The Risk We Face: AIG Nationalization and Other Thoughts

 

The extraordinary risk will not be resolved by the nationalization of AIG or steps to make it easier to borrow from the Federal Reserve. We face the specter of the ‘night of the living dead scenario’ where there are hundreds if not a thousand financial institutions are operating today – but are dead if mark to market accounting was applied to their assets.

The Fed’s #1 priority right now is to reduce the probability of bank runs. If we see just one bank run, it could be contagious leading to runs on many banks. This is the nightmare scenario everyone wants to avoid.

The reason gold shot up by $90 is simple. It is flight to quality. In usual circumstances, flight to quality means that investors pile into U.S. Treasuries. Today, it is not so obvious that the U.S. Treasury bonds are risk-free.

There are two types of risk we are facing. First, there is the systemic risk of a complete breakdown of our financial structure leading to a very negative economic shock that impacts both business and consumers. Second, there is uncertainty. With this type of risk, people are unable to estimate the probability of the systemic risk – maybe its 1% probable or 50% probable – you can’t tell. With extreme uncertainty, business grinds to a halt until some of the uncertainty is resolved.

There is significant collateral damage caused by the crisis. This is not just a story about decreased availability of credit. Businesses are now going into survival mode and that means no hiring and minimal capital spending. We are well past the “crunch” threshold.

So far the policy makers have focused on the large firms. Let’s not make the mistake that Japan made in the 1990s when credit was only available to large firms and the small and medium sized firms were squeezed. Economic growth and jobs are driven by small and medium firms. This fact needs to be central to all policy initiatives.

In years to come, the real story will not be the subprime crisis or some housing bubble, it will be the spectacular failure of risk management systems in our, so-called, leading financial institutions.

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