The New York-based AIG will get $40 billion of new capital from the U.S. Treasury Department’s $700 billion bailout package, to help offset the damage wreaked by four consecutive quarterly losses, including a third-quarter deficit of $24.5 billion that the company announced yesterday (Monday), Bloomberg News reported. The U.S. Federal Reserve also is slashing an $85 billion loan to $60 billion, and is replacing a separate $37.8 billion loan to the insurance company with $52.5…

The New York-based AIG will get $40 billion of new capital from the U.S. Treasury Department’s $700 billion bailout package, to help offset the damage wreaked by four consecutive quarterly losses, including a third-quarter deficit of $24.5 billion that the company announced yesterday (Monday), Bloomberg News reported. The U.S. Federal Reserve also is slashing an $85 billion loan to $60 billion, and is replacing a separate $37.8 billion loan to the insurance company with $52.5…

Dear Friend,

Poor old AIG.

Turns out the government handout it got in September was a bit harsh. But things are looking up. Uncle Sam has now agreed to give it another $40 billion in taxpayers’ money and reduce the rate of interest it has to pay on the loans.

“I think the new package is a quantum improvement over the old one,” said AIG chief Edward Liddy of the new deal.

No doubt, Mr. Liddy is ecstatic.

Mr. Market also had reason to be pleased. News that China had approved a $586 billion economic ‘stimulus’ package sent stocks soaring in the first minutes of trading today.

Never mind that Circuit City has gone belly up…or that Deutsche Bank has declared shares in GM…

This from Money Morning:

If there’s a proverb that captures the outlook for the U.S. economy in the New Year, it’s the one that says: “It’s always darkest before the dawn.”

Regardless of any formal announcement of whether or not the United States drops into an actual recession, the ongoing credit crisis guarantees a contraction of the American economy by virtually every measure…

More from Shah:

My approach was to walk into the pit and chat up the crowd. My intention was to gauge whether the other market makers and locals were net long (bullish) or net short (bearish). Most of the locals are independents and not extremely well capitalized. But I was.

If I gauged the locals to be bullish, meaning they had positioned themselves in anticipation of the underlying stock rising in price, by either being long “calls,” short “puts,” or engaged in bullish “spread” trades, I would start by buying some calls.

I would use coded signals to my clerks to start buying the underlying stock.

The locals would see stock “prints” go up on the New York Stock Exchange (now the NYSE EuroNext (NYX)) at higher prices. I was moving the stock higher. Usually, the locals would start adding to their bullish positions.

At the same time, I would have my clerks send in orders to the post where I was trading to buy puts – a lot of puts. Usually, it was the bullish locals selling the puts to my broker.

When I had the bearish position I wanted, I would offer to sell my calls to the crowd.

Shortly after that, I would signal my clerks to start selling my long stock positions on the Big Board.

I wasn’t trying to get the best price. I was “hitting bids” on the NYSE. After I had sold my long stock position, I started to short the stock. In the meantime, I was doing nothing visible in the pit.

I knew the stocks I traded very well. I knew my capital and leverage. I gauged the psychology of the crowd.

My plan was to cause the stock to drop, triggering the locals and others to panic out of their positions. They would sell their calls and if the price of calls fell too quickly, they would start buying puts to hedge themselves.

As the stock fell and the price of puts rose higher and higher, guess who would be selling the locals puts?

Since I had bought a lot of puts and their price was rising, I would leave the crowd and have a broker in the pit sell my now-profitable put position to the eager crowd.

I am not a bad guy. I am a trader. That’s my job. I trade to make money. That’s what everyone else does. But I succeeded much more often than most of the traders I competed against – because I followed these four basic rules of trading:

• • Know the instruments you are trading.
  • Know your capital and leverage limitations.
  • Gauge the psychology of the market.
  • And have a plan.

PS: This is the eighth installment of an ongoing series in which Shah Gilani breaks down the credit crisis for readers.

Source: How U.S. Missteps Triggered a Spiral of Worldwide Margin Calls and Deepened the Financial Crisis

This from Money Morning:

Neither banks, nor corporations, nor any other commercial paper issuers are able to raise significant amounts of money in the CP marketplace.

Almost all of the commercial paper being sold is only one-day paper. Because of systemic fear, one day’s risk is all most buyers are willing to stomach.

However, all CP issuers have long-term obligations, or liabilities that they need to continue to fund – in short bursts – by borrowing in the commercial-paper market. But there are no buyers, because buyers don’t want to lend to anyone on just their creditworthiness, and they don’t want to lend to anyone who is willing to back their CP with assets.

Why?

Because no one knows what those assets might be worth tomorrow. As far as the banks are concerned, it’s even worse than you think.

Not only did banks lend long to borrowers, banks borrowed short-term CP money to buy collateralized residential and commercial mortgage-backed securities for their own inventories or balance sheets.

Banks paid for these toxic assets by issuing commercial paper: They thought it was a great borrow-short/lend-long spread play. But when these short-term loans come due, they can’t “roll” them over.

Where are they going to get the money to pay back the investors who bought their commercial paper when it comes due – in one day, 30 days, 60, days, or however long they borrowed for? If no one will buy any more paper, that’s a big problem.

In fact, that’s a game-ending problem.

Enter the Fed, investor of last resort.

Between commercial-paper borrowings and floating-rate notes (which are similarly short-term borrowings, but for typically up to two years) for just financial institutions – not including industrial corporations and others – it is estimated that more than $1 trillion will have to be paid off by the end of 2009.

Now you know why the Fed has to backstop the commercial paper market. All these desperate short-term borrowers trying to fund long-term assets (loans and securities) will have to find other funding sources; all of which will be devastatingly more expensive than what they paid in the CP market.

