What AIG’s losses mean

AIG has long been one of the largest and best-capitalized insurance and financial-services organization in the world. Before recent scandals, it was one of a few S&P 500 corporations in the U.S. with a AAA rating. Yet, it just reported a massive $11 billion writedown to go alongside it’s other previous writedowns, causing its stock to suffer its worse day ever. Moreover, it has not ruled out further capital raising in order to shore up its weakening balance sheet.

AIG is a pretty solid company with a huge amount of capital and a solid balance sheet. Bloomberg says:

AIG held $112.2 billion in capital at June 30, the insurer said in a slide presentation, more than the $102.7 billion at the end of the first quarter. The company raised $20.3 billion in May by selling debt and equity.
Bloomberg, 7 Aug 2008

However, the risks AIG took on during the housing bubble have led to a crisis of confidence among the firm’s investors. What the AIG story should tell investors is that there are a lot more writedowns to come — not just at AIG, but across the board. Furthermore, while companies like AIG will survive with massive dilution to their current shareholders, others will not.

The fact that AIG has fallen so much on the back of this news only reinforces the point that there has not been any meaningful capitualtion by investors in financial services. After $500 Billion in writedowns and over $350 in capital calls, investors again and again think we’ve reached bottom.

To me, the AIG losses — which stem from credit default swap (CDS) contracts — demonstrate the problem with trying to reflate the economy with easy money. Obviously, low interest rates make it harder for investors to earn money through lower risk products and encourage risk-taking by any and all investors of capital. In AIG’s case, CDS risk was severely underpriced. But, the same affinity for risky assets because of low returns is what drove otherwise smart investors to buy inflated houses.

Ben Bernanke is trying to do again what Greenspan did to ill effect — lower interest rates to levels at which savings and low-risk investment are not valuable. The net effect will more of the same.

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