Interesting analysis
Financial analyst Ron Thomas of Real Money takes a look at the big write-off at AIG that caused the market swoon on Friday:
The big point of contention is the $11.1 billion of unrealized pretax loss ($7.2 million after tax) in the AIGFP super senior credit default swap portfolio. [see page 20ff. of attached presentation -- ed.] This was greater than I (and probably most other analysts) expected. The company gave out 499 pages of financial information in an attempt to state its case and quell investor fears.
There is now $11.25 billion of unrealized market valuation loss on the GAAP balance sheet, yet via AIG’s own models, a severe stress equal to the 1974-1975 recession would result in a $0.9 billion loss on this same $61 billion of multisector collateralized debt obligations (CDOs) that include subprime exposure.
The financial markets are shut down now, so the bid-ask spreads result in valuations that are not based on rational analysis by participants. The only thing close to rational is the approximate 18% to 23% losses for subprime exposure that the rating agencies are now predicting. These losses are not high enough to cause losses in the super senior (upper level of AAA) CDOs. I believe that there would need to be an approximate doubling of loss expectations for sizable losses to occur there, which could be the reason that Standard & Poor’s decided not to downgrade AIG when the losses were announced.
Market participants will start doing some of their own analysis to gauge when financial markets might start to function again. They will be doing some stress testing, possibly vs. Texas during the oil bust, the 1990-1991 experience in Massachusetts or California, the Great Depression or possibly the 1974-1975 experience that AIG analyzed. So I find it hard to believe that the real losses that the insured portions of these CDOs would sustain would be off by a factor of 12 from AIG’s analysis. I might grant naysayers the benefit of the doubt on the 2006-2007 vintages, which were so badly underwritten that normal analysis might possibly break down, but these are 2005 and prior vintages at issue, which have already had lots of ARM resets.
Investors should put credence in market value of assets, when the markets are functioning normally, but there is no accounting silver bullet. I look at the valuation that the market accords, the capital level of the company and its ability to earn income in concert with one another. In round numbers, AIG earns $22 billion a year in pretax income. Even if you believe that the $11 billion number is the right one based on the subprime situation now — and everybody agrees that mark-to-market losses could get worse in the coming one or two quarters — the company is not liquidating. It has to pay off obligations over time. And over the next two or three years, you get $44 billion to $66 billion of pretax to help cover even the mark-to-market losses, if they become real.
The disconnect was difficult to fathom between AIG’s $11 billion write-down and the $900 million in maximum real exposure its CEO claimed. The analysis above and the AIG presentations make the matter more understandable. GAAP accounting appears to mandate the huge write-offs to satisfy the “lower of cost or market” requirement, whereas the actual economic exposure might be a fraction of that. Indeed, there is now grumbling that the accounting rules currently in force produce grossly misleading results in some cases, though, as Fed Chairman Bernanke said last week: “I don’t know what to do about it.”
March 5th, 2008 at 9:53 pm
The disconnect was difficult to fathom between AIG’s $11 billion write-down and the $900 million in maximum real exposure its CEO claimed.
I’ll take a guess. On one hand, there may be more awry with AIG’s financial position than the has revealed explicitly. On the other hand, overestimating portfolio losses now may lead to outsize profits in the future when the losses are not as bad as expected: are AIG executives positioning themselves for some outsize bonuses?
Scenario: during a bubble, the executive suite takes too much risk and gets fat bonuses. Once the music stops, future portfolio returns are deliberately underestimated in order to overstate losses. After conditions normalize, those portfolios yield large returns, demonstrating the brilliance and bonus-worthiness of management. For executives who retain their jobs during the retrenchment period, the overall returns under this scenario might be higher than if the company were managed conservatively. (However, decisionmakers’ risk of being fired during the downturn must be taken into account.)