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Treasury Department Releases Text of Letter from Secretary Geithner
to Hill Leadership on Administration’s Exit Strategy for TARP

WASHINGTON – The U.S. Department of the Treasury released the
text of identical letters sent today from Secretary Tim Geithner to
Speaker Nancy Pelosi and Senator Harry Reid outlining the
Administration’s exit strategy for the Troubled Asset Relief Program
(TARP) established by the Emergency Economic Stabilization Act of 2008
(EESA). The text of the letter to Speaker Pelosi follows.

December 9, 2009

The Honorable Nancy Pelosi
Speaker          
U.S. House of Representatives
Washington, DC 20515

Dear Madam Speaker:

I am writing to update you on the status of the Obama
Administration’s financial policies, including programs initiated under
the Troubled Asset Relief Program (TARP) established by the Emergency
Economic Stabilization Act of 2008 (EESA), the results they have
achieved, the challenges ahead, and our plan for exiting TARP.

These policies are working.  When the Obama Administration took
office, the financial system was extremely fragile and the economy was
contracting sharply.  The Administration’s financial and economic
policies have helped to shore up confidence in our financial system. 
Credit is starting to flow again to consumers and businesses, and the
economy is growing.  Further, private capital is replacing public
capital in our major institutions.

As a result of improved financial conditions and careful stewardship
of the program, losses on TARP investments are likely to be
significantly lower than previously expected.  We now expect a positive
return from the government’s investments in banks.  These banks will
soon have repaid nearly half of the TARP funds they received.  We also
expect to recover all but $42 billion of the $364 billion in TARP funds
disbursed in FY2009.  Further, we plan to use significantly less than
the full $700 billion in EESA authority.  As a result, we expect that
TARP will cost taxpayers at least $200 billion less than was projected
in the August Mid-Session Review of the President’s Budget.

But significant challenges remain.  Too many American families,
homeowners, and small businesses still face severe financial pressure. 
Although the economy is recovering, foreclosures are increasing, and
unemployment is unacceptably high.  Businesses are still cautious in
the face of uncertainty about the strength of the recovery, and many
small businesses face very difficult credit conditions.  Although bank
lending standards are starting to ease, many categories of bank lending
continue to contract.  This contraction has hit small businesses very
hard because they rely heavily on such lending, and do not have the
ability to substitute credit from securities issuance.  Commercial real
estate losses also weigh heavily on many small banks, impairing their
ability to extend new loans.

Further, the recovery of our financial system remains incomplete. 
And near-term shocks to that system could undermine the economic
recovery we have seen to date.

Exit Strategy for TARP

Our exit strategy for TARP balances the mandate of EESA to address
these challenges with the need to exercise fiscal discipline and reduce
the burden on current and future taxpayers.  There are four broad
elements to our strategy.

First, we will continue terminating and winding down many of the
government programs put in place last fall.  In September, Treasury
ended its Money Market Fund Guarantee Program, which guaranteed at its
peak over $3 trillion of assets.  The program incurred no losses, and
generated $1.2 billion in fees.  The Capital Purchase Program, through
which the majority of TARP investments in banks have been made, is
effectively closed.  Before this Administration took office, nearly
$240 billion in TARP funds had been committed to banks.  Since January
20, we have committed about $7 billion to banks, much of which went to
small institutions.  Major U.S. banks subject to the “stress test”
conducted last spring have raised over $110 billion in high-quality
capital from the private sector.  And banks will soon have repaid $116
billion of TARP funds

Second, we will limit new commitments in 2010 to three areas.

• We will continue to mitigate foreclosure for responsible American
  homeowners as we take the steps necessary to stabilize our housing
  market.
• We recently launched initiatives to provide capital to small
  and community banks, which are important sources of credit for small
  businesses.  We are also reserving funds for additional efforts to
  facilitate small business lending.
• Finally, we may increase our commitment to the Term
  Asset-Backed Securities Loan Facility (TALF), which is improving
  securitization markets that facilitate consumer and small business
  loans, as well as commercial mortgage loans.  We expect that increasing
  our commitment to TALF would not result in additional cost to taxpayers.

