AIG's Declaration of Independence

American International Group's (AIG) $35.5 billion deal to sell the AIA Group, its main Asian insurance operation, to Prudential Plc (PUK) of the U.K. collapsed on May 31 when the insurer's board refused to cut the price. The sale was seen as critical to the firm's ability to begin repaying the U.S. government's $182.3 billion bailout, and its failure was a setback for CEO Robert Benmosche, who had agreed to a lower price, only to be overruled by his board.

Bruce Berkowitz, however, was delighted.

AIG may have become synonymous with recklessness and the global economy's near-death experience in 2008, but for Berkowitz it's pure gold, and the company's luster only grew brighter with the failure to sell AIA—no matter how many headaches it causes the government. For months, says Berkowitz, who manages the $16.5 billion Fairholme Fund, he spent six hours a day studying the battered insurer and bought more than 30 million shares. He now ranks as the largest private holder of the company's stock. Only the U.S. Treasury, which has a nearly 80 percent stake, owns more. The government just wants its money back; Berkowitz says he expects to double his.

"I've got the greatest analysts in the world working for me," says the Miami-based investor, who in January was named stock manager of the decade by Morningstar (MORN). "There's the GAO, the New York Fed, the Treasury, Congress, all the advisers they've hired. And guess what, they're working for me for free. I mean, I don't think people appreciate what the government has put into this. If I'm wrong I don't deserve to be in business."

Berkowitz knows he is making a contrarian bet. He usually concentrates his investments in a small number of stocks in industries he knows, from insurance and banking to energy and telecommunications, and admits to being obsessive about his research. He doesn't like AIG merely because it is a ward of the state. He likes it, he says, because it has been transformed by good managers—and especially by a new, more independent board of directors, with several of its members appointed by the government. "AIG's going to prove to be one of the great restructurings in corporate history and the board is a big part of that," says Berkowitz. "They're doing a great job. They're taking their time."

A little more than a year and a half after the collapse of Lehman Brothers, amid nonstop debate, criticism, and anxiety, many of the government's most controversial financial rescue programs appear to be paying off. While the markets have been volatile, the economy is growing again, creating jobs. Stocks and some housing prices are up, returning many companies to profitability. Bank of America (BAC), Goldman Sachs (GS), Wells Fargo, (WFC) and even General Motors have been repaying some of the hundreds of billions of dollars in bailout funds, and the Treasury announced last week that it realized $1.3 billion in profit on the first sale of Citigroup (C) shares it had acquired.

Of all the wounded firms, AIG has always stood apart. It is the only company to receive money from a special Treasury facility called the "Systemically Significant Failing Institutions" program, and that is just one of its many life-support systems. Even as the firm gets the bleeding under control, skeptics abound. AIG's new board has privately expressed its own concerns about the firm's viability, people with knowledge of the discussions have said. Elizabeth Warren, chairman of a congressional panel overseeing the bailouts, said last month that some AIG units might have to file for bankruptcy to speed recovery.

Cliff Gallant, an analyst at Keefe Bruyette & Woods, wrote a report in late April saying that the insurer's shares, which have traded as high as 44.51 this year, are worth 6 at best, and are possibly worthless. The government's plan to sell off its 79.9 percent holding, he added, "may not be executable." That assessment so concerned AIG's outside directors that they ordered their own review, according to someone with knowledge of the discussions who asked for anonymity because the meetings were private. This analysis, a single page of bullet points, disputed some of Gallant's assertions while conceding that AIG's book value, a critical element in any plan for weaning AIG from federal support, may face "a number of risks."

Days after Lehman Brothers was allowed to fail, AIG received the largest and most complex government rescue of all. Policymakers were concerned about its vast size—it had about $1 trillion in assets at that time—and feared that losses suffered by its vast network of counterparties might imperil the global financial system. Because of "the risks AIG poses to the economy, the most effective thing to do is to make sure the firm can be restructured over time," Treasury Secretary Timothy Geithner said at a congressional hearing in early 2009.

