gradually runs the two behemoths down.

But as Hank Paulson admits, “the ultimate cost to the taxpayer will depend on the business results… going forward.”

The general consensus is that this will make things better.

Ruth Lea of Arbuthnot Banking Group tells The Telegraph: “this is good news for the global economy. The Fed has clearly taken a view that to allow these two to go under would have been horrendous.”

Source: The Fannie and Freddie bail-out: bad news for us all

In case these people hadn’t noticed, governments are already up to their necks in the markets, particularly the ones in the worst trouble. Fannie Mae (FNM) and Freddie Mac (FRE)– the twin financial neutron bombs underpinning the US mortgage sector – are Government Sponsored Entities (GSE) after all. They were created by the US Government to interfere with the property market because at some point the authorities decided that universal home ownership – like full employment – was a desirable goal in itself, regardless of whether people could actually afford a home or not.

Now the very existence of the GSEs threatens to bring down the financial system (you can read more about Fannie and Freddie here: How Fannie and Freddie are pulling the US towards crisis).

These knee-jerk calls for added regulation just show that despite all the talk of Thatcherite revolutions and how we’re all capitalists now, plenty of people still don’t understand how or why markets work.

One very obvious example of this is the constant indulgence of the idea of a windfall tax on energy companies…

How the market system is supposed to work

My colleague David Stevenson wrote about the specific stupidities of a windfall tax on energy on Friday (you can read it here: Why an energy windfall tax is a bad idea). But on a broader note, calls for a windfall tax just show how badly understood markets are. Let’s just clarify roughly how they are supposed to work.

If a good or service becomes expensive, that shows that there’s not enough of it to go around – there’s more demand than supply. The companies involved in the sector then make “excess” profits, or to put it more clearly, they rake it in because they were smart or lucky enough to be in the right place at the right time.

But this happy situation won’t last forever. Just as in the recent housing bubble, everyone else sees them making money hand over fist and decides “I’ll have a piece of that.” Or the company itself realises if it can make and sell more goods, it’ll make even bigger profits. One way or another, supply rises to meet demand, therefore driving down the price.

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Source: Why We Need Less Government Interference, Not More

He clearly didn’t realise while he was Chancellor that he was setting all these little tripwires for his future incarnation as Prime Minister. Now everywhere he turns, there’s a brand new mine waiting to go off under his feet.The latest is the Golden Rule fiasco. When he came up with the Golden Rule and the 40% rule and the whole “prudent fiscal framework”, it must have seemed like a good idea. And it may well have been a good idea – if he’d stuck to it.

But the rules have been battered and bent out of shape until the whole idea has become yet another stick to beat the government with, just when it needs it least.

It’s enough to make you feel sorry for the man. But then again, it’s extremely unusual to see a politician genuinely get what’s coming to them. So enjoy it while it lasts – after all, it may be the only entertainment going during the recession…

The idea behind Gordon Brown’s ‘rules’

Gordon Brown’s rules were always pretty arbitrary. And they were always going to be easy to fiddle.

I’m sure you have a rough idea of what the rules are, but just for posterity’s sake, here they are. The basic idea is that the government borrows only to ‘invest’ over an economic cycle. It has to balance its books over the business cycle as a whole. Meanwhile, the ’sustainable investment rule’ means it has to keep debt to a ‘prudent level’. At the moment, public borrowing isn’t meant to rise above 40% in each year of the current cycle.

To put it more simply, the rules were meant to ensure that the government – unlike Labour governments in the past – wouldn’t simply tax the blazes out of the electorate and then pump the cash indiscriminately into the public sector. Past Labour governments have run the economy like a drunk with a stolen credit card, merrily buying round after round for his fair weather friends until he realises he’s spent so much that he can’t pay the bill. At which point he and his friends are all thrown out of the bar.

This carelessness has, in the past, tended to end up in a sterling crisis. And that memory was one of the things that kept Labour out of power for so long up until 1997.

Mr Brown wanted to get rid of that impression. Hence the rules. These made it sound as if he at least had some understanding that balancing a budget was important, and that getting some sort of return for the money spent on the public sector was needed. The rules gave the idea that there was some sort of restriction on government spending, exactly what the public and the City needed to hear.

And why it’s all meaningless in practice…

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Source: Why Brown’s Rule-breaking is Great News for Trade Unions

Buy commercial property, the City folk said.

Commercial property’s a sure thing. Rents can only ever go up the way, after all. And London is the centre of the Universe. Everyone wants to live and work here. We’ve got financial acumen, great culture, fantastic restaurants, and a congestion charge that keeps poor people from clogging up the roads with their squalid little white vans and cheap cars.

How could demand ever fall?

Well, we all know now that the London bubble was yet another offshoot of the credit bubble. And now that it’s popped, the property market for both business and leisure just isn’t looking such a sure thing anymore…

Demand for commercial property fell at its fastest since 1998 during the second quarter of the year, reports the Royal Institution of Chartered Surveyors (Rics). A full 50% more surveyors said they saw demand falling rather than rising, down from 31% in the first three months of the year.

