AIG: Willumstad's Hard Choice

AIG's earnings yesterday were horrible, no doubt about it, and the stock market meted out condign punishment:

American International Group Inc. (AIG), the biggest U.S. insurer by assets, fell the most since going public in 1969 after writing down more than $11 billion of holdings and saying it won't rule out raising capital...

AIG slid $5.25, or 18 percent, to $23.84 in New York Stock Exchange composite trading at 4 p.m., its biggest one-day drop in 39 years, according to Los Angeles-based Global Financial Data, which keeps records on historical share prices. The stock has plunged 59 percent this year.

But. What I don't see anybody pointing out here is that AIG stock is still 20% above its recent lows of mid-July. Insurers are pretty much the most leveraged financial institutions in the world, and in the present climate one can expect their stocks to be volatile. Here's how AIG shares have behaved over the past month: the best way to sum up this kind of chart is to say that the stock is moving sideways with extremely high volatility.

AIG faces many problems, not least the fact that it's in one of those businesses where you can't operate without a watertight credit rating, and it doesn't have a watertight credit rating.

Historically, AIG was perceived as the Goldman Sachs of the insurance world: bolder, smarter, more profitable than anybody else. Now that it has been revealed to have had feet of clay all along, the market doesn't know what to make of the franchise.

Between now and September 25, when new CEO Robert Willumstad will announce his new strategy, AIG's going to remain in a state of limbo. Historically, AIG has made a great deal of money by being very smart and being able to price risk faster and more accurately than anybody else. But as David Reilly says, it doesn't have that credibility any more:

Last August, AIG argued that the U.S. would have to have a shock twice as bad as the Great Depression before the swaps showed losses. At the first quarter's end, it said final losses could come in between $1.2 billion and $2.4 billion. Now the firm has upped that estimate to between $5 billion and $8.5 billion.
Yet that is still below a $9 billion to $11 billion estimate made this spring by an outside firm hired by AIG. In a research note Thursday, Morgan Stanley estimated the losses could come in at $13 billion.

Granted, those figures are well below the about $25 billion in losses implied by market prices. But the market's extreme pessimism has been more on the mark than AIG's blind optimism.

Reilly thinks that AIG needs to capitulate, much as Merrill Lynch did. What's unclear is whether such a capitulation -- along with the highly dilutive capital-raising that would have to accompany it -- is presently priced in to the stock. What's also unclear is what kind of future AIG would face after selling out at the bottom of the market.

Insurers are meant to be there over the long term; if a giant like AIG can't ride out market volatility, then a large part of its raison d'être is obliterated. Maybe Willumstad should try to tough it out, instead. If he wins, the decision is visionary and clearly right. Capitulation, on the other hand, is tantamount to saying that external observers understand AIG's labyrinthine complexity better than do its own professionals. And if that's the case, the company probably shouldn't exist in its present state at all.

Comments

[I weep for ...:]

You are an idiot. These are unrealized losses.

2008 Aug 08 06:58 AM

[efbdergraf:]

Agree with nygiants58. F.Salmon doesn't have a clue about AIG or the insurance industry - which is NOT where AIG's problems lie. Insurance results may be off but that is the nature of the business cycle. Check the rest of the industry's current PC pricing. All that's needed is another Katrina or so this autumn. The also-rans will be gone and prices will jump along with bottom-line and share price. The capitalized giants such as AIG and Allianz will thrive - as always!

2008 Aug 08 07:51 AM

[Medici:]

AIG is a Sell, o one likes uncertainity, and as for un-realized, does that mean not real? This stock is a teenager in the next few months

2008 Aug 08 08:00 AM

[DaveJ:]

Agree with the first two posters. AIG should be valued as the sum of two things. One is a very good insurance company that is worth about 12 X forward earnings, roughly $70. The other is a box full of derivatives. Anyone investing in AIG needs to value this box of derivatives. A conservative estimate is that the present markdown is overdone. In other words, they will not produce losses going forward. So the sum of these two should be at least $70 which makes AIG undervalued at $26. There is enough margin of safety to allow a long term investor to wait for the inevitable recovery and ignore all of the noise being touted in the financial press.

2008 Aug 08 09:38 AM

[Brradyco:]

While I agree with DaveJ, as far as he goes, I would hasten to add that like many banks, the M to M effect of the unrealized losses could cause a problem (S&P and Moody's are threatening downgrades) in terms of the need to raise additional capital at a lousy prices.

2008 Aug 08 02:48 PM

[lf847:]

How naive. All you need to do is read his sentence "insurers are pretty much the most leveraged financial institutions in the world" to know FS has no idea what he is writing about. A simple equity / assets calculation would show AIG, like all insurance co's, is much LESS leveraged than broker/dealers (GS, LEH, MER) and banks (BAC, C). Not a helpful article at all.

