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AIG: An Attractive Buy, If...

by: Rakesh Saxena October 13, 2008 | about stocks: AIG    

Rakesh Saxena

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If AIG (AIG) can revert to the traditional actuarial-based, risk-placement business model, it could easily rate as one of the most attractive buys in the market today.

Since credit default protections are not predicated on probabilities derived from credible statistical data, AIG should never have engaged in credit default swaps without a comprehensive re-capitalization. Credit default swaps, due their very nature, bring a number of non-traditional factors into play, e.g. ratings, credit events, counterparty risks and mid-stream shifts in fundamentals. And given that there is no genuinely liquid re-insurance mechanism available in the credit default swap market, entities offering credit risk protection need to be capitalized under a structure quite distinct from that required for traditional insurance activity

Cautionary buying under $2.50 could yield substantial near-term returns if the new AIG management can confirm as a matter of policy that, going forward, the company will adhere to businesses which were, in the first place, responsible for its meteoric rise as the pre-eminent international insurance and re-insurance giant in the second half of the last century.

AIG and, for that matter, a significant segment of the insurance industry worldwide, based premium calculations for regular businesses classes on well-researched statistical computations. Those same computation methodologies created the foundations for risk transfers within the insurance matrix. Nobody can doubt that the system was working.

In sharp contrast, risk premiums on credit default swaps were being driven by rating and balance sheet considerations, and by the assumption (misplaced, in hindsight) that there full compliance with the rigid valuation standards was in place. But, valuations apart, an entity pricing risk which cannot be traded must conform to an entirely different, and onerous, set of capital adequacy ratios; otherwise, as in the case of AIG, accumulating obligations to pay pre-determined values for underlying reference instruments in the event of default must result in huge, and unacceptable, contingent mismatches in financial statements.

All that said, AIG’s regular and commonly-recognized businesses constitute a compelling franchise with a far-reaching international reach. AIG’s life and non-life subsidiaries in the developing world are leaders in their domestic markets; AIG has been known to enhance its country exposures by employing hedge contracts (like currency forwards) with ruthlessly efficiency. Furthermore, regardless of AIG’s conservative stance with respect to coverage periods, it remained a key price-maker in the political risk insurance market.

Whether the recommended shift back to the traditional will actually materialize is still an open question. But the AIG brand does incorporate the ingredients to move AIG shares to well over $20 during the second-half of 2009.

Disclosure: Author holds a long position in AIG

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This article has 7 comments:

  •  
    Oct 13 07:36 AM
    Not so quick...AIG has gotten itself into a horrendous mess and just because the gov't has advanced them enough money to keep them afloat for now doesn't mean this company can pay off it's debt and resurrect itself again as a substantial insurance company.

    Why? For one reason I am skeptical that the non-insurance assets that they want to sell to pay off their losses in CDO's and the loans from the gov't will not be enough. This would lead to the selling of their prize assets that u r relying on in ur argument to resurrect AIG as a viable insurance entity.

    U have seemed to buy into managements argument which on the surface can be a compelling story. The trouble is that new management is trying to put a positive spin on their actions to right the ship which is predictable but not always as accurate as they would have one believe.

    U and I really do not have the access to see inside this company to see how deep their money problems go. It is possible that management itself still cannot figure it out so I'm not so sure u should be painting a rosy picture at the end of the tunnel until it is clearer on how deep their financial problems go.

    Another indicator is that all private equity that could buy AIG as a whole if they believed what you do have shown no interest in the firm as a whole just cherry picking some of better assets at fire sale prices.

    Good luck with ur speculation but my instinct tells me to wait until I see more evidence that those insurance assets will be there in the longer run.
    Reply
  •  
    Oct 14 12:12 AM
    Do you know of anyone going bankrupt? They go out and buy lots and lots of stuff. They know they will not have to pay it back and live it up.

    Who do we know that just did that? AIG. They had a half million dollar party in California after getting an $85 billion dollar bailout. It is my understanding that they are on the hook for $225 billion of Lehman loans, and it comes due on 10/24/08. I am thinking that if they need to get bailed out, they are not going to pony up $225 billion.

    But what do I know. I just draw bad cartoons.

    Clark Jenkins
    FishGoneBad.com
    Reply
  •  
    Oct 14 01:31 PM
    You may be right (comments), but I too am long AIG!!!
    Reply
  •  
    Oct 15 05:49 AM
    Rakesh, you are quite correct. I think it will happen that way.
    Since playing stocks are kind of like putting bets on
    horce-racing, so why not . At least it won't go down to zero.
    Reply
  •  
    Oct 15 07:36 AM
    There's also no guarantee that even if the AIG as a business survives, the holding company in which common shareholders own equity will. AIGs insurance operations could be reorganized into a new, separate, debt-free entity, leaving existing common shares worthless.

    It's happened before. Look into the demise of Penncorp Financial a few years back. All the insurance subsidiaries survived in tact, but PFG, the holding company, was gutted. There was not a thing common shareholders could do.

    Note that the government made a point of buying equity in AIG through **preferred shares,** not common shares.
    Reply
  •  
    Oct 15 01:55 PM
    Dear president_war_pig

    There is a huge misunderstanding of the investment vehicle opted by the government for AIG.

    Let's not forget about the fact that the goverment aid was a loan. It was not common stock or preferred stock. A loan was extended to AIG (=> borrower) by the goverment (=> lender). As of today, the government has no preferred stocks outstanding with AIG even though the loan money is outstanding. More correctly, it is preferred convertible bond, not convertible preferred stock. It is a loan to be converted into preferred stocks that guarantee 79.9% ownership IF AIG cannot pay off the loan. Paying off the loan or not is the trigger for issuance of the preferred stocks with 79.9% ownership. Right now, the government does not have any ownership of AIG since it is a loan. The goverment is just a lien holder as lender, and AIG is a borrower who is paying 11% annual interests to the lender. I hope it makes better sense to you.


    On Oct 15 07:36 AM president_wa r_pig wrote:

    > There's also no guarantee that even if the AIG as a business survives,
    > the holding company in which common shareholders own equity will.
    > AIGs insurance operations could be reorganized into a new, separate,
    > debt-free entity, leaving existing common shares worthless.
    >
    > It's happened before. Look into the demise of Penncorp Financial
    > a few years back. All the insurance subsidiaries survived in tact,
    > but PFG, the holding company, was gutted. There was not a thing common
    > shareholders could do.
    >
    > Note that the government made a point of buying equity in AIG through
    > **preferred shares,** not common shares.
    Reply
  •  
    Oct 15 08:32 PM
    Just reading the posts listed above, and some pretty good dd has been done. Has any company been in debt to the tune of 125+b. An may be more in debt that this. They do bring in very large sums of cash per year, and would be able to pay off the debt, but in two years, would have to sell their money making businesses to pay it. what would be left
    Reply
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