Beyond these limited new commitments, we will not use remaining EESA
funds unless necessary to respond to an immediate and substantial
threat to the economy stemming from financial instability.  As a nation
we must maintain capacity to respond to such a threat.  Banks are still
experiencing significant new credit losses, and the pace of bank
failures, which tend to lag economic cycles, remains elevated.  At the
same time, many of the Federal Reserve and FDIC programs that have
complemented TARP investments are ending.  This creates a financial
environment in which new shocks could have an outsized effect –
especially if an adequate financial stability reserve is not
maintained.  As we wind down many of the government programs launched
initially to address the crisis, it is imperative that we maintain this
capacity to respond if financial conditions worsen and threaten our
economy.  However, before using EESA funds to respond to new financial
threats, I would consult with the President and Chairman of the Federal
Reserve Board and submit written notification to the Congress.  This
capacity will bolster confidence and improve financial stability,
thereby decreasing the probability that it will need to be used.  This
is the third element of our exit strategy.

In order to accomplish these goals, pursuant to Section 120(b) of
EESA, I certify that I am hereby extending the authority provided under
the Act to October 3, 2010.  This extension is necessary to assist
American families and stabilize financial markets because it will,
among other things, enable us to continue to implement programs that
address housing markets and the needs of small businesses, and to
maintain the capacity to respond to unforeseen threats, as described
above.

While we are extending the $700 billion program, we do not expect to
deploy more than $550 billion.  We also expect up to $175 billion in
repayments by the end of next year, and substantial additional
repayments thereafter.  The combination of the reduced scale of TARP
commitments and substantial repayments should allow us to commit
significant resources to pay down the federal debt over time and slow
its growth rate.

Even with this extension, we expect that TARP will cost taxpayers at
least $200 billion less than was projected in the August Mid-Session
Review of the President’s Budget, including $25 billion in potential
costs from new TARP commitments in 2010.  We expect that the vast
majority of these potential costs would come from mitigating
foreclosure for responsible American homeowners as we take the steps
necessary to stabilize our housing market.

The final element to our exit strategy is how we manage equity
investments acquired through EESA while protecting taxpayers.  We will
continue to manage those investments in a commercial manner and seek to
dispose of them as soon as practicable.  We will exercise our voting
rights only on core issues such as election of directors, and we will
not interfere in the day-to-day management of individual companies.  In
addition, as the steward of taxpayers’ funds, Treasury will continue to
manage investments in a manner that ensures accountability,
transparency and oversight.  And we will work with recipients of EESA
funds and their supervisors to accelerate repayment where appropriate. 
We want to see the capital base of our financial system return to
private hands as quickly as possible, while preserving financial
stability and promoting economic recovery.

History suggests that exiting prematurely from policies designed to
contain a financial crisis can significantly prolong an economic
downturn.  We must not waver in our resolve to ensure the stability of
the financial system and to support the nascent recovery that the
Administration and the Congress have worked so hard to achieve. 
Improvements in the financial performance of EESA programs put us in a
better position to address the economic and financial challenges many
Americans still face.  I look forward to continuing to work with you to
achieve these
goals.                                                               

Sincerely,

Timothy F. Geithner

Identical copy of this letter sent to:
            The Honorable Harry Reid

cc:       The Honorable Barney Frank
           The Honorable Spencer Bachus
           The Honorable David Obey
           The Honorable Jerry Lewis

In what is the start of the biggest uphill battle in D.C., arguably even bigger than deposing the printing press leprechaun, five democrats are proposing an amendment to reinstate Glass-Steagal, whose repeal, through the Larry Summers orchestrated Gramm-Leach-Bliley Act, in 1999 set the economy on the collision course that culminated with the implosion of every single Goldman Sachs FICC competitor in 2008. The five Democrats who have undertaken the sisyphean task of taking on both Wall Street and their direct boss, are Maurice Hinchey of New York, John
Conyers of Michigan, Peter DeFazio of Oregon, Jay Inslee of Washington,
and John Tierney of Massachusetts.

