The Wall Street Journal-20080213-Is AIG on Slippery Slope-- Change in Accounting Of Subprime Exposures Threatens Credibility

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Is AIG on Slippery Slope?; Change in Accounting Of Subprime Exposures Threatens Credibility

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Since taking over in 2005 as American International Group Inc.'s chief executive, Martin Sullivan has pushed the big insurer to be transparent, hoping to move past the accounting scandal that helped get him the top job.

Suddenly, though, analysts and investors are trying to assess the significance of a new accounting problem that has put Mr. Sullivan in an awkward spot: the "material weakness" that AIG's auditor found relating to exposure to subprime-linked securities.

So far, Wall Street seems willing to cut him some slack -- but patience is limited. After sinking to a five-year low Monday, AIG shares rose 3.1%, or $1.40, yesterday to $46.14 in 4 p.m. composite trading on the New York Stock Exchange.

The scope of the accounting problems appears far narrower than those that swamped the insurer in 2005 and led to the exit of longtime leader Maurice R. "Hank" Greenberg. It also helps AIG that so many other financial companies are wrestling with the valuations of their own subprime exposures.

Still, the current situation could become more painful, especially if AIG has to keep on valuing its exposures in the same way going forward. The change the company announced Monday increased the size of its write-down for a single month, November, by $3.6 billion.

For the full fourth quarter, Goldman Sachs analyst Thomas Cholnoky estimated in a research report yesterday that AIG may be forced to write down $10 billion for those exposures. AIG hasn't announced when it will report quarterly results, but it has until Feb. 29 to file its annual report.

"The estimated market values are having a real-world impact in that they reduce reported earnings, they reduce reported shareholders' equity," says Bruce Ballantine, an analyst at Moody's Investors Service. They also could reduce the company's financial flexibility "to some extent."

Yesterday, both Moody's and Standard & Poor's said they revised their outlook on AIG downward to "negative" from "stable." Among the things S&P said could trigger a downgrade is "if accounting losses are sufficiently large to cause market issues for the company." It added that a downgrade could follow if it determines the material weakness is "significant."

The hit to AIG's credibility was severe not just because of the size of the change in the expected write-down but because analysts and investors found the company's explanation of what caused the increased loss to be difficult to decipher.

At issue for AIG is the valuation of a portfolio of what are essentially insurance contracts that the company sold, known as credit default swaps.

The swaps serve as credit protection on, among other things, $62.4 billion in collateralized debt obligations, or CDOs, backed by collateral that includes subprime mortgages.

The key question now: How to value that portfolio? These kinds of highly specialized instruments aren't traded even in normal circumstances, making them hard to price. Valuing them becomes more difficult when the market for the securities and assets they're linked to is in the kind of distressed situation that currently exists.

Analysts believe AIG originally valued these contracts by looking to prices supplied for a pool of CDOs, among other factors. The company then adjusted these values based on indexes that track subprime securities, analysts surmise.

But AIG didn't directly apply the loss implied by a fall in CDO values because the contracts it had written tend to trade at a premium to the instruments they are insuring. AIG held these contracts, not the underlying CDOs.

AIG's auditor, PricewaterhouseCoopers LLP, appears to have taken issue with the process. That prompted AIG to use market prices of CDOs, which in many cases are considered to be at fire-sale levels, rather than values for a pool of CDOs. In addition, the insurer eliminated the premium that typically applies to the value of the insurance contracts. That was done because it said market conditions had become too uncertain to calculate this.

The moves seem designed to make AIG's valuation place greater weight on market factors that immediately affect the value of the company's contracts. AIG's models seemed to place less emphasis on this and greater weight on the fact that the company doesn't believe it will ultimately suffer losses related to the contracts.

Yesterday, AIG drew a distinction between whatever losses it records based on the current value of the portfolio (an estimate of what someone would pay to take the risk off AIG's hands) and what it may actually have to pay to fulfill its obligations under the contracts.

In a statement, the company said it believes any losses "will not be material."

That calmed investors a bit. "That was a minorly helpful statement," says Ed Walczak, who runs the U.S. value funds for Vontobel Asset Management Inc., which has 3.5% of its $350 million holdings in AIG. As for the company's overall situation, "the grounds are still changing," Mr. Walczak adds.

Still, the wording of yesterday's statement varied slightly from AIG's statement last fall that it was "highly unlikely" the company would have to "make payments" on the portfolio, Kathleen Shanley, an analyst at Gimme Credit, noted in a report yesterday.

"'Not material' can still be a pretty big number when you are talking about a firm the size of AIG," Ms. Shanley wrote. "And investors are right to wonder if the next step on the slippery slope will be from 'not material' to 'material,' especially considering that AIG has not yet finalized its year-end numbers."

In response, a spokesman for AIG said of the prospect of any losses: "We would say it's slightly less than 'highly unlikely,' simply because of further deterioration in the default frequency of underlying mortgages." But if there were any losses, he added, "they would be immaterial" to the company's income statement or balance sheet.