In an effort to calm the harried investors in his latest target, American International Group Inc., New York AG (“Aspiring Governor”) the reigning Lord of Regulation Eliot Spitzer announced yesterday that his office expects to reach a civil settlement with AIG even as he rachets up the criminal investigation into several private entities closely tied to AIG’s business. Here are the previous posts on the developing AIG and Berkshire Hathaway debacle.
After being hammered for over a month, the price of AIG shares responded to the Lord’s announcement yesterday by increasing to $2.35, to $53.30 on the New York Stock Exchange. Even with yesterday’s spike, however, AIG shares are down 26% since the beginning of the Enronesque investigation into AIG’s finances. The seemingly bottomless drop in AIG’s share price is driven by the fact that no major financial company has survived criminal charges in the history of U.S. financial markets.
Meanwhile, seemingly just to make things more interesting, several senior AIG executives were fleeing the boards of C.V. Starr & Co. and Starr International Co,, two closely-owned AIG-associated entities, the former of which controls 12% of AIG’s stock. Former AIG chairman and CEO Maurice R. “Hank” Greenberg is the CEO of Starr International, which uses its stake in AIG to provide deferred-compensation to AIG executives. Inasmuch as the Lord of Regulation does not approve of Mr. Greenberg’s tentacles affecting AIG, the AIG board is scrambling to disassociate itself from the closely-owned entities and reassert control over AIG’s executive compensation program.
Given the Lord’s disapproval of AIG’s arrangement with Starr International, that the structure of the arrangement may actually benefit AIG shareholders does not appear to be a particularly important consideration at this time to the AIG board.

American International Group Inc.’s public admission this week that it engaged in improper accounting practices has placed AIG’s auditor — PricewaterhouseCoopers LLP — squarely in the sights of government regulators and plaintiffs’ lawyers. Here are the earlier posts on the fast developing scandal that has enveloped AIG and Berkshire Hathaway over the past several weeks.
Federal and state investigators (Mr. Spitzer is seemingly everywhere these days) are currently evaluating what AIG told PWC auditors about the questionable transactions, but it is only a matter of time before investigators and class action securities plaintiffs’ lawyers will begin to question PWC regarding its failure to uncover the allegedly improper accounting. As noted in this earlier post, one of the most troubling aspects of the current AIG investigation is that many of these transactions under scrutiny may well have been reviewed and approved by various business professionals working on behalf of AIG. Already, press reports on the AIG investigation assume that the accounting for the transactions was improper, and any defense that the transactions were accounted for properly has been shoved aside in the wave of negative publicity and the AIG board’s efforts to bend over backwards for the regulators in an attempt to limit the collateral damage to AIG’s stock price.
At any rate, if the transactions were accounted for improperly and were material, generally accepted accounting principles require that AIG restate its financial reports for several past years. If the violations are not deemed material, then AIG could correct its financials by taking a one-time adjustment to its fourth-quarter results for 2004. The question of whether an accounting violation is material is determined by whether the financial result of the violation would have influenced the opinion of a hypothetical reasonable investor. AIG has already stated that correcting the known violations would reduce its $83 billion net worth by only 2%.
So, as we wait for the other shoe to drop on PWC, let’s hope that governmental regulators take note of this point.

In the most stunning in a series of revelations that has rocked the U.S. business community, American International Group Inc. admitted yesterday to numerous and substantial accounting irregularities that could reduce its net worth by over $1.75 billion.

Moreover, the company’s accountants — PriceWaterhouseCoopers — received a subpoena for documents relating to the probe.

AIG, the largest insurance company in the U.S., admitted transactions that “appear to have been structured for the sole or primary purpose of accomplishing a desired accounting result.”

The company’s statement listed eight areas in which an ongoing internal review has identified accounting mistakes. The statement specifically declared as improper the treatment of a deal with General Re Insurance Corp., a unit of Warren Buffett’s Berkshire Hathaway Inc., that has been at the center of the probe since it began.

To make matters worse, state and federal investigators believe that the full extent of AIG’s accounting improprieties over the past decade are even larger. According to unnamed sources within the government’s investigation units, the investigations have already uncovered a pattern of alleged misconduct in regard to the business transactions that will likely prompt criminal prosecutions against the individuals responsible for the transactions.

The Lord of Regulation was pleased with AIG’s public admissions. “The board’s decision to provide this information represents a welcome step toward transparency and accountability as our investigation proceeds,” said the Lord’s spokesman.

The market is clearly worried by AIG’s mounting problems. Yesterday, during a broad stock-market rally, AIG’s shares fell almost 2% to $57.16, continuing a slide that began in mid-February after disclosure of the governmental probes. Since that time, AIG shares are down 22% since closing at $73.12 on Friday, Feb. 11. Perhaps even more importantly, Standard & Poor’s yesterday downgraded AIG’s long-term bonds and certain other debt by a notch from its top AAA rating.

