The AIG Paradox

Investors should expect another heart pounding Monday. American International Group (AIG), once the most powerful insurance company in the world, will announce earnings for the last quarter of 2008. It's expected AIG will reveal it lost as much as $60 billion in the last three months of 2008.

If that is true, AIG will account for the biggest quarterly loss in the history of American business. It would dwarf the old record set by Time Warner's $54 billion single-quarter loss in 2002. AIG posted a $24.5 billion loss last fall. This is a company that's already received $150 billion in emergency taxpayer funding. Physicians near Capitol Hill should expect to see a spike in the cases of senators and congressmen suffering from high blood pressure.

"It would be a surprise if they didn't need another $100 billion." predicts Philadelphia based credit analyst Sean Egan of Egan-Jones Ratings Company. "If they didn't have the support if the US government, they would be gone."

It would seem to most reasonable people that AIG has become a money pit. AIG stock has declined over 85% since the government rescue on Sept. 16. The paradox here is that Washington regulators and Wall Street are in agreement that the global financial system could not withstand the unruly collapse of AIG.

AIG underwrites many of the insurance policies that major banks and financial institutions use to protect themselves from losses on bad investments. Such insurance allows the firms to take the risk of buying and selling other investments. This is how the banking system creates $3 of lending from $1 of capital. Should AIG immediately disintegrate, the firms would have to drastically write down the value of any troubled investments on their books. The losses could either cripple the firms or make them insolvent.

"If they went away those institutions would have to take major writedowns ... and they don't have the capital to offset that risk", says Egan. "AIG provides the underpinning for a lot of the financial community."

The challenge is to pull AIG's finger from the Wall Street dike without causing a flood. Government overseers and the AIG management are trying to wind down the company in an orderly way. It still holds a number of desirable assets, like it's property insurance division, that could demand a decent sale price.

According to Egan, "They are essentially breaking up the furniture to keep the house warm. Give them another six months and another big slug of capital and then they will probably be beyond risking others."

Any new government capital would probably have to come from the Federal Reserve.

The Financial Times reports the government will swap the 80% stake it currently holds in AIG for even bigger pieces of three units that would be split off from the company. In return, the government would relax the terms of the $60 billion loan that was at the center of last years $150 billion rescue package.

It may be the only available option left for the government to raise its odds of ever collecting a return on its $150 billion investment.