AIG’s $5 Billion Write-Down Has Rating Agencies, Wall Street Concerned

Some observers speculate the fallout could lead to additional woes for AIG including possibly CEO Sullivan’s exit

While American International Group Inc. sought to downplay its miscalculation of losses on a derivatives portfolio as not “material to the company,” Wall Street was abuzz with speculation over whether the mistake could lead to a change at the top of the giant insurer and whether other insurers might be in the same fix.

Ratings agencies, too, expressed their concerns over the potential impact.

In a Feb. 11 filing with the Securities and Exchange Commission, AIG revised earlier reports and disclosed that it now estimates that its unrealized losses on a credit default swap portfolio within AIG Financial Products (AIGFP) would be just shy of $4.8 billion through November, more than triple its previous disclosure of $1.15 billion.

The company has not yet determined its losses on the portfolio in December. Its fourth quarter earnings report is expected later this month.

AIG acknowledged that the almost $5 billion error in valuation was due to a “material weakness” in its internal accounting procedures.

The news sent AIG shares down nearly 12 percent and has raised concerns on Wall Street.

The next day, AIG tried to calm Wall Street.

“AIG continues to believe that the losses are not indicative of the losses AIGFP may realize over time. Based upon its most current analyses, AIG believes that any losses AIGFP may realize over time as a result of meeting its obligations under these derivatives will not be material to AIG,” the firm said in a statement.

In early November, AIG President and CEO Martin J. Sullivan told Wall Street that the company could handle its mortgage exposure and that it was “highly unlikely” that AIGFP would be required to make payments with respect to these derivatives.

“While U.S. residential mortgage and credit market conditions adversely affected our results, our active and strong risk management processes helped contain the exposure,” he said at the time.

But according to Fitch Ratings, AIG has “relatively large exposure to the current U.S. residential mortgage crisis.”

AIG sold credit default swap contracts to holders of collateralized debt obligations, or CDOs. These contracts pay when there are defaults on the underlying debt. With the number of mortgage foreclosures escalating across the country, the value of these AIG’s derivatives contracts is in question.

Fitch said that AIG had $505 billion in exposure to its credit derivative portfolio in late September, including $62.4 billion of CDOs backed by subprime mortgages.

Fitch has stated that it believes AIG will not be immune to potential losses from U.S. residential mortgage crisis, although at the present time the agency believes these losses should be absorbed by the existing capital base and future earnings stream.

However, Fitch said there is now additional uncertainty to the potential impact on the financial statements. It has placed AIG’s Issuer Default Rating, holding company ratings and subsidiary debt ratings, including International Lease Finance and American General Finance on Rating Watch Negative.

AIG has said that it now has procedures to appropriately determine the fair value of AIG FP’s portfolio. Fitch said it would assess these procedures after reviewing the 2007 audited financial statements.

If weakness at AIGFP leads to a rating downgrade at the holding company, Fitch said it believes the magnitude would be limited to one notch.

S&P Outlook

Standard & Poor’s Ratings Services revised its outlook on AIG and AIG’s core insurance operating subsidiaries to negative from stable.

Standard & Poor’s credit analyst Rodney Clark said the valuation adjustment is “likely to be significant, and will likely cause AIG to report an accounting loss for the quarter, more than offsetting strong fundamental operating earnings in its core insurance businesses.”

However, he added that changes to the fair value measurements affect only the reported market valuation of the securities, and do not affect the ultimate economic losses to AIG under these contracts.

Standard & Poor’s said it believes that all financial firms engaged in similar business are facing substantial difficulties in credit default swap exposure; however, AIG is the first financial firm to disclose a material weakness in this area, which raises concerns about the valuation models and approach. It could be two or more quarters before the valuation of these items becomes clear enough to understand the maximum downside risk, according to Standard & Poor’s.

A.M. Best

Three days after AIG’s announcement, A.M. Best Co. responded by placing the financial strength rating (FSR) of “A++” (Superior) and issuer credit ratings (ICR) of “aa+” of the domestic life and retirement services subsidiaries of American International Group (AIG) under review with negative implications.

In addition, A.M. Best has placed the FSRs of “A+” (Superior) and ICRs of “aa-” of most of AIG’s domestic property/casualty subsidiaries and AIG’s 60 percent majority owned company, Transatlantic Holdings Inc. under review with negative implications. The FSRs and ICRs of these rating groups incorporate implicit support from AIG.

The fair value losses associated with declines in valuations of this particular swap portfolio do not necessarily reflect permanent economic losses but a change in the fair value assessments of the underlying collateral, which includes a mix of approximately 50 percent subprime mortgages as well as asset backed auto loans, credit cards and other collateral, according to A.M. Best, which added that it believes it is likely that true economic losses will not reach the level of fair value accounting adjustments.

A.M. Best said that it “understands that the fair value valuation is exceptionally difficult given market conditions; however, the decline in valuation, negative earnings implications and accounting conclusions are representative of the risk inherent in this business.”

The implied support incorporated into the operating subsidiary ratings will need to be re-evaluated in light of the financial volatility caused by AIG’s derivatives business, A.M. Best said. A.M. Best said that the support incorporated into the subsidiaries’ rating also relies on AIG’s financial flexibility, which it said it continues to believe is significant.

However, the ratings firm added that “that flexibility has been modestly compromised by a decline in stock value, higher financial leverage and tightened credit markets.”

A.M. Best reported that its concerns are tempered by the “strong franchise value and sustainable competitive advantages of AIG’s property/casualty and life and retirement services operating segments, ability to generate significant earnings, overall diversification and considerable intellectual capital.”

A.M. Best said it will re-evaluate the company’s status after seeing the 2007 year-end results and discussions with AIG management.

Sullivan at Risk

There could be additional fallout for AIG from this episode. Wall Street watchers including Bloomberg News have spoken with investors and analysts who speculate that CEO Sullivan could lose his job over this. They also suggest that investor lawsuits and an SEC probe are possible.