S&P Revises Outlook on AIG

February 12, 2008

American International Group Inc. may be quite sanguine about its financial outlook (See related article), but Standard & Poor’s Ratings Services isn’t quite as confident. S&P announced that it has revised its outlook on AIG and its core insurance operating subsidiaries to negative from stable.

However, S&P did affirm its ‘AA’ counterparty credit ratings on AIG and its ‘AA+’ counterparty credit and financial strength ratings on AIG’s core subsidiaries.

The action follows the filing of AIG’s 8-K report released by AIG regarding “clarifications to its methodology for determining fair values on its super-senior credit default swap portfolio covering multi-sector collateralized debt obligations (CDOs), which include subprime residential mortgage-backed (RMBS) collateral,” said credit analyst Rodney Clark (See related articles). AIG also reported that PricewaterhouseCoopers (PWC), its external auditor, has concluded that there is a “material weakness in internal controls over the valuation of these securities,” S&P noted.

Clark explained that the “clarifications to the valuation methodology relates to certain beneficial items in the prior methodology (negative basis adjustment) that the company is no longer able to calculate due to the lack of reliable market data in the current illiquid markets. As a result, the valuation adjustment as of Dec. 31, 2007, 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.”

S&P took pains to point out that the “changes to the fair value measurements affect only the reported market valuation of the securities, but do not affect the ultimate economic losses to AIG under these contracts.” The rating agency acknowledged that it is “evaluating the underlying securities in these pools, and although results are still preliminary, we expect ultimate losses will be meaningfully less than the mark-to-market losses, which would indicate a future recovery of most of the market value losses that will be reported in the company’s 10-K.”

Moreover, the disclosure of the material weakness in controls has led S&P to believe that “all financial firms engaged in similar business are facing substantial difficulties in the current illiquid market in valuing their RMBS, CDO, and related credit default swap exposure.”

However, as AIG is the first financial firm to disclose a material weakness in this area, it “raises concerns about the valuation models and approach.” S&P noted that “AIG believes that it has necessary compensating controls and procedures in place, and the rating agency is planning to evaluate those controls as part of its financial review.

“The negative outlook reflects ongoing uncertainty in the ultimate losses (both accounting and economic) relative not only to AIG’s super-senior CDS exposure, but also its holdings of RMBS and CDOs in insurance company portfolios, its mortgage insurance business, and in direct consumer lending,” said the bulletin. “S&P went on to note that in fact it could be “two or more quarters before the valuation of these items becomes clear enough to understand the maximum downside risk.”

In conclusion S&P said that if the “economic value of losses on these investments, offset by core earnings, will not materially impact risk-adjusted capital, then the ratings could be affirmed and the outlook revised to stable. If, however, economic losses are more material, or if accounting losses are sufficiently large to cause market issues for the company, then the ratings could be lowered by one notch.”

S&P warned, however, that it will “investigate further the nature of the issues that led to the material weakness disclosure, and could respond with a downgrade if the weakness is deemed to be significant.”

Source: Standard & Poor’s – www.standardandpoors.com

Topics Profit Loss Trends AIG

Was this article valuable?

Here are more articles you may enjoy.