The Graham and Dodd formula versus DCF

The Graham and Dodd formula for the Price-to-earnings ratio is given by

PE = (4.4/Y) * [8.5+2*G]

where Y is the discount rate or, as they put it, the AAA corporate bond rate. G is the expected growth rate, both expressed in percent. The formula is not really derived from anything. It is more of a "rule of thumb" than anything else.

I thought it would be interesting to see if I could try to derive it (or something like it) from the discounted cash flow (DCF) analysis.

DCF, first popularized by John Burr Williams, posits that the value of a stock or any security is the sum of the discounted cash flows that it is expected to produce for the owner. When I do DCF calculations, I usually choose a growth rate and some number of year that it will grow at that rate. Then I assume that it stop growing for 20 years and vanishes after that. Usually, I use 6 years for the number of growth years. So this DCF PE estimate will depend on the two variables G and the discount rate Y and we can compare these to the Graham and Dodd formula above. I calculated both of these on a grid of Y and G. Here are the results.

The first figure shows the PE versus the growth rate for fiver different values of the discount rate in five different colors. The solid lines are the DCF calculations and the triangles are the Graham and Dodd formula. Note that the Graham and Dodd formula is linear in the growth rate so those lines are straight. The DCF is non-linear in G so they don't match up perfectly. Nonetheless, the basics trends are the same. The Graham and Dodd formula is not that far off of DCF although it is worse for low discount rates.



This plot shows PE plotted versus the discount rate for five different values of the growth rate in five different colors. As before the lines are the DCF and triangles Graham and Dodd. The Graham and Dodd curves are too steep at small discount rates. One can see from the formula that it scales directly with 1/Y so goes to infinity as Y goes to zero. The DCF does not have that feature if you truncate it after some number of years like I have done. Note also that the very low growth rates (the green curve) are off by quite a bit.



So Graham and Dodd seems to be a quick and dirty way of giving PE results similar to DCF but it by no means exact. In the days before computers, that might have been helpful but now it seems the formula is somewhat obsolete.

There is also the exact DCF result when you assume a small constant growth rate into eternity and a discount rate. The DCF simply becomes a geometric series which can be summed if G is less than Y. The well known result is
PE = 100% / (Y-G) which is different in form from the Graham and Dodd formula. Note also that they differ greatly at G=0. The DCF perpetuity gives PE = 100%/Y and Graham and Dodd gives PE=37.4% / Y; they are off by almost a factor of three The difference could be explained easily by saying that a stock is not guaranteed to produce a stream of earnings forever and should not be valued as if it is. Or one could say that unless the earnings are actually payed out in full, you should not value them at full value. Some combination of these two arguments can easily explain the uselessness of the perpetuity formula.

What does US debt imply about the future?

Here is a not so lovely plot showing the total US debt as a fraction of GDP from the early 1920s to the present.



Yves, at nakedcapitalism has a nice post on this here (the origin of the plot).

The debt is now roughly $54T with a rough breakdown household debt $14T, non-financial businesses $11T, state and local government, $2T and US federal government $10T, financial businesses $17T.

Another source of various charts and figures is
here .

One should keep in mind that it is not really the total amount of debt that matters but rather the carrying cost of that debt. For example, if interest rates are zero, then it doesn't really matter how much debt you have since your interest payments are practically negligible. Interest rates have been dropping steadily since the Volcker recession in the early 1980s and are now essentially at zero.



Now have have clearly reached one of those great turning points in economic history. What is to happen next?

Well, if the US were not the powerful economic and military superpower and holder of the reserve currency the outcome would be fairly obvious. We would suffer the same fate as Iceland or Argentina. Other countries would stop lending to us and refrain from investing in our country. Our currency would plummet and interest rates on our debt would sky rocket. Since a lot of our debt would be in other currencies, devaluing our currency would only alleviate our problem to a limited extent. We would go begging to the IMF for a bailout and would receive it only by accepting their terms which would include higher taxes and in effect a lower standard of living.

However, the US is not Iceland. The US debts are almost entirely in US dollars. The US dollar is also the reserve currency of most central banks. The US is not only the sole military superpower, it is the largest source of consumer demand in the world economy. If any central bank or ALL central banks decide to sell off their dollar denominated holdings and give up the US dollar as reserve currency, the dollar will drop and there will be major economic as well as political consequences.

• Loss of competitiveness in exports as US exporters benefit


• Loss in the value of US dollar reserves


• Major restructuring costs as the world economy rebalances


• US power decreases as it can no longer run large deficits


• Power shifts eastward, the consequences of which are uncertain

The politicians of Asian countries (China in particular) might not be able to withstand a large loss of jobs in exports. For this reason they might not be too keen in allowing the dollar to weaken. This is not a question of whether it is better for them in the long run. It is a question of whether they can throw a lot of people out of work and still remain in office. The European's might not like the monetary situation which empowers the US but probably prefer it to one in which Asia hold more power. They after all share a common culture and are military allies. Likewise Japan and Saudi Arabia (among others) depend on the US military and so have reason to sustain the current situation. So it seems that it is unlikely that any drastic change in the US dollar as reserve currency will be precipitated from abroad. It doesn't appear to be in the best interests of these countries. Asia is too dependent on exports to the US and if Asia does not dump the dollar it is unlikely that anyone else will since that would just allow for a further loss in competitiveness to Asia.

But, one way or the other, the US needs to restructure its debt. Fortunately, there is a way. The Federal Reserve can simply print money and monetize the debt. It could if it wished, simply buy every outstanding loan and then restructure the loan any way it wished. It could simply forgive all the debt and in doing so reduce the debt to zero. This is of course the extreme case but there is nothing in principle stopping the Fed from devaluing the dollar and reducing the real value of this debt load. Some people have a knee jerk response that this is preposterous and would never work. They say, it would cause our foreign debt holders to immediately sell their Treasuries which would cause yields to spike. But this is incorrect. The Fed has unlimited amounts of dollars and could choose to buy every US treasury at 0% yield if they wished. This would effectively make Treasuries and dollars exactly equivalent. If our foreign debt holders wish to sell them, they would simply end up with dollars. They would have to spend those dollars in the US boosting US exports or buy US assets like stocks and real estate.

