American International Group Inc (AIG) 2008 Q2 法說會逐字稿

完整原文

使用警語:中文譯文來源為 Google 翻譯,僅供參考,實際內容請以英文原文為主

  • Operator

  • Thank you for standing by.

  • At this time all participants are in a listen-only mode until the question-and-answer session of today's conference.

  • (OPERATOR INSTRUCTIONS).

  • I would also like to remind parties this call is being recorded; if you have any objections please disconnect at this time.

  • I would now like to turn the call over to Ms.

  • Charlene Hamrah.

  • Thank you, ma'am, you may begin.

  • Charlene Hamrah - VP, Dir. of IR

  • Good morning and thank you for joining us today for AIG's second-quarter earnings conference call.

  • Before we begin I would just like to remind you that the remarks made today may contain projections concerning financial information and statements concerning future economic performance and events, plans and objectives relating to management, operations, products and services and assumptions underlying these projections and statements.

  • It is possible that AIG's actual results and financial condition may differ, possibly materially, from the anticipated results and financial condition indicated in these projections and statements.

  • Factors that could cause AIG's actual results to differ, possibly materially, from those in the specific projections and statements are discussed in Item 1a, Risk Factors of AIG's annual report on Form 10-K for the year ended December 31, 2007 and in the Outlook section of management's discussion and analysis of financial condition and results of operations in the quarterly report on Form 10-Q for the quarterly period ended June 30, 2008.

  • AIG is not under any obligation and expressly disclaims any such obligation to update or alter its projections and other statements whether as a result of new information, future events or otherwise.

  • The information provided today may also contain certain non-GAAP financial measures.

  • The reconciliation of these measures to the comparable GAAP figures are included in the first-quarter 2008 financial supplement or within the presentation available in the investor information section of AIG's corporate website.

  • And now I would like to turn the call over to Bob Willumstad.

  • Bob Willumstad - Chairman, CEO

  • Thank you, Charlene.

  • Good morning to everybody.

  • I'd like to begin with some observations about the current economic and market environment and how they affected AIG's second-quarter results.

  • And I'll ask Steve Bensinger to provide more details on the quarter.

  • Finally, I'll make some comments on expenses and give you an update on our strategic review process and what you can expect from us when we report on that process in September.

  • We'll then take your questions.

  • Our second-quarter results did not reflect the earnings power of AIG's businesses.

  • The loss we reported for the quarter resulted from some external factors as well as some company specific operating issues.

  • Three factors in particular had a significant effect on our results.

  • We reported large investment impairment charges and unrealized losses that were primarily driven by severe conditions in the housing and credit markets.

  • We had a $3.6 billion after-tax unrealized market valuation loss on Super Senior credit default swaps in our capital markets business, and a $4.4 billion after-tax other than temporary impairment charge relating to our investment portfolio.

  • Let me put these figures in context.

  • Regarding the unrealized market valuation loss on the CDS portfolio; clearly this is a big number.

  • That said, this loss is smaller than the after-tax loss of $5.9 billion that we recognized in the first quarter.

  • Regarding the $4.4 billion of after-tax impairment charges in the investment portfolio, approximately two-thirds of the severity component of those charges was already reflected as unrealized depreciation and shareholders equity at March 31st.

  • Steve will go into more detail on these points.

  • In addition to those charges, we also experienced below average investment performance in the quarter.

  • Net investment income in the second quarter was $6.7 billion, lower than the $7.9 billion we reported last year, but above what we reported in the first quarter.

  • Partnership income was the principal driver of the second-quarter result and our focus on liquidity also dampened our returns.

  • We reported an operating loss of $518 million pretax at United Guaranty, our mortgage insurance business, largely reflecting the same housing and mortgage market conditions that drove the unrealized market valuation loss in our CDS portfolio.

  • All three of these factors reflect extreme market conditions.

  • I cite them to put our second-quarter results in context, not to minimize operational issues that need and are getting our immediate attention.

  • Our primary focus is on strengthening our balance sheet, maintaining our liquidity and improving profits.

  • Now I'll turn it over to Steve for a review of the second quarter and I'll come back after his comments.

  • Steve Bensinger - CFO, EVP

  • Thanks, Bob.

  • Please refer to the PowerPoint presentation posted to our website last night entitled Conference Call Presentation.

  • And if you start on page 3, there are four key messages we'd like you to take away.

  • First, and maybe most obvious, is that the disruption in the US housing market that Bob referenced continues to dominate our reported results.

  • We reported a net loss for the third consecutive quarter.

  • That said, there was a tempering of some of the marks in the quarter as exemplified by the reduction in size of the AIGFP unrealized market valuation loss in the second quarter compared to the first and the reduction in the decline of accumulated other comprehensive income which reflects the change in the unrealized appreciation or depreciation of our available for sale securities.

