Recently, Tom Gallagher, an analyst from Credit Suisse lowered his earnings-per-share estimate and price target for American International Group (AIG), due to elevated losses from its derivatives business. According to Gallagher, "Virtually all the aforementioned indices have declined this quarter, with non-AAA (rated) being hit the hardest, declining between 3%-25%."
This news bodes poorly for AIG's 3rd quarter GAAP earnings in that they will likely have to take additional mark to market losses on both their investment portfolios, and CDS/mortgage insurance portfolios. Keep in mind though that AIG has tremendous underlying revenue and cash flow to help offset the write-downs but that is not the point of this article.
AIG is an excellent example of a company whose fundamentals and long term prospects are completely ignored due to overdone fears about short term GAAP earnings, which are far different from the financial reality and true "owner's earnings" of the company. ("Owners Earnings" are best described by Bruce Berkowitz as the money that is left in the grocery store's cash register after all expenses and salaries have been paid.) AIG holds a long term outlook on its investment portfolio, as opposed to a Lehman Brothers (LEH) or Merrill Lynch (MER) that partakes in proprietary trading activities and got caught holding securities that they were hoping to unload in the very near future.
By nature of being an insurer, AIG is forced to be relatively conservative in their investments to protect their policyholders. Holding predominantly AAA securities AIG has indubitably been conservative but the dislocations in the credit markets have drastically distorted the reality of their investment portfolios performance.
In addition to the huge investment portfolio that has a tremendous amount of exposure to residential mortgages, AIG also insures mortgages and CDOs which have seen their prices deteriorate in the current environment. AIG's Financial Guaranty business is somewhat similar to that of an Ambac (ABK) or MBIA (MBI) in that these are not securities that they could sell even if they wanted to, but are forced to mark to market because of GAAP.
Instead of trading these securities like an investment bank would, AIG plans on holding the securities until they mature many years into the future. By the nature of how the super senior securities are structured, they are usually protected from the first 15-30% of losses on a given group of CDOs, and are only responsible for interest and principal when they become due. The time value of the payments and the lack of acceleration clauses are some of the attractive attributes of the business.
One key difference from the portfolios of some of the other guarantors is that 71% of AIG's RMBS exposure in CDOs is from 2005 and earlier which are significantly more secure assets then the 2006/2007 variety. These are super senior positions in which there is no available market to correctly assess their current value even if that were truly relevant for a participant that fully intends on holding the security till maturity. Instead of examining the performance and cash flow of the relevant securities AIG has to mark these positions based on Markit's ABX indices which are extremely illiquid, and that are constructed with very different collateral and structures then the super senior positions that AIG and the other Financial Guarantors insure. Further decreasing the relevance of the ABX indices is the fact that many of the large banks with significant residential mortgage backed securities exposure have attempted to hedge their bets by shorting these indices.
These huge institutions are pushing down the prices of the indices to levels that are in no way indicative of the future cash flows that can be expected from somebody holding their linked securities till maturity. Instead of mirroring the performance of residential mortgage backed securities, the indices are creating a sort of reverse Ponzi Scheme in which firms are forced to bet against their own mortgage backed security exposure by selling the indices short, which in turn causes further write downs of their existing positions based on the indices declines as a result of all the selling, forcing capital raises at consistently lower prices injuring existing shareholders.
If this is confusing to you, that is totally understandable as it is befuddling to me as well, but this is what an ardent reliance on GAAP and Fair Value Accounting has created in the midst of the greatest financial panic since the Great Depression. It is obvious that any company with this type of exposure to the residential mortgage market is likely to be seeing losses and AIG acknowledges that, but the clear and obvious reality to anyone who takes an objective look at the marks to market can see that the losses already booked are in no way indicative of the future cash flows that the securities are likely to bring in.
I don't blame the analysts covering AIG for being focused on the short term GAAP outlooks and complete disregard for the true value of the company. Bold bearish proclamations are easier to sell to their clients and that is also what gets their name in the news i.e. Meredith Whitney in Fortune Magazine. It brings a certain level of celebrity to be the most bearish on a big company like AIG, just like it is sexy to be the most bullish in a bear market like a Henry Blodgett on Amazon. By observing the facts however, an objective analyst can see that this obsession with GAAP is completely distorting the true financial situation of AIG, in addition to many other credit worthy institutions.
Let's break down a few of the numbers to elaborate my point. AIG's Financial Guaranty business has been the main contributor to the mark to market losses of the last few quarters. CDS positions are basically insurance policies on the super senior portions of CDO portfolios, backed by true assets, which in most cases are mortgage backed securities. Through the second quarter AIG has taken $24.8 billion in marked to market losses on this portfolio. AIG's own cash flow driven analysis leads them to believe that actual losses on this portfolio are likely to be around $5 Billion. In their stress case scenario, using extremely conservative default and severity assumptions, they estimate their future losses to be approximately $8.5 billion.
To give an example of their stress case analysis for their subprime exposure, AIG is assuming that 96% of currently delinquent mortgages will default and that net recoveries on a foreclosure will be 28 cents on the dollar as opposed to the 50 cents that is the current national average on foreclosure recoveries. These assumptions seem to be quite Draconian but it takes real work to come up with default and severity rates that in any way can come near to the expected losses that these indices are pricing in, which once again has very little relation to the actual performance of the underlying assets that are insured.
Assuming AIG's stress case estimates prove to be accurate, this would mean that $16.3 Billion of already incurred losses would eventually pass through the income statement and back on to the balance sheet as earnings. This is quite an abstract painting that GAAP is providing in assessing this firm's financial condition.
In its Insurance Investment Portfolio, AIG has suffered from $10.3 Billion in other then temporary impairment losses. 87% of theses charges represent severity charges which are driven from market declines of a certain amount, but that are not at all indicative of the actual performance of the underlying collateral, which has remained AAA or AA rated, and that is performing well. This means that the Investment Portfolio's losses are potentially overstated by approximately $8.9 Billion.
Now I don't believe that anybody could accurately forecast with precision what the final tally of losses or gains will be in these matters. There is no doubt however that the use of GAAP and Fair Value Accounting is creating massive distortions in regards to the true financial position of the Financial Guaranty companies and in this case AIG.
I could go on and on about AIG's business which is one of America's great growth stories of the last half century, but because of limited time I have focused on the largest short term issues just to show why in my opinion analysts are getting the true story all wrong. As time goes by and the true performance of the underlying collateral becomes more important then the temporary views of traders on a completely illiquid market, we will see the real economic fundamentals of AIG. If you have a long term outlook and the backbone to realize it is impossible to pick the bottom, I believe that this is a once in a lifetime buying opportunity of a top of the line insurer with an immense geographic footprint.
At a price of around $20 per share AIG is trading at 2/3rds of a fictionally reduced book value, and I believe that moving forward they should be able to grow book value by 10-13% a year moving forward.
Disclosure: Long AIG, MBI and ABK; short puts on AIG, MBI and ABK.