September saw the collapse of three major financial or insurance institutions in the U.S.: Freddie Mac/Fannie Mae, AIG and Lehman Bros. Although the reasons for each differed, the common denominator in all three cases was the inability of the firms to retain financing.
Freddie Mac/Fannie Mae Takeover
Freddie/Fannie were set up to support the housing market in that they guaranteed mortgages and were able to fund these guarantees by issuing their own debt, which was backed by the government. Many investors, who saw the government-backed debt as the substitute for US Treasury securities, bought lots of it. Weakly supervised, Freddie/Fannie used their subsidized financing to buy mortgage-back securities, which were backed by pools of mortgages that did not meet their usual standards. Their thin capital was not enough to cover losses on the subprime mortgage market, and facing massive collapses everywhere if Freddie/Fannie defaulted, the Treasury stepped in and guaranteed that debt. After that happened, no investor was willing to put in more money to buffer these losses. So, the Treasury ended up taking them over.
Lehman Brothers Bankruptcy
As an investment bank, Lehman relied on “rollover”funding to finance its investment in real estate, bonds, stocks, etc. All investment banks operate similarly, but when it’s hard for a lender to monitor investments or risk portfolio of the borrower (here, Lehman Bros.), the lender opts for short-term financing. Then, the lender can later threaten to withhold the roll-over financing for the next short-term and keep the borrower in check. As short-sellers became convinced that Lehman’s real estate losses were worse than acknowledged (and as news of the Freddie/Fannie collapse was announced), Lehman’s costs of borrowing rose and its share price plummeted. As a result, Lehman’s credit rating was going to be downgraded, which would have prevented certain firms from continuing to lend to Lehman. Other firms who might have been able to lend, even with the lower credit rating, simply concluded that the risk of default was too high – and so, Lehman’s money ran out.
Part of AIG’s business was dealt with a kind of derivative called a credit default swap, or CDS. CDS is like an insurance contact where the buyer pays a premium to the seller (here, AIG) for protection against a default on a package of debt backed by, let’s say….residential mortgages. For a while, AIG was writing a lot of these kinds of contracts because the risk of payout was low and the premiums were an easy profit. As the subprime mortgage market went in the tank, the possibility of further losses caused credit rating agencies to downgrade AIG’s debt. With this lower rating, AIG’s existing contracts compelled them to post that they had sufficient collateral to service the contracts (somewhere around $15 billion in immediate collateral). If AIG could not post the collateral, it would have been considered that AIG defaulted on the CDS’s and that would have called into play cross-default provisions on some of AIG’s other contracts. AIG had about $380 billion in these other types of insurance contracts. No private investors were willing to loan AIG the money it needed to post the collateral. Even if it could post that collateral with current holdings, it would have called into question AIG’s ability to service its own existing debt – which was about $160 billion in bonds held all over the world.
Given the number of intertwined parties and industries, the Federal Reserve decided that a default by AIG would have a catastrophic domino effect on the financial system and cause contagious failures. So, the Fed loaned AIG the $85 billion it needed to post as collateral to honor its contracts.