If adopted, the measure would give banks one year to choose between
being commercial banks or investment banks. The nation’s biggest –
those now commonly referred to as “too big to fail” — would be broken
up. The Obama administration opposes the measure.

Obama, presumably a Democrat, continues to persist in endorsing each and every Republican legacy when it comes to Wall Street’s landed interests (and risk “management” practices). Of course, the last thing the administration needs is for the populace to comprehend the chameleonic nature of the administration’s action.

More from HuffPo:

The act was repealed in 1999 at the urging of, among others, Larry
Summers, now President Barack Obama’s chief economic adviser.

The five congressman all voted against the repeal then — and now they want it back.

Former Federal Reserve Chairman Paul Volcker is one of a number of
financial luminaries calling for at least a partial return to
Glass-Steagall. The Wall Street Journal’s
editorial page also endorsed the concept in a recent editorial as a way
to “reduce moral hazard” and “limit certain kinds of risk-taking by
institutions that hold taxpayer-insured deposits.”

The law’s repeal ushered in an era marked by big banks getting even
bigger. The country’s four largest — Bank of America, JPMorgan Chase,
Citigroup and Wells Fargo – now control more than half of the nation’s
mortgages, two-thirds of credit cards and two-fifths of all bank
deposits.

And because their deposits are taxpayer-insured, there’s a growing
concern that they will feel overly confident about making risky bets
through their investment arms because they know that should they suffer
huge losses, taxpayers will ultimately be there to bail them out.

The five Democrats face big obstacles, including their own leadership and the Obama administration.

At this point the whole systemic regulation debate is getting glaringly amusing. At the core of every conflict are proposed reforms that are so obvious from a risk mitigation debate: audited Fed, split up banks which are now bigger than ever before, propping a bankrupt FDIC, which in turn is backing up bankrupt institutions, and a bankrupt country which is trying to fool the world into a game of M.A.D. knowing full well if the US taxpayer goes down directly or indirectly, the world, and the proverbial flood, follow after. And the only sensible reforms are those getting the biggest push back from Obama, and of course, Wall Street. How these two seemingly traditional opponents have ended up on the same side of the page is testament enough to the cataclysmic legacy of Bernanke and Summers. Of course, nothing will be done about anything, in tried and true American fashion, until it is too late, and Main Street is left sorting through the rubble of Goldman’s new glass-plated headquarters, even as all inhabitants have long-ago departed the country and left the U.S. with a few quadrillion in I.O.U.’s. At this juncture the best option before politicians is to simply delay for one year until mid-term elections provoke some vestige of sensibility in the ruling class.

All you need to know about how the BLS really counts unemployment in one simple cartoon.

And, as we expected earlier, here is Mr. Biderman’s summation on what will likely one day (after Russian hackers get into BLS emails) turn out to be an advance April fool’s joke by the Bureau of Lies and Stupidity:

TrimTabs employment analysis, which uses real-time daily income tax deposits from all U.S. taxpayers to compute employment growth, estimated that the U.S. economy shed 255,000 jobs in November.  This past month’s results were an improvement of only 10.2% from the 284,000 jobs lost in October.

Meanwhile, the Bureau of Labor Statistics (BLS) reported that the U.S. economy lost an astonishingly better than expected 11,000 jobs in November.  In addition, the BLS revised their September and October results down a whopping 203,000 jobs, resulting in a 45% improvement over their preliminary results.

Something is not right in Kansas! Either the BLS results are wrong, our results are in error, or the truth lies somewhere in the middle.

We believe the BLS is grossly underestimating current job losses due to their flawed survey methodology. Those flaws include rigid seasonal adjustments, a mysterious birth/death adjustment, and the fact that only 40% to 60% of the BLS survey is complete by the time of the first release and subject to revision. 

Seasonal adjustments are particularly problematic around the holiday season due to the large number of temporary holiday-related jobs added to payrolls in October and November which then disappear in January. In the past two months, the BLS seasonal adjustments subtracted 2.4 million jobs from the results.  In January, when the seasonal adjustments are the largest of the year, the BLS will add anywhere from 2.0 to 2.3 million jobs. In our opinion, trying to glean monthly job losses numbering in the tens of thousands or even in the hundreds of thousands are lost in the enormous size of the seasonal adjustments.

