by Porter Stans­berry
DailyWealth.com

Some­thing very strange is hap­pen­ing in the finan­cial mar­kets. And I can show you what it is and what it means...

If Sep­tem­ber didn’t give you enough to worry about, con­sider what will hap­pen to real estate prices as unem­ploy­ment grows steadily over the next sev­eral months. As bad as things are now, they’ll get much worse.

They’ll get worse for the obvi­ous rea­son: because more peo­ple will default on their mort­gages. But they’ll also remain depressed for far longer than any­one expects, for a rea­son most peo­ple will never understand.

What fol­lows is one of the real secrets to September’s stock mar­ket col­lapse. Once you under­stand what really hap­pened last month, the events to come will be much clearer to you...

Every great bull mar­ket has sim­i­lar char­ac­ter­is­tics. The spec­u­la­tion must – at the begin­ning – start with a rea­son­ably good idea. Using long-term mort­gages to pay for homes is a good idea, with a few impor­tant caveats.

Some of these lim­i­ta­tions are obvi­ous to any intel­li­gent observer... like the need for a sub­stan­tial down pay­ment, the ver­i­fi­ca­tion of income, an inde­pen­dent appraisal, etc. But human nature dic­tates that, given enough time and the right incen­tives, any endeavor will be cor­rupted. This is one of the two crit­i­cal ele­ments of a bub­ble. What was once a good idea becomes a farce. You already know all the sto­ries of how this hap­pened in the hous­ing mar­ket, where loans were even­tu­ally given with­out fixed rates, with­out income ver­i­fi­ca­tion, with­out down pay­ments, and with­out legit­i­mate appraisals.

As bad as these prac­tices were, they would not have cre­ated a global finan­cial panic with­out the sec­ond, more crit­i­cal ele­ment. For things to get really out of con­trol, the farce must evolve fur­ther... into fraud.

And this is where AIG comes into the story.

Around the world, banks must com­ply with what are known as Basel II reg­u­la­tions. These reg­u­la­tions deter­mine how much cap­i­tal a bank must main­tain in reserve. The rules are based on the qual­ity of the bank’s loan book. The riskier the loans a bank owns, the more cap­i­tal it must keep in reserve. Bank man­agers nat­u­rally seek to employ as much lever­age as they can, espe­cially when inter­est rates are low, to max­i­mize prof­its. AIG appeared to offer banks a way to get around the Basel rules, via unreg­u­lated insur­ance con­tracts, known as credit default swaps.

Here’s how it worked: Say you’re a major Euro­pean bank... You have a sur­plus of deposits, because in Europe peo­ple actu­ally still bother to save money. You’re look­ing for some­thing to max­i­mize the spread between what you must pay for deposits and what you’re able to earn lend­ing. You want it to be safe and reli­able, but also pay the high­est pos­si­ble annual inter­est. You know you could buy a port­fo­lio of high-yielding sub­prime mort­gages. But doing so will limit the amount of lever­age you can employ, which will limit returns.

So rather than rule out hav­ing any high-yielding secu­ri­ties in your port­fo­lio, you sim­ply call up the friendly AIG bro­ker you met at a con­fer­ence in Lon­don last year.

“What would it cost me to insure this sub­prime secu­rity?” you inquire. The bro­ker, who is sell­ing a five-year pol­icy (but who will be paid a bonus annu­ally), says, “Not too much.” After all, the his­tor­i­cal loss rates on Amer­i­can mort­gages is close to zilch.

Using incred­i­bly sophis­ti­cated com­puter mod­els, he agrees to guar­an­tee the sub­prime secu­rity you’re buy­ing against default for five years for say, 2% of face value.

Although AIG’s credit default swaps were really insur­ance con­tracts, they weren’t reg­u­lated. That meant AIG didn’t have to put up any cap­i­tal as col­lat­eral on its swaps, as long as it main­tained a triple-A credit rat­ing. There was no real cap­i­tal cost to sell­ing these swaps; there was no limit. And thanks to what’s called “mark-to-market” account­ing, AIG could book the profit from a five-year credit default swap as soon as the con­tract was sold, based on the expected default rate.

What­ever the com­puter said AIG was likely to make on the deal, the accoun­tants would write down as actual profit. The bro­ker who sold the swap would be paid a bonus at the end of the first year – long before the actual profit on the con­tract was made.

With this struc­ture in place, the Euro­pean bank was able to assure its reg­u­la­tors it was hold­ing only triple-A cred­its, instead of a bunch of sub­prime “toxic waste.” The bank could lever­age itself to the full extent allow­able under Basel II. AIG could book hun­dreds of mil­lions in “profit” each year, with­out hav­ing to pony up bil­lions in collateral.

It was a fraud. AIG never any cap­i­tal to back up the insur­ance it sold. And the prof­its it booked never mate­ri­al­ized. The default rate on mort­gage secu­ri­ties under­writ­ten in 2005, 2006, and 2007 turned out to be mul­ti­ples higher than expected. And they con­tinue to increase. In some cases, the secu­ri­ties the banks claimed were triple A have ended up being worth less than $0.15 on the dollar.

Even so, it all worked for years. Banks lever­aged deposits to the hilt. Wall Street pack­aged and sold dumb mort­gages as secu­ri­ties. And AIG sold credit default swaps with­out both­er­ing to col­lat­er­al­ize the risk. An enor­mous amount of cap­i­tal was cre­ated out of thin air and tossed into global real estate markets.

