The Rational Walk
Intelligent Investing is not a "Random Walk"

Hank Greenberg Ready to Testify About General Re Transaction March 6, 2010

Hank Greenberg

AIG’s former CEO Maurice “Hank” Greenberg has indicated that he is ready to testify regarding AIG’s transaction with Berkshire Hathaway’s General Re group in 2000.  The transaction in question was orchestrated by General Re in a manner that allowed AIG to inflate its loss reserves by $500 million.  Mr. Greenberg was never charged with a crime but prosecutors identified him as an unindicted co-conspirator and he refused to testify citing his fifth amendment right against self incrimination.  Now that the statute of limitations has apparently expired, Mr. Greenberg is willing to provide testimony in the case.

The AIG situation has been a headache for General Re and Berkshire Hathaway over the past decade.  On January 20, General Re finally reached a settlement with the federal government which will allow the firm to avoid prosecution for its role in the accounting fraud. General Re paid $92 million in total fines as part of the settlement.  Several General Re executives were implicated in the sham transaction and the entire episode threatened to tarnish Berkshire Hathaway’s reputation.  (The AIG matter is not the only trouble Berkshire ran into after the 1998 General Re acquisition.  We provide extensive detail regarding Berkshire’s troubled history with General Re in the Berkshire Hathaway 2010 Briefing Book.)

Warren Buffett was never accused of any wrongdoing in the case and willingly spoke to prosecutors regarding his knowledge of the situation.  When the $92 million settlement was announced, Mr. Buffett made the following statement regarding the matter:

“We did something wrong and we paid the price,” Buffett said during an interview on the Fox Business Network. “It shouldn’t have been done, and there’s nothing inappropriate about the fine we paid, so I have no problem with it.”

So on one hand we have Mr. Buffett who willingly cooperated with prosecutors and has taken responsibility for the actions of one of his companies and on the other hand we have Mr. Greenberg who refused to testify years ago and is only coming forward now that the statute of limitations has expired.

Mr. Greenberg had every right to exercise his fifth amendment protection against self incrimination, but Mr. Buffett has clearly set the better example in this case.

Disclosure:  The author owns shares of Berkshire Hathaway and is the author of The Rational Walk’s Berkshire Hathaway 2010 Briefing Book which provides a detailed analysis of the company along with estimates of intrinsic value.

General Re Settlement in AIG Case Closes Difficult Chapter January 21, 2010

General Re, a Berkshire Hathaway subsidiary, has reached a $92 million settlement with the federal government which will allow the firm to avoid prosecution for its role in an accounting fraud involving AIG.  The Wall Street Journal reports that the settlement also includes corporate governance changes that will require Berkshire Hathaway’s Chief Financial Officer to attend meetings of General Re’s audit committee and mandates that General Re appoint an independent director.

The terms of the settlement call for General Re to pay $60.5 million toward restitution for investors who suffered losses in the AIG fraud, $12.2 million to settle the charges with the Securities and Exchange Commission, and $19.5 million to the U.S. Postal Inspection service.

Troubled History

Berkshire Hathaway’s acquisition of General Re in 1998 ran into difficulties almost immediately when underwriting standards proved to be inadequate and large losses ensued.  The September 11, 2001 terrorist attacks demonstrated continued underwriting weakness at the company which Warren Buffett discussed in his 2001 annual letter to shareholders.  Berkshire also inherited General Re’s problematic derivatives book which took years to wind down at a significant loss, as described in Mr. Buffett’s 2002 annual letter to shareholders where he famously referred to derivatives as “financial weapons of mass destruction.”  It should be noted that underwriting issues at General Re appear to be fixed based on results in recent years and the company does provide a large amount of float for Mr. Buffett to invest.

Beyond the financial troubles at General Re, the most troubling aspect has been the serious risks to Berkshire’s reputation based on the alleged impropriety surrounding AIG.  A number of General Re executives were implicated in the case and there were some convictions as well.  All companies depend on their reputation to varying degrees, but none as much as Berkshire Hathaway.  Berkshire’s sterling reputation has enriched shareholders over the years by making it possible to acquire companies whose founders weigh such matters very highly.  Now that the AIG matter is settled, Berkshire and General Re can move past this unfortunate chapter.

The author owns shares of Berkshire Hathaway.

