The 10-year PE ratio

One good valuation technique is the 10-year PE ratio. That is the current real price of the S&P 500 divided by the average of the last 10 years of real earnings per share. This is better than the trailing twelve month PE since it smooths over periods of excessive profitability or un-profitability. The following chart (from Robert Shiller's data) shows this ratio back to the 1880s. The red line shows the median value 15.68 and the blue line is at 10 which appear to be around where the troughs occur. Some were worse than this for example in 1921. Right now we are at 12.95 (S&P 500 = 745) which is somewhat below average but somewhat higher than most troughs. To reach PE(10)=10, the S&P 500 would fall to 575 or another 23%. To reach the lowest ever PE(10)=4.78, it would drop to 275 or another 63%. Lets hope that doesn't happen.



There is another way to look at this however. It is possible that the inflation correction is incorrect. There is an alternative inflation measure which claims to be closer to what was used for most of US history. This is from Shadowstats . The Shadowstats inflation measure is much higher than the government reported inflation rate, especially for the past few years. The following plot is the same as above but with the alternative Shadowstats CPI inflation correction applied to both earnings and price. The effect of this is that it makes stocks look cheaper since the correction to the current price is larger than the correction to 10-year earnings.



Which is correct if any? I don't know but would guess that the best measure is probably somewhere in between.

Conclusions: stocks are probably approaching their lows and buying solid blue chip companies is likely the right thing to do. Certainly, selling now look like the wrong thing to do.

The TALF. What hath God wrought?

The New York times has a fascinating article on the Fed's new program. The Term Asset-Backed Securities Loan Facility or TALF is an attempt to jump-start lending in the economy. The reason for the credit crunch is not that traditional banks like Bank of America are not lending. The Fed has a fairly firm grip on the balls of the CEOs of these banks since all are on the verge of government takeover. If the Fed says lend, they say "How much?".

The trouble is that over the past few decades a new banking system has arisen. This so called "Shadow Banking System", a term coined by PIMCO's Paul McCully, is just the network set up to securitize credit instruments and move them off bank balance sheets and onto the balance sheets of hedge funds, insurance companies, pension funds and any other investors looking for fixed income type investments. Many but not all of these loans are made by commercial banks. There are also finance companies like AIG's American General Finance or GE's GE Capital. Hedge funds and investment banks were also involved in credit creation and securitization. Someone willing to start a small business could go directly to a hedge fund for capital rather that to Bank of America.

This shadow banking system has collapsed. More accurately, it still exists but has dramatically reduced the amount of credit that it is willing to extend. Insurance companies and pension funds are saying "thanks but no thanks" to those BBB rated tranches of securitized auto loans. They will stick with US Treasuries, thank you very much.

The Fed has concluded that growth cannot resume while this major source of lending has been shut off. So its solution is to try to get it going again by subsidizing it.

It works basically like this. From the New York Times.

"Under the program, the Fed will lend to investors who acquire new securities backed by auto loans, credit card balances, student loans and small-business loans at rates ranging from roughly 1.5 percent to 3 percent. Depending on the type of security they are borrowing against, investors will be able to borrow 84 percent to 95 percent of the face value of the bonds. Investors would not be liable for any losses beyond the 5 percent to 16 percent equity that they retain in the investment."

So in essence, the Fed is creating a new system of unregulated or lightly regulated banks from the stock of hedge funds and private equity investors around the world. To a hedge fund, it might look like this. You borrow at 2% and buy assets yielding 12%. Maybe your loss rate on these would be 6% so your final yield is 6% with a Net Interest Margin of 4%. Now you get to leverage this by a factor of 10. Now you are making 40% return on invested capital before expenses and taxes. Expenses for running a large fund are small. A team of 20 hot-shot hedge fund guys might run a fund with $10B of capital taking on $100B in assets making $40B on profits per year. They might pay themselves 2% of assets and 20% of profits which is $2B/year + $8B = $10B/year leaving $30B/year in pretax profits for the investors which is a 30% return. The 20 hedge fund guys each make half a billion per year if it is divided equally. If something goes horribly wrong and these credit instruments result in massive losses, the investors lose all of their invested capital but are not on the hook for the losses. The Fed (or maybe the taxpayer) is on the hook for the losses. If the hedge fund makes their expected profit for say three years before the shit hits the fan, they still make $1.5B each and then need to look for new jobs.

Some would say that the cause of the crisis was too much borrowing, too much leverage and too much greed. The Fed's solution appears to be more borrowing, more leverage and more greed. Somehow, I don't think the American people are going to like that plan.

Who owes who what

The Federal Reserve publishes their quarterly flow of funds report. It is a fascinating document with all kinds of interesting figures.

One table shows the assets and liabilities in the US credit markets. So it shows you who owes who what.

Here are some statistics. Everything is in Trillions of dollars.