Now of course this is highly inflationary. The US money supply is roughly $10T. If the Fed converted $50T in debt to $50T in dollars, this would increase the money supply roughly by a factor of six. Every real asset would be about 6 times more expensive. That would be the cost of eliminating all of our debt. However, even in this extreme scenario, this is not really hyperinflation. A devaluation by a factor of six is roughly the same as was experienced in the US between 1960 and the present. It is not like Zimbabwe whose currency has an inflation rate (Dec 2008) of 516 quintillion percent (516 followed by 18 zeros).

Now, the Fed need not erase all of the debt. It would be enough to reduce household debt by $5T which would put the US household back to where it was in the late 90s. It could also do things like buy up all the credit card debt from the US banking system (there is about $2.6T) and refinance it at a fixed 5% interest rate. Keep in mind that the average interest rate on credit cards is about 17%. This would greatly reduce the interest payments for US consumers and keep the debt from growing too quickly. They may even be able to pay it off. It could also offer to buy any outstanding mortgages at face value (or some reasonable discount to that) and refinance them at a lower principal to reflect the lower home price. This would keep many of these people in their homes and repair the balance sheet of the American homeowner. It would also be a giant bailout for the US banking system. Businesses then would also want some kind of bailout. Where this stops is hard to know. The point is, that the Fed has almost unlimited power in terms of printing dollars and spending them wherever they want. If they lack certain powers, the congress can vote to give them new ones. But the US itself has the power to determine the real value of their debt since it is entirely in their own currency.

Foreigners can gripe out how we have duped them. They have traded real assets for pieces of paper and then we devalued those pieces of paper. But they can't simply blame us. They knew what they were getting into. They never expected us to act in any other way then what was in our own best interest. The situation is akin to a bank who makes loans to people unable to pay them back. They deserve to share the pain. There is really no other way. They may be harmed even more if the US does not prevent deflation from setting in. Deflation in the US will simply spread to every other country.

What will result from this however is that we will have to give up forever the idea that we operate under a capitalistic system. We will have to admit the role of the Federal Reserve as massive central planner. What looks like capitalism is really play-capitalism and when the play gets too rough, mommy comes in and breaks it up.

The result of all of this is likely to be a more balanced world economy. The world will be a lot more reluctant to lend money to the US. But the US will have less need to borrow since its debt load will be reduced. Perhaps the dollar will remain devalued and the US can export more and erase the trade deficit. Of course lots of things can go wrong. But one should keep in mind the tremendous power of the Federal Reserve in being able to create as many dollars as it wishes. The outcome will not be determined simply by economic factors. Political factors are at least as important for an economy with a fiat monetary system.

Would printing by the Fed be fair? Well, if your attitude is that anyone who borrows is morally obliged to pay it back then the answer is no. But the world isn't fair. Countries all act in their own best interest. That should not surprise anyone who is a realist. Paying back our debt in full value is not in the best interest of the United States and might not even be in the best interests of our debtors. Likewise, since bankruptcy is always an option, it benefits banks to restructure the loans to consumers so that they can service them. Obviously, some ways of restructuring the debt are more fair than others. It is uncertain how far the Fed would go or how far they would need to go.

So what are the investment implications? Well, the Fed probably won't be able to act too aggressively until the situation has worsened further. They need political cover in order to convince the US and foreign politicians that there is no other way. So stocks will likely fall further as earnings vanish. The weaker businesses will fail and other banks will be brought down. Panic is likely to rise as the world economy approaches the brink of complete meltdown. The near term outlook then is for deflation. At some point however there will be no more deflation plays. Yields on treasuries will have approached zero. Stocks will have fallen to extremely low valuations. Bonds will be in a bubble. At this point, the Fed will act aggressively to reflate the economy. So stocks will be a good bet here and also commodities. Gold should do well as there will be great uncertainty of the future monetary system and the dollar is likely to end up devalued. Stocks that may do the best are those with low debt and plenty of foreign currency exposure. In particular, ones with less exposure to bad, or at least uncertain, economic conditions. JNJ, CL, KO come to mind. Times of economic and political turmoil will likely be good for the consulting agency ACN. Energy companies should do fairly well though probably less well than the past few years. I will revisit this in more detail in the future.

Nikkei back to 1984 prices

The 1980s were an incredible decade for Japan. From 1984 to 1990 the Nikkei rose fourfold from 10000 to 40000. Today it is at 9444. It has gone up and down and 24 years later it is right back where it started. Pretty depressing. Is it time to look at some Japanese stocks?

Over the same time the Dow went from about 1100, peaked around 14,000 and is now about 9447. The Dow and Nikkei are almost exactly at the same level. But in the case of the Dow it is up by a factor of 8.6.

Notes on valuation of AIG

This post is to collect various notes on valuing AIG.

This story attempts to estimate a break-up value for AIG.

"CreditSights estimates that the company's general insurance business is worth $95.2 billion, its life insurance and retirement services business is worth $147.7 billion, its financial services business, including its aircraft leasing unit, is worth $9 billion and its asset management operations are worth $3.6 billion, said Haines. That valuation, which assumes limited stress in the financing markets, comes to a total of $255.5 billion."

That works out to $19/share after the 80% dilution. That seems much higher than any other estimate. I am also not sure of they are including the mark-to-market losses. Probably not. If we take out another say $30B for CDS losses, that would still be $16/share. The book value as of last 10-Q was $5.80/share including the dilution.

Recently (after the bailout) Bill Ackman, the hedge fund manager of the Pershing Square, bought AIG. I think he paid around $3.50. He
estimates book value to be around $6. This estimate takes into account the mark-to-market losses and the 80% government dilution. He also thinks there is a chance that some of the dilution can be reversed if AIG pays the loan back very soon. I agree.

