The Unraveling of AIG

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Since late last week, AIG had been desperately trying to stave off a downgrade by ratings agencies that might trigger further problems in its portfolio of credit default swaps, a credit derivative instrument. By the evening of Sept. 15, even with extra funding in place, that chance seemed to be slipping away. Insurance rating agency A.M. Best downgraded most of the company's subsidiaries and slashed AIG's rating to "bbb" from "a+." An hour later, Fitch Ratings had followed suit, downgrading AIG's long-term rating and the ratings of its outstanding debt.

Insurance 101

Late on Sept. 15, Standard & Poor's, which like BusinessWeek is owned by The McGraw-Hill Cos. (MHP), also cut AIG's credit rating, citing concerns about reduced flexibility in meeting additional collateral needs and increasing residential mortgage-related losses. Assuming current market conditions persist, S&P said it expects AIG to continue to pursue additional access to liquidity and the sale of certain businesses to cover potential further investment losses. "In years to come, the real story will not be the subprime crisis or some housing bubble," says Campbell Harvey, professor of finance at the Fuqua School of Business at Duke University, "it will be the spectacular failure of risk-management systems in our so-called leading financial institutions."

How AIG got into this terrible spot draws, in some ways, on the lessons of classic risk mismanagement—what Schiff calls "Insurance 101." The job of an underwriter is to spread risk around. If you write earthquake insurance, you don't write it only in California as that could leave your entire business exposed to one terrible turn of events. AIG appeared to ignore that practice when making just such a dangerous bet on subprime mortages. At least until 2005, various divisions of the company were writing subprime mortgages, selling mortgage insurance for borrowers, writing derivatives on collateralized debt obligations (CDOs) with subprime exposure, and investing premium dollars in mortgage-backed securities as well.

The mortgage insurance business, United Guarantee, started to rack up big losses last year. By early 2008, it became clear that the company's derivatives were following suit. That's when AIG's audit firm, PricewaterhouseCoopers, forced the company to change how it was accounting for the value of its derivatives. That caught the attention of Gradient's Vickery, who began to question the company's earnings quality. He went back into the company's Securities & Exchange Commission filings and chronicled the rise in the gross cumulative decline in valuation of its derivatives from $352 million as of Sept. 30, 2007, to $5.964 billion as of Nov. 30, 2007. AIG, which had already been battered by an accounting scandal that resulted in the ouster of iconic CEO Hank Greenberg, was again under the microscope as a number of analysts began to question the company's exposure to the spiraling mortgage crisis.

Breakup Speculation

Over the course of the spring, the stock fell, and by June criticism was getting closer to home. That's when former AIG director Eli Broad, and two prominent investors—Shelby Davis of Davis Selected Advisers and Bill Miller of Legg Mason (LM)—sent a letter asking the board to name an interim CEO to replace Martin Sullivan, while a search committee found a new leader for New York-based AIG. Greenberg, who still controls big chunks of stock, had sent a letter criticizing management as well.

In June, board chairman and former Citigroup (C) executive Robert Willumstad was named CEO. When the company issued its second-quarter 2008 results in August, it was up to him to announce that marked-to-market losses on its derivatives had climbed to a whopping $25 billion. Speculation began that the company might have to break itself up, or at least sell off some assets to raise capital, on top of the $20 billion raised in May. With parts of its core insurance businesses reporting weaker results—a 54% operating income decline in its property and casualty business—speculation about the sale of other parts of the business began to rise. International Lease Finance, AIG's aircraft leasing subsidiary, was often mentioned as a possible sale candidate. American General Finance, its $29 billion consumer-finance unit, is considered another possible spinoff.

AIG management has yet to present a plan for its restructuring. Negotiations continue over a possible capital infusion from outside the firm. Investors remain skittish as the future of one of the world's biggest brands remains unclear. And nobody is quite sure if the trouble for AIG has passed, or the worst is yet to come.

Byrnes is a senior writer for BusinessWeek in New York.

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