The total credit markets $51.80T. The following table shows who owes the debt and who owns those same credit market instruments as assets. Categories less than $1T are not shown.

Liabilities
Borrower	2009	2004
Household and Non-profit	$13.92T	$9.50T
Non-farm, non-financial, corporate	$7.01T	$4.97T
Federal Government	$5.80T	$4.03T
Issuers of asset-backed securities	$4.21T	2.21T
Government Sponsored Enterprises	$3.15T	$2.60T
Non-farm, non-corporate, business	$3.75T	$2.20T
State and local government	$2.22T	$1.57T
Rest of World	$1.96T	$1.25T
Commercial Banks	$1.46T	$0.66T
Fianance Companies	$1.28T	$1.00T
Total US credit market debt	$51.80T	$34.60T
Assets
Rest of world	$7.85T	$3.84
Commercial banks	$7.85T	$5.99
Domestic non-financial sectors	$6.15T	$4.79
US Agency and GSEs total mortgages	$4.89T	$3.32
Issuers of asset-backed securities	$4.11T	2.12T
Households and Non-profits	$4.09T	$3.04
Insurance companies	$3.79T	$3.11
GSE credit and equity instruments	$3.02T	$2.56
State and local governments	$1.48T	$1.12
Pension funds	$2.37T	1.51T
Mutual funds	$2.37T	$1.51
Finance companies	$1.621T	1.201T
Savings Institutions	$1.32T	$1.29

One thing that is trivially true but also something that most people don't think about is that debt nets to zero. All debts or liabilities are someone else's assets. The net debt of the world is zero. This table above shows that the net debt in the US is $7.85T-$1.96T = $5.89T. This is the difference in the gross amount that we lend to them minus what we owe to them. The rest, $45.9T, is debt that we owe to ourselves. That is it nets out to zero inside America. But who are the borrowers and who are the savers?

Basically it breaks up into three groups. There are the net debtors: households, non-financial businesses and government. Then there are the net savers, banks, pension funds, insurance companies and mutual funds. You can also include "rest of world" here. Then there are what you can call arbitrageurs. These are entities that have large gross debt but little net debt. That is, they borrow from the capital markets but invest in other debt instruments. These are: GSEs, issuers of asset backed securities and finance companies. This would also include hedge funds, investment banks and the like.

So do we have too much debt? Remember debt is a gross measure. Much of this debt is just due to the rise of the arbitrageurs. Whether that is good or bad is hard to say. All of this extra leverage helps with liquidity. It makes it easier to borrow and therefore probably lowers interest rates and lubricates the wheels of industry. Whether or not it does anything else useful is hard to say. It also of course adds complication to everything and we have been paying the price for this over he past few years.

There is clearly too much household debt. As you can see from the table above, household debt grew from $9.50T to 13.92T from 2004 to 2009. Most of that is mortgage debt but is also made up of credit card debt, home equity loans, student loans, auto loans etc. During that time, average salaries did not increase. People simply over-consumed. Now their assets, homes and stocks, are falling in value and so they are getting poorer and they will have great difficulty servicing this large debt load.

Businesses also borrowed heavily. Corporate and non-corporate together increased their borrowing from $7.17T to $10.76T. Earnings may have increased over that period but they are now dropping at the fastest pace since ... well maybe ever. They won't be able to service this debt either. According to Standard & Poor’s, nearly 66% of nonfinancial companies have below investment grade ratings. They are predicting a default rate for this group of about 14% in 2009.

We may have about $7T of unserviceable debt which is roughly the increase from 2004. Much of that will be restructured, foreclosed on etc. Maybe only 30% of that will becomes losses. But even still that is $2.1T. We can see above where those losses will show up - with the savers: banks, pension funds, insurance companies and mutual funds and the "rest of world".

So in total, it looks like this. Savers who wanted to accumulate more wealth loaned money to people who bought either consumables (e.g. steak dinners), over-priced assets (e.g. houses) or unproductive capital assets (e.g. steak house restaurants). These tuned out to be bad loans. All that principal will not come back to the savers. But the wealth that was lost by the savers didn't all go up in smoke. All the extra steak dinners might be gone but the houses and commercial real estate and businesses are not. They might have less value than everyone thought but they are not valueless. So part of the loss in wealth is just a realization that it wasn't real wealth to begin with. We as a country are really no poorer than in 2002. We just thought we got rich in between. There has of course been a transfer of wealth between many individuals but not much in the way of real net loss.

This isn't quite right though. We did increase our US net debt by about $3.3T since 2004. That works out to be about $33,000 per american family. We have assets in return however even if we might have over-paid for some of them (like houses). With our assets falling in value and wages falling due to unemployment we have to spend much less. We need to save more. This will be the main dynamic of the next few years. The world will have to adjust to a US consumer which is spending a lot less. This adjustment is likely to be very painful. Our economy is out of balance. We have too many of somethings like restaurants and retail stores and too little of other things like factories for exporting goods. Since the economy is out of balance much of the investment will be required to restructure it to the new reality. This is likely to sop up any actual economic growth for a few years.