In November, the BLS revised their September and October job losses down a surprising 44.5%, or 203,000 jobs. In the twelve months ending in October, the BLS revised their job loss estimates up or down by a staggering 679,000 jobs, or 13.0%. Until this past month, these revisions brought the BLS’ revised estimates to within a couple percent of TrimTabs’ original estimates.

The large divergence between the two results begs the question of what is causing the difference.  While we don’t have an answer today, we will be poring over the data in an attempt to answer that question.

Charles – here’s a hint: FOIA Obama’s TV tour for January. That way you will know what kind of NFP numbers to expect next month.

From The Daily Capitalist
December 3, 2009

Since the biggest financial collapse in world history was built on credit related to housing, it is pretty obvious that we should be paying very close attention to that market. The reasons are complex, but a recovery must be based on the liquidation of bad debt. The sooner that happens the quicker a recovery will happen.

When we mean “liquidation of debt” we are talking about a mountain of credit built on the housing bubble. This phony bubble wealth permeated the entire economy. When home owners saw the price of their home rising, they saw it as a source of capital to use for a variety of things, but let’s face it, most people spent it.

New stores opened, malls were built, financial institutions grew, cars and boats, second homes, vacations, and restaurants all flourished. Credit card debt mushroomed. Home mortgages were increased to pull cash out for spending. Yes, some of it went to good things, like our children’s education, helping our aged parents, and paying off bills. But the reality was that our debt kept growing.

The clever lads created even more phony wealth under the guise of insurance, but as we found out, companies like AIG really had no idea how large their obligations were for credit default swaps written against almost any financial risk. And these instruments were further leveraged without understanding the magnitude of these triple-counted obligations or their relationship to housing.

It all comes back to housing as the fuel for the 70% of our economy that was consumer spending. The thought was that housing has always gone up, and if it went down, it really never went down if you averaged growth since the post-WWII-period. A drop of 10%? Never has happened. 20%? Not even a 6th deviation possibility.

My thesis has been that this was all fueled by the Fed through monetary policies that created and supported the bubble. Aided and abetted by governmental policies and financing schemes that favored housing and risky loans. This was not a “free market” phenomenon. Far, far from it.

My thesis has also been that we can’t recover until all this bad debt is liquidated, and capital generated by savings is created and ultimately invested in profitable enterprises. It would be a mistake to rekindle the bubble. But, as we know, that’s what our government is trying to do. The government creates uncertainty as it flails around with programs, spending, and debt schemes to revive the economy. As a result mark-to-market accounting is thing of the past and banks are guarding their balance sheets, corporations are sitting on a lot of cash, cutting costs, and becoming leaner, and Mr. and Mrs. America still favor savings and debt instruments over equities and spending.

The big question: is the housing market bottoming out? Because once it does, debtors and debt holders will then have a handle on how great their losses are. When the bottom is falling out, it is difficult to get lenders to lend if they are afraid their remaining cash reserves will be needed to shore up the bank because of loan losses. The holders of subprime debt find it difficult to value their assets while housing values are still dropping.

Lenders have been shepherding their cash, reducing debt obligations, and cutting back lending and new investments because they do not know how deep their hole will be until housing bottoms out. Keynes called this a “liquidity trap.” More reasonable people, especially the Austrian school economists, call this a reasonable and necessary response to uncertainty.

The Fed and the federal government have been flogging this liquidity trap issue without let up and basically credit is still drying up. A 0.25% Fed Funds rate is basically a negative rate and they still can’t get banks to lend. The Fed’s balance sheet is at a record high. They have bought $850 million of mortgage backed securities. They are injecting cash into lenders. They have basically suspended mark-to-market accounting.

In Q3, the FDIC reported that bank lending still contracted by 3%:

Loans and leases held by U.S. commercial banks have declined for 10 straight months, falling to $6.7 trillion as of Oct. 28 from $7.2 trillion at the end of 2008, according to a separate statistical release from the Fed.

