This Arcane Deal at AIG Reveals a Shocking Truth About Pre-2008 Mortgages

AIG's (AIG) - Get Report  stock surged Tuesday after the company accomplished what it described as a first: obtaining almost $300 million in reinsurance for home-loan policies issued before a meltdown in the $15 trillion U.S. mortgage market sparked the 2008 financial crisis.

The move shows that investors are once again willing to place a monetary value on mortgage products from the period, something many had been loath to do after widespread defaults starting in 2006 rendered the worth of such securities impossible to measure. That eventually led to the collapse of investment bank Lehman Brothers and left AIG on the hook for more than $500 billion in credit-default swaps that were written to protect investors from just such an invent.

In the aftermath, the government funneled $182 billion in bailout funds to AIG to keep it afloat and prevent further shocks to a fragile financial system. While the government eventually recouped its investment and AIG underwent significant restructuring, the New York company agreed to further changes amid pressure from activists early this year, including shedding up to a fifth of its United Guaranty mortgage-insurance unit, the business that obtained the reinsurance, in an initial public offering.

"I see it as a prudent move to basically shore up a book of business in anticipation of an IPO in the hopes of getting the upper end of the valuation range," said Cathy Seifert, an analyst with S&P Global. The reinsurance will be provided by Bellemeade Re, a special-purpose provider based in Bermuda.

"This marks the first time a mortgage insurer has accessed the capital markets for a risk transfer involving a mortgage insurance portfolio made up of policies issued in 2008 and earlier years," United Guaranty president and CEO Donna DeMaio said in a statement. "The transaction not only helps United Guaranty manage risk, but also demonstrates that investors are willing to assign value to this type of portfolio from the 2008 and earlier period."

Prior to the financial crisis, the housing market was considered among the safer investments because default rates were typically low. That changed with the popularization of so-called mortgage-backed securities, which let lenders lump loans of widely varied credit quality into a security together and sell them to investors, recording a relatively quick profit and transferring the risk off of their books.

The easy returns also prompted many to relax lending standards write adjustable-rate loans for the riskiest borrowers, who counted on being able to refinance as home prices rose steadily. When the housing bubble imploded, however, many found themselves unable to refinance or to meet the increasing monthly payments and their loans were foreclosed.

With its massive bailout, AIG became a poster child for pre-crisis excesses and was labeled a systemically important financial institution by the government, a designation that subjects companies large enough to threaten the broader economy if they go bankrupt to more stringent oversight and higher cash-reserve requirements.

Two AIG investors, Carl Icahn and John Paulson, have argued that breaking up the insurer allow it to escape those rules and boost shareholder returns. Their pressure prompted the company's board to offer both both men seats and announce streamlining including the United Guaranty IPO and the sale of its Advisory Group to private-equity firm Lightyear Capital and Canadian pension manager PSP Investment. 

AIG climbed 1.7% to $56.20 in New York trading on Tuesday afternoon, paring its decline in the past year to 5.1%.