A not-so-funny thing happened on the way to the bank this month. The U.S. financial market experienced its biggest collapse in nearly 80 years.
Unless you've been hiding under a rock, you're probably well aware of the body count: Three of the nation's five largest brokerage firms have disappeared (Bear Stearns, Merrill Lynch and Lehman Brothers), and the world's two largest lenders (Fannie Mae and Freddie Mac) have been taken over by the federal government.
In another disconcerting development, the Reserve Fund, which is one of the nation's oldest and largest money market funds, lost 3 percent of its principal Tuesday because of the default of Lehman Brothers debt securities held by the fund. In other words, if you had $100 in the money market fund on Monday, by Tuesday you would only have had $97. (By Thursday, the principal was fully restored.) In 25 years of covering the financial markets, this is the first time I can remember a money market fund losing principal.
But perhaps the biggest blow to our collective confidence was the collapse of the nation's largest insurance company, American International Group (AIG). The very thought of our insurance giants -- the bedrock of the financial world -- going under sent shockwaves throughout the financial world. After initially declining to help stabilize AIG, the federal government made the wise decision to save the company and attempt to restore some confidence in the financial markets by giving AIG an $85 billion loan.
Will other insurance giants follow suit? Most of the major players in the insurance industry currently appear to be on solid ground. Travelers Companies, a St. Paul-based insurance company, refused to comment for this article or to elaborate on how the AIG situation and the recent wave of hurricanes might affect the company's bottom line.
But Travelers' financial fundamentals look pretty solid, particularly compared with AIG. In a report issued Tuesday by Morgan Stanley, analyst William Wilt gave relatively high marks to Travelers (TRV) and two other insurance giants, Chubb (CB) and Ace Limited (ACE). "A cardinal rule in property and casualty insurance is to maintain financial flexibility and integrity on the premise that one never knows when dislocations will materialize," said Wilt.
The three insurers "have adhered to this principle and will reap benefits at the expense of AIG. But we don't offer unbridled enthusiasm. Scraping away reserve releases in 2009, we expect TRV to produce accident year return on equity of 11 to 12 percent. We think high quality insurers, including ACE and TRV, can go higher, but hopes of a broad-based cycle turn on the back of AIG's woes may prove illusory."
Travelers has been a fairly solid stock recently. Shares have traded around $44 to $54 the past 12 months, and were recently trading at around $48 with a dividend yield of about 2.7 percent. It closed Friday at $50.76.
In the second quarter, the company reported a 17 percent decline in earnings per share, but Travelers Chairman and CEO Jay Fishman said "our balance sheet and liquidity continue to be extremely strong, as demonstrated by the recent upgrade by Moody's of both our debt and insurance financial strength ratings."
A different story at AIG
AIG has seen its fortunes deteriorate steadily over the past two years, with losses of $18 billion over the past three quarters. Although its insurance and financial subsidiaries remained solid, its financial guarantee business has been hemorrhaging red ink. The culprit? The same problem that felled Fannie Mae, Freddie Mac, Lehman Brothers and all the other financial casualties this year -- the subprime mortgage crisis.
Like many of the other failing financial firms, AIG loaded up on mortgage securities and then leveraged their position to jack up returns. But the wave of foreclosures and defaults began to take its toll. The damage was exacerbated by the steep leveraging of the firm's mortgage holdings.
Why did management of AIG risk their company by investing so heavily in subprime mortgage securities? To boost revenue and earnings and pump up the stock. Subprime mortgages -- with their ballooning interest rates -- offered an attractive return. And by leveraging those securities, they could bump up returns even higher.
But when the subprime mortgage market began to collapse, that leveraged position inflated the losses. As defaults mounted so did AIG's losses.
Under terms of the bailout, the federal government has taken a 79.9 percent stake in AIG's equity. In return, the government will loan AIG $85 billion over the next two years at a rate now about 12.5 percent. The loan is secured by AIG's assets.
When will the next financial domino fall? Perhaps soon. Several banks and financial institutions are reportedly faltering. But it may be a long time before free-market capitalists repeat their mantra that the government needs to cut regulations and get out of the way of the private sector to let capitalism work freely. With hundreds of billions already committed in government bailouts, the free market -- and corporate managers who fell prey to greed and irresponsibility -- has proved to be anything but free.
Gene Walden is the author of more than 20 books about business and investing. He lives in the Twin Cities. Send questions or comments to: email@example.com.