The unprecedented government rescue of insurance giant calms the market's angst, but the question is whether credit markets will cooperate with the Fed and what other shoes are there left to drop.
The Federal Reserve late Tuesday acknowledged that it would provide up to $85 billion to AIG and sell AIG's businesses in an orderly manner to raise capital. The loan facility has a two-year term and is backed by all assets of AIG and its main units. The government would receive a 79.9 percent stake in AIG .
- The Federal Reserve's Statement on AIG
Word that such a plan was being formed helped lift stocks Tuesday and could push the market higher early Wednesday. Concerns that AIG could go into bankruptcy had worried investors, who feared that it would have a cascading effect and potentially pull down other financial institutions globally.
The question now is whether the Fed's loan is big enough, and Fed officials say that it is more than enough. Treasury Secretary Hank Paulson, in a statement, said the Fed's loan to AIG is aimed at limiting market disruptions and protecting taxpayers money.
"Honestly we're paying for two decades of sin ... that's the reality of it," said Joseph LaVorgna, chief U.S. economist at Deutsche Bank. LaVorgna said the stock market though is ignoring the underlying issues of the credit crises.
Stocks scored their biggest gains of Tuesday's session after the Fed said it was leaving interest rates unchanged. Many traders had expected a rate cut to help the worsening credit situation but there was a collective sigh of relief from market participants who took the Fed's inaction as a sign it was willing to help AIG. The Dow finished up 141 points, or 1.3 percent.
"What the market is missing is the restriction of credit. You're seeing it in a few ways," LaVorgna said. He said one of those is significantly tighter lending standards. "Spreads have blown out so companies are not getting access to capital. The spreads are reflecting the fact that dealers/banks don't' want to underwrite debt. The cost of funding for everybody has gone up in the last couple of months."
Late Tuesday, one disturbing side effect of Lehman's bankruptcy earlier in the week played out in a major money market fund's announcement that it was paying $0.97 on the dollar, or "breaking the buck." The Reserve said it was putting a seven-day freeze on redemptions of Primary Fund RFIXX after its net asset value fell below $1. It said that its $785 million holding of Lehman Brothers debt was valued at zero.
"I think The Reserve fund going below a dollar a share is probably just as important as the AIG news ... It's just reinforcing the notion of where do you put your money ...I t's going to make people nervous and you don't have economic growth when people aren't going to take risk," he said.
"It takes a while for these events to play out. These shock waves occur both short-term and long-term. That Reserve Fund is a very good fund but people didn't expect Lehman to be in bankruptcy ... so you don't know what other funds may have exposure to Lehman or to any other company," said LaVorgna.
The monumental restructuring of the financial industry in just several days has included in the government rescue of AIG, the bankruptcy of Lehman Brothers , and the $50 billion sale of Merrill Lynch to Bank of America. There are also continuing rumors swirling around other financial institutions including Morgan Stanley and Goldman Sachs. Morgan, in an effort to quiet speculation, issued its earnings reportafter Tuesday's close, a day early.
The firm's earnings fell three percent but Morgan beat expectations. Its stock recovered some ground in late trading.
Tim Smalls, head equities trader at Execution LLC, said the AIG story is the one that counts most for stocks Wednesday. "There's a ton of things out there but this is the only thing that takes center stage," he said just after Tuesday's close. "Too bad we have all this financial unwinding because the real thing is the price of oil, but I think they're interconnected. When you need to raise capital, you sell the things you can sell."
NYMEX crude Tuesday fell $4.56, or 4.8 percent to $91.15 per barrel, giving it a 23 percent decline in 13 days. But it was moving higher in Asian trade Wednesday and was above $94 per barrel after the AIG news helped push it higher.
M.F. Global senior vice president John Kilduff said if AIG is rescued in a way that makes the market comfortable with its liquidity and stability, oil and commodities could move higher. Weekly oil inventory data is reported Wednesday at 9:30 a.m.
"The inventories will be startling in the magnitude of the drawdown in gasoline and crude oil because we've been looking at several weeks of disruption of refinery operations due to Hurricanes Gustave and Ike," he said.
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