On Sep­tem­ber 15, all of the major credit-rating agen­cies down­graded AIG – the world’s largest insur­ance com­pany. At issue were the soar­ing losses in its credit default swaps. The first big write­off came in the fourth quar­ter of 2007, when AIG reported an $11 bil­lion charge. It was able to raise cap­i­tal once, to repair the dam­age. But the losses kept grow­ing. The moment the down­grade came, AIG was forced to come up with tens of bil­lions of addi­tional col­lat­eral, imme­di­ately. This was on top of the bil­lions it owed to its trad­ing part­ners. It didn’t have the money. The world’s largest insur­ance com­pany was bankrupt.

The domi­noes fell over imme­di­ately. Lehman Broth­ers failed on the same day. Mer­rill was sold to Bank of Amer­ica. The Fed stepped in and agreed to lend AIG $85 bil­lion to facil­i­tate an orderly sell off of its assets in exchange for essen­tially all the company’s equity.

Most peo­ple never under­stood how AIG was the linch­pin to the entire sys­tem. And there’s one more secret yet to come out...

AIG’s largest trad­ing part­ner wasn’t a name­less Euro­pean bank. It was Gold­man Sachs.

I’d won­dered for years how Gold­man avoided the kind of huge mortgage-related write­downs that plagued all the other invest­ment banks. And now we know: Gold­man hedged its expo­sure via credit default swaps with AIG. Sources inside Gold­man say the company’s expo­sure to AIG exceeded $20 bil­lion, mean­ing the moment AIG was down­graded, Gold­man had to begin mark­ing down the value of its assets. And the moment AIG went bank­rupt, Gold­man lost $20 bil­lion. Gold­man imme­di­ately sought out War­ren Buf­fett to raise $5 bil­lion of addi­tional cap­i­tal, which also helped it raise another $5 bil­lion via a pub­lic offering.

The col­lapse of the credit default swap mar­ket also meant the invest­ment banks – all of them – had no way to bor­row money, because no one would insure their obligations.

To fund their daily oper­a­tions, they’ve become totally reliant on the Fed­eral Reserve, which has allowed them to for­mally become com­mer­cial banks. To date, banks, insur­ance firms, and invest­ment banks have bor­rowed $348 bil­lion from the Fed­eral Reserve – nearly all of this lend­ing took place fol­low­ing AIG’s fail­ure. Things are so bad at the invest­ment banks, the Fed had to change the rules to allow Mer­rill, Mor­gan Stan­ley, and Gold­man the abil­ity to use equi­ties as col­lat­eral for these loa
ns, an unprece­dented step.

The main­stream press hasn’t reported this either: A pro­vi­sion in the $700 bil­lion bailout bill per­mits the Fed to pay inter­est on the col­lat­eral it’s hold­ing, which is sim­ply a way to fun­nel tax­payer dol­lars directly into the invest­ment banks.

Why do you need to know all of these details? First, you must under­stand that with­out the government’s actions, the col­lapse of AIG could have caused every major bank in the world to fail.

Sec­ond, with­out the credit default swap mar­ket, there’s no way banks can report the true state of their assets – they’d all be in default of Basel II. That’s why the gov­ern­ment will push through a mea­sure that requires the sus­pen­sion of mark-to-market account­ing. Essen­tially, banks will be allowed to pre­tend they have far higher-quality loans than they actu­ally do. AIG can’t cover for them anymore.

And third, and most impor­tantly, with­out the huge fraud per­pe­trated by AIG, the mort­gage bub­ble could have never grown as large as it did. Yes, other fac­tors con­tributed, like the role of Fan­nie and Fred­die in par­tic­u­lar. But the key to enabling the huge global growth in credit dur­ing the last decade can be tied directly to AIG’s sale of credit default swaps with­out col­lat­eral. That was the barn door. And it was left open for nearly a decade.

There’s no way to replace this mas­sive credit-building machine, which makes me very skep­ti­cal of the government’s bailout plan. Quite sim­ply, we can’t replace the credit that existed in the world before Sep­tem­ber 15 because it didn’t deserve to be there in the first place. While the gov­ern­ment can, and cer­tainly will, paper over the gap­ing holes left by this enor­mous credit col­lapse, it can’t actu­ally replace the trust and credit that existed... because it was a fraud.

And that leads me to believe the com­ing eco­nomic con­trac­tion will be longer and deeper than most peo­ple understand.

You might find this strange... but this is great news for those who under­stand what’s going on. Know­ing why the econ­omy is shrink­ing and know­ing it’s not going to rebound quickly gives you a huge advan­tage over most investors, who don’t under­stand what’s hap­pen­ing and can’t plan to take advan­tage of it.

How can you take advan­tage? First, make sure you have at least 10% of your net worth in pre­cious met­als. I pre­fer gold bul­lion. World gov­ern­ments’ gigan­tic lia­bil­i­ties will vastly decrease the value of paper currencies.

Sec­ond, I can tell you we’re either at or approach­ing a moment of max­i­mum pes­simism in the mar­kets. These kinds of pan­ics give you the chance to buy world-class busi­nesses incred­i­bly cheaply. A few worth men­tion­ing are Exxon­Mo­bil, Intel, and Microsoft. I have sev­eral stocks like these in the port­fo­lio of my Invest­ment Advi­sory.
Third, if you’re com­fort­able short sell­ing stocks (bet­ting they’ll fall in price), now is the time to be doing it... sim­ply as a hedge against fur­ther declines.

Keep the fraud of AIG in mind when you form your invest­ment plan for the com­ing years. By fol­low­ing these three strate­gies, you’ll sur­vive and pros­per while most investors sit back and won­der what the hell is going on.

Good invest­ing,

Porter Stans­berry