I know that's a grim title but that's pretty much where we are this morning. Will AIG pull it off? CNBC just said if AIG can't pull it off today they will probably have to file for bankruptcy protection.

It looks grim, so, I'm interested in Stirling's, Ian's and Numerian's comments on this in the post. And all of your comments will be very appreciated.

If it looks like AIG will indeed fail, what will happen to the markets?

Some headlines:

Money-Market Rates Double Amid Global Credit

Bond Risk at Record on AIG's $441 Billion Counterparty Concern

Stocks in Europe, Asia Fall on AIG Debt Rating Cuts; UBS Drops

Numerian comments in a previous thread, after the jump:

At some point the market catches on. American International's shares already trade a few pennies north of $5 - just where Fannie Mae was before they collapsed. Once they cross below that line, there are all sorts of investment firms, mutual funds, hedge funds, which can't hold them in their portfolio because $5/share is their lower limit. Hence the rapid move down into pennies a share, where the market says effectively "you are bankrupt".

If this is what the market says, then if there are healthy subsidiaries with billions in customer deposits and an ability to pay claims to these customers as needed, there must be something else (like the parent company in this case) with losses that dwarf that of the subsidiaries. That's why you get all this fanciful talk of separating out the good bank from the bad bank, but this only works if the Fed or Treasury takes on the liabilities of the bad bank. And here we are talking about trillions of liabilities on paper in the collateralized debt swap and debt obligation market, something at least Timothy Geithner at the NY Fed is very familiar with and probably wants kept completely separate from the Fed balance sheet.

But in this case he seems happy to let the good bank and bad bank get all mixed up at AIG to buy time for some miracle loan to be created by the banking industry's survivors. If and when the loan does show up, even if it is tomorrow, it now seems that it will be used to allow AIG to be wound down in an orderly manner through the bankruptcy courts, while the derivatives market sorts through all the swaps and options on mortgage backed securities, and all the insurance guarantees made by AIG. Maybe the $75 billion will even be used to absorb all the losses caused by these derivatives, though you might remember just a month ago industry experts were telling us at most these losses would come to $15 billion. Just like Richard Bove, the analyst, was telling us the worst was over and a bottom had been reached on financial stocks. Funny how we all forget these things, because he is all over TV this week dispensing more wisdom as if he never said anything a month ago about a bottom.

Maybe also that line of credit will allow the good bank to be sold intact to Warren Buffett or someone who knows how to run an insurance company. Then there would be a favorable outcome to all this. But as the hours tick by and no loan materializes, with bankruptcy looming, it sure looks like those insurance premiums people paid in over the years, and the investments AIG put them into, are going to get swallowed up in derivatives losses. If that happens, the stock market will catch on, as will the general public, to the fact that your bank account is not safe anywhere. This is the type of panic that the authorities are toying with in trying to save AIG.

Indeed, more is coming.

Stirling Newberry:

I'm going to write more about this later today, but the root cause of this is a crisis of legitimacy. We had an illegitimate government installed in the the world's dominant economy in late 2000, early 2001. This illegitimate government stole an election, and intended to profit from it. Greenspan, Bush, and the Five were ideologically aligned in the belief that with appropriate action they could create a political climate where most Americans were beholden to the corporate ownership ssytem, and therefore would, ever afterwards, vote anything so long as they could hold on to their small part of the system. However, at the same time, this same political movement promised the ability to make the largest military gamble, quite possibly since the Confederacy engaged in an act of war against the remaining United States. Like that previous gamble, it has not worked out so well.

This is the fundamental contradiction: on one hand a political theory which rested on a conservative interlinking of a petit-bourgeois society, on the other hand, a vast casino where almost unlimited risks could be taken without being in any way hedged against. Both the leadership, and the public were participants in this internal contradiction.

The second crisis of legitimacy is a crisis of intellectual legitimacy. Since the 1970's government regulation of markets has been in disrepute, and the answer which was adopted was a stochastic monetary theory, derived from Mundel-Fleming, which essential argues that monetary policy is better than fiscal policy which is better than regulatory policy. Therefore, all other things being equal, downsize fiscal policy, or treat it as a net loss, and focus on monetary policy.

This theory has a problem, and it is one reason why a good Liberal like Krugman has been acting like a cheerleader for failure in Ben Bernanke. That problem is that there is no such thing as pure monetary policy per se. All monetary policy is regulation plus monetary policy, and it has a structural reality, that is money from monetary policy, contra the equations, does not appear everywhere all at once to everyone, but to some before others. With these factors taken into account, monetary policy is no better than, and can often be worse than, fiscal policy as a means of stimulus.

We are thus facing a crisis of currency, because it rests on a politically illegitimate system, one accepted by the participants for their own short term interests, and a crisis of intellectual legitimacy. Both of these run across the political spectrum.

What we are going to see now is more of the "crash of the peripheries." Shanghai is down 67% from it's peak... last year. Russia is down 50% from it's peak earlier this year. Japan, Hong Kong and other peripheries are about to be razed to the ground. This will be an excellent time to diversify into peripheries, but carefully, and once the turmoil is over. The center is going to be propped up, but how long is a very different question...