Behind AIG's Nasty Surprise

Behind AIG's Nasty Surprise
The insurance giant's far larger-than-expected first-quarter loss rouses investor ire and renews fears the credit crisis may still have a way to go
by David Bogoslaw
American International Group's (AIG) financial results took a sharp turn for the worse in the first quarter and sent a shock wave through the equity markets, renewing concerns that there's likely to be more fallout from the credit crisis.
After the market close on May 8, the world's largest insurance company reported a net loss of $7.81 billion, or $3.09 per share, in the first quarter, vs. a profit of $4.13 billion, or $1.58 per share, in the year-earlier period. Excluding mark-to-market writedowns and other asset impairment charges, the company had an operating loss of $3.56 billion, or $1.41 per share, in the latest quarter, compared with adjusted net income of $4.39 billion, or $1.68 per share, a year ago.
The bulk of those writedowns was related to credit default swaps, the complex credit derivatives used either by debt owners to hedge against credit events or by speculators to bet on changes in credit spreads. New York-based AIG said the loss included the impact of successful hedging activities that didn't qualify for hedge accounting treatment or for which hedge accounting wasn't used, including related foreign exchange gains and losses.
Seeking Fresh Capital
AIG also said it plans to raise about $12.5 billion in capital to shore up its balance sheet and provide greater financial flexibility to be able to respond to future events in the turbulent financial markets. First, it will raise roughly $7.5 billion through a common stock offering and an equity-linked offering, to be followed later by an offering of hybrid securities made up of debt and equity.
The loss far surpassed the per-share loss of 76¢ that analysts had expected, prompting AIG shares to tumble 8.8% to close at 40.28 on May 9.
Hank Greenberg, AIG's former chief executive, who has been very vocal in his public criticism of AIG's current management in recent months, told BusinessWeek that he was "stunned as a shareholder, and very disappointed and very upset" at the extent of the losses in the latest quarter.
He says he was surprised by the size of the impairment charges not only in AIG's Financial Products business but also in its partnership and equity investments, as well as how funds were allocated to various asset classes, which he wouldn't elaborate on. The increase in the expense ratio from about 19% a few years ago to the current 26% is also distressing to him.
Downbeat Assessment from Analysts
An AIG spokesperson wouldn't respond to Greenberg's remarks except to say that the motivation behind them should be considered given the multiple lawsuits Greenberg is facing. Among those, AIG is seeking to recover losses that resulted from writedowns and settlements due to accounting irregularities under Greenberg, and the insurer has also sued Greenberg and six other former AIG executives, claiming that after they left AIG in 2005 they illegally seized control of Starr International, an affiliated company that owns $20 billion in AIG shares.
Analyst Cathy Seifert at Standard & Poor's Equity Research said she expected to see weakness in AIG's "outsized" mortgage-related exposures but was "troubled by what we view as a pretty significant deterioration in a number of core insurance underwriting lines." She reaffirmed her hold rating on the stock and stuck to her 2008 earnings estimate of $2.50 per share, but said this forecast assumes underwriting results improve. She also said she believes the company is long overdue for a major restructuring. (Like BusinessWeek, S&P is a division of the The McGraw-Hill Companies (MHP).)
Tom Kersting, an analyst at Edward Jones in St. Louis, went as far as to say there needs to be a change in leadership at AIG, not limited to Martin Sullivan, the chief executive, but the entire management team. "They have come out time and time again on earnings calls and at analyst day [presentations] saying losses will only be this much, and they continue to go up and up," says Kersting. "At this point they have lost most of their credibility."
He lowered his rating on the stock to hold from buy on May 9 after assessing the latest results. "I'm not sure they had or have a complete handle on what's going on with some of their riskier investments," he says.
Dividend Hike Disappointment
The latest results were hurt by a pretax charge of about $9.11 billion for a net unrealized market valuation loss related to super senior credit default swaps held by AIG Financial Products Corp. Another weight on earnings stemmed from $6.09 billion in pretax net realized capital losses, mostly for other than temporary impairment charges in AIG's investment portfolio, which dwarfed $70 million in similar losses recorded in the first quarter of 2007.
Some analysts expressed dismay at the company's plan to raise its quarterly dividend by 10% to 22¢ per share at the same time that it's saying it needs to raise fresh capital. On the May 9 conference call with analysts and investors, Sullivan said the dividend hike reflects "the board and management's long-term view on the strength of AIG's business, earnings, and capital-generating power." The dividend increase will amount to about $200 million in annual expenses, small compared to the amount of capital AIG is trying to raise, the company said.
In a research note that Goldman Sachs (GS) put out on May 8, analyst Thomas Cholnoky said he expected the market to react negatively to the nearly 16% decline in book value and the need to raise capital, which is sure to dilute future earnings per share.
Reacting to Credit Ratings?
"The focus will be on the implications of the capital raise, especially given the company's belief that it has $2.5 billion to $7.5 billion of 'excess economic capital,'" Cholnoky wrote. (That's sharply lower than the $15 billion-$20 billion range prior to the onset of the credit crunch.)
He concluded that the capital-raising effort is primarily a defensive move prompted by Fitch Ratings' downgrade of AIG's claims-paying ability, S&P Ratings Service's downgrade of AIG's debt, and the possibility that AIG may now have to post collateral on its AIG Financial Products exposures. (Goldman Sachs has received compensation for investment banking services from AIG in the past 12 months.)
On the call, Steven Bensinger, AIG's chief financial officer, denied that the plan was directed by rating agencies and said management "felt this was the absolute right thing to do," and should be viewed as a proactive move to be prepared to respond to potential further turbulence in the financial market.
He conceded that the equity offerings would initially lower earnings per share, but said that over the longer term "it is something we hope we can offset by the use of net capital in very productive ways as opportunities manifest themselves over the course of the next few quarters."