Do you know what a 2a-7 put is? If you don't, here's a tip: Don't invest in AIG ( AIG). On Thursday's earnings call, AIG said 2a-7 puts -- whatever the heck they are -- are likely to cost them money at some point. How much money? They don't know. Dan Johnson, an analyst with $20 billion Chicago hedge fund Citadel Investments, asked AIG management about 2a-7 puts in a conference call to discuss the insurer's $5.36 billion second-quarter loss reported after Wednesday's closing bell. Few sane individual investors are familiar with these obscure derivative investments, hedges by AIG counterparties that certain bond investments will fail, which takes their name from a Securities and Exchange Commission rule. But Citadel's interest in them speaks to their import, as the firm is one of the few institutions that may be a match for Goldman Sachs ( GS) in the brains department. If the above illustration of the complex instruments AIG is involved with doesn't convince investors they are better off at the blackjack tables than investing in the insurer, perhaps nothing will. AIG is not alone, of course. It is merely plagued by the same virus that has infected a great number of the large financial companies around the world: Its business is way too complex, and investors are running for the hills from them until they can clearly and honestly explain what they're worth. The transcript of the conference call does little to clarify the situation. Citadel's Johnson asked AIG management about 2a-7 puts based on something he found buried on page 87 of the insurance giant's quarterly earnings report. Elias Habayeb, CFO of AIG Financial Products, a derivatives-trading AIG subsidiary, told Johnson "we do have 2a-7 puts that continue to be outstanding, and given the current state of the market, we would be expecting to be buying back those underlying reference obligations."
So Johnson asks the next obvious question: "any sense on what that means from capital consumption?" Translation: Any idea how much will this cost? The answer from Habayeb: "Not at this point." AIG spokesman Nicholas Ashooh, asked to explain the exchange after the call, said some of the 2a-7 puts have failed, but were covered by backstop facilities. "I don't have a figure in terms of impact on capital but it's not material," he says. AIG has similarly allayed credit crisis-related concerns in the past. In December, the company soothed Wall Street nerves frayed by the mounting credit problems 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. Just months later, the insurer reported a quarterly loss fueled by toxic credit derivatives. The company's streak of losing quarters has now reached three. Its stock was shedding 16% to $24.23 in recent trading. Atlantic Securities analyst Alan Devlin thinks more dilution may be in the cards for AIG shareholders. "Unless the current capital market environment improves they're going to potentially have to raise capital again at some point," Devlin says. Indeed, that may be AIG's only option to shore up its balance sheet. Though CEO Robert Willumstad has said a thorough review of AIG's businesses is underway, Devlin doesn't interpret that to mean that major asset sales are in their cards. "Apart from the core operations, there's not much to sell and I don't think they want to sell the core operations," he says.
While AIG's business may appear to be indecipherable to many investors, help appears to be on the way. Gerald Corrigan, the no-nonsense former chief of the New York Federal Reserve who is now at Goldman Sachs, has thrown the full weight of his skepticism behind a report, released Thursday, that recommends a dramatic overhaul of the financial services industry. Containing Systemic Risk: The Road To Reform includes among its recommendations that strict limits be placed on investments that can be made by unsophisticated investors. What is especially heartening about the report is that it has a much broader definition of unsophisticated investors than is typical in the ineffective rules and proposals of the past few years that have got Wall Street into its present mess. According to Corrigan's report, an unsophisticated investor is not just a middle class retiree trying to strike it rich. It can also include large pension funds, whose health, of course, also affects the health of the middle class retiree. If Corrigan's recommendations are followed, even the rube at AIG who bought 2a-7 puts MIGHT no longer be allowed to do so. That sounds like a good thing. In the meantime, investors may want to stick to something they have a hope of understanding.