Investors Slam AIG Over Swaps

The giant insurer may be facing a big writedown after auditors noted shortcomings in the way it values some of its credit derivatives

American International Group (AIG) said in a regulatory filing on Feb. 11 that its outside auditors have found deficiencies in the way the company values some financial derivatives it has written based on collateralized debt obligations (CDOs).

The disclosure almost certainly means the world's largest insurance company will take a much larger writedown for losses in its portfolio of super senior credit default swaps in the fourth quarter than it had led the market to believe just a couple of months ago. And the news has even sparked rumors that some top AIG executives may be forced to resign.

New York-based AIG said in an 8-K filing to the Securities and Exchange Commission that PriceWaterhouseCoopers, its independent auditor, has determined that the company had a "material weakness" in its internal controls over financial reporting relating to how it estimates the fair value of the super senior credit default swap portfolio of AIG Financial Products Corp (AIGFP), one of its business units.

AIG said it is still evaluating its internal controls relating to the fair valuation of these obligations, but said it believes it has the necessary compensating controls and procedures in place to appropriately gauge the fair value of this portfolio for its year-end financial statements.

On Feb. 11, AIG shares closed 11.7% lower at $44.74, after hitting a new 52-week low of $44.50 earlier in the session.

Although investors were quick to hit the panic button on the stock, the implications of the 8-K filing appeared to baffle equity analysts who cover AIG, most of whom had yet to issue research updates on the stock as of the market close Feb. 11

Credit default swaps are the mostly widely traded of credit derivatives and are used either by debt owners to hedge against credit events or by speculators to bet on changes in credit spreads.

The disruption in the credit markets caused by the subprime mortgage meltdown and the resulting loss of liquidity has made it extremely hard to price these CDOs. Multi-sector CDOs such as the ones AIG has written swaps on include auto loans, credit cards and many other kinds of debt in which defaults have so far been limited but could become a problem depending on how severe the slowdown in the U.S. economy.

The problem in assessing fair market value of the CDOs stems from there being two different ways to estimate default rates in the CDO market, said Matt Nellans, an equity analyst at Morningstar. One uses the actual market prices of collateralized debt obligations and the other uses the implied pricing of the credit default swaps written on those CDOs, he said.

"So which market do you mark to [to determine the fair value]? That's the question," he said.

The issue with the mark-to-market losses on the swaps, according to Nellans: It's unclear how accurately they predict what AIG may end up paying out in claims if the credit quality of the most highly rated tranches of debt drops dramatically.

One key component in mark-to-market losses is the benefit of the spread differential between the CDO and the swaps based on that CDO, which AIG refers to as the "negative basis" adjustment. The lack of liquidity in the CDO market has prevented the company from being able to calculate a fair value for the negative basis adjustment and AIG therefore plans to exclude it from its estimate of mark-to-market adjustments in the fourth quarter.

Eliminating that adjustment implies that the loss on AIG's exposures will jump from $352 million at the end of September to $5.23 billion at the end of November, an increase of $4.88 billion, which is significantly larger than the $1.05 billion to $1.15 billion range the company had indicated to analysts in early December, Morgan Stanley said in a Feb. 11 research note.

"While this is a sizable charge, some if not all of the charge will reverse in future periods if indeed the guarantees are money good, as we believe they are," analyst Nigel Dally said in the Morgan Stanley note. "The company has significant excess capital, and the stock is already trading at trough levels."

Still, the potential size of the writedown has investors worried about other skeletons in AIG's closet, which will keep pressure on the stock, said Dally, who reaffirmed his outperform rating on the shares. (Morgan Stanley has provided investment banking services to AIG within the past 12 months and as of Jan. 1, 2008, held a net long or short position of $1 million or more of the company's debt.]

Standard & Poor's Equity Research downgraded the stock to a sell from a buy rating on Feb. 11, calling the latest news "troubling" and saying AIG's management will have a tough time regaining investor confidence. S&P also cut its price target to $43 from $69 on an assumption the shares will trade at 1.1 times its estimated tangible book value for 2008, "a discount to peers that we think warranted in light of these disclosures." (S&P, like BusinessWeek, is a division of McGraw-Hill Companies.)

Fitch Ratings placed AIG's debt rating and that of its subsidiaries on Rating Watch Negative, to be resolved after Fitch reviews AIG's audited financial statements for 2007 and assesses how the weakness in internal controls affects its view of AIG FP's exposures.

AIG expects to report its fourth-quarter results around Feb. 29, Chris Winans, a company spokesman, told BusinessWeek on Monday.

While Fitch has predicted AIG won't be immune to potential losses from the residential mortgage crisis, the agency believes these losses should be absorbed by AIG's existing capital base and future earnings. If weakness at AIG FP prompts a rating downgrade at the holding company, Fitch said it believes the downgrade would be no more than one notch.

The default rate of the collateral will determine the value of the claims that AIG may eventually have to pay out. But the business hasn't seized up yet and that market would have to be much worse than it is currently before AIG have to pay a claim, said Nellans at Morningstar.

He said he has questioned the quality of the earnings generated by the credit swaps business and hasn't given them much weight when assessing the fair value of the stock. Even if the market is pricing the credit swaps correctly and the mark-to-market losses end up being $10 billion, or double the current estimate, it would reduce his fair value estimate by less than 5%, he said

A writedown that big would halt the growth of the company's book value for one quarter, he said.

"Whoever owns the triple-A securities [within the CDOs] would have to lose their entire investment before AIG will pay a claim," Nellans said.

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