The Wall Street Journal-20080212-AIG Is Forced To Write Down Mortgage Links- -Material Weakness- Found in Accounting- Stock Hits 5-Year Low

Return to: The_Wall_Street_Journal-20080212

AIG Is Forced To Write Down Mortgage Links; 'Material Weakness' Found in Accounting; Stock Hits 5-Year Low

Full Text (963  words)

American International Group Inc., which has struggled to recover from an accounting scandal, will be forced to write down the value of financial instruments tied to mortgages after its auditors said they had found "material weakness," in its accounting systems, a signal that accounting firms may get tough on already battered financial giants.

The finding by AIG's auditors, PricewaterhouseCoopers LLP, forced the big insurer to lower the value of insurance contracts it holds by an estimated $4.88 billion, before tax. Late last year, AIG went to great lengths to tell investors about the company's exposure to subprime mortgages and estimated its losses on those instruments would be much smaller, just above $1 billion for October and November.

The write-down is a blow to Chief Executive Martin Sullivan, who took over AIG from longtime leader Maurice R. "Hank" Greenberg amid an accounting scandal in 2005 and has fought to improve the company's disclosure and put to rest criticisms that AIG manipulated earnings.

"I think that's going to give the market a fair amount of concern," Andrew Kligerman, an analyst at UBS Securities LLC said of the auditors' finding.

Investors sold AIG's shares aggressively, sending them down $5.94, or 12%, to $44.74, a five-year low, and below its nadir during its accounting scandal. The decline wiped out $15 billion in stock market value and was the biggest percentage drop for AIG's shares since the 1987 stock-market crash. AIG's shares have lost a third of their value in the past year and are down 23% this year. Bond-rating firm Fitch Ratings announced yesterday that it is putting AIG's issuer default rating on "negative" watch.

"AIG had made significant strides in putting the accounting and regulatory issues of the Greenberg years behind it," GimmeCredit analyst Kathleen Shanley said in a report yesterday. "But the latest disclosures about a 'material weakness' in the internal controls related to the company's credit default swap portfolio undermines credibility with investors."

Another big insurer, CNA Financial Corp., was hit yesterday with $61 million in write-downs on subprime securities. Shares of the insurer, which is controlled by Loews Corp., fell 19% to a three-year low of $26.07, on the write-down and a weak outlook for the year.

The move by PricewaterhouseCoopers comes as auditors are poring over the year-end financial statements of hundreds of companies that hold securities tied to mortgages. Already, firms have announced more than $100 billion in mortgage-related write-downs, and investors fear many more are still to come.

"It will be interesting to see if there will be similar material weaknesses cited for other latecomers to the write down game," said Mark Cheffers, chief executive of Audit Analytics, a research firm that tracks financial reporting errors.

PricewaterhouseCoopers's finding that there was a material weakness in the internal controls used to value the insurance contracts is one of the first of its kind involving a major company since the financial crisis erupted last August, said Mr. Cheffers. He added that more such findings could come as auditors go through year-end numbers, which are more closely scrutinized than quarterly figures.

For AIG, having an auditor say it had weak internal controls was a serious blow. The company had long been considered too complex and opaque for investors to thoroughly analyze. To own the stock, investors essentially had to take the company at its word that its accounting systems were solid. Other big financial companies such as Freddie Mac and Fannie Mae haven't recovered from the exposure of their accounting systems as flawed.

AIG said in an SEC filing disclosing the auditor's finding that its "assessment of its internal controls" related to valuing the portfolio "is ongoing," but said it believes that it now has the "necessary compensating controls and procedures to appropriately determine the fair value" of the portfolio for its year-end financial results.

At issue was the way AIG valued credit default swaps, which are contracts that insure against default of certain securities. In valuing those swaps, AIG had benefited from what it assumed were differences in value of the swaps and the securities they were insuring. Now, its auditor has found the material weakness in the way the firm valued the swaps; AIG says it won't rely on the gains from such differences because market conditions have grown so murky.

AIG was put in this awkward position because it had disclosed the value of these holdings during investor updates at the end of last year. Those updates covered only the first two months of the fourth quarter, meaning additional write-downs could come when AIG includes December, when values of these securities fell further. AIG has until Feb. 29 to file its annual report.

AIG said in its SEC filing that it took the action in part because of "current difficult market conditions" and that it wouldn't use that method to report its year-end financial results.

The accounting firm's actions are in line with a push by auditors to force companies to use market values for securities they hold even if there is little trading going on. That, some observers believe, has accelerated the pace of write-downs in recent months.

The practice is also at odds with executives who say they believe that it would be better to look to the long-term value of securities rather than at distressed prices being thrown out by markets that in many cases have ceased functioning.

Not everyone gives the auditors, or even PricewaterhouseCoopers in this case, such high marks, though. The finding of a material weakness by PricewaterhouseCoopers, was "absolutely" a step in the right direction, said Janet Tavakoli, president of Tavakoli Structured Finance Inc., a Chicago research firm. But she said that disclosures were still insufficient in regard to the way AIG and others are coming up with values for such complex securities.