AIG’s problems may well yet get worse. CDO writedowns look set to increase massively in the insurer’s year end figures.
On news Monday that auditors thought that the world’s largest insurer had a “material weakness” in the evaluation of its structured finance portfolio, the company lost $15bn from its market capitalisation.
The disclosures AIG has previously made to the market about its CDO writedowns don’t look quite right, think PricewaterhouseCoopers.
When the world’s largest insurer’s figures are published for 2007, AIG could be looking at total writedowns on CDOs in excess of $5bn.
On September 30, when it filed its 10-Q, AIG reported a writedown on its CDO exposure of $352m. By October 31, that figure had risen to $899m. And by November 30, it was $1.6bn.
That series of figures is what everyone has hitherto known about.
But underneath that, the raw marked-to-model numbers tell a different story. The gross writedown was $352m in September, $899m in October and… $5.9bn in November.
The two series differ in November because AIG decided suddenly to apply two “benefits” to its pricing model in that month. And it’s perhaps quite rightly these arbitrary, management-applied “benefits” that PwC has a problem with.
The first benefit applied in November, not seen in previous months, was a “cash flow diversion feature.” This one is probably the most understandable and reasonable of the two:
AIG’s CDO exposure is via swaps on super-senior CDO tranches. We can assume that a significant number of the CDOs to which AIG is exposed have triggered “events of default”, which gives control of those CDOs to… the super-senior tranches. One of the options available to the super-seniors is putting the CDO into “acceleration”; whereby the structure’s cash flow is completely diverted to pay off all the coupons and all the principal of the super-senior noteholders before anyone else is paid a penny. It is indeed conceivable that that should have an impact on the AIG valuation model. In the event, AIG said it amounted to a benefit deductable from the $5.9bn figure of $732m.
It’s AIG’s second “benefit” then, which is troubling.
As well as the above cash flow diversion benefit, AIG applied an additional $3.6bn benefit, deductable from the $5.9bn figure, based on a negative basis “spread differential”.
This was derived from the fact that AIG didn’t actually own any tranches of CDOs and is instead exposed via swaps on those tranches.
As do many monolines, AIG insured owners of CDO paper. Making it a party on one side of a negative basis trade. AIG reasoned that its valuation model had churned out a $5.9bn writedown based on the cash bonds of those CDOs - not the swaps on those cash bonds. So it squared that by applying a “benefit” it approximated as equivalent to the spread between the cash bonds and the CDS it owned on them - a figure of $3.6bn.
As Alea points out, that negative basis differential is always uncertain.
PwC clearly think so too, because as AIG says at the foot of its 8-K:
AIG will not include any adjustment to reflect the spread differential (negative basis adjustment) in determining the fair value of AIGFP’s super senior credit default swap portfolio at December 31, 2007.
In other words, AIG’s 2007 figures, when released, will include at least an extra $3.6bn writedown, bringing the total as at November 30 alone, to $5.2bn.
Given too the assumption that CDO tranches declined even further in value through December, and the figure may well be more.
Then, of course, there’s January too.