Given these latest developments. the question of the moment is whether AIG is headed for an Enronesque meltdown.

Financially, it would appear that such a meltdown is unlikely. In 2004, AIG reported net income of over $11 billion on revenue of about $98.5 billion. Consequently, the accounting problems identified to date probably will not deplete shareholders’ equity by more than about 2%, which would leave the company’s net worth above $80 billion. That’s not chump change.

However, the reason that Enron collapsed is that Enron’s business-model — as does AIG’s — requires its customers to rely on the company’s financial integrity and not necessarily the company’s net worth.

Accordingly, when customer confidence in a company such as Enron or AIG is undermined, participants in those companies’ markets become less willing to engage in the purchase or sale of long-term contracts that might not be fulfilled. Thus, as the “bid-ask” spreads on Enron’s trading contracts diverged in late 2001, Enron’s markets unraveled and Enron’s formerly profitable trading business collapsed.

Enron and AIG’s business models are quite similar to that of a bank. Banks take in money from depositors on a short-term basis and then loan it out on a long-term basis. The bank only keeps a small fraction of its assets available as working capital.

Consequently, as sometimes happens, if too many depositors try to withdraw funds from a bank (i.e., a “run on the bank”), then the bank will not have adequate cash on hand to pay them their withdrawals and the customers will be have to be turned away.

So what prevents a run on the bank? Beyond federal deposit insurance, the only thing that really prevents the run on the bank is that the bank’s depositors trust that the bank will be able to fulfill their demands for withdrawals. Stated another way, the bank will fail when its depositors stop trusting the bank.

That’s one of the reasons why banks traditionally have built huge and impressive bank lobbies and offices to advertise the strength of the bank’s assets and its concurrent financial integrity. Enron followed that example in building the Enron office tower in downtown Houston, and AIG’s New York building is equally impressive.

However, regardless of the financial soundness of any bank, when its depositors stop believing in the financial integrity of the bank, the bank will fail.

Life insurance companies such as AIG operate in much the same way. Insureds deposit money with a life insurance company for years and build up equity. However, if the insurance company fails (as they sometimes do), then the investment is lost.

Thus, customers rationally hesitate to use a life insurance company that is not financially solid, and insurance companies attempt to fulfill that customer expectation regarding their financial stability through public accounting, by building enormous offices, and by advertising themselves as bastions of stability. In that regard, governmental regulation of companies in the life insurance and banking industries help those industries by reducing the public’s fear of hidden financial problems.

Enron was similar to a bank or life insurance company because Enron’s largest business was in natural gas contracts. Inasmuch as Enron created the long-term natural gas market, Enron became the market maker for such contracts and, thus, offered to buy or sell long-term natural gas contracts in that market.

That raises an important attribute of Enron’s business that led to its downfall — Enron was a party to every transaction in its trading business. That is, buyers and sellers did not contract with each other, but with Enron. Thus, every company that conducted trading business with Enron had credit exposure to Enron and, as a result, a big part of the value placed on a contract depended on Enron’s creditworthiness. This exposure is greater in long-term contracts, particularly for buyers who prepaid some or all of the contract.

Therefore, as the revelations of Enron’s accounting problems began to emerge in late 2001, buyers of such contracts from Enron began to bid lower — the value of a contract fell with the increased risk.

On the other hand, sellers of contracts began to demand a higher price from Enron because of the increased risk that the contract might not be fully consummated.

Moreover, the foregoing process was not limited to Enron’s natural gas trading market. It also occurred in regard to electricity, plastics, chemicals, metals, oil, fertilizers, coal, freight, tradable emissions (pollution) permits, lumber, steel, and other markets that Enron had created.

Almost overnight, Enron’s profit margins in its trading business diminished dramatically or disappeared completely, and that process ultimately led to the implosion of Enron’s trading markets.

Consequently, accounting improprieties are unlikely, in and of themselves, to lead to AIG’s collapse. By way of comparison, bad accounting alone would not have brought down Enron.

However, bad accounting can undermine the business customers’ trust in AIG’s financial integrity, and the disappearance of that trust in the marketplace can cause AIG’s business to decline dramatically or, in the worst of all scenarios, collapse completely. That lack of trust is what truly brought Enron down, and AIG needs to be concerned with that same dynamic.