The real valuation of AIG would have to include the following:

1) Figure out what they are going to sell and what they will get for it and how long it will take them to pay off the loan. Also consider the interest on this toxic loan.

2) Figure out what the real losses will be on the CDSs. Also consider the fact that the mark-to-market losses could get worse. They could also reverse if the TARP bailout moves these MBS priced higher. This will have some effect on liquidity and might effect how much of the company they have to sell.

3) Then figure out the earnings and earnings growth of whatever is left over and model it in the usual way with a DCF.

4) Estimate the actual dilution that the government will demand. Will they take the full 80% or something less.

5) Think of anything else that could go wrong.

################# UPDATE ###############

They are reworking the deal. This info comes from the Wall Street Journal.

Lets go over the details. They are scrapping the original deal. Now the are giving AIG a 5-year loan for $60B at LIBOR plus 3% which comes to about 6% given that LIBOR is about 3%. That is much better than the original 14% loan. They are also giving them $40B in preferred stock with 10% dividend yield. Not sure if it is cumulative. In addition they are injecting $50B in common capital. The government still will keep a 79.9% equity stake. I assume that means common equity but I am not sure.

First of all this is pretty good so far. Instead of paying 14% on $85B or $11.9B pretax per year, they will pay $3.6B pretax in loan interest and $4B aftertax for preferred dividend. At 40% tax rates that saves them about $1B per year after tax. Not a big difference but it helps. The real advantage is that this increases total capital by $90B which will greatly improve the capitalization of AIG and should raise their credit rating. Also it increases common capital by $50B. So instead of giving away 79.9% of the company in exchange for just a loan, common shareholders get $50B common capital in return. This seems a lot more fair to me. At least it is better than before. Now they will have to sell roughly $40B worth of assets over the next 5 years to pay back the loan. That is only half of the $85B in asset sales that was required by the first deal. Plus, they get 3 extra years in which to get it done.

Then the story gets a bit more complicated. The government is setting up one "vehicle" to handle AIG's CDSs on CDOs and another to handle the securities lending business. The first one will be capitalized with $30B from the government and $5B from AIG. That would take on the $70B CDS porfolio on the CDOs. As of last credit presentation, they has $57.8B net exposure to multi-sector CDOs including subprime and $22.5B in multi-sector CDOs without subprime for a total of $80.3B. This may have shrank down the $70B quoted in the journal. It is not clear if this capital is in addition to the other capital injected into AIG. I think almost certainly not. So this would be setting aside $30B out of the total $90B in new capital and $5B of current AIG capital. In addition it says that AIG (or presumably this new vehicle) will attempt to buy the insured CDOs from their counterparties for 50 cents on the dollar so that it can tear up the CDS contracts. The notional exposure (before AIG's subordination) was $112.6B as of last presentation. So 50 cents on the dollar would be $56.3B. If it buys the CDOs back, it gets the collateral back that it had to post.

I can't say I understand this bit. There are 112 different transactions. What makes them think that the counter parties want to take a 50% hit on these if they can make AIG pay anything over the subordination level. AIG's average subordination on the CDSs including subprime is 23.9%. The subordination on CDSs without subprime is 16.3%. So if we just take the ones with subprime, those counterparties can only take a 23.9% hit before AIG covers them. So why sell it back to AIG for a 50% hit? Is it because they don't think AIG could actually pay them off? Perhaps it has more to do with asset reduction. This is confusing.

The other vehicle would be set up to handle the problems in the securities lending facility. AIG lent out securities to short sellers and took in collateral. It used this collateral to buy mortgage backed securities collateralized by subprime loans. Pretty dumb move. When the short sellers closed their shorts (presumably because of the short selling ban and/or deleveraging), they wanted their money back and AIG couldn't sell the RMBSs. So they borrowed money from the Fed to pay back the shorts. The new vehicle would take $20B from the government and $1B from AIG and buy the illiquid RMBSs from AIG at 50 cents on the dollar. So does that mean that AIG will realize a $21B loss on those or is some of that money simply for liquidity?

So the first part of this is good news. The second part concerning these two vehicles is confusing. It sounds like this will improve AIG's liquidity, solve the securities lending problem and protect them from future CDS losses. But what is the cost to AIG? It isn't clear to me what this unwind will cost them. They have already written down about $30B to cover these losses. Will this result in losses above that?

Lets do a rough calculation. Lets say that this unwind results in a $50B total loss. That is $20B on top of what was already written down. Last 10-Q showed $78B in equity. So after the unwind that would be $20B pretax and maybe $12B after tax so that would make equity $66B before the equity infusion. They added $90B but appear to putting $35B on this into the first vehicle. So that leaves $55B of equity left in AIG. Total equity is now $121B including the $40B preferred stock leaving $81B in common equity. Original shareholders own only 20% of that which is $16.2B. There are 2.7 billion original shares so book value per share would be $6/share.

If this is correct (a big if), the stock should be worth at least book value and so should go roughly to $6/share but probably not right away. If the break up value by CreditSights is correct, then it should be worth even more.

A worst case scenario might look like this. Assume the $70B in CDSs are completely worthless and are written off entirely. This is $40B in additional write-downs pretax and $24B after tax. Even this leaves book value per share at $5.11/share. Seem like the stock is a good investment at less than $3/share. I expect it will trade above $3 tomorrow morning.

There are other stories out now saying that if the securities purchased at 50 cents on the dollar result in profits, the government will share them with AIG but keep 2/3 of them. This adds a little more value to AIG.

Time for America to refinance their debt

Why should the US go on a borrow and spending spree?

The US consumer is in debt in a major way. The typical american has a mortgage at say 6% interest. Most have credit card debt at say 14%. Many have a home equity loan at 9%. I don't know the weighted average interest being paid but it is probably about 10%. So why don't we all just refinance? The government can borrow at 4% and send us all a "stimulus package" to pay down their higher interest debt. Sounds good to me. This is a kind of arbitrage of refinancing. It works as long as people are willing to buy treasuries at these low rates.

