RealMoney Silver - AIG Undervalued?

AIG Undervalued?
By Ron Thomas
RealMoney Contributor
5/9/2008 2:39 PM EDT

American International Group (AIG) reported a first-quarter loss of $7.81 billion, or $3.09 per share, which was worse than the Street's estimate for a loss of 76 cents per share and the $5.3 billion net loss of the fourth quarter.

Trends in the income from AIG's various operations were about as expected. Competition continues to increase cyclically in commercial property casualty insurance around the world. Personal property casualty in the U.S. had income down $100 million vs. last year, as the agency business especially is being hit by increased accident frequency in a cyclically more competitive market. Life and retirement services was about as expected. United Guaranty lost $352 million, and premiums rose 14%. Management still expects a terrible 2008 for this segment. American General Finance only earned $11 million but awaits a better consumer-lending environment while loss costs are still low. AIG Consumer Finance Group had only $11 million in earnings vs. $21 million last year as it makes non-capitalizable investments in expenses for lending in Poland and Latin America. The International Lease Finance Corporation (ILFC) subsidiary is still doing well. Asset management operating income fell to $154 million from $788 million due to lower hedge fund investment returns (about 3%), which were comparing against nearer 20% returns last year. AIG Financial Products (AIGFP) is doing well (excluding marks).

The culprits were marks-to-market in the accumulated other comprehensive income for the super-senior collateralized debt obligations (CDOs) and losses on its residential mortgage-backed securities (RMBS) investments going through regular income in mostly the insurance subs.

There were $5.7 billion in gross unrealized losses in the quarter, in the RMBS investments, about $3.8 billion of which came in the Alt-A portfolio (no surprise looking at Fannie Mae (FNM) ), which now has a 23% loss against its amortized cost. Another $1.2 billion came against prime non-agency securities, including foreign and jumbo U.S. mortgagees. Here, much like in the upper senior AAA CDO portfolio, management says that it does not see much risk of long-term losses but, importantly, cannot make the case that the decline in value will be only temporary.

These changes seem to have come heavily from the writedowns of AAA and AA securities. I tend to agree with management on this, but its case is not as strong as on the super-senior CDO issue. I note that the AA-rated 2006-2007 subprime RMBS (only $1.7 billion) now have a significant potential for loss.

The market value of the super senior AAA CDOs held at AIGFP declined by $9.1 billion in the quarter, to a $19.3 billion total, or a 25% haircut on $77.5 billion in notional amount.

Management said that it has updated its stress test model, with a now $1.2 billion loss estimate vs. $0.9 billion last quarter, and has developed a new roll rate stress test that gets to a $2.4 billion loss. All three ratings agencies (RAs) still rated 82% of the super-senior CDO portfolios with subprime collateral at AAA levels, as of March 31, with 69% still rated that way at April 30. The decline in book value to $30 per share, however, which was part of the downgrades by two RAs, was too much, so management has moved to raise about $12 billion in capital. The present rating is holding company at AA- and insurance subs at AA+, which means, according to management, only that ILFC pays a bit more for its debt.

Now, $15 billion to $20 billion of excess capital has seemingly morphed into a measure of how much excess capital that management wants to keep on hand. Management said the company is currently in the $2.5 billion to $7.5 billion range, and that is a too low level of excess capital, so it's going higher. Proceeds will go to the holding company. Management also said that AIG went to the RAs and told them that that the company was going to raise capital, not the other way around (in this environment, possibly a distinction without a difference).

In property casualty insurance, terms and conditions are stable, rates are down 10%, and new business is down 13%. Aviation and Workmen's Comp are the only concerning lines of business. A seemingly disturbing increase in casualty reserve development was an increase for MTBE (gasoline additive) litigation. That sort of reserve setting is lumpy, implying no trend.

I had figured that $7 billion to $8 billion in capital-raising was the absolute worst case, though the stock is still very undervalued here, too. This was an unfortunate result for the quarter, as the marks-to-market do not seem to stop. I was even less happy with the cuts in the values of the RMBS portfolio. The bright side is that the writedowns are shifting to Alt-A, where there is less ultimate loss content, so the end of the write-offs is closer.

While I believe that the market is wrong on the ultimate loss content, if the marks get too out of line, the capital has to be raised, regardless of what I or management think. Another rating notch down cannot be tolerated. The new money raised by AIG will be initially dilutive, though the company may well be able to do make it non-dilutive, when, I believe, the marks will reverse themselves. The stock still looks very undervalued.

For Thomas's preview heading into the AIG conference call, please click here.