Berkshire Lends a “Helping Hand” to AIG and XL Capital September 1, 2009

Warren Buffett is not one to deny a friendly helping hand to companies in financial distress — at a price, of course!  The Wall Street Journal reported today that a subsidiary of Berkshire Hathaway signed “cut-through endorsements” with AIG and XL Capital when they were struggling last year due to impaired credit ratings.  Cut-through endorsements directly protect the buyer of a policy by providing backup coverage in cases where the primary insurer defaults on its obligations.

A brief excerpt from the Wall Street Journal article:

“Buffett is able to do this because of his credit rating, and if there are no claims, he puts the 5% in his pocket,” said Andrew Barile, a reinsurance consultant in Rancho Sante Fe, Calif. He called the surcharges very high for such coverage. A potential concern for AIG and XL Capital would be “the detail [Buffett] gets on your biggest accounts,” which could give Berkshire Hathaway’s insurers a competitive advantage when it came time for the policies to renew.

Just as we have seen in the deals with General Electric, Goldman Sachs, and others, Berkshire Hathaway’s “helping hand” can be a win-win proposition.  The entity seeking help gains credibility and Berkshire shareholders earn healthy returns made possible by the company’s Fort Knox balance sheet.  And of course, that competitive intelligence on insurance pricing should be useful for underwriting as well.

Disclosure:  The author owns shares of Berkshire Hathaway.

Unwinding AIG’s Derivatives Exposure April 5, 2009

I found a recent article by Carol Loomis regarding AIG’s continuing troubles to be quite interesting.  As most Berkshire Hathaway shareholders know, Carol Loomis is a longtime friend of Warren Buffett and also edits his annual letter each year.  According to this interview, Loomis purchased Berkshire Hathaway shares in the 1960s at under $200 and has never sold a share.  Carol Loomis also published a much longer analysis of AIG earlier this year which can be found here.  In this analysis, there is also extended discussion of Berkshire’s experience winding down the Gen Re derivatives operation.

Needless to say, when Loomis has something to say, investors would be well advised to listen carefully.  This is even more true when the subject involves AIG, the government majority owned problem child of the insurance industry.  I suspect that Loomis and Buffett have discussed AIG in recent months and Loomis has also edited Buffett’s writings regarding the pain involved in winding down a book of derivatives. 

Remaining Exposure:  $1.6 trillion

Loomis reports that the notional value of AIG’s derivatives exposure fell from $2.7 trillion to $1.6 trillion during 2008 due to some contracts maturing, the close out of transactions due to negotiation between AIG and its counter parties, and over $60 billion in credit default swaps cancelled by government action.  The problem is that reducing the remaining exposure could be more difficult.

According to Loomis’ report on CEO Edward Liddy’s testimony before Congress last month, the derivative book of AIG Financial Products may take another four years to completely wind down.  The remaining exposure is extremely complicated and often based on underlying exposures that  span decades. 

Buffett’s Warnings on Derivatives

For some insight into the pain involved in unwinding unwanted derivatives exposure, one can refer to Warren Buffett’s annual letter to shareholders that appeared in the 2005 annual report.  In this letter to shareholders, edited by Carol Loomis, Buffett writes at length about the process of unwinding the derivatives book of General Re.  Buffett decided to unwind the derivatives exposure at the time of the 1998 acquisition of General Re but it took several years to achieve this objective.

In the excerpt below, Buffett refers to the difficulty of coming up with valuations related to derivatives that span multiple decades.  According to Loomis’ article, AIG currently has an energy related contract due to mature in 50 years, not unlike the situation Buffett mentions here.

Remember that the rationale for establishing this unit in 1990 was Gen Re’s wish to meet the needs of insurance clients. Yet one of the contracts we liquidated in 2005 had a term of 100 years! It’s difficult to imagine what “need” such a contract could fulfill except, perhaps, the need of a compensation conscious trader to have a long-dated contract on his books. Long contracts, or alternatively those with multiple variables, are the most difficult to mark to market (the standard procedure used in accounting for derivatives) and provide the most opportunity for “imagination” when traders are estimating their value. Small wonder that traders promote them.

The extended excerpt below is particularly interesting given that Buffett’s warning almost exactly came to pass in 2008, two years after he wrote about the lurking dangers related to situations just like those encountered at AIG Financial Products:

Our experience should be particularly sobering because we were a better-than-average candidate to exit gracefully. Gen Re was a relatively minor operator in the derivatives field. It has had the good fortune to unwind its supposedly liquid positions in a benign market, all the while free of financial or other pressures that might have forced it to conduct the liquidation in a less-than-efficient manner. Our accounting in the past was conventional and actually thought to be conservative. Additionally, we know of no bad behavior by anyone involved.