  • More on that in a moment.

  • Second, our capital position is stronger today than it was as of the end of the first quarter.

  • Granted we raised capital, but that was the prudent action to take in light of the volatile capital markets we continue to face.

  • Third, you've seen the results of our four segments in last night's release.

  • There are clearly some challenges.

  • Nonetheless, our franchise continues to show resilience.

  • I'll comment on that in more depth shortly.

  • And finally, our priorities.

  • Bob has made it clear about our focus in these turbulent times -- protect our capital and reduce risk, focus on expenses and complete the business review.

  • Bob will comment more on these in a moment.

  • Let's turn to slide 4.

  • As you can see, our total equity in hybrid capital increased in the second quarter to $96.8 billion as a result of our capital raise; that's less than a 5% decline from our year-end position.

  • Our financial debt to total capital ratio has declined to 13.7%, indicating increased financial flexibility.

  • While we can't predict what the future holds in terms of capital market conditions and the effects of the ongoing US housing market disruptions, based on what we know today our capital position is sound.

  • Let's take a look at slide 5.

  • As I said earlier, we reported a net loss for the quarter which totaled about $5.4 billion.

  • Included in that total, as Bob mentioned, are approximately $4.4 billion of after-tax other than temporary impairment charges.

  • Now they're reflected in the caption titled Realized Capital Losses, but in fact represent almost entirely unrealized market valuation losses.

  • Actual sales activity of securities in the quarter resulted in a pretax net gain of about $200 million.

  • Importantly, as Bob mentioned, almost two-thirds of the severity component of the other than temporary impairment charge was already reflected as a reduction in AOCI as of March 31st.

  • This is in stark contrast to what occurred in the first quarter.

  • There continues to be a diversity in practice among companies in terms of taking impairment charges through P&L.

  • At AIG we have a rigorous process where we evaluate several dimensions of potential impairment on a security-by-security basis.

  • Of the $6.8 billion pretax other than temporary impairment charge $4.8 billion relates to severity losses.

  • Almost two thirds of that severity charge related to securities rated AAA and nearly 80% related to AA and AAA combined.

  • The securities continue to perform.

  • Our judgment to take an impairment charge is based on the uncertainty of the timeframe for price recovery.

  • We cannot yet make an assertion as to the recovery period.

  • The $337 million after-tax effect of the credit valuation adjustment relates to the effect of credit spreads on AIGFP's assets and liabilities accounted for under the fair value option using the guidance in FAS 159.

  • While credit spreads in the quarter widened on both AIGFP's invested assets and on AIG's own credit spreads, which affect the fair value of AIGFP's liabilities, the net result was a loss.

  • We have summarized in the boxed area on the slide the adjusted net income excluding the AIGFP unrealized market valuation loss and the credit valuation adjustment to highlight some of the key themes for the quarter which I'll cover now.

  • If you would, please turn to slide 6.

  • As we've stated previously, partnership and mutual fund income is volatile from quarter to quarter and the first half of 2007 generated very strong results.

  • While the second-quarter of 2008 results include $190 million in partnership and mutual fund income, this is still down $1.1 billion year-on-year and affected most of our segment's results.

  • Looking ahead, the second half of 2007 also generated strong results, so we anticipate that year-on-year comparisons will remain difficult for the remainder of 2008.

  • In addition, we've been building liquidity within the insurance companies as a prudent response to the market dislocations.

  • However, this does have a negative affect on net investment income which we estimate in the range of $100 million to $200 million pretax in the quarter.

  • As everyone on this call is well aware, the US housing market continues to be very difficult and that's reflected in the substantial increase in losses at UGC.

  • First and second lien losses increased 264% and 107% respectively over the second quarter of 2007 and include the effect of lower reported cure rate probability assumptions.

  • We anticipate UGC's operating losses will continue into 2009.

  • American General Finance net receivables were down 1% sequentially, but up 6% year-on-year, primarily due to the Equity One portfolio acquisition in February.

  • Loan loss provisions increased significantly in the quarter and delinquency rates have increased to 3.56% which remains within AGS' target band.

  • Let's turn to slide 7.

  • Commercial insurance is facing an increasingly challenging environment; nonetheless, our overall view is that rates are still adequate with the exception of certain lines of business, most notably workers' comp and aviation.

  • We continue to look for ways to shift our product mix to compensate for declining rates and are certainly maintaining our underwriting discipline.

  • Our underwriting results continue to suffer from the drag of adverse development in excess casualty in the 2003 and prior accident years, although in the second quarter this was substantially offset by positive development in the 2004 and later accident years.

  • The effect of the Midwest flood was about 1.4 points on the loss ratio in the quarter.

  • In Foreign General our results benefited from AIG's broad global footprint and strong franchise, up 15% in dollar terms, net premiums written rose 5% in original currency due to growth in continental Europe and the Middle East as well as due to high retention levels in major accounts despite declining rates in certain markets.