Rics’ chief economist, Simon Rubinsohn, said it was “the sheer negativity” of the survey that struck him. The idea that tenant demand is now falling, as well as investment demand is the worrying aspect. “There are no positives out there right now,” he told The Telegraph.

On top of this, retailers in particular – where the market and demand are at its weakest – are starting to get bolshy. According to weekend press reports, big players including Boots, Argos, and Sir Philip Green’s Arcadia empire, are getting together to try to put an end to the practice of paying quarterly rental payments in advance. They’d rather pay monthly.

The big commercial landlords of course won’t like this. Getting that kind of money up front is a valuable safety precaution in a downturn. And the retailers have signed contracts after all. One told The Sunday Times that “the idea that we will roll over and let our tummies be tickled is way off target.”

But from a retailer’s point of view, having to pay that money upfront is a lethal threat to cashflow during a downturn.

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Source: Why Rents Won’t Rise Enough to Save Buy-to-Let Landlords

According to this particular group, rampant house price growth was justified. The world was in a new era, where interest rates could remain permanently low because of the internet and globalisation and ‘independent’ central banking, and all the other good things that have happened to us over the last decade.

So needless to say, the credit crunch came as a bit of a surprise for them. And now they expect the Government to step in and bail us out. This would make things worse of course, so it’s a good thing the Government is basically too broke to do anything of the sort.

The reality is that all of this was in fact predictable. You’d have to be psychic to pick the exact date, and the exact manner of the collapse. But it was obvious that there was too much money flying around the world. The bubble was bound to pop sometime.

So can we learn anything from this? And more to the point, will we listen to the lessons?

The idea that monetary policy has been far too lax for the past decade at least, is not especially controversial. It’s just that people were having too much fun in the boom times to accept that it was true.

No less authority than the Bank for International Settlements (also known as the central banker’s central bank) makes it pretty clear where it believes the fault for the current crisis lies.

“The fundamental cause of today’s emerging problems was excessive and imprudent credit growth over a long period. Policy interest rates in advanced industrial countries have been unusually low,” says Dr Bill White in the BIS’s latest annual report.

As we’ve said many times before, Alan Greenspan and the rest of the world’s central bankers got away with keeping interest rates ludicrously low, because price inflation was kept down by cheap Asian imports. In fact, for a short while a few years ago, the Bank of England’s biggest challenge was to keep Consumer Price Index (CPI) inflation from falling below 1%, which would have also entailed writing a letter to Gordon Brown, the Chancellor of the time.

But of course, keeping interest rates low merely fuelled other imbalances in the economy. All that borrowed money ended up in the housing market, and we know where that got us.

So what should central banks have done differently, if anything? Ambrose Evans-Pritchard argues that “in the 1990s, they should have torn up the rulebook and let inflation turn negative in light of the Asian effect.”

This is a good point. But the use of the word ‘inflation’ gives away what the core problem is. When Evans-Pritchard talks about inflation here, he means the consumer price index, or some other measure of prices.

Now most central banks and policy-makers fear negative inflation, or deflation, more than anything. That’s partly because genuine deflation goes hand-in-hand with depression, but mostly because Western societies have become obsessed with the idea that the key to constant growth is consumer spending.

The worry is that if prices are falling, then people will stop spending – because why buy now if you can buy cheaper later? And why spend your savings now when they increase in value by the day?

But the trouble with judging inflation and deflation by what’s happening to a basket of specific individual prices, is that it makes no distinction between ‘good’ price changes, and ‘bad’ price changes.

Take milk for example. If all the cows in Britain became twice as productive overnight, and the price of milk halved tomorrow, would you buy more or less? Well, you’d probably buy the same, or maybe a bit more and stick it in the freezer. Would you put off buying it at all because you thought it might halve again next week? Of course not, it’s milk.

What would be bad about milk price deflation? Assuming it was down to higher productivity, and profit margins along the line from farmer to retailer stayed the same, then nothing. In fact, it would be a good thing. If you need to spend less on milk, that means you can spend more on something else. Or heaven forbid, you might even want to save some of that money.

All the stuff we get from Asia has been getting cheaper anyway. Computers are undoubtedly cheaper. I remember that when I bought my first laptop in 2001, the cheapest entry level PC I could find was around £700. Now you can get a far more advanced laptop for about half that price. Does this rampant price deflation stop people from buying computers? Not that I’ve noticed.

So the real problem is in the way that we measure inflation and deflation. Price changes happen for lots of reasons. Oil demand is up, supply is stable or falling, so the price goes up. Computers get cheaper to make, there are lots of factories competing to make them, so the price goes down.

But none of this is about inflation. What inflation really is, is an increase in the money supply. Deflation is a decrease in the money supply.

When the amount of money available to the economy is rising, it’s got to go somewhere. In this case, it largely went into chasing house prices higher. Now that the supply of money has been cut off, as banks stop lending, house prices are falling.

