AIG’s Black-Box Pickle Firm Not Worried [Investor’s should be, tho] About Valuations,
But Investors Are Really Screwed
By DAVID REILLY and PETER EAVIS May 10, 2008
Investors in American International Group Inc. have long forgiven the black-box nature of the insurance giant’s finances because of its ability to produce prodigious profit year in, year out.
Now, the insurance giant has racked up a $7.8 billion, first-quarter loss and is raising $12.5 billion in new capital. Investors have rightly lost faith, especially since management didn’t adequately explain how a firm in the risk business had so misjudged it.
The capital raising “may come as a surprise for many who relied on management’s [previous] estimates of $15 billion to $20 billion excess capital,” Bank of America analyst Alain Karaoglan wrote to clients.
[AIG chart and photo]
Further eroding investor confidence: Even as AIG said it would dilute investors by raising new capital, it said it would increase its dividend payout. That struck many investors as nonsensical. AIG stock fell 8.8% Friday on the New York Stock Exchange to $40.28.
Over the years, AIG entered into derivatives contracts that were tied to securities underpinned in many cases by subprime mortgages. The contracts called for AIG to make up for losses on those securities, should they default. While that could mean a loss, AIG had models showing that a loss was unlikely.
Then the housing crisis hit. The value of the securities connected to the contracts plunged in value. That left AIG sitting on unrealized market losses, which it initially refused to acknowledge because it felt its own models, rather than the markets, were right.
But continued turbulence in financial markets, along with a tougher line taken by AIG’s auditors, forced the firm to acknowledge those market losses. That led to losses at the end of 2007 and in the first quarter of this year.
Despite this, AIG is still arguing that the losses won’t prove to be real in the long term and that the losses will reverse when this happens, bolstering profit at some future date. That prospect could tempt some investors to hold their noses and buy the company’s beaten-down shares.
But this would mean placing new trust in the company’s own approach to thinking about those losses and ignoring what markets are saying.
At issue are $19.3 billion of market-value losses AIG already has taken on the derivatives. AIG is predicting actual losses will be $1.2 billion to $2.4 billion.
Yet a third-party analysis of the losses provided to the company as it prepared for the capital raising announced Thursday argues otherwise. AIG disclosed that this unidentified outside firm had estimated that the losses would be $9 billion to $11 billion.
Asked if that higher range is a better estimate, an AIG spokesman said no because it placed too much emphasis on market values.
Some analysts weren’t as ready to favor internal, management-driven models over the markets. “I’m reluctant to dismiss what market-driven valuation levels are signaling,” said Kathleen Shanley, credit analyst at Gimme Credit. “No one really knows for sure how credit deterioration will develop over time, and it remains possible that internal models are using estimates that will prove overly optimistic.”
Another reason against trusting AIG on the value of these derivative contracts: In a short time, the company has gone from saying that actual losses on these instruments would be “highly unlikely” to saying they would “not be material” to forecasting a maximum actual loss of $2.4 billion.
The company also is sitting on $10.5 billion in so-far unrealized losses on securities. These losses have yet to make their way into income because they are considered temporary.
Given all this, AIG’s black box is looking pretty empty.
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