Having saved it, the government has had a difficult time figuring out when and how taxpayers will be repaid. AIG's board, led by Chairman Harvey Golub and other corporate veterans with deep experience in rescue operations, is asserting itself and steering the insurer toward what it hopes will be long-term health. That was evident this past weekend, when the board rejected the revised Prudential deal worked out by Benmosche. Prudential had sought to cut its offer to $30.4 billion after shareholders complained it was overpaying. Not only is the board standing up to its CEO—despite the potential embarrassment for Benmosche, there is no indication that either he or the board is contemplating a divorce—it also says it will not give the government preference in repayment of its equity over the minority shareholders who were almost wiped out during the crisis.

Golub, the former chairman of American Express (AXP), said in an interview that the company was setting its own agenda, not letting the government set it. "We're a Delaware corporation, we operate under Delaware law and our responsibility is to all shareholders," he said. "We'll come up with the best restructuring plan we can, one that makes sense for all shareholders. The plan has to be acceptable to all constituents."

Several months ago the Treasury gave AIG a repayment strategy, a brief PowerPoint presentation, according to a person with knowledge of the plan. It proposed repaying the Fed loans first with the proceeds of the sale of two overseas insurance businesses for $51 billion, assuming those deals closed on schedule. Then, the Treasury proposed converting its billions of dollars in preferred shares into common stock and selling them over a two-year period. The Treasury asked for a response in June. Golub says there is no time pressure. "If it takes until August, it takes until August," he says. "If it takes until next year, it takes until next year. We don't have a time frame, but the board would like it done as quickly as possible."

That represents a significant shift. When Edward Liddy, who had been chairman of Allstate (ALL) until 2006, took over as AIG's $1-a-year CEO in September 2008, he had to deal with problems beyond merely navigating markets in free fall and tens of billions of dollars in losses. He also faced crushing payments of more than $10 billion in the first year for the Fed's initial $85 billion rescue loan. Then there were the government's restrictions on compensation for top executives, as well as on bonuses, perks, and lobbying.

The terms of his service were clear—his job was to remove the firm from the government's embrace as swiftly as possible. "The mess we're in is solvable," Liddy told employees, largely by selling some businesses quickly so AIG could repay the loan. The initial plan involved selling off more than two-thirds of the company. "Every day we don't do something, it will hurt us."

Months later the company said that the rushed sales would not yield enough cash to ever fully repay the government. Yet waiting for the company's profits to grow enough to return the taxpayers' money wouldn't work either. A new strategy was needed.

So Liddy was replaced by AIG's fifth CEO in five years, Benmosche, the former chairman and CEO of MetLife (MET), who did not agree to a salary of $1. His pay package provides $10.5 million a year, and he threatened to quit last year if the government's pay czar, Kenneth Feinberg, did not ease pay cuts on some top officers, according to a person with knowledge of the discussions. Feinberg held his ground and Benmosche stayed.

The government's initial emergency loan has ballooned into a six-part, $182.3 billion package of loans and loan commitments from the Fed and investments by the Treasury in three different types of preferred stock. The components include a $60 billion credit line from the Fed, $52.5 billion of Fed money used to purchase the toxic-mortgage-linked assets that nearly destroyed the insurer, and a further $69.8 billion from the Treasury for the preferred stock.

The company that was on a tear to unload businesses is now engaged in a long-term workout, its priorities rearranged. The government has tacitly endorsed this by relieving AIG of the punitive repayment terms; the firm is not being forced to pay roughly $5 billion a year in dividends on the government's preferred shares, according to Warren, the congressional overseer, and the insurer has been allowed to accrue an additional $5.75 billion in unpaid interest on Fed loans as of Mar. 31.

Since the credit crisis, AIG has sold 26 businesses for $12 billion, pocket change for a firm as huge as AIG. It still has approximately 400 companies that operate in 130 countries with a total of $864 billion in assets as of Mar. 31. If AIG succeeds in selling the two overseas businesses, AIA and another called Alico, that would remove about a third of the remaining assets. AIG has 96,000 employees, 20,000 less than it had at its peak. The market value of its outstanding shares has dropped from $186.4 billion at the end of 2006 to about $5 billion.

