AIG's Real Mess Is Far From Over

Ousted CEO Greenberg still wields considerable power -- most of it through offshore entities.
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If the mess at American International Group (AIG) - Get Report were over, I'd be urging you to buy this stock hand over fist at current prices.

The market for U.S.-style financial services, such as life insurance and annuities, is going to grow by leaps and bounds in the developing countries of India and China. As more people there achieve enough wealth, they will need to protect their financial futures.

AIG is better positioned than any of its global competitors to capture that growth. The stock is down about 30% from its 2005 high on Feb. 11, and it would be a table-pounding bargain if the worst were behind the company.

But it's not.

Oh, the worst of the accounting scandals are over, though investors don't yet know the exact bill the company faces. Investors should expect more restatements of earnings and reserves, more hits to capital and reserves, the discovery of yet more offshore affiliates that were little more than excuses for some very "creative" accounting, more fines and, ultimately, lawsuits.

But nothing on this long list of bad news events does significant damage to the company's competitive position and financial strengths -- even if the final bill turns out to be twice the $1.7 billion hit to net worth that the company now projects.

Greenberg Still Powerful

So why not buy today?

Because of the nonaccounting half of this mess. The investigation into the company's accounting has turned up a warren of offshore entities. The ones that concern me, and that keep me from buying the stock, are about accounting, for sure, but their biggest effect was to cement the power of ousted CEO Maurice Greenberg.

Greenberg may be gone from his chair at AIG, but he still heads offshore companies that own almost 16% of the company's stock and that control past and future bonuses for many of the executives that replaced his team. The battle to unwind these relationships and to regain control of corporate power from these offshore companies has already turned nasty, and it's by no means over.

Nibble at AIG shares, if you've the appetite, until it's clear that there's at least the outline of a deal to cut through this web of companies. The biggest threat -- and it's a sizable one -- now hanging over the stock is that these offshore companies will dump some or all of their AIG shares.

'Business as Usual'

AIG's accounting has been under scrutiny for a while now, but it was the investigation into a deal between it and the General Re unit of

Berkshire Hathaway

(BRKA)

that put the company in the headlines and forced the board to remove Greenberg. General Re transferred a block of insurance business to AIG, which would collect the premiums and take the risk for paying off on the policies.

AIG accounted for the $500 million in premiums it acquired as revenue and added $500 million to its reserves to cover the potential losses. Since the premium revenue and the reserves balanced out, AIG got to add reserves to its balance sheet -- something Wall Street had been urging -- without damaging its earnings on the income statement. General Re received a $5 million fee for its role in the transaction.

Regulators, led by New York State Attorney General Eliot Spitzer, have focused their investigation on whether AIG really faced any risk as part of the deal. Only if there were a real risk that the policies would lead to losses would the company be entitled to use the accounting method it picked to add reserves.

AIG and General Re funneled everything in this transaction through offshore companies. General Re's Germany unit, Cologne Re, sold those claims and premiums to National Union, an AIG unit in Bermuda. The extra reserves and premiums ultimately made it from National Union to AIG's books.

There's nothing illegal or shady about using offshore entities to do business. Companies use offshore units, subsidiaries and entities all the time for specific deals, but at AIG the practice was, well, business as usual. It's been an open secret for years on Wall Street that no one outside the company really understood its accounting. AIG has long been called "opaque" on Wall Street, which is what analysts say when they can't figure out a company's books because so much of the detail is off the books.

For an investor, a big part of the problem is that it's so hard to tell if a deal is really an arms-length transaction between independent companies or a charade in which a company just shifts money from one pocket to another. For example, there's the case of the Barbados company

Coral Reinsurance

. In the 1990s, Coral owed AIG about $1 billion in what are called "recoverables," potential payments owned by reinsurance companies as a result of policies sold to AIG by the reinsurer.

AIG booked these recoverables as assets on its balance sheet. In the 1990s, regulators looking into the accounting argued that Coral was effectively controlled by AIG and therefore the company wasn't entitled to book premiums it owed to itself as assets. That investigation ended when Coral closed down in 1999, but investigators are now looking into two other small reinsurers in Barbados,

Richmond Insurance

and

Union Excess Reinsurance

. At the end of 2003, AIG had $1.2 billion in recoverables on its books from these two companies.

Offshore Entities

Offshore entities have more uses than just "creative" accounting. They can also be set up to enhance the power and control of a specific individual or group of individuals. That's the case with a collection of offshore companies named after C.V. Starr, the founder of AIG.

First, there is

Starr International

, a private Panamanian company with offices in Bermuda that controls about 12% of the shares of AIG. American International has used Starr as part of a deferred-compensation plan for its executives. As part of that plan, shares of AIG owned by Starr are set aside as bonuses for AIG managers. About 700 AIG executives get a sizable piece of their compensation through Starr. In 2003, stock bonuses paid by Starr included $11.1 million to Greenberg, and $1.8 million each to co-chief operating officers Donald Kanak and Martin Sullivan.

