Market Recap

Now it's simply getting redundant. Yet another large financial firm has hit the skids. This go-around features American Insurance Group, a huge multi-line insurance company. AIG lost its mojo dealing in credit derivative swaps – contracts that transfer and, ideally, insure against credit risk. In short, AIG used its formerly sterling credit rating to insure other companies' collateralized debt obligations, many of which were backed by subprime mortgages, against loss. The subprime mortgage market has experienced substantial trouble of late, to understate the obvious, and so has AIG.. Exacerbating matters, AIG also loaded up on money-losing mortgage-backed securities for its own account.

On Tuesday, the Federal Reserve agreed to inject $85 billion into AIG, marking the central bank's biggest market intervention ever – and that's saying something. It had no choice; AIG is the biggest player in the credit-default swaps market, which is at the core of the financial crisis roiling the global economy.

It's recondite stuff, to be sure, but it's important. Credit-default swaps help keep credit markets liquid by allowing people who want to forgo credit risk to transfer it to people who want to accept credit risk. It's an opaque but huge market. Credit-default swaps involve $60 trillion worth of debt – roughly five times the U.S. gross domestic product. AIG's percentage of the tally is about half-a-trillion dollars.

In addition to pulling AIG's rear end out of the wringer, the Federal Reserve also voted to keep the federal funds rate at 2.00%, although it acknowledged increasing problems in the market. The Fed noted that overall inflation “has been high” due to rising food and energy prices, but it repeated that it “expects inflation to moderate later this year and next year.”

The good news is that inflation already appears to be moderating. The consumer price index, a measure of retail goods and services, fell 0.1% in August from the previous month, marking the first CPI contraction of the year. A contracting CPI, in turn, could lead to contracting interest rates down the road.

Resolution Redux?

An interesting report – one that can be filed under the “more things change, the more they remain the same” category – appeared on Housingwire.com's website last week. It appears the Treasury Department is making overtures to establish an entity, one similar to the Resolution Trust Corp., to take over the banking system’s bad mortgage debts.

Readers with a long memory will remember the Resolution Trust, a U.S. government owned asset-management company charged with liquidating real estate and mortgage assets in the late 1980s through the mid 1990s. The Treasury Department's current proposal is to create a similar facility to buy mortgage-backed securities, which could cost a half-trillion-dollars and would involve the purchase of both private-label and government-guaranteed mortgages. But unlike the Resolution Trust of yesteryear, the new entity would hold the securities to maturity instead of liquidating them.

It's an expensive proposition, to be sure, but not necessarily a bad one. The quicker the subprime infection is excised from the financial system, the sooner normalcy will return to the housing and credit markets. Besides, reporting on large Wall Street failures each week is growing somewhat tiresome.