Predyct Analytics - Coverage of AIG - 2001 through 2007

Predyct Analytics was commissioned by The Economist Magazine (New York Bureau Chief, Tom Easton) in 2001 to perform a valuation of AIG. Predyct Analytics then operated under two names: Seabury Insurance Capital (SIC) and Seabury Analytic. SIC performed its analysis of AIG during the summer months of 2001 but the report was not published by The Economist until February 28, 2002 as the cover story by Tom Easton entitled: ďShine a Light.Ē. SICís report was published in its entirety on the website of The Economist that month. Tom Eastonís story of AIG included excerpts from SICís analysis. The main point from SICís analysis was that for AIG to be valued at its then price of $189 billion investors had to believe that AIG would grow two-thirds faster than all of its peers for the next 25 years. See SICís 2002 valuation of AIG. Translated, this means that SIC was valuing AIG at about one-third to one-half its then market value of $189 billion.

Hank Greenberg (AIGís Chairman and CEO) went ballistic threatening SIC with a lawsuit. Shortly thereafter, Sanford Bernstein Company (SBC) published a critique of SICís valuation indicating that AIG was not overvalued by one-half as SIC had indicated, but significantly undervalued. See Sanford Bernstein 2002 Valuation of AIG and SIC's response to Sanford Bernstein Valuation.

In 2005 , after three years of AIGís troubles springing forth, Tom Eastonís 2002 article in The Economist was beginning to look as if he had been very much a head of the curve. Tom was interviewed by NPRís Market Place Radio respecting what had tipped him off to AIGís troubles. Market Place Radio also asked Tom why The Economist Magazine would risk so much of its reputation on a small firm like SIC when no such contrarian opinions were coming forth about AIG from the brand name Wall Street firms which all had lavished praise on AIG. See transcript from Market Place Radio of Tomís response.

In the years between 2002 and 2007 SIC, at the request of one of its significant financial backers, ceased its coverage of AIG. SICís financial backer feared more retaliation from AIG as well as forgone business opportunities that it hoped to achieve with AIG. In the Fall of 2007, at the request of a few institutional investors, SIC elected to update its 2002 analysis. By now, chairman and CEO Hank Greenberg had been forced to resign as a result of a series of scandalsóthe primary one being the misrepresentation of earnings using finite insurance. We thought that there might be an opportunity for rapprochement with AIGís new CEO, Martin Sullivan. We performed all the preliminary analysis that usually accompanies our valuations and intended to meet with Sullivan to indicate our findings. Sullivan indicated an interest and we scheduled a meeting for November 16, 2007. AIG had been highly critical of our 2002 analysis notwithstanding that our prediction of AIGís collapse in value was realized within 13 months of The Economistís cover story. We felt that if we could provide substance that our 2002 analysis had been correct (i.e., correct valuation for the right reasons) then AIG may be interested in retaining our advisory services going forward.

Our late Summer early Fall 2007 analysis of AIG confirmed our 2002 analysis: AIGís growth had strongly converged to that of the peers that we benchmarked it against in 2002 and AIGís shareholder growth (total return) had been zero for the years 2002 through 2007óworst among its peers and strongly indicating that AIG had been overvalued by investors in 2002 as we had forecast. Most Wall Street analysts at this time were recommending a strong buy for AIG stock believing that AIG was a sleeping giant that would soon recover (See Merrill Lynchís report. Merrill Lynchís report was strongly indicative of most analystsí reports at that time). But something else showed up in our analysis that was extremely troubling: AIGís systematic risk (as measured by Beta. Also called Market risk) had increased from slightly less than 1.0 in 2001 to 1.5 in 2007 for an increase of 50%. This is huge increase in market related risk and we searched for the source of this risk. We didnít have too look far. We observed that AIGís capital marketís group was now producing nearly 30% of AIGís operating income. This is a huge capital marketís contribution to operating income for an insurance company. Most of this income had been produced by AIG Financial Products Group (AIG_FP). But what did AIG_FP do? We poured over AIGís 10K reports (all in excess of 300 pages) for the years between 2002 and 2006 trying to learn what AIG_FP did as our task was to identify publicly traded peers that would help us to understand how to value AIG_FP. Through a combination of phone calls and interviews we had narrowed our identification of suitable peers to (prophetically) Bear Stearns, Lehman Brothers and Merrill Lynch as suitable peers for assessing AIG_FPís risk.

All three investment banks would later fail or merge with other institutions to avoid failure. No doubt, there would be many differences between these peers and AIG_FP but one thing was certainóall were dominated in one way or the other by subprime mortgages and all had been heavily engaged in credit default swaps (CDS). The effectiveness of peer analysis is conditioned on the fact that the peers accurately reflect the operations of the company that you are trying to value, so we knew that our assessment of AIG_FP was highly conditional. But our analysis of the three investment banks indicated that they had a very high chance probability of failure within one year. How could this be, we thought? All three banks had high investment grade ratings by all the leading rating agencies. We had applied a Merton Framework to assess their expectation of default. In a Merton Framework a default is defined when the market value of a firmís assets are worth less than the market value of its debt. The genius of Mertonís framework is that it is very forward looking whereas the financial statements of these institutions are historical and not terribly predictiveóbut financial statements is what most Wall Street analysts and rating agencies use.

After sizing the risk of the investment banks to that of AIG_FP we were left with no other conclusion but that AIG was (most likely) technically insolvent if our peer selection was suitable. We would later learn that our selection of peers was not correct in-so-far as these peers were actually less risky than AIG_FP. Yes, it was true that all of these players were dominated by the subprime market and all the players had vigorously participated in the CDS market, but AIG_FP had run a one-way book of CDS-- that is, AIG_FP only sold credit protection for the most part. AIG_FP didnít buy credit protection and thus had a huge net exposure. The peers we had selected had both bought and sold credit protection using CDS so that they ran a lower net exposure position than did AIG. The peers had gone out of business largely as a result of their participation in the collateralized debt obligation (CDO) market. A CDO represents a portfolio of assets (in this case mostly subprime mortgages) against which the sponsor issues securities. If the value of the mortgages declines (as happened with subprime mortgages) the sponsor is forced to add new collateral or investors will take a loss. As it happened, the investment bank peers simply ran out of collateral and net worth while trying to prop up the value of their CDOís.

We observed that in all of AIGís 10K reports they never once mentioned the term CDS and said practically nothing about the substance of AIG_FPís activities. The 10K reports prior to 2008 did indicate that AIG_FP engaged in certain types of hedged derivative transactions with counterparties but took no speculative positionsóthat assertion was almost completely false. The big write down in financial services operating income from $43 billion in 2005 to $524 million in 2006 was attributed solely to the disallowance of hedge accounting in accordance with FASB 133 and certain currency fluctuations. The real devaluation of AIG_FPís income had occurred as a result of deterioration in the credit quality of the subprime mortgages on which AIG_FP had written CDS credit protection. If disclosed, this would have been a huge signal to investors. But AIG did not disclose its activities in the CDS market until after its bankruptcy, appointment of Edward M. Liddy as successor CEO and release of its 2008 10K in 2009, nearly two years after SICís analysis foreshadowing AIGís extremis and likely insolvency.