It could be a different story for others in the future. Imagine, if you will, one or more firms (troubles often spread) with positions that are many multiples of ours attempting to liquidate in chaotic markets and under extreme, and well-publicized, pressures. This is a scenario to which much attention should be given now rather than after the fact. The time to have considered – and improved – the reliability of New Orleans’ levees was before Katrina

Will AIG Come Begging Again?

At the end of her article, Loomis warns that AIG could very well come back to Uncle Sam for more funds in addition to the $180 billion already committed.  In my opinion, the complexity of the task only highlights the short sighted nature of the actions taken regarding AIG’s bonus retention payments.  The unfortunate result of the government’s punitive actions against the very AIG employees needed to unwind the derivatives book will most likely lead to a more drawn out and expensive process for AIG and ultimately for the United States taxpayer.

AIG’s Bonus Debacle March 23, 2009

Anyone reading this who is a taxpayer in the United States is, in effect, a shareholder of AIG due to the Federal Government’s infusion of $173.3 billion in bailouts over the past six months.  These bailout funds have resulted in the near total nationalization of AIG with the Federal Government owning nearly 80% of the business.  Putting aside the question of whether the government was correct to bail out AIG in the first place, it is very important to look at the potential problems that now exist as a result of government ownership and the political, rather than economic, calculations driving the operations of the company. 

The Bonus Fury

Normally, shareholders of a company want to make smart hiring and compensation decisions for the business with the goal of profit maximization in mind.  While there are still plenty of businesses that can operate with high levels of turnover and relatively unskilled labor, this is clearly not true in finance, technology, and numerous other industries. 

The question for AIG shareholders should be what compensation policies and practices will do the most to salvage value at the company.  Much of this will depend on two key factors that have been all but ignored in discussions of the bonus situation.  First, the wind down of the derivatives portfolio must be well managed by highly trained individuals who have an in depth understanding of extremely complicated instruments and the mind numbingly intertwined nature of the counter parties involved.  Second, the value of AIG’s ongoing insurance subsidiaries will be based on how underwriting decisions are made going forward and will depend on intelligent underwriting practices by highly competent individuals.  Retention of key personnel is obviously critical in both areas.

Fairness or Results?

Is it “fair” that many of the individuals who made unwise decisions have to be paid retention bonuses in order to ensure that proprietary knowledge remains within the firm?  It is both unfair and unseemly that individuals who had a part in the debacle should now profit from the fact that the company still needs them to unwind the derivatives book.  However, the fact that this may be “unfair” does not necessarily mean that it is not logical for AIG to pay out such retention bonuses if the end result is a maximization of shareholder value. 

There is much talk of the individuals involved being greedy and not caring about much other than themselves.  For the sake of argument, let us assume that these individuals are all in fact greedy and care for nothing other than their own financial well being.  To the extent that these individuals are needed, does it not follow that it is necessary to ensure that greedy individuals have an incentive to stay?  If they are as evil as many would have us believe, is it realistic to think that they will stay out of a sense of altruism?  Clearly not!  The question then becomes whether such individuals could be easily replaced.  If not, the logical thing to do is to pay out the bonuses regardless of whether it is “fair” or not in the interests of protecting the ongoing value of the enterprise.

It’s All About Politics

The reality is that decisions are being made not in the interests of maximizing shareholder value but in order to score political points.  Clearly, no one likes to see these payouts and the gut reaction of most people would be to fire everyone who was involved in the situation.  But sometimes doing things what make us “feel good” ends up being the exact opposite of intelligent behavior.  However unseemly, it is far better to pay out the funds than to suffer the consequences of a mass exodus of individuals possessing significant proprietary information that is necessary to successfully wind down the derivatives that would have brought AIG to its knees without government assistance. 

Those who would score political points here are doing nothing to protect AIG’s owners — and that would be all United States citizens.   It is perhaps too much to expect politicians to do much more than propose what feels good to most people which is an excellent reason to rapidly move toward privatizing the parts of AIG that still have intrinsic value.  This would also be the best outcome for the taxpayer since the proceeds would be available to partially offset the cost of the cash infusions of the past six months.