This is actually not a bad idea. After all, the stimulus package can be structured to give fixed amounts to American middle class families. The bill that gets stuck with the taxpayers gets payed in the normal progressive fashion. That is, rich people pay more of it. So this acts to redistribute wealth from the rich to the middle class which is exactly what is needed. This is inevitable anyway if the economy is to survive. The only other option is mass bankruptcy which effectively does the same wealth redistribution. If someone who is underwater by $100K declares bankruptcy, he becomes richer by $100K and his creditor becomes poorer by the same amount. If we use tax policy or inflation to reduce their debt load we can fine tune the wealth redistribution more gradually.

The dollar must die

What is the inevitable conclusion to this world financial crisis?

1) The US dollar must drop but it will drop slowly over the next decade or so. It will not be caused by a sell off in Asia.
2) This will increase US exports and decrease the US trade deficit.
3) This will slow global growth and so most commodity prices will not increase much in dollar term despite the dollars weakness.
4) US nominal wages will rise and US denominated debts will shrink in real terms.
5) Gold should increase in dollar terms as it becomes a more stable source of money.
6) China will suffer as it needs to decrease exports and increase consumer spending as a percent of GDP.
7) US treasury yields will increase but not very much. The Federal reserve will absorb more and more treasuries and allow the dollar to weaken as it needs to do.
8) A long period of slow growth and poor returns to capital will prevail.
9) The best sectors will be US exports with foreign currency exposure and recession resistant business models, healthcare companies should do the best, JNJ, PFE, MDT etc.
10) US military spending will decrease. US will rely more on its allies for security.

The wrong-headed media coverage of AIG

The media has been writing all kinds of garbage about the fall of AIG. The general themes are that 1) AIG didn't know how to handle risk. 2) They should not have stepped outside of their familiar territory, insurance, and ventured into credit derivatives and 3) They were brought down by massive CDS losses related to mortgages.

Lets start with the first one that AIG does not know how to handle risk. These CDS derivatives that everyone is blaming for the collapse in not what brought them down. They have experienced very little actual losses on these instruments. What brought AIG down was the confluence of mark-to-market accounting with overly aggressive credit rating agencies combined with a panicked credit market leading to a liquidity crisis. I will get back to this later.

Now on to the second one, that AIG should not have ventured into the market for these credit default swap, CDSs, that were the specialty of investment banks like Goldman Sachs. People say, they should have stuck with what they know, insurance. The reason this is absurd is that CDS ARE insurance contracts. The opposite conclusion should be reached that ONLY insurance companies should be writing these instruments NOT banks. CDS are contracts where the writer agrees to make a payout when some event of default occurs. This is no different from when an insurance company agrees to make a payout when a fire occurs. They just need to estimate the chance of such an event and be sure that they are adequately capitalized to handle the losses. In fact, Eric Dinallo, the New York, Superintendent of Insurance is now pushing for CDSs to be classified as insurance and demanding that anyone writing such contracts get an insurance license.


Now let me explain why CDS losses did not bring down AIG.

AIG had $441B worth of CDSs as of last quarter, June 30, 2008. $307B (3/4 of the portfolio) of these are "regulatory capital" related. These are not risky by any means. In short AIG agreed to accept some of the risk of bank loans in order to allow banks (about half of them European banks) more room to lend until the new Basel II regulatory capital changes go into effect in about a year. Generally speaking, AIG will start to suffer losses on this portfolio when loss rates on these loan portfolios hit 23%. This is for bank loan portfolios. Since banks are generally leveraged about 10 to 1, a 10% loss on a portfolio are usually fatal for banks. Losses like this generally only happen during major depressions like the Asian financial crisis or the Great Depression and have never happened all over the world at the same time. Losses as large as 23% are that much rarer. It has never happened and short of nuclear armageddon, never will. Losses to date on this $307B regulatory capital portfolio is $125 million or 0.04% of the portfolio. To put this in perspective, AIG makes about $10B/year from insurance and probably more than a billion dollars from the premiums on these very contracts.

So that takes care of 3/4 of their CDS portfolio. There are three other parts of this CDS portfolio that I will discuss, corporate credits, CDOs with subprime and CDOs without subprime.

CDSs on corporate credits of which they have $54B of exposure. These are CDSs which will pay out in case certain companies go bankrupt. Losses to date have been about $1B or less than 2% of the exposure, which is about the same as losses experienced on a typical corporate bond portfolio. This can easily be made up by having yields 2% higher than risk-free treasuries. So far these have likely been very profitable just like the regulatory capital related CDSs discussed above.

Then there is the CDSs on the multi-sector CDOs which can be broke up into subprime related and not subprime related. The exposure of the part not related to subprime is $22B. The "losses" to date have been $3.5B. The CDSs related to subprime have an exposure of $57B with "losses" to date of $21B.

Now I will discuss these "losses" and explain why I put this in quotes. One needs to understand a bit about how these losses are calculated. I will also explain a bit about how these CDSs work. The CDSs are insurance contracts against defaults in things called CDOs. The CDOs are the instruments which receives the cash flows from underlying mortgage backed securities which are pools of mortgages. I won't go into the details here but the key thing to understand is this. If the CDOs start producing losses then the writer of the CDS, that is AIG, has to pay the CDO holder the cash that was not received. So far, hardly any of these CDOs have defaulted. That has to do with the fact that these are "super-senior" CDO tranches. This means basically that there are other less senior tranches that need to be wiped out completely before they lose any money at all. That is the issue of subordination. It is like being in the 10th row of the British army. If you get attacked, the people in front of you will get the bullets and you won't get shot at until all of them are dead. It affords protection.

