The news seems to be reasonably clear: according to an 8-K it filed today, AIG has suddenly discovered that the value of its credit default swaps is $4.88 billion lower than it had previously indicated. That’s Bloomberg’s number, and the WSJ’s too, and they both cite the same 8-K. But in reality it’s incredibly arbitrary, even if you take the 8-K as gospel truth.
The $4.88 billion number is made up of three inputs. You start with $5.964 billion, which is the gross decline in valuation of AIG’s CDSs. You then subtract $352 million, which is the losses that AIG already took in September. And then you subtract another $732 million, which is the benefit of "structural mitigants" which AIG has now started calculating. Apparently these are things like "triggers that accelerate amortization of the more senior CDO tranches"; despite the fact that they’re apparently worth almost three quarters of a billion dollars, AIG hadn’t bothered to account for them up until now.
It gets better: AIG has also discovered $3.628 billion of "spread differential benefits" (don’t ask), which would bring that $4.88 billion number down to a more manageable $1.25 billion, but those benefits won’t even make it as far as the next quarterly results:
As a result of current difficult market conditions, AIG is not able to reliably quantify the differential between spreads implied from cash CDO prices and credit spreads implied from the pricing of credit default swaps on the CDOs, and therefore AIG will not include any adjustment to reflect the spread differential (negative basis adjustment) in determining the fair value of AIGFP’s super senior credit default swap portfolio at December 31, 2007.
In other words, there’s something on our books which we’re pretty sure is worth $3.628 billion, or was worth $3.628 billion at the end of November, but we’re going to ignore that when we release results as of the end of December.
Does this all seem incredibly arbitary to you? Chris Whalen would certainly seem to agree.
One of these days, we hope somebody explains to us why these "fair value" adjustments are useful to investors, especially when applied to illiquid assets and liabilities. If corporate managers made such adjustments without a mandate from the Financial Accounting Standards Board and SEC, we’d be prosecuting them for securities fraud.
Indeed, if you go back and read the academic literature on fair value accounting, you see that, as with more general theoretical discussions of market efficiency, a high level of transparency and thus market liquidity was assumed in the utopian world where fair value accounting rules were to operate.
Applying the rules now mandated by FAS 157 to illiquid assets strikes us as a really bad idea, in large part because such an exercise is entirely subjective and violates the basic rules of forensic investigation.
AIG has lost $15 billion of market cap today, thanks to this 8-K filing which desperately tries to put hard figures (to the nearest million dollars) on extremely illiquid and untraded instruments. Who is helped by all this noise? It’s not clear. The "fair value accounting" that AIG is using certainly seems to be generating more noise than signal. Surely there’s a better way.