m It was the week that shook the financial world to the core.

m On Friday, Sept. 12, traders left the New York Stock Exchange for the
weekend.

m But key banking officials, began a series of weekend meetings in an

effort to prevent a possible collapse of the global financial system.

m Over the next seven days financial leaders, captained by Treasury

Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke,
produced a rapid succession of moves that reversed a decades-long
trend toward financial deregulation and fundamentally changed the
face of the American financial system.
m The trading week ends with the fate of 158-year-old Lehman
Brothers in grave doubt.

m Its stock had fallen sharply due to fears over its financial condition.

m Paulson, Bernanke, and New York Fed President Tim Geithner begin
a series of meetings with top bankers in an effort to engineer a
bailout of Lehman, which had bet heavily in the subprime mortgage
market.

m Two possible buyers emerge: Britain's Barclays and Bank of

America.
m Talks on a possible Lehman buyout continue.

m The would-be rescuers look to the government to take on some of

the risk, as it did in the shotgun sale of Bear Stearns to JPMorgan
Chase in March and the effective nationalization on Sept. 8 of
mortgage giants Fannie Mae and Freddie Mac.

m Government officials hold fast that there will be no federal bailout.

m Talks are inconclusive.

m The negotiators continue meeting, facing a deadline to act before
Asian markets open for Monday morning trading.

m But government officials insist there will be no federal backing of a

Lehman rescue.

m With no help from Washington forthcoming, BarclaysͶthe only

possibility left after Bank of America leaves the table.

m Meanwhile, Merrill Lynch CEO John Thain, seeing the writing on

the wall, arranges the sale of his company to Bank of America for
about $50 billion.

m In one day, the fates of two storied companies are sealed.

m Lehman Brothers Holdings, the bank's holding company, files for
Chapter 11 bankruptcy protection and says it will try to sell key
business units.
m Investor concern now turns to the fate of AIG, fearing a liquidity
crisis.
m Rating agencies cut AIG's credit rating.
m The stock market plummets. The Dow Jones industrial average
drops more than 504 points, or 4.4%
m The failure also roils overseas stocks, sending them plunging.
m Concerns about a slowing economy take oil below the psychological
benchmark of $100 a barrel
m The Federal Reserve meets and keeps the federal funds rate
unchanged at 2%.
m Asian markets, some of which had been closed for a holiday on
Monday, plummet
m The Russian stock market goes into a tailspin, with the largest
exchange down more than 17% before the Russian government
halts trading
m Managers of the Primary Fund, a supposedly supersafe money
market fund, say that shares have fallen below the sacrosanct $1
valuation.
m Meanwhile, Goldman Sachs and Morgan Stanley, report stronger
than expected results.
m Amid all the turbulence, U.S. officials decide that AIG is indeed "too
big to fail.͞

m In a move that would have been unthinkable before the credit crisis
began, the Fed arranges to lend $85 billion

m Exchange of 79.9% equity stake.

m The deal is announced Tuesday evening.

m Even before the deal is finalized, the Dow reverses an earlier loss
and gains 141 points.
m The government bailout of AIG fails to stem investor fears as they
flee to safety.

m Credit markets tighten.

m j

j

 reports that Washington Mutual , the nation's
largest thrift, has put itself up for sale

m The Dow plunges 449 points.

m j

j

 reports that Morgan Stanley has "stepped up"
merger talks with Wachovia

m The Fed moves to pump money into the financial system through
lending programs operated by several overseas central banks and
the Fed's own moves.

m At the same time, the government begins action on the hugest

bailout of all, committing hundreds of billions of taxpayer dollars to
buy troubled mortgage assets from beleaguered financial
institutions.

m Stocks rally. The Dow closes up 410 points.

m The buyout plan with few firm details is announced and stocks soar
worldwide.

m SEC places a temporary ban on the short-selling of nearly 799

financial stocks.

m The Dow closes up 368.75 points, 45 points below where it was a

week earlier but still 911 points over its bottom on Thursday
morning.

m It will be hard to match events that have reshaped the U.S. financial
landscape for years, if not decades to come.
m AIG has grown to become the world's biggest insurer. With
operations in over 130 countries and a customer base of 74 million
worldwide, the company has a balance sheet size in excess of $1
trillion.
m AIG is mainly in the business of life, commercial and property
insurance besides retirement products.
m There is no sudden increase in claims in any of these businesses,
anywhere in the world.
m In fact, these business lines of AIG remain very healthy, are market
leaders in many countries and hold much value.
m All those subsidiaries, like the joint ventures with Tata group in
India, are well capitalised and can service all potential claims.
m However, unlike most other insurers, AIG also had a business of
insuring investors in bonds and credit derivatives against defaults.

