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AIG Bodes Ill for Insurer Stocks

Nat Worden

Wall Street auditors who have long signed off on opaque accounting methods for valuing mortgage-related derivatives are starting to get worried.

On Monday, American International Group (AIG - Cramer's Take - Stockpickr) disclosed in a regulatory filing that PricewaterhouseCoopers has concluded that the world's largest insurance company had "a material weakness in its internal control" related to its accounting for its portfolio of credit default swaps.

So, is the insurance industry next in line for billions of dollars in writedowns as a result of the U.S. housing downturn?

In early December, as mortgage woes were leading to billions of dollars in writedowns for major Wall Street banks, AIG soothed frayed nerves by assuring investors that it had "little to no exposure" to asset-backed commercial paper, structured investment vehicles or collateralized debt obligations tied to residential mortgage-backed securities.

Now, the New York insurer is reporting a $4.88 billion writedown in gross market value for its credit default swap portfolio in October and November -- more than four times the $1.15 billion executives reported earlier.

AIG sold credit default swap contracts to holders of collateralized debt obligations, or CDOs, guaranteeing payments in the event of defaults on their underlying debt. Now that mortgage foreclosures are spiking as the U.S. housing market grapples with a decline of historic proportions, the estimated market value of AIG's portfolio is in a tailspin.

With the company set to report its quarterly results in late February, its latest estimate for losses on derivatives in the quarter don't include December, a month when the financial markets deteriorated dramatically.

It has yet to determine the full extent of "the amount of the increase in the cumulative decline in fair value" of its super senior credit default swap portfolio, it said in a filing with the Securities and Exchange Commission.

Shares of AIG dropped 11.7% after the disclosure. Bond insurers MBIA (MBI - Cramer's Take - Stockpickr) and Ambac (ABK - Cramer's Take - Stockpickr), both of which have huge exposures to similar securities, were down 7% and 4.6%, respectively.

Investment banks that already have suffered huge writedowns on mortgage-related investments like Citigroup (C - Cramer's Take - Stockpickr), Merrill Lynch (MER - Cramer's Take - Stockpickr) and Bank of America (BAC - Cramer's Take - Stockpickr) declined despite a broader rally in the stock market.

Also, AIG's announcement raised the prospect that other insurers would see such losses. Allianz (AZ - Cramer's Take - Stockpickr) closed down 2%. Hartford Financial Services (HIG - Cramer's Take - Stockpickr) shed 4.6%, and Chubb (CB - Cramer's Take - Stockpickr) was off 2.4%.

Insurers such as AIG invest in a wide range of securities, bonds and derivatives to build up their capital reserves. That being the case, it's not surprising AIG would have exposure to credit default swaps, which became increasingly popular amid the housing boom of the past several years.

Chubb CFO Michael O'Reilly told investors on a conference call in January that the company has no exposure to CDOs. Other major insurers couldn't be immediately reached for comment for this story.

Fitch Ratings analyst Mark Rouck says AIG is unique in the insurance industry for its exposure to credit default swaps on mortgage-backed securities.

"AIG has a unit that competed with investment banks and commercial banks for this business," says Rouck. "It's different than the traditional property and casualty or life insurance company."

Fitch responded to AIG's disclosure by putting its issuer default rating on "negative" credit watch, signaling the possibility of a downgrade. It noted that AIG had $505 billion in exposure to its credit derivative portfolio in late September, including $62.4 billion of CDOs backed by subprime mortgages.

Still, the company's disclosure harkens back to warnings about trafficking in such trades that came years ago from a giant of the insurance industry: Berkshire Hathaway (BRKA - Cramer's Take - Stockpickr) Chairman Warren Buffett.

The legendary investor said in a letter to shareholders in 2002 that "derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal."

He noted that there is often no real market for derivative securities, so mark-to-market accounting methods for valuing them can be easily substituted with mark-to-model methods that can encourage "large-scale mischief."

Buffett also pointed out that the chain reaction of big losses that can result from derivative trades are especially dangerous outside the banking system, where the Federal Reserve was created in part to prevent problems at smaller banks from spreading to larger ones.

"The Fed now insulates the strong from the troubles of the weak, but there is no central bank assigned to the job of preventing the dominoes toppling in insurance or derivatives," said Buffett. "In these industries, firms that are fundamentally solid can become troubled simply because of the travails of other firms further down the chain."

Berkshire's insurance units don't have exposure to the sort of derivatives that got AIG into trouble, but when the company acquired General Re in 1998, it found itself with a small portfolio of roughly 23,000 contracts. In a recent interview with Canada's National Post, Buffett said that Berkshire had a difficult time unwinding the portfolio over a four-year period, and it ended up costing the company over $400 million.

"We unwound them in a very benign period [in the financial markets]," Buffett said. "We were not under stress. We had lots of money. It was not a forced liquidation, but we ran into an expensive process in unwinding these things."

The current market conditions are anything but benign, with a global credit crunch whipsawing stock markets around the world, and Wall Street all but resigned to a recession in the U.S.

Whitney Tilson, a hedge fund manager with T2 Partners, says AIG's losses on credit default swaps could get bigger, and he won't be surprised if they keep spreading to others in the financial industry. Tilson notes that a number of high-profile investors, like John Paulson of Paulson & Co., made enormous profits betting against the housing market on credit default swaps last year.

"I want to know who paid these guys," says Tilson. "Who was on the other side of these trades? We haven't accounted for all that money in these write-offs yet. It looks like AIG had $5 billion of it, but who had the rest?"

Morningstar analyst Matt Nellans says that if AIG's eventual losses are double what it already has disclosed, that would cause only a 5% decline in his $83 fair value estimate for the company.

"It's not a risk to the whole company, but they are risking a very large loss," says Nellans. "The accounting is convoluted on this portfolio, and the company has a problem with its auditor. The pricing is convoluted. It's a black box business, but it's a small part of the company."