Credit Default Swamped

Bloomberg has reported that AIG, the world's largest insurer, has overvalued their credit default swaps meant to insure it against declines in its assets. It owes this bad mark to mark to market, the real world version of the mark to model virtual world of the credit melt-up phantasmagoria. (More on the story at MarketBeat.)

Trying to allay investor concerns, AIG's CEO Sullivan told everyone way back in December (2 months ago), no worries, she'll be right. But, the story reports, "The contracts lost about $4.88 billion in value in October and November according to the estimate in today's filing."

AIG produced the revised figures after its auditors, PwC, concluded that there was a “material weakness” in the way it valued its exposure.

The WSJ also kindly provided a link to an earlier story it ran in its Heard On The Street column on this same subject, back in August 2007:

The insurance giant did its best to reassure markets late last week that it wasn't going to get slammed by the crisis gripping mortgage and debt markets. Although AIG sees mortgage delinquencies rising, executives said during an earnings conference call that the bulk of its mortgage insurance and residential loans aren't at risk.

The company also said it didn't see problems related to a kind of insurance contract, or derivative, it has written against financial instruments that include some subprime debt. AIG based its all-clear signal for those derivatives on the fact that its internal models show that losses are extremely remote in the portions of the investment vehicles it's insuring. No likely losses means no reason to worry, the company reasoned.

Yet the company's valuation models seem to ignore the fact that those derivatives would likely take a haircut if sold in today's depressed market. "There's no way these aren't showing a loss," says Janet Tavakoli, president of Tavakoli Structured Finance Inc., a Chicago research firm. That's simply a market reality, she adds, that should be showing up in AIG's results.

"We disagree" with those questioning the company's valuation, said Elias Habayeb, chief financial officer for AIG Financial Services, a division of the insurer. "I believe we come up with our best estimate of the fair value [of these instruments] based on all the information available to us and that's reflected in our financial statements."

Stock analysts seem satisfied .... [They would say that, wouldn't they?]

As this develops, expect some kind of the "Paper Moon" defense that MBIA is trying to run with. The context for that was presaged in that Heard on the Street column:

Accounting experts don't fault AIG for using models to value the derivatives since there isn't a ready market for them.

The conflict over a slice of AIG's books and subprime exposure underscores a bigger question facing investors: Are companies and investment funds realistically pricing hard-to-value securities, or are they basing values on in-house models that reflect wishful thinking [i.e., the Paper Moon]?

AIG's Mr. Habayeb says the company records all its derivatives at fair, or market, values as per accounting rules. In the models it uses to derive this fair value, the company says it looks to the performance of the underlying assets, expected losses, credit ratings and interest rates as well as what's happening in the market.

Ms. Tavakoli, the research-firm president, argues that the drastic change in mortgage markets since April should gain greater weight in those estimates of value. And that, she says, should result in AIG showing some loss on the derivatives.

If that occurred, the loss would be taken as a charge to profit. The extent of any charge would be difficult to estimate. Even though it would likely be small compared to AIG's recent second-quarter net profit of nearly $4.3 billion.... [which, coincidentally, is slightly less than the mark to mark downs they took today, as mentioned above].

Barry Ritholtz is characterizing the whole "insurance" concept (of which the credit default swap is a part), as described by Bill Gross, as "Massive fraud on a widespread structural basis."