AIG is a BIG insurance company. A couple of years ago, it had a market value of $190 billion. Last Christmas it owned over $1 trillion in assets, but was leveraged roughly 10:1. For every $1 in equity, it owned $10 in assets and had $9 in liabilities. This is not necessarily unusual for an insurance company, however it does leave them vulnerable in the event that irrational instability spreads like wildfire through the financial system.
AIG made a few bum investments, but the Q2 write-offs of around $10 billion shouldn’t wipe out a company with a market capitalization of $190 billion. Now the rumor is that write-offs for the company will soar to perhaps $60-70 billion, but even that shouldn’t take the company to the brink.
At the end of last year, AIG had $380 billion of “current liabilities,” which is usually defined as coming due within a year. By mid-2008, however, bond buyers went on strike. Though AIG was highly rated, the rating agencies no longer have any credibility. In fact, the rating agencies helped drive a stake through the heart of AIG just this week by downgrading the company in the midst of crisis, and even then the bonds remained investment grade. With no investors willing to buy their bonds, and $380 billion coming due through the course of the year, the clock kept ticking.
AIG, like hundreds of other companies in the financial services sector, have been forced to reduce the size of their balance sheet, selling assets at the worst possible time. This has caused the price of corporate bonds, junk bonds, mortgage-backed securities and all things paper to drop. Because new accounting rules implemented in November of 2007 require that these assets be “marked-to-market” (price) so with each succeeding wave of liquidations, prices go lower, more write-offs are required, and the problems spiral out of control.
Mark-to-market accounting makes sense for assets held in short-term inventory for sale, but not for long-term investments. Were individuals subject to mark-to-market accounting during the real estate boom, they would have been forced to mark up the value of their homes each year and pay income taxes on these phantom gains. Worse yet, now that home prices are sinking, homeowners would have to subtract the losses from income which would reduce your income tax burden, but leave you subject to having the bank step in and call-in your mortgage given that your negative income suggests that you can no longer afford the home you’re living in. Forget for a moment that your real (cash) income hasn’t changed. If the bank comes knocking on your door and forces you to refinance, but no one else will loan you the money because they also think you have negative income, the end result is that you’re out in the street with nowhere to live while the bank sells your house out of foreclosure for less than its worth, and next year it’s your neighbors who are out on the street because they had to mark their houses down in value.
Do you see how irrational this is? That’s the situation we’re facing in the markets today.
A modern day “run on the bank” doesn’t necessarily involve tellers pulling money out of an institution. Today the financial institutions are so dependant on the bond market providing liquidity that a buyers’ strike in the bond market creates havoc.
Who are these bond buyers? Many are pension funds. However, only a small portion of bond money is dedicated to the junk bond market. If a company (like AIG) is at risk of falling to junk status, most of the pension fund money will look elsewhere. Financial institutions, themselves, are major bond investors – but remember, these companies are shrinking their balance sheets, which only adds to the problem. Closed-end funds are sometimes buyers, but many of them are being forced to de-leverage as well, so they tend to be net sellers at the moment. You’re left with a few retail mutual funds with money to buy, but they finished spending their available cash in August of 2007, and shareholder redemptions are forcing them to liquidate as well. AIG has $380 billion of paper to refinance, but everywhere they go they get the cold shoulder.
AIG, and other companies like it, are reasonably sound entities being forced into the unwilling arms of the government because their short-term debt is maturing and no one is willing to buy their paper.
The government has been criticized for bailing out rich Wall Street shareholders. But the real end game is to bail out bond holders. AIG has lost $185 billion in market value, and that’s okay. Stock investors take that sort of risk every day – it’s just that it’s a rare day that they actually have to absorb that sort of loss. The Secretary of the Treasury is trying to protect AIG’s $900+ billion in creditors by making a bridge loan to help the company survive the credit crunch. Those creditors include annuity holders who are depending on AIG to provide them a lifetime income stream. They include retirement plan participants who bought bonds through their pension plan because until this week AIG had one of the highest ratings out there.
Is it fair that a run on the bank caused by idiots at Lehman Brothers, Bear Stearns, IndyMac and a bunch of independent mortgage company brokers that offered mortgages to deadbeats on overpriced rental condos in the vacation hot spot of your choice with little money down and no income verification --- is it fair that the credit crisis that followed imperil retirees depending on AIG for their grocery money?
Probably not.
We have reached the point where the credit crisis is unfair and probably irrational. The Treasury is doing whatever it can to restore stability. When trust is destroyed, however, a restoration of faith cannot be mandated by government fiat. The only credit that buyers trust, at this point, is the government itself. That is why the government now explicitly backs the bonds of Fannie Mae and Freddie Mac. That is why the government is able to raise $85 billion which is lent to AIG (at an 11% interest cost).
- What does this mess mean for stockholders?
The rest of the market can keep falling until it is so incredibly cheap that buyers come in even in spite of Wall Street’s lack of credibility. Drug stocks have reasonably stable earnings and sell at 12X earnings. Is that cheap enough? Big oil sells below 8.5X earnings. Is that cheap enough? Software companies are selling at about 14X earnings and have attractive growth prospects. When do buyers step in? At 13X? At 10X?
The May-Investments fund portfolio has 30% in bonds and much of the equity portfolio in historically defensive sectors like healthcare and consumer staples and pharmaceutical companies. The May-Investments portfolios did not sell-off today as much as the market, which fell 450 points (-4.7% today for the S&P 500 Index). Still, the market feels like it’s wound tight as a spring and could rocket down more, just as it could (and I hope will) rocket up.
To me, the government deciding to throw its support to AIG bond holders was a good thing. The stock market can go to hell, but if the bond market stops working the whole country is in a world of hurt. It seems to me that the Treasury understands that.
Rather than springing up, though, the market tanked some more. Not just financials, but across the board the sell-off was severe. Though I remain an optimist (…this too shall pass), at the end of the day when the mid-day rally failed to hold, we sold our position in industrial stocks and for a few days, at least, will let the money sit in cash.
We told investors that when the market is tanking, our philosophy is to take some steps to “get out of the way.” The sell-off in commodities and international stocks is consistent with a world view that says the U.S. recession (which still hasn’t been classified as such by the economists) has spread to the rest of the globe. I don’t know if I agree with this observation, but in a liquidity crunch the resulting irrational instability can even force good companies into bankruptcy, and cause prices to sink far below “fair value.”
We might be setting up another “once in a lifetime” buying opportunity, a la 1974, but if that is what’s actually happening the entry point will more likely come somewhere below 9,000. All we’ve got at this point is a run-of-the-mill attractively valued market.
If the market falls from here, we’ve got 40% in bonds or cash equivalents that we can redeploy in stocks at much more attractive levels.
If the market rockets UP from here – as I truly hope it does – we will have locked in a loss on our industrials and left a little more money on the table. That market, however, would mark the beginning of a new, rationally stable capital market, and I would welcome that outcome even if it means a little short-term underperformance up front.
Yesterday’s post admitted that I am optimistic, but have little confidence in my forecast. For that reason, we have shifted back to our most defensive position in the face of persistent selling. Though the Treasury is taking heroic steps to support the market, the bond buyers strike shows no signs of abating.
The good news is that I believe that the current bout of instability is irrational. The bad news is that the market doesn’t care one iota about what I think. Prepare for the worst. Hope for the best. Don’t freeze, but remain watchful. Keep your bearings along the way.
Volatility creates opportunity. This just happens to be one of those days where it isn't a very pleasant sensation.
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.
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