The Bull/Bear Report - American International Group, Inc. (AIG)

Insurance and financial company American International Group, Inc. (AIG) took its turn at the credit crisis whipping post by recently reporting larger losses than expected. The bigger problem than the losses was the apparent lack of understanding of when and if the crisis will cause further damage to an already wounded balance sheet.

At one point in its history AIG was the glamour boy in finance attracting some of the best and brightest minds to its shop. The company led the way in structuring and trading complex derivative securities that are now causing so much trouble.

Of course when times are good and profits are rolling in, nobody stops to notice that maybe the company was succeeding due to its own version of the pyramid scheme. It sure seems like it to me.

Now the bill is coming due erasing billions of dollars in capitalization. Investors reacted accordingly by sending AIG shares below already discounted levels.

Once trading for over $70 per share AIG lost more than half its market cap to current levels in the low $20's.

Does such a state provide an opportunity for investors?

I'd be skeptical.

Get more of Jamie's take on AIG, and find out what two of our top bloggers think when you continue reading this week's Bull/Bear Report here.

In some cases there are financial companies worthy of speculation in this environment. The end will be near and some companies will be able to survive and thrive.

The problem with AIG to me is that investors can never really know where this company stands given the complexity of its balance sheet. What is the true value of assets?

It may be more or it may be less what we currently see.

That's troubling to me as an investor and though I will admit to being interested in AIG given the depreciation in stock value, I think I will use patience here. My analysis suggests that there will be one more shoe to drop before we can give the all clear with AIG.

What do you all think? Here are two good blogs on the subject:

Bull Case: Tom Armistead

AIG just reported its third consecutive quarterly loss, (2.06). The shares were pummeled, trading at 23.62, down 18.8% when last I looked. I have been a buyer of AIG at prices under 30 and initiated a very small position in my Marketocracy portfolio today. I listened to to the conference call and browsed the presentations on their website. My take: AIG will be downsizing and simplifying itself, resulting in a well capitalized international multi-line insurance company, solid but not glamorous. However, there is substantial risk of unnecessary hemorrhaging.

The process will involve surgery, in the form of selling non-core operations and reducing the risk profile of assets and liabilities. Over the past ten years AIG has grown rapidly and profitably, but under today's economic conditions is revealed as bloated by excessive risk and complexity of operations. I think mark to market losses are overstating the company's difficulties: and, accordingly, the test of the surgeon's skill and patience will be the extent to which assets and liabilities are taken off the balance sheet without holding a fire sale. Other financials, such as Merrill Lynch, seem to be willing to buy their way out of trouble, to the detriment of shareholders.

The resulting slimmed down company would do P&C Insurance, Life and Annuities, and Aircraft Leasing as core operations. Businesses such as AIG Financial Products Corp, with its super senior credit defult swap portfolio, which has generated a stunning run of mark to market losses, would not be part of the core and would require to be dealt with.

Earnings going forward might be 3.00 per share, book value could be maintained at 30 per share, and a realistic target price would be around 42 per share. From where the stock is trading today, you could make money. However, I see less value than I did a week ago.
My estimated outcome is not very ambitious - the reason being, 2 month CEO Willumstad sounds resigned about mark to market losses, already in capitulation mode. My view is that the credit crisis has got the value of all mortgage related assets and liabilities way out of sync with the performance of the underlying collateral. With a balance sheet that has large amounts of both assets and liabilities that are mortgage related, it would be all too easy to erase a lot of value needlessly, in the interest of placating shareholders who have lost their appetite for risk.

In addition, Willumstad was unwilling to rule out a capital raise. AIG has already raised 20 billion: shareholders do not need further dilution. A capital raise would drive the stock down further, resulting in a self-fulfilling loss of value. AIG uses an Economic Capital Model that is driven by market values. They complain of the difficulty of getting a stable indication of required capital. I interpret that to mean that if market values of their assets decrease further, or if they have to take more mark to market losses on their bond insurance, they will raise capital to meet the rating agency double A requirements.

The company's discussion of the super senior CDS portfolio mark to market was strange: last quarter, they saw 1.2 to 2.4 billion of maximum stress losses: now they see 5 to 10 billion of maximum stress losses. Their representative declined to provide a figure for expected losses, saying only that it was less than 5 billion. They talked about new processes to stress test the business: I would guess it's like ABK's AA Bespoke transaction - AIG's underwriters missed the point when they wrote the business and now they see their error as losses are on the horizon.
The mark to market on the investment portfolio was mostly moving losses from Accumulated Other Comprehensive Income to the Income Statement. Book value is not affected, but earnings are reduced. Most of the portfolio is investment grade and performing adequately. Losses have been realized for accounting purposes, but there has been no fire sale as of yet.

To summarize, I see a lot of value but question management's ability and willingness to solve the problems in the best way for shareholders. I can't figure out whether it's a deer in the headlights sort of thing, or management being deliberate in exploring their options. I plan to hold my small position through September, when Willumstad should be articulating his plans to get the company back to its core businesses. If I hear a good plan and the resolve to execute it properly, I will stay with the position: if not, I will exit. I expect a downward trajectory of the stock, and increasing clarity as to the values that can be salvaged and the prospects of future earnings. Somewhere in this process there might be a very interesting buy point.

Bear Case: Randal LaBine
Complexity is in most cases an opportunity in that markets have a tough time efficiently pricing said complexity. That being said the complexity with AIG could result in further deterioration of its capital base. Additions of capital to shore up the balance sheet could dilute current shareholders.

As tempting as it may be to dip your toes into the AIG water, I would stay high and dry.

Jamie Dlugosch
Executive Editor, InvestorPlaceBlogs

by The Freshman |  08/15/08  |  Stocks: AIG,