The notorious division that caused most of the losses, AIG Financial Products, is still operational. Most of its worst performing assets—tens of billions of dollars of collateralized debt obligations and other asset-backed securities—were taken over by a specially created vehicle financed by the Fed to remove the risk from AIG's books. The insurer has since been busy winding down what remained of AIG Financial Products. According to the Treasury, the unit cut the notional value of its derivatives book to $755 billion from $2.7 trillion at the end of 2008. By the end of this year the remaining derivatives positions will be transferred to other divisions and the unit closed.

Instead of focusing on raising cash for the government, then fixing the remaining insurance businesses, Benmosche and the more activist board that chose him are now engaged in a methodical restructuring, intending to leave a vibrant business even after the government is repaid. The board has been restocked with veterans of long, difficult bankruptcies, including a restructuring committee chaired by Douglas Steenland, who saw Northwest Airlines (NWA) through a bankruptcy as its CEO. Also serving on that committee is Robert Steve Miller, who was CEO of the auto parts maker Delphi (DPH) during a bankruptcy; Henry Miller, head of a banking firm that specializes in restructurings, Miller Buckfire & Co.; and Morris W. Offit, chairman of an investment firm. Their goal is to build a company that will produce healthy returns for all shareholders, according to Golub, reclaiming the company's standalone investment-grade credit rating and then repaying the government in full.

To do that, Golub says the company might seek yet another improvement in the terms of its bailout before moving on to repayment. In the past, that has meant replacing part of the government's debt with equity or cutting interest terms. Such changes would constitute the fifth easing of those terms. Repayment would be delayed in favor of building AIG for the future and providing more value for minority shareholders, like Berkowitz' Fairholme Fund. "We would follow whatever course of action would accomplish our business objectives, whether it's one step, two steps, three steps, four steps, to accomplish those objectives," Golub says. "We don't care how many steps it may take."

The government is not objecting. At a hearing of the congressional panel overseeing bailout spending last week, Jim Millstein, Treasury's chief restructuring officer and a former investment banker, acknowledged that "it will take time to repair fully the damage to" AIG's franchises. "That said," he went on, "the company's progress to date is encouraging."

One of AIG's recovery strategies has been to seem less AIG-like. The fund management arm was renamed PineBridge Investments, the U.S. auto insurance unit was rebranded as 21st Century, and AIG said it would change the name of an annuities unit to Western National Life.

The core property-casualty company that, if all works out, will survive the rescue, has been renamed Chartis. It had $879 million in operating income in the first quarter, as AIG reported overall net income of $1.45 billion. The company said that its other core business for the future is SunAmerica Financial Group, which specializes in retirement products.

Not everyone is so sanguine about AIG's health and the prospects for taxpayers getting all their money back. Officially, Treasury has said that it may suffer losses of $45.2 billion on its AIG investment. Elizabeth Warren noted in a hearing last week that AIG is finally reporting profits again only because it is not paying $5 billion in dividends on the preferred shares owned by the Treasury, which equals nearly a year's worth of profits, based on how the insurer did in the first quarter.

After Gallant of Keefe Bruyette & Woods testified about his concerns, Benmosche rejected the pessimism as uninformed. At the hearing he told taxpayers, "you'll get your money, plus a profit." He said he based his view on the increased health of the company, which could earn as much as $8 billion next year.

Golub said AIG has the luxury of time to develop the profitability of the businesses while working to repay the government. "If we concluded that maximizing shareholder value meant that we should hold on to a business for longer periods, we would do that," he says. "If we thought we would maximize shareholder value by selling off businesses more quickly, then we would do that."

In his testimony, Gallant said that it was only the government's support that gave AIG those options, and the support was contingent on a belief that AIG's failure could destabilize the financial system. A person with knowledge of the Treasury's thinking reiterated that concern. "The most important thing is to keep it stable so it doesn't cause another conflagration, and to exit as quickly as possible consistent with that goal," he said.

Gallant questioned how long the government would cling to that view. "As systemic risk fades, the treatment of AIG is likely to change," he said.

If that raised questions for Gallant about AIG's future value, Berkowitz said he found it a bedrock of his confidence that the government will be repaid by the end of 2011 and that shareholders will prosper. "Ultimately, I don't think the Treasury's in the business of giving money away and it's going to see that it gets the real value there," he says. "This has to be the most complicated restructuring in the history of the U.S., and when it's done we'll all be very proud of it."

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