AIG Downgraded As Shares Appreciate, SIFI Headwind Ahead

AIG was thinking of suing the Government (not of Argentina) several days ago. The latest news is that American International Group, Inc. (NYSE:AIG) will not file the lawsuit, but instead sue the Fed for the right to sue BAC. The news about  American International Group, Inc. (NYSE:AIG) over the past several days is almost as exciting as the  Bill Ackman Herbalife Sandwich. However, there has been other developments with AIG over the past few days. AIG’s price target was lowered by Goldman Sachs.

Wells Fargo issued a report yesterday downgrading AIG, but this not a typical sell-side downgrade. Many downgrades come as stocks start to decline and there is a herd mentality (or some prefer lemmings) to jump ship(see Apple). However, in this case the stock has risen . Wells Fargo has downgraded AIG because the investment thesis has mostly played out.  AIG shares appreciated 52% in 2012 (versus the 13.4% rise in the S&P). We summarize the points from the report below.

Wells Fargo’s  investment thesis for AIG had been predicated on the U.S. government’s exit from ownership of AIG and the company’s potential to aggressively manage its capital with proceeds from the sale and liquidation of non-core assets such as the Maiden Lane partnerships and AIA Group Ltd. (HK:1299). These events have largely come to pass.

Wells Fargo downgraded their rating on AIG shares from outperform to market Perform. They lowered their valuation range to $38-40 (from $44-49). Shares of AIG closed at $35.23 in Friday’s trading session. The analysts price target has also been cut, 2012E/2013E EPS moves from $3.89/$3.62 to $3.95/$3.40, respectively.

So why is AIG one of the most crowded hedge fund stocks, and what does Wells Fargo see to justify the current valuation?

The Good 

The analysts see opportunity associated with AIG shares linked to the company’s capacity to improve its property-casualty results. These efforts include re-underwriting, re-pricing, re-tooling claims administration and reallocating capital to consumer lines. Over time, they expect AIG to be successful in these endavors, but they  are not projecting a substantial P&C improvement over the next year.

Additionally, AIG has made clear that its near-term focus for capital management involves improving the company’s interest coverage ratio. They expect this focus to come at the expense of share repurchase, a considerable source of shareholder value creation in 2012. While AIG sold its remaining stake in AIA in December, the analysts expect that much of these proceeds will be used to repurchase or retire outstanding debt in an effort to lower the interest coverage ratio.

There is a big potential headwind coming up for the company, and it could harm AIG more than the company’s competitors

Wells Fargo expects AIG to receive designation as a non-bank systemically important financial institution (SIFI) during 2013. Many others expect this to happen as well, as AIG’s near collapse in 2008 caused the Fed and Treasury to arrange a massive bailout. The repercussions to AIG as could potentially more harmful to AIG than other insurers such as Metlife Inc (NYSE:MET) and Prudential Financial Inc (NYSE:PRU) that are likely to be designated.

If AIG is required to carry above peer capital as a non-bank SIFI, the analysts would not expect other global property-casualty insurers to follow suit.  Their reasoning is that while property-casualty coverage is purchased with an orientation toward balance sheet strength, they believe that the minimum standards are slightly less than with life insurance coverage.

What is SIFI? We provide those details below.

Stage 1. Identify nonbank financial companies (NFC’s) that should be subject to further evaluation.  Financial Stability Oversight Council (FSOC) will formally notify the NFC that it is under consideration for a Proposed Determination through a Notice of Consideration (will likely contain a request that the NFC provide certain add’l financial information relevant to the FSOC’s analysis).

Six quantitative thresholds used: 1) $50B in total consolidated assets 2) $30B in gross notional CDS outstanding for which a NFC is the reference entity 3) $3.5B of derivative liabilities 4) $20B in total debt outstanding 5) 15 to 1 leverage ratio (excluding separate accounts) 6) 10% short-term debt ratio (excluding separate accounts).

Stage 2.  FSOC reviews NFC’s indentified in Stage 1 using the six-category analytic framework.

Analysis will be based on a broad range of quantitative and qualitative information available through existing public and regulatory sources, including industry- and company-specific metrics beyond those analyzed in Stage 1, and any information voluntarily submitted by the company.

Stage 3 (where we are today).

FSOC reviews NFC’s identified as potential SIFIs using quantitative and qualitative information collected directly from the NFC.  FSOC will formally notify the NFC that it is under consideration for a Proposed Determination through a Notice of Consideration (will likely contain a request that the NFC provide certain add’l financial information relevant to the FSOC’s analysis).

The NFC will be allowed to submit written materials contesting the FSOC’s consideration of the NFC for a proposed determination.

Stage 4 (next).

After completing the Determination Process, the FSOC will vote on whether to make a ‘Proposed Determination’ with respect to a certain NFC.  If the FSOC decides to issue a Proposed Determination, it will issue a written notice outlining the basis of the Proposed Determination. The NFC will be permitted to request an evidentiary hearing to contest the Proposed Determination.  After the hearing, the FSOC will determine by a 2/3 vote of its members (incl the Treasury Secretary) whether to subject the NFC to Fed supervision.

Impact on Insurers

Makes a lot of sense right?!

The truth is that there is little consensus about how the final regulatory framework will look. While the industry initially expressed confidence that regulators would use an insurance-centric approach to look at SIFI insurers, recent commentary suggests a market-driven framework similar to Basel III is a more likely outcome.

This is potentially problematic for insurance companies that have sizable investment portfolios (which are given higher risk charges than loan portfolios), significant separate account assets, and are in the business of taking on risk. Given some companies, such as MET’s experience with the CCAR in 2012 (when it failed the stress test and was barred from returning capital), investors are justifiably worried about the implications if a bank-centric capital framework is applied to insurers. Other concerns are that SIFI insurers will be forced to hold more capital and may be restricted on buying back stock or increasing shareholder dividends.

Conclusion

As a result, Wells Fargo thinks designation as a non-bank SIFI for AIG may represent a modest competitive disadvantage and impede the company’s progress in driving up its consolidated return on equity according to the schedule articulated at its re-IPO.

Disclosure: The author of this article owns LEAPs of AIG.