Thursday, August 20, 2009

AIG: The Lesson Not Learned

Almost a year ago in the aftermath of the Lehman Brothers collapse, our government decided to change tactics and bailout AIG. We were told that failure to step in would result in a global disaster as the "insurance" company was essentially bankrupt but too interconnected to be allowed fail. AIG's problems were due to their exposure to Credit Default Swaps and other derivative products that obligated the company to make up for losses in various fixed income products. Naturally, the worst losses were related to mortgage related structures.

Although the complete details of their exposure remain, in my opinion intentionally, a mystery, we do know that the government contributed several billion dollars in different facilities and guarantees (I believe the analysis done by Propublica here looks reasonably accurate). We were also told that the company would sell its assets to repay the government. Since the assets, to my knowledge, look to be worth less than the government's stake, the expectation is that the equity is worth zero. Of course, nobody knows the future, and there is a lottery ticket chance that AIG makes a lot of money from asset sales, or that their obligations are worth a lot less than the market says right now, or that their accounting is wrong and they do not really owe anything, or that this has all been a nightmare and we really never had a housing collapse and prices indeed have never gone down, but I digress.

So, using the time-honored Cartesian analysis here are the facts:

  • AIG still owes the government several billion dollars and they have not sold many assets.
  • At least some of their senior bonds are offered at $90 for 2010 maturity. In case you care to buy some, yields are 15% and higher.
  • 5Y CDS are offered at 21 points +500bps which means dealers still charge a steep price for AIG protection (as a rule the points reduce your protection making it more expensive).
Opinions are a dime a dozen but I would pay attention to CDS dealers since they actually put money on the line. Clearly these guys don't think the common equity is worth $4.5B as implied by an AIG-common price of $33.50.

So why is AIG up over 100% in less than a month?

Wouldn't you know? Because the new chairman gave a pep-talk to the troops (here). Of course there is nothing wrong with an all-American pep-talk and Benmosche, his troops, and equity holders can believe whatever they want, except for this.

In other words, we have two alternative theories:

1) Things are much better at AIG than the CDS dealers, Paulson, Bernanke, Geithner, and Liddy, among several well informed players, had anticipated and the company just needed a leader with a vision. Or,

2) Benmosche landed a prime-job in this difficult economy and sees nothing wrong with talking up his stock while offering a wildly optimistic assessment of the company.

Naturally, as was the case with Mozillo who famously announced a positive quarter for Countrywide right before selling the company to Bank of America, or Dick Fuld rebuffing a $10 offer for Lehman right before it went to zero, you never quite know what these CEO's really think. While it is clear that Mozillo knew he was lying it is possible that Fuld believed his own statements at that time.

The facts, however, seem to point to option (2) above. The fact that nobody can prove what is really in Benmosche's mind does not obscure the obvious conflict of interest or the incredible compensation package for what is in essence a government job.

I am sure that many would argue that talking up the assets will eventually benefit the taxpayer as we may get more of our money back. Notwithstanding the fact that it is unlikely that potential buyers of AIG assets will ignore the prices in the CDS market, I believe that our government is following a dangerous road if they are attempting to make money by deceiving the potential buyers. In addition, I am not sure how good people would feel if they found out that the assessment made by Bernanke et al about the seriousness of the AIG situation proved to be totally incorrect in less than a year. After all, a great deal of trust (and money) has already been invested in the judgment of these individuals.

In my opinion, the real problem we continue to have is that we, as a society, seem to want to continue to play this duplicitous game. On the one hand, we know that the crisis was really our fault because we allowed a few individuals to run amok with our financial system. On the other hand, we try to play the game one more time to see if we can avoid paying for the losses. In this instance, we have given Benmosche a big payout in the hope that he can make magic and turn around what US government had deemed a financial house of cards. Furthermore, it seems to me that Benmosche's behavior is entirely rational. It pays for him to believe. Whether it pays for us is another story.

As for the lawyers at the SEC investigating this guy for stock manipulation you can rest assured that it will not happen. The most likely scenario is that, after all is said and done, he will declare that he didn't know things at AIG were as bad as he discovered later. Or that he thought the recovery would be far stronger. By then he will probably be in agreement with Liddy, Geithner, and everyone else on the list.

caveat emptor

Disclosure: long AIG debt, short AIG common (much smaller position). By the way, I am disclosing my positions for the sake of fairness. My purpose here is NOT to give financial advice.

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