Almost on cue, this Wall Street Journal article($) is reporting that Warren Buffett, the famed investor who is chairman and CEO of Berkshire Hathaway Inc., will be questioned by regulators next month over his involvement in the transaction between Berkshire’s General Re insurance unit and American International Group Inc. that has led to the resignation of Maurice “Hank” Greenberg as AIG’s chairman and CEO.
Here are the previous posts on the probe into AIG and Berkshire, and a NY Post article from last week that reported on a leak from New York Attorney General Eliot Spitzer‘s office that Mr. Buffett was not a target of the investigation.
H’mm. I guess Mr. Spitzer has changed his mind.
Mr. Buffett’s interview is scheduled for April 11, a day before Mr. Greenberg’s interview unless he has decided to assert his Fifth Amendment privilege in light to his resignation from AIG. At this point, Mr. Spitzer’s office and the Securities and Exchange Commission are handling the probe, although Justice Department lawyers will also be present at both interviews.
Mr. Buffett will be questioned specifically about his involvement in a 2000 reinsurance transaction between AIG and General Re that regulators contend allowed AIG to boost its financial position improperly. The transaction shifted half a billion of expected claims to AIG from General Re along with a commensurate amount of premiums. AIG booked the premiums as revenue and then added $500 million to its reserves to account for its obligation to pay the claims at a time when market analysts were questioning whether AIG had adequate liability reserves. Regulators contend that the premium was designed to ensure that AIG was not at risk and, therefore, that the half billion was improperly booked as premium revenue. For its trouble, General Re received a $5 million commission on the deal and now even more investigative scrutiny into similar transactions with other companies.

The NY Times Gretchen Morgenson provides this lucid analysis of the deal that prompted American International Group’s board to call upon Maurice “Hank” Greenberg to step down as AIG’s CEO after a generation of phenomenal wealth building for AIG shareholders. Here are the prior posts on AIG and Mr. Greenberg’s mounting troubles.
Ms. Morgenson asserts that the purpose of the questionable transaction that led to Mr. Greenberg’s ouster was to mask AIG’s declining financial performance from the market. Unless AIG’s stock price was maintained, AIG risked overpaying for American General Insurance Co. in 2001, which was a key acquisition in Mr. Greenspan’s strategy of diversifying AIG’s insurance business.
Nevertheless, Ms. Morgenson’s analysis fails to address the nuance that the transaction in question was not performed in Mr. Greenberg’s basement where no one could see it. Rather, it was a material transaction that was fully disclosed after careful review and approval by AIG and General Re’s executives, auditors and attorneys. Presumably, Mr. Greenberg would not have approved the transaction without such disclosure and approvals. In fact, Ms. Morgenson’s article simply assumes that the transaction was at least wrong without even entertaining the notion that numerous experts in such transactions had approved the transaction and are prepared to defend AIG’s booking of it.
Despite all this, Mr. Greenberg faces a possible indictment on criminal charges that could result in a substantial prison sentence in the autumn of his long and successful business career. In a couple of weeks, Mr. Greenberg will be removed from the the board of directors of the company he built into a financial powerhouse unless he waives his privilege against self-incrimination in connection with the regulatory investigation into the transaction.
Maybe AIG took risks with certain transactions that should result in restatement of its earnings and reserves. Although the value of AIG’s shares are fallen 24% for over $46 billion in market value since the beginning of the above-described probe, perhaps the value of such shares should be hammered in the market as a result of such a restatement. But do we really want the government criminalizing talented people such as Mr. Greenberg simply because he approved a questionable transaction that multiple experts in such deals had previously blessed?
That a reporter of Ms. Morgenson’s stature does not even mention that troubling issue reflects just how socially acceptable it has become for the government to abuse its awesome police power to criminalize merely questionable business transactions.

In what is becoming a typical development in such sagas, this NY Times article reports that the board of financial services giant American International Group Inc. is considering a move to restate its financial statments as a result of suspected accounting mistakes on its financial statements that may total as much as $3 billion from as many as 30 different insurance transactions. Here are the earlier posts on the the government’s assault on AIG.
As the governmental probes into AIG’s accounting is now far broader than what was believed just a week ago, the AIG board is assessing whether to restate its financial statements in regard to an additional 60 transactions that internal AIG investigators have identified as being potential problems. The potential errors under scrutiny occurred over five year period and include the possible booking of revenue and income prematurely and improperly transferring liabilities off the company’s books. Many of the deals in question could have been designed either to boost AIG’s reserves or to “smooth the earnings” of the company to meet Wall Street expectations.
Gosh, isn’t this starting to sound downright Enronesque?.
Nevertheless, even a multibillion-dollar writedown of earnings should not damage AIG’s long-term financial stability much. The company had net income of over $11 billion last year on revenue of almost $100 billion.
Former AIG chairman Maurice “Hank” Greenberg, who remains as AIG’s nonexecutive chairman, is tentatively scheduled to give a sworn statement to investigators from New York AG Eliot Spitzer’s office and the SEC on April 12. At the rate this scandal is developing, Mr. Greenberg better think seriously about stepping down and taking the Fifth. It is becoming increasingly clear that the Lord of Regulation is going to want more from AIG than simply financial sacrifices.