 

Commercial and industrial loans have dropped to $1.37 trillion from $1.6 trillion, commercial real-estate loans have declined to $1.66 trillion from $1.72 trillion, and consumer loans have fallen to $847 billion from $857 billion at the end of last year.

What do banks do? They have decided they would rather hold Treasury paper instead of make loans. This chart shows what’s been happening. No wonder T-rates have stayed so low despite massive deficit financing.

This is what makes Bernanke, Geithner, and Summers lose sleep at night. “It’s supposed to work, dammit!” Maybe this is why Summers is always falling asleep. No matter what they’ve tried, they can’t get banks to lend. I think they are very worried about this and while they say the economy is recovering nicely, they are crossing their fingers at the same time.

Back to housing.

I have been saying that I think the housing market is finding a bottom. I thought that low prices and rising affordability was the main driver of the housing market. If this were so, then housing prices would reflect real market valuations and this would finally bring about the liquidation of assets and debt wastefully invested during the prior artificial credit cycle. Lenders would know where they stood financially and would liquidate bad assets and rebuild their balance sheets. No more waiting around wondering what the Fed or the government would do to save housing.

I was wrong.

The housing market I now believe is being sustained almost entirely by the Fed and the federal government. This rekindling of the housing bubble is counterproductive and will hinder a real recovery of the economy because an artificially backed market will delay the necessary liquidation of the prior cycle’s malinvestment of capital.

Here is why I changed my mind:

First, 59% of new home buyers are relying on government-backed FHA, the Veterans Administration, and the Department of Agriculture loans. Most of these sales are driven by the first-time home buyers tax credit. The tax credit program has been extended through April, 2010.

Second, existing home sales are being driven by the tax credit and by foreclosure and short sales. Existing home sales are up 10.1%. Distressed sales — mainly foreclosures and short sales — accounted for 30% of transactions in the third quarter. And. according to the NAR, home sales are being driven by first time home buyers trying to make the previous November deadline.

This will have a negative impact on future sales. Like Cash for Clunkers, these government-driven sales may just be eating into sales that would have occurred in 2010. Many economists are referring to this phenomenon as “payback.”

Third, mortgage rates are now at 30 year lows. Another Fed related gift to home buyers. The average 30-year mortgage rate was 4.95% in October, down from 5.06% in September, according to Freddie Mac. Today, Freddie said the rate was down to 4.7%.

But … home prices are still falling. The S&P/Case-Shiller index of prices fell 8.9% for the July-through-September period from a year earlier. That was an improvement from the 14.7% drop in the second quarter and the 19% decline in the first three months of 2009. Median prices of existing homes fell in 123 of 153 metropolitan areas during the third quarter compared with a year earlier. The national median price was $177,900, down 11.2% from the third quarter of 2008. [Don't ask me to explain the disparity. Case-Shiller and NAR measure this differently.] Last month the median price for an existing home was $173,100, down 7.1% from $186,400 in October 2008.

Thus, despite record interference in the housing market by the government, home prices are still falling. There are several reasons why it is likely that home prices will continue to fall.

Almost 25% of home owners are upside down with their mortgages. Nearly 10.7 million households had negative equity in their homes in the third quarter, according to First American CoreLogic. This shadow market is huge:

Home prices have fallen so far that 5.3 million U.S. households are tied to mortgages that are at least 20% higher than their home’s value, the First American report said. More than 520,000 of these borrowers have received a notice of default, according to First American. …

 

But negative equity “is an outstanding risk hanging over the mortgage market,” said Mark Fleming, chief economist of First American Core Logic. “It lowers homeowners’ mobility because they can’t sell, even if they want to move to get a new job.” Borrowers who owe more than 120% of their home’s value, he said, were more likely to default.

 

Mortgage troubles are not limited to the unemployed. About 588,000 borrowers defaulted on mortgages last year even though they could afford to pay — more than double the number in 2007, according to a study by Experian and consulting firm Oliver Wyman. “The American consumer has had a long-held taboo against walking away from the home, and this crisis seems to be eroding that,” the study said.