Second,

C.V. Starr & Co.

, a privately owned insurance broker, does its business predominantly with AIG, a publicly owned and traded company. (A Louisiana lawsuit charges that accurate accounting would show 100% of C.V. Starr's business is with AIG.) Further, C.V. Starr is owned and operated by executives from AIG and owns about 1.8% of AIG shares.

And lastly, the Starr Foundation, a charity, owns about 2% of AIG shares. Its head? Maurice Greenberg.

Starting to see the problems here?

On the accounting side, the compensation relationship with Starr International made it possible to keep the stock bonuses paid to AIG executives off the company's books. AIG didn't take a charge for the bonuses, and since the stock being paid to executives was already issued and held by another company, AIG didn't suffer any dilution when the bonuses were paid. And because C.V. Starr is a private company, it's just about impossible for investors in the public company to know if the transactions between C.V. Starr and AIG were at true market rates.

In addition, ousted CEO Greenberg wields tremendous power over his old company because of his clout at the three Starr companies. Greenberg is chairman of Starr International and owns 8.3% of its stock. He's president and CEO of C.V. Starr and owns 16.4% of its stock. All together, Greenberg runs and substantially controls three companies that own about 15.7% of AIG's stock. Add in his own 1.7% direct ownership of AIG stock, and you can see that if Greenberg isn't sitting in the CEO chair anymore, he's still a player.

Greenberg Calls the Shots

Nobody knows

how

Greenberg will use this power, but so far the signs are that he

will

use it -- and he's hopping mad at the new management of his old company. The board of directors of Starr International threw several AIG executives off the board, including Martin Sullivan, Greenberg's successor as CEO, and Kanak, its executive vice chairman.

Still on board at Starr International are Howard Smith, former CFO, and Michael Murphy, a tax specialist, both fired by AIG for failing to cooperate with investigators. Last month, Starr lawyers removed 87 boxes of documents from Bermuda offices that it shares with AIG. That forced the

Securities and Exchange Commission

to seek, successfully, a court order barring the destruction of the records.

If this is the beginning of a divorce between AIG and the Starr entities controlled by Greenberg, it's clearly going to be a very messy one. And Greenberg is essentially calling the shots when it comes to the terms of the separation.

Starr International still holds all those shares of AIG paid as bonuses to AIG executives. The terms of the plan say those shares were voted solely at the discretion of the board of directors at Starr International -- an essential feature if the stock wasn't to count as compensation on AIG's books. That gives Greenberg a huge pile of bargaining chips in any deal with AIG.

But the executive-compensation program isn't Greenberg's biggest edge. The enforcement powers of the SEC and the New York attorney general don't stretch very effectively to Bermuda. By severing the ties between AIG and the Starr companies, Greenberg has given himself significant wiggle room with investigators. His options certainly include delay, obfuscation, legal challenges and the like that could leave AIG unable to settle with regulators.

That's a powerful weapon to use against a company that so badly wants to put this all behind it.

That leaves investors interested in picking up shares of what is likely to be one of the key global financial stocks of the next decade in a quandary. The rule on Wall Street is, "Don't buy until all the shoes have dropped." In this case, however, Greenberg essentially controls what the last shoe will be and when it will drop. And that means that it's just about impossible for investors to say, "I can see the end of this."

Nibble if you like at AIG shares in the range of $50 to $53. But don't do the bulk of your buying until you see at least the outlines of a deal between Greenberg and the company that he ran so well for so many years. The headlines about accounting scandals aren't the real story for AIG anymore.

Changes to Jubak's Picks

Buy Apache:

I'm going to use the recent retreat in the price of oil to $52 a barrel to add a position in

Apache

(APA) - Get Report

. The recent correction in oil prices, and in the price of oil-company stocks, has dropped Apache shares from the top of their price channel near $65, back to the 50-day moving average at $60. That doesn't make the shares a bargain, but it puts the price back near what I'd call reasonable: Wall Street analysts project 19% earnings growth for 2005, and the stock now trades at a trailing 12-month price-to-earnings ratio of 12.

In an era when most oil companies are raking in huge profits but struggling to find good investments for all that cash, Apache has found a strategy that I think assures long-term growth. The company buys older reserves from even bigger oil companies and then applies the newest and most expensive technologies to increase production. That extra spending means Apache pays more to extract its oil and gas, but that pays off in big leverage to higher oil prices.

The company has just about doubled its asset base since 2000. That doesn't mean the company doesn't conduct any exploration on its own. One of its biggest recent finds is natural gas in Egypt, where Apache is expecting gas production to double. As of April 12, I'm adding Apache to Jubak's Picks, with a target price of $69 a share by October 2005.

At the time of publication, Jim Jubak was long Apache.