So if the CDOs have not defaulted, then why do they have "losses". This is due to so called mark-to-market accounting. Basically this is because the CDOs are marketable. Parties occasionally, but rarely, sell them. The accounting rule FAS 157 requires that the CDOs be marked to the market prices. The CDS writer needs to assume that these prices are correct in predicting what the losses will be in the future. So regardless of what the losses actually will be, the CDS writer can be brought down simply by the market panicking and selling off these CDOs which is exactly what happened to AIG. So the trouble is not really that AIG underestimated the risk of losses on these instruments. It is that they did not foresee the effect of market panic of the value of their insurance contracts because usually this has no bearing. For example, if there is a major hurricane like Katrina, people often and irrationally get more risk averse to hurricanes. They think that maybe global warming will result in more dangerous and more frequent hurricanes. This may be true but the event of a hurricane does not change the truth of it.
If insurance contacts traded on the market, you would find that they would increase in value and that the writers would experience large losses. But they don't trade on the market and insurers do not account for hurricane insurance contracts in this way. Insurance companies are allows to estimate their own losses and keep reserves for what they think they will be. This has been the way insurers have accounted for losses as long as there has been insurance and accounting. So far, it has worked pretty well as long as they are regulated by insurance commissions.

If CDSs were only written by insurers, they would likely be accounted for in the same way. If they were accounted for like insurance contracts then AIG would not have taken large losses, not yet anyway. AIG has estimates that their losses from CDSs related to subprime loans would be less than $8B even in extreme circumstances. They have been forced to mark down $25B due to the market panic and sell off in CDOs. I won't even get into all of the facts that explain why AIG's losses will be much smaller than people think.

What happened to AIG was this. Due to mark-to-market accounting, they have to write down their CDS portfolio to unrealistic levels. Because of this, they had to raise capital to avoid credit rating downgrades from companies like Moody's and Standard and Poor's and Fitch. These companies being accountants cared only about the numbers and the rules and not the reality of the situation. Credit rating downgrades would force AIG to come up with cash collateral to give to those holding the CDS contracts, mostly New York investment banks like Goldman Sachs and Morgan Stanley. The credit ratings agencies realized that AIG might not be able to raise the cash to do this. Because of this, they saw this as a major business risk. A downgrade and a collateral call would cause a default which would cause a bankruptcy event at AIG. Because of this new risk, they felt AIG needed to be downgraded anyway. It was a catch-22 of sorts. If they were vulnerable to a liquidity run, then they were not deserving of their current rating. Because of this the downgrade the liquidity run was assured. So the credit agencies gave AIG a short amount of time to find the cash. Once the markets became aware of AIG's situation, AIG because radioactive. No one would be first to put in any cash if they were not sure that others would join in. If you put in cash and it wasn't enough, then your money might get locked up in bankruptcy and you might not even get it back. So the liquidity run began on AIG. S&P gave AIG just three days to sell off some of their subsidiaries to raise the cash to avoid a downgrade. AIG was not able to do this in time and as a last resort went to the Federal reserve. The rest is history as the Fed seized 79.9% of the common shares in return for a high interest collateralized loan. Such was the fate of AIG.

So in summary, the media is reporting all kinds of non-sense about AIGs fall. The reality is that AIG did not anticipate the difference that mark-to-market accounting would have on their CDS insurance contracts as opposed to their typical insurance contracts. They did not underestimate the risk of losses. They underestimated how a market panic could create fictitious losses that would have real effects, ultimately fatal ones, on their business.

AIG, is there any hope?

The credit agreement on AIG's toxic government loan is now out . It is spelled out clearly that the treasury is going to own and control 79.9% of the company. I don't see any way around this. So must we give up our last bit of hope that this massive dilution can be undone?

Let us quote Lady Galadriel from Tolkiens's "The Lord of the Rings".

"Even now there is hope left... But this I will say to you: your quest stands upon the edge of a knife. Stray but a little and it will fail, to the ruin of all. Yet hope remains while all the company is true."

There are a few options left. These are 1) The practical option 2) The political option 3) The legal option

The practical option: a capital injection.

The first of these options is that the shareholders can still try to find an alternative source of capital to inject into the company. If they are able to find say $100B of capital (say from Sovereign Wealth Funds) they might try to buy out the company. Obviously, if they are going to do this, they will need the government to take back their loan money, and give back their 79.9% equity position. So they need to have enough capital so that the government has no worries that AIG will need further cash. Now you need to think of the Fed and Treasury's incentives. They don't really want to be lending AIG money, nor do they want ownership of an insurance company. I think they will feel that the taxpayers would rather get AIG off the government books since this will be the minimum risk position for taxpayers. Taxpayers don't want a high risk, high return opportunity. That is not what the Treasury is for. I think if the shareholders can find such a group willing to invest such a large sum of money, the deal will probably happen. However, I think the chance of this happening is no better than 5%. Even if it does happen, the current shareholders are not likely to get more than 30% of the company. So this is not much better than the current situation. The chance of us getting 100% of the company back through this kind of deal is basically zero.

The political option.

There is a chance that the powerful shareholders of AIG can exert pressure on politicians to act to reverse some of this deal. Remember the Treasury is subservient to Congress and the President. If it turns out that AIG's losses on CDSs are minimal and that we find that its demise was caused by some conspiracy of hedge funds attacking the stock and CDS market to create a panic, there might be some sympathy for AIG shareholders. It would seem somewhat unfair, I think, if AIG comes out of this with massive dilution and other companies like Goldman get saved by some kind of bailout. This might seem kind of arbitrary and there is a chance that politicians will act to correct some of the things that were done. Perhaps they would reduce the government stake from 79.9% to 50%. Again, I think the chances are small, maybe 3% that this will happens.

The legal option
This might be our best option since there are so many ways to go about it. Clearly the shareholders are going to sue a lot of people, the management, the BOD, the Fed, the government, etc. They might even be able to sue certain hedge funds for manipulating the stock. Who knows how this could turn out? I think it is very likely that they will win some judgements. How much this will produce for shareholders is hard to say. The chance of getting the credit agreement pronounced invalid is probably very small but could be maybe 2%.

