Don’t miss this Wall Street Journal ($) editorial today, which addresses the same issue that many of these earlier posts address in regard to the Lord of Regulation‘s ongoing public flogging of American International Group, Inc. and its former chairman and CEO, Maurice “Hank” Greenberg:

[Y]ou don’t have to belong to the ACLU to wonder about the lack of due process here. Mr. Spitzer uncovers questionable accounting about an insurance transaction and demands that the board fire the CEO. He then uses that firing to justify a public accusation of “fraud” that he hasn’t yet proven to anybody, much less to a jury of Mr. Greenberg’s peers.
To which our reaction is, then why not get on with it and indict the man? If Mr. Greenberg’s behavior is so heinous that it warrants a denunciation as “fraud” on national TV, what is Mr. Spitzer waiting for?

As an aside, this post addressed the Lord’s unusual public statement from last week in which he stated that his public flogging of AIG would probably not result in a criminal prosecution of the company, although the same could not be said about Mr. Greenberg. AIG and Berkshire Hathaway board members and shareholders heaved a joint sigh of relief and gave thanks to the Lord for his public statement.
Well, it turns out that the Lord may have had more than market stabilization as a motive for that public statement. The Lord is already running for Governor of New York, and it turns out that some of the Lord’s largest campaign contributors are partners in the law firm that is defending AIG in the Lord’s investigation of the company. Inasmuch as that firm has apparently been advising AIG to roll over for the Lord during the investigation, do you think the AIG board knew of the connections between the company’s law firm and the Lord before acting on that advice?

Let’s review the landscape of regulating business for a moment.
Various former executives of disgraced and insolvent Enron Corp. are under indictment for using structured finance transactions that independent lawyers and accountants approved to mislead investors regarding Enron’s true financial condition. Although such transactions came to light almost four years ago, no such Enron executive has yet to be tried on such charges. In the meantime, Enron has been effectively liquidated.
Several years ago, General Reinsurance Corp., a unit of Berkshire Hathaway, and American International Group, Inc. entered into at least one large structured finance transaction with each other. As with Enron’s structured finance transactions, numerous executives, lawyers, accountants and perhaps even consultants for both companies reviewed and approved the deal. Here are the previous posts on the saga involving AIG and Berkshire.
New York Attorney General Eliot Spitzer, the new Lord of Regulation, believes that the companies did not account for the transaction properly and, as a result, that the transaction made AIG and Berkshire’s financial performance appear better to each company’s investors than it really was. Despite not having heard his side of the story, the Lord has already concluded that former AIG chairman and CEO Maurice “Hank” Greenberg — a rather hard-knuckled executive — committed a crime in regard to the transaction.
Yesterday, as this NY Times article reports, the Lord had a nice chat with the avuncular Oracle of Omaha, the chairman of Berkhsire, in which he questioned the Oracle over his knowledge of the transaction. The Oracle replied that he knew about the deal generally, but that others at General Re handled the details of the transaction. The Oracle also stated that he understood that the deal had been properly accounted for, but again, he did not really know much about the details of all that.
By the way, the Oracle agreed to chat with the Lord because the Lord assured him that — unlike the dastardly Mr. Greenberg — the popular Oracle is not a target of the Lord’s investigation. In appreciation for the Lord’s courteous gesture, the Oracle served up some more juicy tidbits of AIG’s involvement in the transaction for the Lord to chew on.
In the meantime, former Enron chairman and CEO Ken Lay’s defense of the criminal charges against him relating to Enron’s structured finance transactions is precisely the same as the Oracle’s above explanation of his role in the transaction with AIG.
In the wake of almost unprecedented negative publicity — much of which has been flamed by prosecutors pursuing him — Mr. Lay is facing the prospect of spending much of the remainder of his life in jail. The same is probably true for Mr. Greenberg.
Meanwhile, another large company that engaged in similar structured finance transactions — and which collapsed at about the same time as Enron — announced yesterday that it had settled civil charges with the SEC over its involvement in such transactions. No criminal charges were ever filed in regard to that matter.
And the Oracle returns to Omaha to work on his next letter to shareholders.
Quare: Is this any way to regulate business?

Eliot Spitzer, the New York AG (i.e., “Aspiring Governor”) made the Sunday talk show circuit yesterday in regard to his campaign against corporate wrongdoing generally and his ongoing investigation of transactions between AIG and a unit of Berkshire Hathaway (earlier posts here) specifically.
The investigation — which has not yet resulted in a single indictment, but has battered AIG’s stock and credit rating — involves scrutinizing complicated financial transactions that were approved by scores of transaction lawyers, accountants, and consultants for both AIG and Berkshire. Indeed, the MSM reporting on Mr. Spitzer’s campaign have not even attempted to obtain an explanation of the transactions from the persons involved in structuring the transactions. Nevertheless, the Lord of Regulation said yesterday that he had strong evidence that former AIG chairman and CEO Maurice “Hank” Greenberg committed fraud in initiating the deal between A.I.G. and General Re, the subsidiary of Berkshire. Mr. Spitzer’s following comments will give you a flavor for the entire interview:

These are very serious offenses, over a billion dollars of accounting frauds that A.I.G. has already acknowledged. . .
That company was a black box, run with an iron fist by a C.E.O. who did not tell the public the truth. That is the problem.

