Willumstad's Hard Choice

AIG's earnings yesterday were horrible, no doubt about it, and the stock market meted out condign punishment:

American International Group Inc., the biggest U.S. insurer by assets, fell the most since going public in 1969 after writing down more than $11 billion of holdings and saying it won't rule out raising capital...
AIG slid $5.25, or 18 percent, to $23.84 in New York Stock Exchange composite trading at 4 p.m., its biggest one-day drop in 39 years, according to Los Angeles-based Global Financial Data, which keeps records on historical share prices. The stock has plunged 59 percent this year.

But. What I don't see anybody pointing out here is that AIG stock is still 20% above its recent lows of mid-July. Insurers are pretty much the most leveraged financial institutions in the world, and in the present climate one can expect their stocks to be volatile. Here's how AIG shares have behaved over the past month: the best way to sum up this kind of chart is to say that the stock is moving sideways with extremely high volatility.

AIG faces many problems, not least the fact that it's in one of those businesses where you can't operate without a watertight credit rating, and it doesn't have a watertight credit rating.

Historically, AIG was perceived as the Goldman Sachs of the insurance world: bolder, smarter, more profitable than anybody else. Now that it has been revealed to have had feet of clay all along, the market doesn't know what to make of the franchise.

Between now and September 25, when new CEO Robert Willumstad will announce his new strategy, AIG's going to remain in a state of limbo. Historically, AIG has made a great deal of money by being very smart and being able to price risk faster and more accurately than anybody else. But as David Reilly says, it doesn't have that credibility any more:

Last August, AIG argued that the U.S. would have to have a shock twice as bad as the Great Depression before the swaps showed losses. At the first quarter's end, it said final losses could come in between $1.2 billion and $2.4 billion. Now the firm has upped that estimate to between $5 billion and $8.5 billion.
Yet that is still below a $9 billion to $11 billion estimate made this spring by an outside firm hired by AIG. In a research note Thursday, Morgan Stanley estimated the losses could come in at $13 billion.
Granted, those figures are well below the about $25 billion in losses implied by market prices. But the market's extreme pessimism has been more on the mark than AIG's blind optimism.

Reilly thinks that AIG needs to capitulate, much as Merrill Lynch did. What's unclear is whether such a capitulation -- along with the highly dilutive capital-raising that would have to accompany it -- is presently priced in to the stock. What's also unclear is what kind of future AIG would face after selling out at the bottom of the market.

Insurers are meant to be there over the long term; if a giant like AIG can't ride out market volatility, then a large part of its raison d'être is obliterated. Maybe Willumstad should try to tough it out, instead. If he wins, the decision is visionary and clearly right. Capitulation, on the other hand, is tantamount to saying that external observers understand AIG's labyrinthine complexity better than do its own professionals. And if that's the case, the company probably shouldn't exist in its present state at all.

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