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I found a recent article by Carol Loomis regarding AIG’s continuing troubles to be quite interesting. As most Berkshire Hathaway (NYSE:BRK.A) shareholders know, Carol Loomis is a longtime friend of Warren Buffett and also edits his annual letter to investors each year. According to this interview, Loomis purchased Berkshire Hathaway shares in the 1960s at under $200 and has never sold a share. Needless to say, when Loomis has something to say, investors would be well advised to listen carefully. This is even more true when the subject involves AIG, the government majority-owned problem child of the insurance industry. I suspect that Loomis and Buffett have discussed AIG in recent months and Loomis has also edited Buffett’s writings regarding the pain involved in winding down a book of derivatives.

Remaining Exposure: $1.6 trillion

Loomis reports that the notional value of AIG’s derivatives exposure fell from $2.7 trillion to $1.6 trillion during 2008 due to some contracts maturing, the close out of transactions due to negotiation between AIG and its counter parties, and over $60 billion in credit default swaps cancelled by government action. The problem is that reducing the remaining exposure could be more difficult.

According to Loomis’ report on CEO Edward Liddy’s testimony before Congress last month, the derivative book of AIG Financial Products may take another four years to completely wind down. The remaining exposure is extremely complicated and often based on underlying exposures that span decades.

Buffett’s Warnings on Derivatives

For some insight into the pain involved in unwinding unwanted derivatives exposure, one can refer to Warren Buffett’s annual letter to shareholders that appeared in the 2005 annual report. In this letter to shareholders, edited by Carol Loomis, Buffett writes at length about the process of unwinding the derivatives book of General Re. Buffett decided to unwind the derivatives exposure at the time of the 1998 acquisition of General Re but it took several years to achieve this objective.

In the excerpt below, Buffett refers to the difficulty of coming up with valuations related to derivatives that span multiple decades. According to Loomis’ article, AIG currently has an energy related contract due to mature in 50 years, not unlike the situation Buffett mentions here.

Remember that the rationale for establishing this unit in 1990 was Gen Re’s wish to meet the needs of insurance clients. Yet one of the contracts we liquidated in 2005 had a term of 100 years! It’s difficult to imagine what “need” such a contract could fulfill except, perhaps, the need of a compensation conscious trader to have a long-dated contract on his books. Long contracts, or alternatively those with multiple variables, are the most difficult to mark to market (the standard procedure used in accounting for derivatives) and provide the most opportunity for “imagination” when traders are estimating their value. Small wonder that traders promote them.

The extended excerpt below is particularly interesting given that Buffett’s warning almost exactly came to pass in 2008, two years after he wrote about the lurking dangers related to situations just like those encountered at AIG Financial Products:

Our experience should be particularly sobering because we were a better-than-average candidate to exit gracefully. Gen Re was a relatively minor operator in the derivatives field. It has had the good fortune to unwind its supposedly liquid positions in a benign market, all the while free of financial or other pressures that might have forced it to conduct the liquidation in a less-than-efficient manner. Our accounting in the past was conventional and actually thought to be conservative. Additionally, we know of no bad behavior by anyone involved.

It could be a different story for others in the future. Imagine, if you will, one or more firms (troubles often spread) with positions that are many multiples of ours attempting to liquidate in chaotic markets and under extreme, and well-publicized, pressures. This is a scenario to which much attention should be given now rather than after the fact. The time to have considered – and improved – the reliability of New Orleans’ levees was before Katrina.

Will AIG Come Begging Again?

At the end of her article, Loomis warns that AIG could very well come back to Uncle Sam for more funds in addition to the $180 billion already committed. In my opinion, the complexity of the task only highlights the short sighted nature of the actions taken regarding AIG’s bonus retention payments. The unfortunate result of the government’s punitive actions against the very AIG employees needed to unwind the derivatives book will most likely lead to a more drawn out and expensive process for AIG and ultimately for the United States taxpayer.

Disclosure: Long Berkshire, No position AIG

Source: Unwinding AIG’s Derivatives Exposure: Loomis and Buffett