As we’ve repeatedly pointed out, this credit crisis is exposing every weakness.

Source: Credit Crisis Update: An Inside Look at the Commercial Paper Debacle

As part of the just-passed U.S. bailout bill, the government has reiterated the Securities and Exchange Commission’s authority to relax the mark-to-market standards. If the SEC actually follows through on that directive, many professional investors worry that we won’t catch on to the next leg of the ongoing credit crisis until it’s way too late.

While politicians point to mark-to-market rules as the cause of the billions in write-downs and losses suffered by financial firms in recent quarters, in fact, it was mark-to-market accounting that first exposed the underlying problems in the complex markets for mortgage-backed securities (MBS) and credit-default swaps (CDS).

“Mark-to-market is reality-based accounting,” said Money Morning Contributing Editor Shah Gilani in a phone interview yesterday (Tuesday). “Anything else requires a looking glass and a ticket to Wonderland.”

“To me, mark-to-market accounting is the clarion sound of beagles barking, letting transparency hunters know down which dark hole the fox is hiding,” said Gilani, a former hedge-fund manager who recently penned a five-part investigative series on the U.S. credit crisis – including an alternate bailout plan that he says would’ve cost taxpayers very little.

Without the early warnings raised by mark-to-market accounting standards, the problems in the CDS market could have gone unnoticed for much longer, leaving no time to hedge or prepare for the ultimate carnage to the financial sector.

“In the past couple of weeks, fair-value accounting has been under attack,” JPMorgan Chase & Co. (JPM) analyst Dane Mott wrote in a recent report, Bloomberg News reported. “Blaming fair-value accounting for the credit crisis is a lot like going to a doctor for a diagnosis and then blaming him for telling you that you are sick.”

Prior to the current credit mess, mortgage-backed securities were priced according to Markit’s ABX Index, which used the average weight of four series in the index to track the price of housing derivatives. But once the subprime market collapsed, the ABX Index plunged - and has yet to recover.

Mark-to-market accounting standards kicked off a round of write-downs at global financial firms that highlighted the overexposure of many to these risky securities. Without such standards, investors would have been unaware of the coming credit crunch.

The Rise of Fair Value

Mark-to-market accounting, or fair-value accounting as it is sometimes called, arose partly in response to the U.S. Savings & Loan Crisis of the late 1980s and early 1990s. Financial institutions had inflated the value of assets on their books, which ultimately led to their financial collapse.

In order to bring more order and transparency to financial firm balance sheets, there was a shift from valuing balance-sheet assets at their purchase price to holding assets at fair market value – or the price the assets would fetch out in the marketplace if they were sold.

In mid-November, with the U.S. subprime mortgage crisis already taking its toll on global financial firms, the Financial Accounting Standards Board (FASB) released Statement No. 157, entitled “Fair Value Measurements.”

Due to the timing of its issuance, FASB 157 has been pointed to by many as a cause for the financial crisis currently gripping the United States and other markets abroad. But it is important to note that FASB 157 only clarified the fair-value accounting practices that had already been in place for decades – with perhaps one noted exception.

"FASB 157 is not the primary cause of this crisis - greed and poor judgment are," Paul Shifrin, a principal at SC&H Group LLC, a Maryland CPA and management-consulting firm, said in an interview with Money Morning.

What FASB 157 did introduce was an asset hierarchy based on the market available for the assets. Assets are assigned to one of three categories based upon how liquid the assets actually are and, in turn, how easy they are to value, or price:

• Level 1 assets are fully liquid, and easy to price.
• Level 2 assets can be priced with the benefit of "comparable assets."
• And Level 3 assets are completely illiquid and nearly impossible to price.

A Growing Crisis

As the market for MBS and collateralized-debt obligations (CDO) dried up, financial firms were caught holding billions in securities for which there was no longer a market. That led to a steep decline in prices and huge write-downs, which translated into escalating quarterly losses. These complex securities, which had been “Level 1” assets, were quickly becoming “Level 3” assets.

But rather than place the blame on the over-leveraging or the risky securities in question, some politicians and banking lobbyists blamed mark-to-market accounting for the resulting huge losses at global financial firms.

“Onerous mark-to-market rules for certain financial assets that have no market value have worsened the credit crisis, and changing them has been a priority for House Republicans,” U.S. Rep. John Boehner, R-Ohio recently told The Wall Street Journal reported.

Congress and such financial-firm lobbying groups such as the American Bankers Association have called for a relaxing of the mark-to-market rules. But doing so would represent a grave error, says Money Morning’s Gilani.

“Nobody is going to trust anybody,” says Gilani. “That’s a real problem if you do away with mark-to-market accounting.”

And that’s an even bigger problem in a market that is already seized up with a crisis of confidence.

The main argument against fair-value accounting is that in a “disorderly market” such as the one we have now due to the ongoing credit crunch, mark-to-market doesn’t take into account the actual cash flow of CDO securities or if the owner plans to hold those securities until maturity. In other words, the security could be worth more than the current sale price if it is held and not sold.

"It’s a knee-jerk reaction from politicians and the banks are trying to find a scapegoat to blame for their own errors in judgment," said SC&H Group’s Shifrin.

If mark-to-market rules are relaxed or eliminated, financial firms will be able to hide future errors in judgment from investors, allowing corporate executives to falsely protect their companies’ share prices, and to protect their own salaries and bonuses.

“To suggest you don’t track and report fair values means you end up in a world where management still knows the real prices, as do market counterparties, but not the investors,” Sam DiPiazza, chief executive officer of the accounting firm PricewaterhouseCoopers, told The Financial Times.