Overall, I would say there is still maybe a 10% chance of some kind of upside coming out of the various possible ways to undo some (probably not all) of the dilution. This should be factored into the price of the AIG stock. However the most likely situation is that the dilution will stick. So one needs to try to value the company as it is and then divide by 5 to come up with a price for the diluted common stock.

I won't go into detail here abut this. It depends on many things. If this bailout goes through where the government buys up illiquid MBSs, then the CDS marks that we have now will probably reverse. We will end up paying out some cash losses on the CDSs but they may be smaller than it would be if the government stayed out of the housing market completely.

I think it is fairly conservative to say that the CDS and MBS losses will be less than $30B. That is only another $5B mark from last Q which leaves total tangible equity around $60B or $4.40/share. However this is probably not the right way to value AIG. People have estimated the breakup value of AIG from $150B-$180B. Lets use $130B due to the loss of brand value from all of this and the illiquid marketplace. Lets take off another $30B for mortgage related losses and another $10B for interest payments on their toxic government loan. So leaves about $90B or $6.60 per diluted share.

The current price is about $3 and so it seems relatively attractive. However there are still risks to this. How valuable is AIG as a company controlled by the government? How much damage will be done to the brand? Will a credit crunch result in mostly fire-sale prices for their subsidiary assets? Are the CDS losses really greater than we think? All of these worries should keep the price of AIG well below the "rational" value of the company for some time. I think what really needs to be done is that these CDS contracts get unwound. But what price will AIG have to pay to do this? Does the government have the incentive to act in the interests of shareholders or will they act more in the interests of the financial system as a whole? That is a scary question.

Given all of these uncertainties, the stock looks fairly priced at $3.

The Rape of AIG: Open Letter to Mr. Paulson

To Mr. Henry Paulson, Treasurer of the United States,

A few days ago, the nation's largest insurance company, AIG, came to New York Fed and said, "We need help. We are having a liquidity crisis. If we are not given a loan, we are going to default on our collateral calls to Goldman Sachs, Morgan Stanley and other investment banks and declare bankruptcy". The company and the Fed knew that this would be the fatal blow to Wall Street and, in fact, the world financial system. If AIG had chosen to file for Chapter 11 bankruptcy (reorganization not liquidation), their $400B+ in credit default swaps (CDSs), a guarantee of sorts, would have been declared not-secure. The counter-parties to these would then have to mark these instruments down as the guarantee would no longer have firm backing. Three quarters of this CDS portfolio was for "regulatory capital relief" for banks all over the world; half of it from European banks. These banks offloaded much of the risk on their own loans to AIG so they could grow their asset base faster than their capital base while waiting for the new Basel II capital accords which will allow for higher leverage ratios. These banks would instantly be undercapitalized and unable to loan.

But even more pressing would be the crisis that would hit Goldman Sachs. Goldman has survived, unlike Bear Stearns and Lehman Brothers, because they have effectively hedged their exposure to subprime lending by buying this insurance from AIG. Many people, including myself, Ben Bernanke and yourself have claimed that the "fire-sale" prices for mortgage backed securities is not indicative of the true value of these securities. However it is these "fire-sale" prices, combined with mark-to-market accounting that have damaged the balance sheet of companies like AIG and the investment banks. The difference, however, between AIG and Goldman is that Goldman has been able to hedge its exposure. That is, it's mortgage backed securities may have been marked DOWN to unrealistic levels but its CDSs with AIG have been marked UP to unrealistic levels. In other words AIGs pain has been Goldman's gain. If AIG had instead chose the protection of Chapter 11 bankruptcy, then Goldman would be instantly insolvent and the last two of the New York Bulge Bracket firms would have failed.

What did AIG get in return for agreeing to the Fed's offer of a loan and saving Wall Street and the world financial system? It got 80% of its equity stolen and handed to the Fed. AIG did not have a solvency problem. They had a liquidity problem. AIG's breakup or liquidation value has been estimates at $180B after paying off its liabilities. That would have corresponded to roughly $66/share. Maybe we would have only received half of that, $33/share, in a bankruptcy auction and restructuring. Instead our shares trade at $4/share now that the government owns 80% of the company and effectively controls it. Whose interest was it really to enter into this deal?

Lets compare this to the way Goldman Sachs, the company you led as CEO from 1998 to 2006, was treated when they ran into a liquidity crisis earlier in the year. Goldman along with the other investment banks normally raise their funds through commercial paper and relatively short terms bonds. That is because, despite the names, they are not banks. They do not pay FDIC insurance premiums, cannot raise deposits and do not normally have access to the Fed's discount window. They are regulated by the SEC not the Fed, FDIC or OTS that regulate real banks. In fact, they are no more real banks than the subprime mortgage lenders who went bankrupt from a liquidity run earlier in the year. These, you might recall, were thrown to the wolves by the investment banks when the IBs decided that the business model would no longer be profitable. "Well, that's capitalism!", I guess you can say. No one ever promised them a guaranteed line of credit. I guess it was their fault for not securing longer term lines of credit.

So when Goldman Sachs and the other IBs (with 30-40 times leverage) discovered that the commercial paper market was effectively shut off for them, what might one expect to happen to them? Bankruptcy? Perhaps the Fed, to protect the financial system from freezing up would give them a toxic loan, like AIGs, at 11% and take 80% of their equity? Is that what happened? No. Instead the Fed and treasury made unprecedented changes to the entire Federal Reserve System in order to accommodate these companies. They created the Primary Dealer Credit Facility (PDCF) so that the IBs could borrow funds at the discount rate 2.25% (lower than the commercial paper rate they were issuing before) against "good collateral". Eventually the "good" part was removed and any collateral was OK, even common stocks. Then they were given access to the discount window. Then, the Term Auction Facility was created where you just auctioned off money at rates not far above the discount rate to these "banks". because the "banks" said that going to the discount window created a stigma for these "banks".

