naked capitalism

Even though all eyes have been on Lehman, the potentially more troubling slow-motion train wreck is AIG. The insurer is a large credit default swaps protection writer and provides a host of financing products. Not only is AIG a larger firm than Lehman and could trigger a systemic event in the CDS market alone, but it isn’t clear how it could be bailed out if it continues to unravel. Insurers are state regulated; the Fed and Treasury have no relevant expertise and no regulatory authority. While insurers are not vulnerable to runs, how can investors who have CDS positions that are hedged by CDS written by AIG manage their exposures? While they are hedged on paper, in practice they might not be, or more relevant, might be perceived by counterparties not to be.

From Bloomberg (hat tip reader Saboor):

American International Group Inc., Lehman Brothers Holdings Inc. and Merrill Lynch & Co. led a rise in the cost of protecting financial-company bonds from default amid concern firms will be hard-pressed to raise needed capital.

Credit-default swaps on New York-based AIG soared to a record and its bonds traded at distressed levels….

Credit-default swaps on AIG, the biggest U.S. insurer, soared on concern that it may be the next big financial firm to run short of capital after $587 billion in contracts guaranteeing home loans, corporate bonds and other investments plunged in value. Standard & Poor’s and Moody’s Investors Service have said AIG’s credit ratings may be cut if its mortgage assets fall further or if potential capital needs aren’t addressed. AIG may have to post more than $13 billion of collateral following a downgrade, it has said in regulatory filings.

Credit-default swap sellers demanded 12.5 percentage points upfront and 5 percentage points a year to protect AIG bonds from default for five years, according to broker Phoenix Partners Group. That means it would cost $1.25 million initially and $500,000 a year to protect $10 million in AIG bonds for five years. Yesterday, it cost $688,000 a year with no upfront payment, according to CMA Datavision.

Yves here. The change to up-front payment is significant. Only credits in serious distress require upfront payment. Back to the story:

AIG’s market value shrank by 46 percent this week on concern its credit ratings will be cut. Chief Executive Officer Robert Willumstad has promised to deliver a turnaround plan on Sept. 25 after the firm posted three straight quarterly losses totaling $18.5 billion…

“As distressed as they are, raising new capital could be extremely hard,” said Tim Backshall, chief strategist at Credit Derivatives Research LLC in Walnut Creek, California, today in an e-mail.

The article mentioned that the investor presentation might be moved up, and the Wall Street Journal tells us it has been. Given how well that worked for Lehman, I’m not sure that is a great move.

From the Journal:

On Friday, credit-ratings firm Standard & Poor’s threatened to downgrade American International Group Inc., citing the significant decline in the company’s share price and the increase in credit spreads on the company’s debt. Meanwhile, AIG will likely hold an analyst call Monday morning and could announce a series of steps aimed at reassuring investors, including possible asset sales, a person familiar with the matter said.

A rapid plunge during the week in the price of AIG shares — the stock fell more than 30% on Friday alone — coupled with equally worrisome signs for the insurance giant in the debt markets, appeared to increase the heat on management to act….

As for AIG, which has posted $18 billion in losses over the last three quarters, it’s in a chicken-egg game. As it’s stock and debt woes brew, it could face a ratings downgrade that would force it to raise capital. But the lower its stock price, the harder it becomes to raise capital. On the plus side, as an insurer, AIG has advantages that some other financial institutions don’t.

It isn’t vulnerable to a run on the bank for its standard insurance policies — those typically are promises to pay future claims, not accounts subject to withdrawal. And AIG has a number of strong businesses it could sell to raise capital — businesses that aren’t as directly impacted by market conditions as those of investment banks. These include life insurance and property/casualty insurance operations in the U.S. and abroad, in addition to a consumer lending unit, a mortgage insurance unit and an aircraft leasing unit.

Still, investors and analysts weren’t assuaged. Prices of some junior AIG debt fell Friday to distress levels of as little as 35 cents on the dollar, down from 65 Thursday morning. The current price represents a yield of 16%, said Tom Atteberry, a partner at First Pacific Advisors, LLC. AIG’s most recently issued bond, a $3 billion 10-year note issued just a month ago, traded Friday at about 79 cents on the dollar, down from 93 Thursday.

Reader Jon passed along this telling reminder of AIG’s belief that risk taking was virtuous. Conversely, Warren Buffett is of the view that insurance is about taking as little risk as possible, and getting paid handsomely when you do.