AIG Bodes Ill for Insurer Stocks

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."

« Previous Page

1 2

Next Page »