And the real problem with deflation like this, is that as people get more and more concerned about the availability of money, they start to hoard it. That means that not only does no one spend money, they don’t invest it either. They don’t take the sorts of entrepreneurial risks with their money that are necessary to make an economy grow, because they are too scared of losing their scarce cash.

So the truth is that, even though prices are rising at a rate of knots just now, deflation is also a very genuine threat to Western economies. How it plays out remains to be seen, but a period of inflation followed later be a longer period of deflation does look quite possible.

But what does this mean for ‘policy’? Well, arguably, if central banks are going to target anything, they should be looking at something objective like the money supply, rather than something subjective like a basket of goods that is believed to be representative of the average person’s spending. Using the term ‘average cost of living’ when referring to the various price indices, rather than inflation, might help make the distinction clearer for everyone.

Better yet, we could just scrap central banks and let the market decide where interest rates should be. After all, that’s pretty much what’s happening now that everything’s gone horribly wrong.

Source: Why we should be worrying about deflation

US hedge fund Harbinger Capital shorted HBOS stocks, revealing under new disclosure rules that it held a 3.3% short position, worth about 345 million pounds.

Lansdowne Partners and Meditor Capital Management also revealed short positions of less than 1% in the bank, according to a report by Thomson Reuters.

HBOS shares have plunged since it announced a plan to raise £4 billion last month. And yesterday they dropped below the rights issue price.

Of course, as John Stepek points out in his Money Morning newsletter, shorting Britain’s biggest mortgage lender is hardly rocket science, given the overall shape of the British housing market. The real question is who the hell would go long on the likes of HBOS?

You have to laugh really. Though perhaps not if you’re an HBOS shareholder.

The Financial Services Authority has just introduced a rule forcing short-sellers of shares to disclose when they hold short positions of more than 0.25% of the stock of a company undertaking a rights issue (if you’re long, then you have to reveal when you hold 3%).

The FSA’s move was partly in reaction to a sharp plunge in HBOS’s share price back in March. The FSA blamed this on false rumour-mongering and vowed to hunt down the culprits, but the watchdog has been forced to admit defeat.

Meanwhile, its new rule on short disclosure forced Harbinger Capital, headed up by one of the world’s best-paid hedge fund managers, to reveal it was shorting not 0.5%, not 1%, but a whole 3.29% of HBOS stock.

When confronted with evidence that one of the smartest (at least, if you judge investment skill by the size of his pay packet) of their number was betting so extravagantly on Britain’s biggest mortgage lender to fall, all those independent-minded contrarians in the City did exactly what you’d expect.

They sold in droves…

HBoS saw its share price sink beneath the 275p price of its rights issue yesterday, falling 4% to 270.25p. We’ve already written about this (see: Why British property could be China’s next dud investment), but it looks increasingly like the underwriters, Morgan Stanley and Dresdner Kleinwort will have to carry the £4bn can for this one.

There were plenty of good reasons for HBOS to fall. There was the news from Rightmove that even house asking prices are now falling. A hammering for commercial property stocks after a heavy downgrade from HSBC also cast a general pall over the banking sector.

So it isn’t all down to revelations that hedge fund managers are shorting the stock by any manner of means. After all, that’s what hedge funds are supposed to do – generate ‘alpha’ (market-beating returns, basically) by taking advantage of anomalies in the market that no one else has spotted.

And this is the slightly worrying thing. After all, it shouldn’t have taken a genius to figure out that HBoS is not in a great position at the moment. Sure, March’s sharp sell-off had a whiff of rumour-inspired panic about it, but in the rather fevered post-Northern Rock atmosphere, it wouldn’t have taken much to inspire a run on bank share prices. More to the point, the stock has fallen by nearly 40% since then.

The real wonder is that anyone is long on HBOS, not that some highly-paid ‘experts’ are shorting it. After all, this is Britain’s biggest mortgage lender we’re talking about here. It has a great big loan book secured against what is the single most vulnerable asset class in Britain right now – residential property.

Now that wouldn’t be such a big deal if you thought that the management team has been prepared for a downturn, After all, all good things come to an end, don’t they? Yet it seems that they believed their own hype. Even now, after several downward revisions, they’re arguing that house prices will end the year down just 9%, which is frankly optimistic by most counts these days.

But there’s no point in the HBOS board just keeping their fingers crossed and hoping things will get better, because they won’t. HM Revenue & Customs data released yesterday showed that the number of property sales (both commercial and residential) has fallen by nearly 40% in the past year. There were 100,000 transactions in May, compared to 158,000 the year before.

Just how low can prices go? The latest participants at our property RoundTable had a wide range of predictions, spanning a range from ‘gloomy’ to ‘positively catastrophic’.

Suffice to say, the property market’s going to get a lot worse before it gets better. And that pretty much means the same for the outlook for HBOS. Even if the share price does manage to claw its way back up above 275p, I wouldn’t be taking up the rights on this one.

Source:  Why Shares in HBoS could Fall Yet Further