This overhang will continue to drive prices down. There is no way the Feds can force lenders to modify enough loans to make a serious dent in this overhang. It’s imply too big. Eventually the losses from forced modifications will mount and the FHA or any other agency will not be able to pay off their guarantees to lender. Nor should they try.

Mark Zandi, who correctly predicted a crisis in the housing market, but not the Crash, said on Wednesday, “The housing crash is not over.” He said the lull in foreclosure sales for the past few months, due to the government’s pressure on lenders to modify loans, has resulting in higher prices. He expects Case-Shiller to bottom by Q3 2010 with an overall price decline of 38% (now at 32%).

“Foreclosure sales will increase, and home prices will resume their decline by early 2010 as mortgage servicers figure out who will not qualify for a modification,” he said.

 

Zandi said 7.5 million foreclosure sales will have taken place between 2006 and 2011. The majority of these sales, however, have not emerged yet, with 4.8 million foreclosure sales expected between 2009 and 2011.

What this means is that the housing supply, now down to a 7+ months supply, will rise again, and prices will continue to decline. We haven’t seen the bottom yet.

US consumers keeps on purchasing Kindles on credit cards which they apparently have no intention of every paying off.  The most recent Fitch report disclosed that October delinquencies have continued their steady climb, and together with charge-offs, are at near record highs: “Consumer credit quality remains under significant strain as a result of the  persistent weakness in the labor markets,” noted managing director Michael Dean. The Labor Department will report unemployment data Friday; the jobless rate is expected to hold steady at 10.2%, the highest level in decades, while the decline in payrolls is seen mitigating from the previous month.

Dow Jones reports:

All types of consumer lending have worsened the past several years, with borrowers falling increasingly behind and lenders writing off many billions of dollars of owed loans.

Fitch’s credit-card performance indexes show late payments rising to their highest levels in five months and indicate higher charge-offs in the months to come.

Fitch’s index on delinquencies of at least 60 days rose to 4.41% from 4.22% in September. Late-stage delinquencies are now 31% higher than year-earlier levels and just below the record high of 4.45% in June. Delinquencies of at least 30 days rose as well.

As Zero Hedge pointed out, and as Meredith Whitney has voiced her concernes about, the biggest threat to the economic going into 2010 may be that not only are banks dropping reducing overall credit availability, but that ongoing credit contraction to the tune of almost $2 trillion over the next several years will mean existing credit limits are tapped out as existing ones become increasingly maxed out.

This will likely further entrench the consumer into an accelerated deleveraging mindset, and no matter what the incremental liquidity from the Fed is, the deflationary pressures will likely continue. Which means that markets will continue in full melt-up mode to compensate for real economic losses, which benefit exlusively the top percentile of the US population as the middle and lower classes continue experiencing the brunt of the credit contraction. At some point the economic reality is sure to catch up with the market surreality. That will be the point when all the flawed market policies by the Administration and Bernanke become exposed for the clothesless emperors they are.

by Marla Singer and Geoffrey Batt

Buried in the depths of page 26 of the Office of the Special Inspector General for the Troubled Asset Relief Program’s (SIGTARP’s) November 17, 2009 report “Factors Affecting Efforts to Limit Payments to AIG Counterparties” hidden in footnotes 33 and 34 is something of a mystery.  It might be the beginning of an interconnected financial chain involving Dubai, the Federal Reserve, AIG, Basel I, Eastern Europe and even Switzerland and which, even if it doesn’t worry you, probably should.  Or it might be nothing at all.

Consider first “footnote 33,” that reads as follows:

The first Basel Accord, known as Basel I, was issued in 1988; it focused on the capital adequacy of financial institutions. The capital adequacy risk—the risk that a financial institution will be hurt by an unexpected loss—categorizes the assets of financial institution into five risk categories (0 percent, 10 percent, 20 percent, 50 percent, and 100 percent). Banks that operate internationally are required to have a risk weight of 8 percent or less….