So instead of punishing these companies for their greed, poor management and investing mistakes, you did everything in your power to bail them out. Despite the fact that they are not real banks you let them borrow directly from the Fed at lower rates than real banks (who pay into the FDIC) can get on their certificate of deposits. When Bear Stearns and Lehman brothers actually became "insolvent" (and who can tell anyway at 40 times leverage), they were allowed to fail but not Goldman and Morgan Stanley. They just had a liquidity crisis. They are solvent and so deserve your protection, right? And AIG? You claimed that because they are just an insurance company, they don't deserve the same protection. After all, they don't pay into the FDIC. They might look like a bank, but they are not really a bank. So you gave them a toxic loan and took 80% of their equity so that they would not declare bankruptcy and destroy the remaining members of the Wall Street money club. You derisively called AIG a "hedge fund on top of an insurance company". Well what is Goldman? It is a giant hedge fund on top of nothing and has four times the leverage of AIG. The difference in treatment between AIG and Goldman is no doubt due to your giant conflict of interest as a Goldman lifer and former CEO and now the secretary of the treasury.

Now you ask for a $700B bailout from the taxpayers so that Goldman can dump mortgage assets worth maybe five times their equity at "hold-to-maturity" (read: wishful thinking) prices. I think the tax payers are going to want a few terms with that. How about 80% equity in Goldman Sachs and Morgan Stanley. They have been already been bailed once by completely restructuring the Federal Reserve System. Then they were bailout out again by convincing AIG to avoid bankruptcy. Now you want another $700B handout? Not without 80% of Goldman. If you don't like those terms, well, that is what bankruptcy protection is for.

Signed,
David Johnston
An AIG shareholder and a taxpayer

AIGs bailout and what it means for investors

As an AIG shareholder, I was shocked an dismayed at the crisis at AIG and bailout from the Fed. Now I sit here with an enormous loss on my hands and an AIG stock worth only $2. So what to do now? Sell or hold? How much is this ghost of AIG worth?

I have no idea nor does anyone else. The reason why is that there has been no clarification of what really happened and what this deal with the Federal Reserve really entails. Nor do we know what really caused the liquidity crisis and whether the bailout has helped or hurt their cash problems. AIG is now a laughing stock and people appear to be pulling their money out as fast as they can.

So let me try a few scenarios to try at a valuation. First the simplest one. Before the liquidity crisis, I had estimated the stock to be worth about $40/share. So if the shareholders get to keep only 20% then the stock should be worth about $8. Of course everything has changed. AIGs reputation has been severely damaged. They may still face a liquidity problem. On the flip side, they may be liquidating a lot of their subsidiaries and so the AIG reputation may not matter as much. Also the break up value of AIG may be even higher than my estimated fair value. People have estimated the break value at $150B. Others say $180B. There are $2.7B shares so that is $11/share even with the 80% dilution, using $150B for the total. Of course all of this depends on the final losses from the CDS portfolio. Still, I have estimated these to be less than $20B. Certainly not $100B that would be required to come up with the current price.

So even with the 80% dilution, there is a chance that the company is worth substantially more.

However the real reason that people might consider investing in this cigarette butt of a stock is that this deal with the NY Fed may not stand. If AIG can liquidate assets quickly or find the money somewhere else, they may be able to get back that 80% equity stake.

Before I discuss how this is possible, let me comment on the deal. We don't really know the facts since there is no term sheet or anything in the public domain. From press releases from the Fed and AIG we know that the loan is 8% above LIBOR and has a 2-year term. There are some loan covenants but they are not disclosed other than that the Fed reserves the right to prevent dividends to shareholders. There is also some vaguely worded mention that the taxpayers will get "up to" a 79.9% equity stake. There was an 8-k from AIG saying that they issues a warrant to the Fed and that this required a shareholder vote. Then another 8-k came out to correct this and simply said that shareholder action would depend on the form of the equity. In other words it is not clear at all and the deal is likely still being formed.

There has been some
discussion from corporate lawyers on whether any of this is legal. It is possible that the Fed will screw it up and create an illegal contract which can be thrown out in court later on. There isn't exactly a lot of precedence on this kind of thing.

There is talk that some major shareholders led by Hank Greenberg are trying to come up with an alternative plan. Greenberg mentioned on the Charlie Rose Show that they could raise capital in various ways: from sovereign wealth funds, from selling assets, from current shareholders etc.

So lets looks at this and try to game how it is likely to work.

First of all lets look at the incentives of shareholders. Anyone holding AIG shares likely believes that the CDS losses are manageable. If not, they would probably not still be holding shares. So they likely believe that the company is worth at least $60B and so losing 80% to the government would be a major and avoidable loss. They would likely want to do everything they can to undo this deal including investing more of their own capital.

Same with SWFs and other PE investors. They likely see the value in AIG as long as they can provide the needed liquidity. With a recession looming and the $700B federal bailout coming, an insurance company with 60% of sales overseas looks like a great place to invest long term.

The main thing to look at is the incentives of the NY Fed and the US government. This is much harder to figure out.

They clearly didn't want to give this loan. If someone else could come in and take over they might be happy about it. However, they need to be sure that this party provides enough liquidity so that failure is not possible. That is because they don't ever want to be in this same situation again. So this might require something like $150B. It needs to be an overwhelming amount of money so that AIGs credit worthiness is completely secured.

There is the issue of the warrant (if it exists). Naturally the Fed does not want to give up an asset that may be worth $50-80B. An assets is an asset after all and nobody gives them up for nothing in return. However this asset might be more trouble than it is worth. There could be all kinds of legal action on the part of AIG shareholders. There is the issue of liability. A warrant does not usually mean ownership however the marketplace is not likely to see it this way. As long as the Fed has this loan outstanding and the warrant in place, the world will expect the Fed to keep AIG functioning.

