Wednesday, December 17, 2008

Blackholios and dark matter

Dec. 17 (Bloomberg)
By James Sterngold

American International Group Inc., which already has suffered more than $60 billion in writedowns and losses, may have to absorb almost $30 billion more because of flaws in the way its holdings are valued.

An examination of AIG’s credit-default swaps guaranteeing more than $300 billion of corporate loans, mortgages and other assets not covered by a $152.5 billion federal rescue shows the New York-based insurer may value some of its positions at levels that don’t reflect distress in the markets, according to an analyst at Gradient Analytics Inc. and a tax consultant who teaches at Columbia University Business School in New York.

Robert E. Lewis, AIG’s chief risk officer, said the company has properly valued all of its swaps and underlying assets and doesn’t need to take additional writedowns.

The U.S. rescue plan announced in November, the government’s second effort to save AIG, covers only its most troubled credit-default swaps, about 20 percent of the $377billion on the insurer’s books as of Sept. 30. Under the plan, a new government-backed entity will acquire collateralized debt obligations with a face value of $72 billion that had been insured by AIG swaps. An initial transfer of $46.1 billion of CDOs was announced on Dec. 2. A second fund bought troubled residential mortgage-backed securities with a face value of $39.3 billion, AIG said on Dec. 15.

In November 2007, when AIG reported a $352 million loss on its swaps, it said it was “highly unlikely” the insurer would have to make payments on them. And last December Sullivan assured investors that losses from swaps on U.S. subprime mortgages were “manageable.”

AIG swaps not covered by the government program include guarantees on $249.9 billion of corporate loans and residential mortgages, most of them made by banks in Europe, according to the company’s third-quarter 10-Q filing. There are also swaps covering $51 billion of collateralized loan obligations, or CLOs, and $5 billion of lower-rated mezzanine tranches.

Writedowns on these AIG holdings total less than $1.5 billion so far this year, according to company filings, compared with $20 billion for the swaps guaranteeing the $72 billion of CDOs being acquired under the federal rescue.

Based on the loss AIG has reported, as well as indexes showing declines in the value of European corporate loans and prime mortgages, Vickrey estimated that AIG may face at least $15.6 billion of additional writedowns on its swaps with the banks. He said other swaps not covered by the government rescue, including those on CLOs and mezzanine tranches, may result in another $12.6 billion of losses.

“That’s based on what we know currently, and it could be higher,” he said.

Estimating the size of future writedowns is difficult because AIG doesn’t disclose details about many of the underlying assets.

Lewis, the AIG risk officer, said in an interview that the company has “limited information” on which to base the value of most of the European loans and mortgages it has guaranteed.

AIG’s view on valuing its swaps with European banks turns on an interpretation of accounting rules involving risk transfer.

Lewis said the insurer normally marks the value of the assets underlying swaps to market levels since it is taking some risk in the transactions. The swaps with the European banks are different because they didn’t insure against losses, he said. Instead, they were bought to take advantage of European accounting rules that allow the banks to use the swaps to reduce the capital they’re required to set aside as loss reserves.

The swaps are kept in place only until new accounting rules, known as Basel II, are phased in. Those rules eliminate the ability of financial institutions to reduce the capital they need to set aside by buying swaps. Once the rules kick in, Lewis said the swaps will be terminated.

Lewis said the insurer had unwound $95 billion of these regulatory-capital swaps without any losses as of the end of the third quarter. And Gerry Pasciucco, hired from Morgan Stanley on Nov. 12 as interim chief operating officer of AIG’s financial- products subsidiary, said the company continues to “experience early terminations according to our schedule at par.”

As a result, Lewis said, even if the assets underlying the remaining swaps fall in value, AIG isn’t required to mark them to lower market levels.

That’s because, as the insurer said in its third-quarter filing, it “estimates the fair value of these derivatives by considering observable market transactions.” And the only relevant transactions are the swaps AIG has successfully unwound with the European banks, according to the filing.

AIG’s interpretation of accounting rules is different than that of Robert Willens, CEO of Robert Willens LLC, a corporate tax and accounting advisory firm in New York, and a professor at Columbia. He said AIG can’t have it both ways, calling the transactions swaps and then saying there’s no risk.

“If these are bona fide swaps, you look at them like any other transaction of this type with a transfer of risk,” Willens said. “If they do that, there would probably be very substantial writedowns because of what we’re seeing in the markets. If you’re using a different paradigm and saying there’s no risk transfer, these aren’t credit-default swaps. You’re getting a fee for renting the counterparty your name. There’s no third approach. The purpose of the swap is totally irrelevant.”

Stephen Ryan, a professor of accounting at the Stern School of Business at New York University, said that if the swaps reduce potential losses faced by European banks there must be some transfer of risk and AIG must mark the assets to market by looking at a broad array of similar credit-default swaps, not just other swaps that were unwound without losses.

“I can’t believe the banks’ intent affects the contractual terms” of the swaps, Ryan said.

Two other companies that sold swaps to European banks also disputed AIG’s interpretation of accounting rules. C. Robert Quint, chief financial officer of Radian Group Inc. in Philadelphia, and Steven Kennedy, a spokesman for Bermuda-based Primus Guaranty Ltd., both rejected the idea that how a swap is used can affect its accounting treatment. They said their firms mark their swaps to market to reflect price declines.

“We did some of that business, but we’re an insurance company, so we don’t care what purpose the counterparty is using the swap for,” Quint said.

Lewis said AIG would only have to revalue the underlying assets if the banks that bought the swaps no longer used them to meet capital requirements.

That’s what happened in this year’s second quarter with one European bank that purchased a swap to cover $1.6 billion of mortgage-backed securities. When AIG determined the purpose of the swap wasn’t to reduce capital requirements, it took a loss of $397 million, equal to about 25 percent of the face value of the assets, according to company filings.

AIG spokesman Nicholas Ashooh said the case was unusual because the swap covered mortgage-backed securities, not just pools of mortgages like the other European swaps. He added that even if other swaps required writedowns, the losses wouldn’t necessarily be 25 percent of face value.

Ashooh also explained that, under the terms of most of the swaps, the European banks would have to absorb about 10 percent to 15 percent of any losses from defaults before they could turn to AIG. That also reduces the insurer’s risk, he said.

That’s not how Vickrey of Gradient Analytics sees it. While the logic might be sound under normal circumstances, he said these aren’t ordinary times. With economies shrinking and markets falling, the European banks that bought the swaps may face such high levels of defaults on their corporate loans and mortgages that they would need to alter the purpose of the swaps, requiring revaluations.

AIG acknowledges such a possibility in its 10-Q filing. “Given the significant deterioration in the credit markets and the risk that AIGFP’s expectations with respect to the termination of these transactions by its counterparties may not materialize, there can be no assurance that AIG will not recognize unrealized market valuation losses,” the company said. AIGFP is the insurer’s AIG Financial Products unit that sold the swaps.

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