How Much Can the US Government Guarantee? For now, whatever they want, or so it seems.? Perhaps the new question should be what dodgy assets can the Federal Reserve cram into the monetary base?

I’m talking about AIG, and this is one place where only the Fed could have acted, aside from the State of New York (too small).? The Fed can act because in a crisis, they can lend to anyone on a collateralized basis.? Essentially, they took most of the company as collateral for the loan with 80% ownership if things go right.? If things go wrong it will only increase our monetary inflation.? (Note: regulators typically take over financial companies, and though AIG is a holding company with many insurers domiciled in NY, most of the company is not regulated by the State of New York.? The Treasury could not act, and the State of New York did its best, but it was not enough.)

Consider some of the good articles posted on the deal:

• • Fed Ponders Provides $85 Billion Rescue for AIG (Update: Now Official)

(Naked Capitalism live-blogs, almost)

• • U.S. to Take Over AIG in $85 Billion Bailout; Central Banks Inject Cash as Credit Dries Up

(WSJ)

• • AIG Bailout: $85B in Loans, 80% AIG Taxpayer Owned

(Big Picture)

• • Fed?s $85 Billion Loan Rescues Insurer

(NYT)

• • AIG Gets $85 Billion Fed Loan, Cedes Control to Avert Collapse

(Bloomberg)

I find it amusing that the former CEO of Allstate, Ed Liddy, is the new CEO.? Allstate, for all its complexity, is a matchbox car compared to AIG’s non-functional Maserati.? That said, I like the pick.? He will simplify, simplify, simplify.? He will also have the time to do it.? (And, if he found getting Allstate’s stock price up to be a challenge, so he said to me once, oh my, here is the challenge of a lifetime.)? I also find it amusing because AIG often did not think much of Allstate.

Now, the senior secured bank loan effectively subordinates all other holding company debt.? That said, that debt will probably rally as a result of the rescue.? I’m not so sure about the stock, though, this is a lot of dilution to swallow.? Even though the preferred may not get dividends for two years, that might rally on the rescue.

But could this have been avoided?? Yes.? It comes down to one simple concept: Risk Based Liquidity.? Never finance illiquid assets with liquid liabilities.? Doing so invites a run on the bank.? Now in the modern context, one has to consider contingent liquidity: do you have ratings triggers in your bonds, insurance agreements, or derivative agreements?? That sets up a slippery slope where a cliff used to be.? AIG got killed primarily because they allowed for short-term calls on cash as credit ratings declined.? If the troubles from Life Insurers regarding GICs is not enough, nor utilities or reinsurers with ratings downgrade clauses, certainly this should show the folly of allowing ratings triggers in insurance/financial agreements.? I’m not saying that insureds are stupid to ask for them; I am saying that they should be illegal.

AIG left itself in a position where a very bad credit environment could destroy the company.? That resulted from writing insurance on seemingly unlikely credit events that are now more likely than one could have expected.? Also, there are the years of accounting misstatements because of the culture of fear that pervaded the company.

What can I say?? The financial companies that have failed had liquid liabilities and illiquid assets.? The first job of risk control is to assure sufficient liquidity under 99.5% of all scenarios.? This was not true of Fannie, Freddie, Merrill, Bear, Lehman, AIG, Countrywide, etc.? LIquidity costs money, which is why short-sighted managements intent on current earnings scrimp on liquidity.? But liquidity is the lifeblood of business, far more so than earnings.

Remember this when you invest, and look for companies that provide for significant adverse deviation.? And, all this said, I worry for our republic.? Our liberties are slowly disappearing before us, in a haze of government rescues.