Today, this NY Times article today reports that Mr. Greenberg is probably going to refuse to testify based on his Fifth Amendment privilege at a deposition that Mr. Spitzer has scheduled for Tuesday.
After Mr. Spitzer’s public comments of yesterday, how could Mr. Greenberg responsibly do anything else?
By the way, it’s nice to see that someone else is noting that Mr. Spitzer is manipulating prejudices in an unhealthy manner.

In an extraordinary development in the unfolding criminal investigation of transactions between American International General, Inc. and Berkshire-Hathaway, Inc., this NY Times article reports that Berkshire chairman Warren Buffett — in an effort to win leniency for Berkshire in an unrelated case — directed Berkshire’s lawyers several months ago to turn over documents describing the transaction between Berkshire unit General Re and AIG that is at the heart of the criminal investigation. Here are the previous posts on the AIG and Berkshire saga.
As a result of Mr. Buffett’s peace offering, former AIG chairman and CEO Maurice “Hank” Greenberg is facing the prospect of giving a deposition next week to the Justice Department, Securities and Exchange Commission, Eliot Spitzer and the New York attorney general’s office, and New York insurance regulators. In comparison, Mr. Buffett will merely be “interviewed” on Monday by the investigators, who consider him merely a witness in the AIG probe at this point.
According to the Times article and this similar Wall Street Journal ($) article, Mr. Buffett and Berkshire served up AIG and Mr. Greenberg on a platter to prosecutors in December when prosecutors were questioning Berkshire officials regarding General Re’s transactions with Reciprocal of America, a failed Virginia-based insurer. The prosecutors are investigating whether General Re had helped Reciprocal disguise loans as reinsurance to hide losses from insurance regulators. Two Reciprocal executives have copped plea deals and began cooperating with investigators, which led prosecutors to inform Berkshire lawyers that General Re and Berkshire executives may face criminal charges in connection with their probe of Reciprocal. A couple of weeks later, the Times and WSJ report that, at Mr. Buffett’s behest, Berkshire lawyers gave investigators documents regarding General Re’s questionable transaction with AIG.
Sort of makes one feel warm and fuzzy about doing business with that American business icon, Warren Buffett, doesn’t it?

Don’t miss Wall Street Journal ($) columnist Holman Jenkins’ Business World piece today. In analyzing the Lord of Regulation’s assault on American International Group, Inc. and its long history of being rewarded by the market for its adroit management of earnings, Mr. Jenkins makes an interesting point about the importance of trust — or, as he dubs it, the “predictability premium” — in AIG’s business, something that was touched on in this earlier post:

That Mr. Greenberg did his accounting as he thought best was no secret to anybody, even before recent revelations. Money Magazine called AIG a “faith stock,” lumping it with other giant, complex money machines such as GE and Citigroup. This newspaper dubbed it one of the economy’s great “black boxes.” Indeed, the whole reason to own AIG in the 1990s was to reap the predictability premium built into its stock price thanks to Mr. Greenberg’s ability to generate uncannily rising earnings from a complex of more than 100 businesses, including not just insurance, but aircraft leasing, commodity trading and much else.
In some ways, this model was already falling out of step with the business mainstream by the 1980s, long before Enron made “transparency” the central virtue of the new corporate value system. But exceptions were granted to AIG and a few others (like GE). Their opacity might have earned them skepticism in the marketplace, but instead they were awarded higher share prices. AIG sold for about 26 times its earnings, compared to 10 or 15 for most insurers.
Let’s dwell on this for a moment: When the market was the arbiter, it unambiguously rewarded Mr. Greenberg and AIG’s shareholders for applying the techniques of earnings management. The market understood that behind the screen lay all the volatility and mishaps that insurance is heir to, but it applauded Mr. Greenberg for using his wiles to create a security (AIG’s stock) that transmuted that volatility into unnaturally smooth reported earnings.
One big albatross for [former AIG chairman and CEO, Maurice “Hank” Greenberg] will be the Enron overhang. By far, the largest factor in AIG’s stock decline is the evaporation of its predictability premium, not the accounting scandal. But that won’t stop trial lawyers, prosecutors or the media from assuming that the distance between AIG’s peak and its ultimate low reflects the damage Mr. Greenberg personally did to investors.

And in closing, Mr. Jenkins notes that it may still be a tad early to be making a play for AIG stock, which is down almost 30% in value from the beginning of the year:

[AIG’s board of directors] no interest in defending any of this, since board members have learned that their personal fates are best served by running up a white flag. Eliot Spitzer, New York’s attorney general, let it be known this week that their compliance had met with his approval.
There’s also a question of whether, in a market where skepticism rather than trust is the rule, it’s possible or sensible to maintain an organization as complex as AIG. Hold onto your seats for the battle over Starr International, a peculiar entity set up years ago and holding much of the incentive wealth of the company’s top executives. We can’t think of a quicker way to destroy the morale of AIG’s remaining leadership, and thus perhaps the company.

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.