The original paragraph that references the footnote reads thus:

As of September 30, 2009, AIG had $172 billion in exposure to swaps in its foreign regulatory capital portfolio.  The portfolio contains swaps purchased by financial institutions, principally in Europe, to provide regulatory capital relief under Basel I. [note 33]  AIGFP’s COO informed SIGTARP in July 2009 that they expect that most of these swaps will be terminated by the end of the first quarter 2010 as most financial institutions complete their transition to Basel II.  Currently, financial institutions are required to hold a certain level of capital against their assets, and one way for a financial institution to reduce the amount of capital is to purchase swap protection on its assets.  However, new requirements decrease the level of capital required for such assets and, in most cases, there will be limited capital benefit to holding on to the existing swaps. Nonetheless, AIG warned in a June 29, 2009, SEC filing that if credit markets deteriorate, the company may recognize unrealized losses in AIGFP’s regulatory capital credit default swap portfolio. [note 34]  AIG could continue to be at risk if the swaps in its regulatory capital portfolio are not terminated by the end of first quarter 2010 as expected. (Emphasis added).

Taken together we read the thrust of this section to mean that a number of European banks, seeking to limit their regulatory capital requirements under Basel I (read: seeking to increase their leverage) bought swap protection on their assets from AIG.  These obligations still sit with AIG and, in the event credit markets sink materially, AIG is likely to take losses on these instruments.  Not just that but:

According to an AIG SEC filing, an ongoing concern for AIGFP is whether it will have to post more collateral if credit markets continue to deteriorate.  The amount of future collateral postings is partly a function of AIG’s credit ratings, which may be affected by any further decline in AIG’s financial condition. (Emphasis added).

Simply put, AIG might also have to post more collateral.  Moreover, though AIG initially expected most of these swaps to “be terminated by the end of the first quarter 2010 as most financial institutions complete their transition to Basel II,” we see from footnote 34 that:

Subsequent to the June filing, European regulators adjusted the implementation timing of Basel II, potentially affecting the holders of AIGFP’s regulatory capital swaps to hold beyond previously anticipated termination dates.

In other words, AIG is still on the hook- and hadn’t planned to be.

This raises a number of questions:

1. If the European banks that bought swap protection from AIG are still relying on this protection to meet their capital requirements, and AIG might be unable to make good on the agreements, are these banks actually out of Basel I compliance as we type this?
2. Are the banks still able to use swap protection to reduce their collateral requirements because of the implicit or explicit backing of AIG by the Federal Reserve?
3. If this situation existed in September-November 2008, as it certainly appears to have, how exactly can the Federal Reserve claim in good faith that it lacked the leverage to negotiate with these banks from a position of strength?  (One assumes that many of the same names collecting payment from AIG were also AIG swap protection buyers of the sort mentioned in the SIGTARP report).  Failure to back up an insolvent AIG would have resulted in near-immediate Basel I non-compliance as the protection offered by these swaps, and on which these banks depended for their reduced capital requirements, evaporated- a near death sentence.
4. Or had these banks somehow, and in the middle of the credit crisis, managed to boost their capital to levels that made the swaps unimportant?
5. If so, why keep them on the books now, instead of unwinding them?
6. Since it doesn’t seem likely that a teetering AIG could make good on these agreements without substantial assistance is the Fed is currently the ultimate backstop for AIG?
7. Does this mean that the Fed is effectively underwriting these swap agreements?
8. Will the Fed post collateral if deteriorating credit conditions at AIG (today’s -$11 billion news suddenly seems especially daunting if the potential insurance shortfall has an effect on credit ratings) or general credit market issues require it?  Or are we missing something significant?  By September 30, 2008 AIG had already posted $974 million in collateral for its “Foreign Regulatory Capital” portfolio.
9. What if European banks are hit with more losses from, oh, we don’t know, say… Dubai?  Deleveraging, risk reduction and credit tightening would have an effect on LIBOR, the Eurobond market and, of course, Eastern Europe.  Might not that sort of contagion easily spread to, say, Switzerland, which enjoyed the other side of the carry trade for years by lending Swiss Franc like mad to any Eastern European mortgage borrower who could sign documents?
10. Could it be that the Fed, once again, might have to bail out the world?

Or maybe we are just missing something obvious.