Investors and rating agencies reacted negatively to disclosures by American International Group about a derivative portfolio, which included the revelation that its auditors gave the thumbs down to the company's internal controls for financial reporting.
AIG's potential losses from its investments in certain derivatives could range from not material to a total write-off of earnings for fourth-quarter 2007, a Citigroup analyst said in a note to investors last week.
In addition, rating agencies, reacting to the failing grade delivered to AIG by its auditors in connection with the valuation of a credit default swap portfolio of AIG Financial Products Corp., said they would put a negative outlook on some of the insurer's credit ratings.
The credit default swaps, the rating agencies explain, are contracts that AIGFP wrote against defaults on collateralized debt obligations (CDOs), which include subprime mortgage content.
The New York-based insurer disclosed the view of its independent auditors, PricewaterhouseCoopers LLC, in 8-K filing with the Securities & Exchange Commission last Monday.
The filing revealed the auditors' conclusion that AIG "had a material weakness in its internal control" over financial reporting related to the valuation of AIG Financial Products Corp. super senior credit default swap (SS-CDS) portfolio as of Dec. 31, 2007.
Chicago-based Fitch Ratings was the first rating agency to react, putting the insurer on Rating Watch Negative, with Standard & Poor's and Moody's following a day later.
By 2 p.m., the company's shares on the New York Stock Exchange, which had closed the previous Friday at $50.68, were down to $44.84 a share. Prices hovered in the $45-to-$46 range for much of the week.
In a statement released on Tuesday morning, the company said: "AIG continues to believe that the mark-to-market unrealized losses on the super senior credit default swap portfolio of AIG Financial Products Corp. are not indicative of the losses AIGFP may realize over time."
"Based upon its most current analyses, AIG believes that any losses AIGFP may realize over time as a result of meeting its obligations under these derivatives will not be material to AIG."
In addition to disclosing the issues of the auditors, AIG, in its 8-K filing also sought to clarify and expand on prior disclosures about methods used to put fair values on the credit default swap portfolio in question.
Reacting to the disclosure, the Citi note to investors prepared by analyst Joshua Shanker said that trying to project the potential consequences of this portfolio "involves looking into a box so dark it is difficult to see in or out."
Mr. Shanker quantified AIG's comments as saying that AIG's "worst-case scenario" will be that it writes off all subprime collateral rated "triple-B" or lower for the second half of 2005, all 2006 and 2007 subprime, and all CDOs rated "A" or lower, and only suffers a $600 million loss.
But Mr. Shanker said the numbers could be much bigger. He said that AIG said the portfolio observed a mark-to-market loss of $1.6 billion as of Nov. 30, 2007.
"That number could be as high as $6 billion, compounded by any further deterioration observed in the past 11-to-12 weeks," Mr. Shanker said.
Citi, he said, is assuming a $5 billion loss, bringing its estimate of AIG's fourth-quarter earnings per share down to zero.
Separately, billionaire investor Warren Buffett in a comment to CNBC last week about AIG's financial disclosure said it is "very, very, very tough to evaluate a lot of these securities."
"You know sometime back I called them–derivatives–'weapons of mass destruction.' I probably should have called them 'weapons of selected destruction,' but it's been pretty massive in some cases," he said.
In its announcement last Monday, Fitch said its Watch affected AIG's issuer default rating, holding company ratings and subsidiary debt ratings, including International Lease Finance and American General Finance.
Fitch said the material weakness cited by the auditors, together with current market conditions, contributes to uncertainty regarding the valuation of AIGFP's SS-CDS portfolio prior to the publication of Dec. 31, 2007 audited financial statements.
AIG's announcement, Fitch said, indicates that it believes it has compensating controls and procedures to appropriately determine the fair value of AIGFP's portfolio. Resolution of Fitch's Rating Watch, the firm said, will include an assessment of these procedures. AIGFP's obligations are guaranteed by AIG.
AIG, said Fitch, has relatively large exposure to the current U.S. residential mortgage crisis. The firm said it believes the area of AIG most exposed to further deterioration in this market is the credit derivative portfolio within AIGFP, with its large net notional exposure of $505 billion at Sept. 30, 2007.
Included in this total is $62.4 billion of CDOs backed by structured finance collateral–mainly subprime U.S. residential mortgage-backed securities.
In spite of the Watch status, Fitch said it believes that potential losses to AIG from the U.S. residential mortgage crisis "should be absorbed by the existing capital base and future earnings stream."
© Arc, All Rights Reserved. Request academic re-use from www.copyright.com. All other uses, submit a request to TMSalesOperations@arc-network.com. For more information visit Asset & Logo Licensing.