Earlier, I posted an article which accused the market of incorrectly valuing AIG based on the company's current Tangible Book Value. After publishing the article and reading the comments, I thought to myself, "What if emotions aren't the real reason the market has priced the stock so low?"
Quick notes: Due to the many moving parts involved in buying, selling, and maturing bonds, my estimates are inherently rough. These estimates are merely meant to provide investors with a better grasp on the interest rate risk inherent in owning shares of AIG.
Greatest Asset Might Be Greatest Liability
Although AIG does boast a much healthier balance sheet today than it did before, according to page 173 of their quarterly report, $331.5B of AIG's assets are yield sensitive assets according to the most recent 10-Q released last month. According to the company's estimates, a parallel increase in market interest rates by 100BP for all of these interest rate sensitive assets would result in the loss of $15.7B worth of value. To understand just how many Basis Points the worst possible case (within reason) is from current rates, the current market rate for 10 Year US Treasuries is sitting about 450BP below average. Although AIG's main holdings aren't based in Treasuries, interest rates base themselves off of treasury rates, and so it can be safe to assume that comparable rates are also about 450BP off their averages. In our analysis, it would not be right to assume that treasury rates jump from under 2% to over 6% in one night. For the sake of argument we can judge the effects of rates increasing by 200BP (still a very large amount in a short amount of time).
Based on the estimates of losing 4.736% of current value for a 100BP increase, if the market rates for all the yield sensitive assets held by AIG increased instantaneously by 200BP, it is safe to assume a 10% drop in value of these assets, bringing the total value to about $298B. Just to be nice (or mean), let's tack on another 5% drop in the original value, bringing total decline to 15% due to the uncertainty about the company's possible profitability/safety in the future (Volcker rule). Now our yield sensitive asset base has been reduced in value from $331.5B down to $281.78B. If AIG got stuck with it's asset base the way it is, and interest rates increased, this would likely be the picture in the near future of the company's value.
Now looking at the Tangible Book Value of the company, the company now holds about $51.94B above water, or about $35 a stock.
Good job market!
But Let's Face the Facts
This type of risk is definitely a big part of the bearish case for AIG, and about $20B of the current assets are already held at a loss. But can this loss continue to grow to the levels previously estimated?
The Federal Reserve has stated its intentions are to keep interest rates low until mid-2015, and boy has Ben Bernanke kept that promise! The yield on the ten-year treasuries I mentioned earlier reached rock bottom in the 1.4X% yields as recently as this past July. However, don't mistake my exclamatory remarks for excitement, as the absolute bottom rates for borrowing have been met, and the only way left to go is up.
And investors should be just fine with that. In the next two years, wherever interest rates are, AIG will still be holding on to a bond portfolio which provides steady payments and should return the same amount of money borrowed back to AIG. Although value of today's investments technically decline, the payouts on the bonds do not. A loss through bonds is not as detrimental to a company's cash hoard as a loss from other methods because of the promised repayment of borrowed capital at the settlement date of the bond.
So even if AIG was stuck with sub-par interest bearing assets, their total calculated loss in these assets is limited to only losing the net gains in fair value the company has made to date, or about $26B. This decline is only $7B less than the 10% decline estimated earlier, but this difference is an early indication of the market's overreacting. Investors should note that while the Book Value of the company is still capable of dropping by more than this if the market rates increase fast enough, this kind of decrease is on the order of nearly impossible in such a short amount of time.
The quick rundown: The Volcker Rule restricts certain institutions from participating in proprietary trading. The main reason for these restrictions is to prevent similar bailouts as in AIG's past from occurring again. This limits the possible returns a company will be able to generate, but more importantly it ensures that the companies subject to the rule do not become liabilities to the government requiring future bailouts as a "systemically important financial institution" (AKA Too Big to Fail).
Taken directly from page 180 of the recent Quarterly Report:
"In July 2012, Section 619 of Dodd-Frank, referred to as the ''Volcker Rule,'' became effective though the final rule implementing Section 619 has not yet been released. Under the proposed rule released in October 2011, if AIG continues to control AIG Federal Savings Bank, AIG and its affiliates are considered banking entities for purposes of the rule and, after the rule's conformance date of July 21, 2014, would be prohibited from ''proprietary trading'' and sponsoring or investing in ''covered funds,'' subject to the rule's exceptions. Even if AIG no longer controlled an insured depository institution, it could be subject to restrictions on these activities if it is designated as a SIFI, as Dodd-Frank authorizes the FRB to subject SIFIs to capital requirements, quantitative limits or other restrictions if they engage in activities prohibited for banking entities under the Volcker Rule. The Volcker Rule, as proposed, contains an exemption for proprietary trading by insurance companies for their general account, but the final breadth and scope of this exemption is uncertain."
This uncertainty is more than priced into the stock. The initial market reaction if and when AIG was classified as a SIFI might be negative due to forgone profits, but investors must also see the forgone risks which were all too real and realized in the prior crisis. The fact earnings over this past year have beaten analysts estimates every quarter so far should be an indication that this company is very capable of creating opportunities for itself while the market does not.
It is only a matter of time before the market switches its mood and recognizes this.
By now, the Treasury's ownership in the company has decreased from over 90% to a much more digestible 16%. Though many still view the ownership as a liability, I view the guaranteed future sale as an asset. Here's why:
$13 billion was used toward share repurchases associated with the offerings by the Treasury. In September alone, over 153 million shares were repurchased. When comparing the total number of shares sold by the Treasury to shares purchased by AIG, AIG represents nearly 30% of the buying side of the deal. As I have said before, the company's repurchasing of shares compounds the book value per share while the share price is below book value.
There are still reservations about future buy backs of the Treasury's final stake. The company has stated in its recent report that,
"[p]otential future repurchases by AIG of its shares will depend in part on the regulatory framework that will ultimately be applicable to AIG. This framework will depend on, among other things, AIG's status as a savings and loan holding company under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) and whether AIG is determined to be a systemically important financial institution."
This same concept applies to dividends, and though there is uncertainty in the air about whether AIG will be able to control its future, this uncertainty is coming at a very attractive price. It is almost as if the market feels that the worst of the worst is still in store for AIG.
I'm here to tell you it is not. Whether the market fears rising interest rates, increased government regulation, or even the awful past which is "doomed to repeat" by big money, the possible losses in this stock are already greatly factored in. Once the good news rolls around for this stock, the projections for the company change. And the greatest part about projections is that they compound upon themselves. Gains of 5% compounded annually create a 60% return 10 years down the road. Thankfully, perceived future declines do the same, and are already calculated into the share price. The opportunity presented to investors has already taken into account the risks to be faced. Though there is always the chance that some of these fears will be realized, Wall Street is being generous by starting off investors with a handicap on top of a heavy-hitting company.