There are some groups that are likely to benefit. Poorer people who had no or negative equity to begin with may now have large negative equity especially if they bought a house with no money down that has plummeted in value. If they walk away and declare bankruptcy, their net worth goes from a large negative number to zero. It has increased. Since they will no longer have to service this debt, they will have more discretionary income. They will be richer. Their creditors however will take the loss. This is a rather direct transfer of wealth from rich to poor. This commonly happens in depressions.

It is official: Obama is a tool

Ok, I was admittedly excited when Obama was elected. Finally, there was someone who would help reverse the plight of the middle class in America. It has taken less than a month for me to decide that his presidency will be a failure. It is not that he lacks good intensions. It is that he is not a strong leader. He is another Jimmy Carter. He is too impressionable, too willing to keep the status quo, too willing to try to please everyone. What we need right now is someone willing to be confrontational and make hard decisions. He is not that person.

Foremost is his handling of the economic crisis. For a while there was some hope when he hired Paul Volcker. The hard nosed former Fed chairman is exactly the kind of person that should be leading the handling of banking crisis. Unfortunately Paul seems to be losing favor in the administration. Larry Summer seems to be in charge. Summers, the protege of Robert Rubin was one of the chief proponents of deregulation and free markets. In other words, he is one of the people that caused all the mess to begin with. The foxes are guarding the hen house. Goldman Sachs in firmly in control.

We are already seeing some of the bad policies that will come out of this administration. The right thing to do is to nationalize the insolvent banking systems like Sweden did in the 90s when they had a financial collapse. However, that is not the Obama plan. He said in an interview that this would not be possible due to the "different culture" in the US. Different culture? What does culture have to do with whether a bank is insolvent? I assume that he is saying that Swedes are pinkos and that we in America believe in capitalism. But taking over the banks is not socialism. It is capitalism. In a capitalistic system, when a company becomes insolvent, it's equity is wiped out and ownership is transferred to it creditors. Usually this is what happens in bankruptcy court. The banks are insolvent and they should be handed over to their creditors which are the depositors. Propping up banks with government money is socialism, not the other way around. For banks, this is done by putting them into receivership. This is what needs to be done.

Today in the Wall Street Journal there is an article saying that Obama's aid David Axelrod says Obama has a solid plan on housing. His plans will prevent foreclosures and "put a floor under house prices". Now preventing some foreclosures makes sense. It is in the interest of both the homeowner and the banks. However "putting a floor under house prices" is absurd. House prices like everything else are set by supply and demand. Houses are still over-valued which is why people are not buying them. They were in a bubble. The huge demand for houses was primarily due to two things 1) Speculators hoping to flip houses for a profit and 2) a huge group of people that got fooled into believing that they could afford a house when the really could not. Clearly neither of these two sources of excess demand are coming back and there is more supply than ever. Houses prices will continue to go down regardless of what Obama does. But the fact that he is trying to prop up housing prices shows that he is an imbecile. When house prices have fallen to the point where the price-to-income ratio is normal, people will buy them and they will have more money left over to spend in the economy. It does not do any good if we keep house prices unaffordable. High house prices is one of the reasons why people could only afford to live by running up lots of consumer and home equity debt. The sooner house prices fall to normal levels, the sooner we can come out of this recession. If the government tries to manipulate house prices upward, it will only prolong the pain.

Credit problems ahead

Here is a nice slide from a great (but scary)

presentation by T2 partners.

If you go through and apply reasonable loss rates to these categories, it isn't hard to get $3 trillion dollars in total credit losses.
(note: agency double counts prime loans). Maybe half of that is concentrated in US banks. The total capital of the US banking system is roughly $1 trillion which basically makes the banking system insolvent.



HERE is another estimate from Nouriel Roubini.

A theory of boom bust

• Anti-progressive policies allow wealth to accumulate more quickly at the top of the economic spectrum.
  
• The wealthy save most of the money and much of the wealth gets lent to the middle classes keeping interest rates low.
  
• The middle classes have less income but are able to borrow cheaply to support the same standard of living.
  
• Higher amounts of leverage, profit growth and more capital accumulation pushes asset prices higher leading people to believe their wealth is higher than it really is. This creates a wealth effect which supports debt-supported spending.
  
• Eventually, the debt cannot be serviced and the process goes into reverse. Asset prices fall. Debt goes bad. The middle classes stop consuming beyond their income.
  
• Ultimately the wealth accumulation reverse as social unrest forces the government to adopt more progressive policies and wealth redistributes more equally.
  

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.