BOSTON (TheStreet) -- Bruce Berkowitz, whose Fairholme Fund (FAIRX - Get Report) is trailing the benchmark S&P 500 Index for the first time in eight years, caught a break, as top holding AIG (AIG - Get Report) and the Treasury announced a smaller-than-expected sale of shares in the insurer.

The $8.9 billion stock offering in AIG, most of which is owned by the government after it was bailed out because of bad debt, is at the low end of a range of $7 billion to $25 billion. That's created expectations the government may sell additional stakes at a higher price, pushing up its shares as much as 7.3% today.
Fairholme Fund's Bruce Berkowitz

Berkowitz's bet on AIG soured after the government said it would go ahead and sell a stake this month, even as the shares were trading at less than $30 and its break-even price is $28.70. In a conference call with shareholders Monday, the fund manager said "I was wrong" in assuming the government would sell its shares at close to book value, about 50% higher than the current price.

AIG's share-price weakness was reportedly a factor in the smaller-than-expected offering. The stock is down 49% this year. The smaller sale should help support AIG's share price in the near term, including Berkowitz's stake, but it also postpones the government's day of reckoning on the sale of the balance of its 92% stake.

Fairholme Capital Management, which includes several mutual funds, is by far the largest institutional investor in AIG, holding 1.6% of outstanding shares as of January.

AIG will offer 100 million shares, while the government will offer 200 million, the Wall Street Journal reported today. The Treasury also plans to grant the deal's underwriters the option to purchase up to 45 million additional shares to cover overallotments.

The company, run by Chief Executive Officer Robert Benmosche, is scheduled to hold its annual shareholders meeting today, to be followed by a "road show" to promote the shares to potential investors.

In 2008, AIG got a $130 billion infusion from the government that included loans, and the purchase of shares and a mortgage securities portfolio, under a "too big to fail" effort after the stock market collapsed.

AIG plans to use the proceeds to pay back some of the government's ownership stake, part of its $47.5 billion share purchase in 2008. The company has already paid back more than $40 billion in loans, including interest and fees.

The Fairholme Fund began buying AIG shares in early 2010, when they were trading in single digits, but the bulk of the purchases came later, when they were selling for $32.

AIG's shares rose steadily through 2010 and, by late in the year, the government was crowing that it could turn a big profit on the deal for taxpayers.

AIG shares had topped $50 this year, which made Berkowitz look like a genius. But, in February, the company raised its estimated losses from insurance claims by $4 billion, and that raised red flags for investors. Its shares subsequently slid.

Berkowitz said on the conference call Monday that he was caught by surprise from the government's decision to sell its shares over the next few months at below a break-even price. "I found it very hard to believe the government would sell its stake below book value and right now AIG is trading at two-thirds of book value," he said, according to the Wall Street Journal.

The insurer's book value was $47.66 per share at the end of March.

AIG isn't Berkowitz's only big loser this year, as he bet heavily on a financial-services rebound and made the industry 74% of the fund's assets.

As of the end of February, the fund's 20-stock portfolio was led by AIG, at 7.6%, Sears Holdings ( SHLD), 6.1%; Bank of America ( BAC - Get Report), 5.6%; Morgan Stanley ( MS - Get Report), 5.3%; Goldman Sachs ( GS - Get Report), 5.1%; and Citigroup ( C - Get Report), 5%.

All five of the financial stocks in that group are in the loss column this year. Excluding AIG, their declines range from about 6% for Citigroup to about 16% for Goldman Sachs.

The $20 billion Fairholme Fund is down 4.9% this year through May 9. It's up 8.3% over the past 12 months and has a sterling 6.7% average annual return over five years, beating 95% of its rivals. The S&P 500 Index is up 7.7% this year and 24% over 12 months.

Morningstar analyst Kevin McDevitt said in a May 5 research note on Fairholme that investing in financial-sector stocks have been Berkowitz's strong point "dating back to the early 1990s' (savings and loan) crisis. As always, the fund's success hinges on Berkowitz getting such bets right. And while he has been early in the past, he has rarely been wrong."

This year Berkowitz's reputation for outwitting the market will be severely tested.

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