2008 Aug 08 02:51 PM

[Gigi:]

My concerns about AIG are not just for the stock shareholders. What's going to happen if there is a "run" of withdrawals from the zillions of AIG annuity products sold a few years ago when banks pushed these annuities as alternatives to low CD rates?
Might we have a meltdown equal to recent bank failures (only in this case, with uninsured investments)? If so, it won't just be the shareholders who stand to loose. Please discuss how AIG currently stands to pay-out it's annuities.

2008 Aug 09 11:45 AM

[Tom Armistead:]

AIG's increase of the stress case loss estimates on the portfolio of super senior CDS was coupled with a hesitancy to answer the question of what were expected losses. All we got was an evasive "less than 5 billion."

Insurance adjustors like to increase loss reserves so they look good when they settle the claim. Perhaps AIG intends to buy their way out of the claims. On a GAAP basis, they would look good. Presumably it would increase rating agency capital. The same deal as ABK did.

Where I have trouble with it is that they will take a totally unnecessary loss. If Willumstad is able and willing to tough it out, the mark to market would revert over time, increasing shareholder value.

My guess is that AIG will buy their way out. GAAP accounting in cases like this invites waste, since so many market participants treat the totally insane mark to market losses as real. If they also conduct a fire sale on their investment assets, there will be more waste.

Willumstad sounded like he was in capitulation mode, which leaves me thinking more in terms of a 42 target.

2008 Aug 09 07:32 PM

[Vegasjoe:]

As Barron's also reported, AIG is a sum of the parts break up story. At $26, the parts are very undervalued. Expect 09/25 news of spin-offs and sales of various units.

2008 Aug 10 05:16 AM

[orca:]

Said it before, say it again, AIG is run like some sort of mob outfit, with their STARR shell in the Caribbean, headed by uncle Hank. Nobody has a clue what they are holding, where they are holding it and how it's accounted for. IMHO examining their balance-sheet is dangerous, since you are seeing only what they want you to see. First you have to trust a company. Honestly, do you?

2008 Aug 11 09:44 AM

[E Nuff Sed:]

First some facts,

AIG is currently levered about 13 X. A little more than most depository banks and much lower than investment banks.

Also it is still generating huge cash flows from its insurance businesses. Sure the derivative investments will take some losses but losses to date have been manageable (AIG incurred a $13.1 billion net loss in the first half of 2008, $12.1 billion of realized losses on its investment portfolio and a $14.6 billion unrealized mark-to-market loss on its credit default swap business.)

A 27 Billion $ loss on a 1 Trillion $ portfolio amounts to less than 3%. My guess is that it can take another $15 Billion loss before raising more capital. Dilutive capital raising in my opinion is the biggest short term risk. If AIG can tough it out, I think the stock can go to the 50's in 2 years given core earning power of $5+/share/year.

2008 Aug 12 09:09 PM

[orca:]

E Nuff Sed, I have no clue where you got the leverage 11x number but suppose, for arguments sake, that it is correct, then you must have gotten it off their on-balance statements. My point was, is, and will be that they can show you anything on-balance they want you to see, but you can not see their off-balance exposure. This is the problem with a lot of the financials, so before even bothering with numbercrunching ask yourself 1 simple question: Do you trust this company? The market sure doesn't, not only with regard to stockprice but more important with regard to credit spreads. I will be crystalclear here: I hate AIG and everything it stands for (uncle Hank comes to mind, the Angelo Mozilo of the insurance world, and his sons chipped from the same wood), have hated it for years, and the day they implode will be a joyfull day.

2008 Aug 13 10:21 AM

[E Nuff Sed:]

Orca - curious as to why do bear such animus for AIG? Have they done you or your family some wrong.

I have no reason to distrust the company, however I am just a small investor.

AIG's business model is simple and enduring. Berkshire and AIG are virtually a duopoly in high end insurance. It is the assets they hold which are complex and I would hope that the accountants and auditors are reporting the right figures.

2008 Aug 15 10:56 PM

[Mike S.:]

It has been very interesting to hear the comments from the peanut gallery. As someone with 20 years in the industry, I can advise you to strongly consider where you get your "facts". Do not believe everything you read. Just because a company and/or it's "auditors" value an asset at a certain value, you must understand what these assets actually consist of and how they are evaluated. Sub-prime backed securities in the past were always sold as safe due to their ultimately being supported by real estate. However, there was little scrutiny as to how the real estate was evaluated. Now we know the appraisers ("auditors") were fraudulent, or at the least incompetent. In addition, there never has been very close scrutiny as to how these assets performed over time - i. e. the real estate was not even annually visited!
In the current recession, we've got a lot worse coming. The US Government is scrambling to mitigate the problem in the short term, (and you've got an industry insider running the Treasury), but time is the only sure cure for the problem.

2008 Sep 11 02:49 PM