m This business was under a separate division called AIG Financial

Products or AFP and mostly issued derivative instruments called
Credit default swaps or CDS.

m Investors seeking risk protection bought CDS from issuers like AFP,
which stood guarantee against any default by the issuer in case of a
bond or retail borrower in case of a credit derivative like mortgage-
backed securities.
m A CDS contract involves the transfer of the credit risk of municipal
bonds, emerging market bonds, mortgage-backed securities,
or corporate debt between two parties.
m It is similar to insurance because it provides the buyer of the
contract, who often owns the underlying credit, with protection
against default, a credit rating downgrade, or another negative
"credit event.͞
m Seller- receives a periodic protection fee and is obligated to pay
only if a negative credit event occurs.
m It is important to note that the CDS contract is not actually tied to a
bond, but instead references it.
m For this reason, the bond involved in the transaction is called the
"reference entity."
m An investor with a positive view on the credit quality of a company
can sell protection and collect the payments that go along with it
rather than spend a lot of money to load up on the company's
bonds.
m An investor with a negative view of the company's credit can buy
protection for a relatively small periodic fee and receive a big payoff
if the company defaults on its bonds or has some other credit
event.
m CDS contracts are regularly traded.
m Value fluctuates- based on probability.
m Increased probability- worth more for buyer and vice versa.
m Trader speculates that credit quality of reference entity will
deteriorate in the future, he will buy protection for the short term
in the hope of making profit.
m CDS are traded OTC and intricate knowledge of the market.
m CDS issuers like AIG enjoyed AAA credit ratings and hence the
default risk on the insured securities was considered almost
eliminated.
m When defaults are low, CDS is a good business for issuers with
healthy cash flows.
m AIG expanded this business furiously and easily became the market
leader.
m At the peak, AFP had underwritten bonds and credit derivatives
worth nearly $500 billion.
m Sub Prime crisis hit and defaults started rising.
m AIG started shelling out huge sums to settle the claims and made
increasingly higher provisions, quarter after quarter.
m To make it worse, the company also had other businesses directly
related to US mortgages and suffered huge losses there as well.
m This steady erosion forced AIG to raise more than $20 billion in
additional capital earlier this year
m At the beginning of the April-June quarter, the company had more
than $15 billion in additional capital.
m By the first week of September, that excess capital was wiped out
and the company was desperately seeking nearly $25 billion in
additional funds to protect itself from further credit rating
downgrades.
m $25 billion doesn't appear like a big deal for the AIG group which
has investments of over $750 billion.
m But, all that money is insurance premium received from its main
businesses and set aside to cover future liabilities.
m AIG, the parent company, has no access to even a small part of it.
m Desperate attempts to find private investors failed and finally
pushed AIG into the hands of the Fed.
m The Fed's takeover of AIG is not an open ended, sweetheart deal.
Existing shareholders will see their holdings cut to a fifth of what
they were and the Fed will get an 80-per cent stake without paying
a dollar.
m The $80 billion in credit support comes at a very heavy cost, LIBOR
plus 850 basis points.
m Quite profitable for the Fed if AIG repays the loan without defaults.
m The Fed statement makes it clear that the loan is secured by all the
assets of AIG and has to be "repaid from the proceeds of the sale of
the firm's assets͞
m So, the very high interest rate is to force AIG to liquidate its assets
within the loan period of two years.
m If the Fed wants AIG to be liquidated anyway, why not just allow the
company to collapse right now?
m The Fed is not worried about a failure per se, but a "disorderly"
failure will be of serious concern.
m If left alone, AIG will be forced to liquidate its valuable business
assets at very low valuations to meet its liabilities.
m It is quite possible that it will not be able to raise sufficient cash to
meet its CDS obligations.
m That would be disastrous for CDS holders, many of them struggling
global banks.
m This will erode market confidence even further and unleash
another wave of write-downs.
m On the other hand, the Fed's credit facility will enable AIG to meet
its immediate cash requirements.

m The company gains time, up to two years, to liquidate its assets.

m It is possible that markets would have stabilised when AIG starts

looking for potential buyers and hence can avoid a fire sale.

m This is a far less risky and infinitely more preferable option than
letting AIG go bankrupt.

m In other words, the Fed preferred the slow death of AIG to a quick
kill.
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