There is the issue of making an example of AIG. People (i.e. taxpayers and homeowners) are mad and want blood. It looks good for Paulson to say that he was hard nosed with AIG just like he was with Lehman and FNM and FRE. However there are problems with this as well. A couple of days after AIG they announced the mother of all bailouts. Coincidentally, this was when the fires had reached the gates of Goldman Sachs where Paulson was CEO. That doesn't exactly look hard nosed. It looks rather self serving and inconsistent. Why is it OK to save Wamu, Goldman, Morgan Stanley and others but take 80% of AIG? AIG is actually the only one of these that is probably solvent. Their problem was liquidity not solvency. If they were a small company they likely would have gone into Chapter 11 until they could obtain financing and come out unharmed. Avoiding Chapter 11 likely had more to do with systemic issues.

If the party led by Greenberg can present an alternative plan that gets some or all of this equity back, then Paulson and company might go for it. It would relieve the government of the problem and might help them in a couple of ways. It would show the world that private capital still exists and is still willing to invest in US companies. It would likely be good PR for Paulson as it would be a step away from the socialist tactics that they have been forced to apply. Although the loan to AIG probably has no real risk (since it is a senior loan with a company that has a trillion in assets), the public probably doesn't understand this.

If the Fed refuses to give up their equity stake, can AIG shareholders play hardball? Perhaps. Remember that the executives at AIG are also large shareholders. What if they all threaten to quit? What would happen to AIG then? They may figure that they have lost 90% of their value now. What is another 10%? I think that if they acted with solidarity, they could exert enormous pressure on the government. How could the Fed run AIG if everyone knowledgeable quit and refused to give them any information. They could also threaten to refuse the loan and take the company into Chapter 11. It is possible that they can get foreign governments to put pressure on the US government. Do foreign leaders want AIG controlled by the NY Fed? I doubt it. How powerful is Greenberg really? He used to be the worlds most powerful businessman. Does he still have this kind of power? Is he as shrewd as he used to be? I am betting that Greenberg will play hardball if needed.

So overall, I think there are many reasons to be hopeful that the AIG stock will recover. It is far from a certainty but even with a 20% chance of success, this adds enough speculative value to the stock to make it worth far higher than $4 where it is trading now.

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New valuation

Ok, so lets assume that the government gives in and lets this group of investors replace the loan with capital. What kind of deal might be expected from new investors? Well, probably not a very good deal. Lets do a new valuation assuming this deal happens.

First we need to value the company as is. The equity of the company as of last Q was $78B. The real equity is probably somewhat higher. Lets just say $80B as a round number. There are 2.7B common shares. The normalized earnings for AIGs core company is about $4/share or $11B/year after ignoring the financial products group fluctuations. That is a ROE of 13.5% which is about average for the company (using $80B for equity).

Such a company is generally worth about 1.5 book value. That is about $120B. Valuing it on 9 x earnings would put it at $97B. A DCF would be much higher since the interest rates (i.e. discount rate) is so small. Lets say it is valued somewhere between these as $100B. This of course assumes that they become essentially an insurance company again with plenty of capital. Lets call this valuation V so we can some up with a formula.

So lets say the investors want to put in C=$60B of new capital. Then it would be worth about V+C=$160B. Let say they demand some haircut, H, on the value. Perhaps they will pay only H=60% of the value of the total company. This determines the percentage of the company that they get to own, P. The present owners get to keep 1-P. The haircut is given by

H= C/((C+V)*P) and so P=C/((C+V)*H). Using H=60% and C=$60B and V=$100B, this is P=62.5%. Current shareholder would keep 37.5%.

That would mean that our share of the company should be worth $160B*0.375=$60B or $22/share.

The full formula for the value of the share price is given by

PPS = (1-C/((C+V)*H))*(C+V)/2.7 = [V+ (1-1/H)*C]/2.7
where C and V are expressed in billions of dollars.

A more extreme case would be a that they only pay H=40% for the value they get back. What a deal! That would be PPS=$3.70/share. That is below the current price. This shows how sensitive the PPS formula is to H. You can see that P=1 when H=C/(C+V). So current shareholders have no incentive to do this deal when H is greater than or equal to this.

Probably the most likely haircut would be H=50% which gives PPS=$14.8. This would be a great deal for the new investors and still a pretty good deal for the current investors given that the current share price is about $4.

The alternative to this would be just leaving the deal with the government as is. In that case the shares might be worth $8 or so depending on how the deal goes. That value should be considered a floor for the stock. Assuming that the government deal has a 80% probability of sticking and therefore the buyout deal has a 20% chance of going through, I come up with a weighted average PPS of $9.36. That is about twice the current share price which not coincidentally is about the same haircut demanded for the new investors. It may take a couple of years to reach this price since the company may see a lot of trouble in the year ahead.

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Other info about the governments stake (both positive and negative)

First the good news. There has been lots of contradictory information on the form of the governments stake. Reading between the lines and interpreting all of this leads me to conclude that the 79.9% equity stake is a worst case scenario, not the most likely scenario. They might not yet even have the deal completed. I think they have structured this so that the company has the incentive to raise capital, sell assets and pay off the loan as quickly as possible. For example the WSJ mentioned that the form is an equity participation note . Today the new CEO said on CNBC that the government has convertible preferred shares. Obviously, I have no idea. But the CEO also said that IF they can't pay off the loan, the government will get 79.9%. So I don't know what to think but it appears that the 79.9% stake is a threat and not a certainty.

There is however something I am quite afraid of. There is the possibility that Paulson and company will decide to use AIG as the sacrificial lamb. Paulson is after all the former CEO of Goldman Sachs. Goldman is probably the biggest counterparty to AIG's CDS contracts. The New York Times has just reported on this meeting of shareholders today to discuss an alternative to the Fed's plan. Here is a quote:

"One person involved in the planning, who spoke on condition he not be identified, said that in the worst case, winding down the unit’s affairs could consume the Fed’s entire $85 billion loan."

So basically, the Fed could decide to make AIG pay off the counterparties in return for cancellation of the contracts. This could easily erase all of the equity of AIG. This would be great for Wall Street, great for the economy and terrible for AIG. AIG is much better off holding their subprime CDSs to maturity and paying them off as defaults happen.