  • Underwriting income fell 5.9% due to an increase in severe but non-catastrophic losses and increased loss frequency as well as increased expenses due to the realignment of the legal entity through which Foreign Gen operates.

  • In personal lines good growth in AIG's Private Client Group was offset by reductions in net premiums written in AIGdirect.com and Agency Auto as a result of planned reductions in these lines as we seek to improve underwriting performance.

  • Turning to slide 8.

  • Domestic life and retirement services generated 14% growth in premiums reflecting AIG's all seasons product portfolio.

  • Private placement VUL and payout annuity sales were up strongly but life insurance and home service were up 5%.

  • With continued uncertainty in equity markets consumers favored individual fixed annuities where deposits increased by $450 million and surrender rates fell 300 basis points.

  • Spreads on key products reflected lower investment income.

  • Foreign Life results benefited from AIG's product breadth.

  • While growth in life products was muted, accident and health, group, fixed annuities and variable annuities all had strong growth, so growth was favorably affected by exchange rate movements.

  • Life insurance and retirement services reserves continued to grow in excess of 15% reflecting AIG's success in accumulating assets.

  • Net investment income fell 5.9% primarily due to losses on investment-linked products in the UK though reduced partnership and mutual fund income also affected results.

  • Turning to slide 9.

  • ILFC had record results in the quarter.

  • Revenues increased 14% while operating income was up 85% on the back of higher lease rates and strong demand for ILFC's modern fuel-efficient aircraft.

  • New aircraft are 100% leased through 2008 and 2009 and all of the 16 aircraft returned to ILFC were leased as of July 31st.

  • Results in asset management continued to be affected by the runoff of the kick GIC program.

  • External assets under management were down sequentially due to market price declines despite attracting new assets of $2 billion in the quarter.

  • Operating income in the core external asset management business was negatively affected by lower carried interest and the timing of real estate-related gains.

  • Comparisons with the second quarter were also unfavorable due to a $398 million gain in the second quarter of '07 related to the sale of a portion of AIG's holdings in the Blackstone Group's IPO.

  • Turning to page 10.

  • I'd like to turn your attention to a roll forward of our shareholders equity as a framework for some further comments about the effects of the AIGFP unrealized market valuation losses and the affects of the declines in the value of portions of our investment portfolio.

  • Let's turn to slide 11.

  • In the quarter AIGFP recorded a further $5.6 billion pretax unrealized market valuation loss on its Super Senior credit default swap portfolio, bringing the cumulative valuation loss on this business to $25.9 billion.

  • The preponderance of that amount, or $24.8 billion, pertains to the credit default swap portfolio covering multi-sector CDOs.

  • The primary drivers of the write down were declines in market prices for Alt-A and subprime RMBS collateral and rating agency actions taken in the quarter.

  • Based on the cumulative loss to date the portfolio is now marked to an average of about $0.69 on the dollar.

  • For those CDOs containing subprime collateral the average mark is now $0.66 for high-grade deals and $0.56 for mezzanine transactions.

  • The total Super Senior portfolio declined by a net $28.5 billion in the quarter to $441 billion.

  • This reduction results from $5.9 billion in amortizations across the portfolio and $22.6 billion in early terminations in the regulatory capital relief book.

  • Included in the net decrease was an increase in exposure due to honoring an existing commitment to conclude a $5.4 billion transaction in the multi-sector CDO portfolio.

  • With regard to the regulatory capital portfolio, there continues to be no market value adjustment for the vast preponderance of that book.

  • The early terminations of transactions by counterparties at no cost to AIGFP provide the most important information supporting our conclusion that these transactions are motivated by regulatory capital relief and not by transferring risk on the underlying portfolios.

  • We'll continue to monitor counterparty behavior to inform our decisions on valuation of this book.

  • I should point out that there was one European RMBS regulatory capital relief transaction with a notional amount to $1.6 billion that was not terminated as expected.

  • This transaction has specific features not found in the remainder of the regulatory capital book.

  • We took a mark on that transaction in the second quarter of $125 million.

  • Let's turn to slide 12.

  • Despite the marks taken, the portfolio of CDOs is showing resilience.

  • We have not yet incurred any realized credit losses in the portfolio.

  • Further, the level of defaulted assets in the underlying collateral of CDOs is very low compared to the weighted average attachment points in those structures.

  • We continue to refine our analytical methodologies to produce stress test scenarios of potential ultimate realized credit losses in the portfolio.

  • In the first quarter we introduced a roll rate analysis to develop estimates of potential ultimate loss.

  • Applying this methodology last quarter resulted in an estimate of potential credit losses of $2.4 billion.

  • In the second quarter we've introduced enhancements to the model methodology.

  • We now include prime RMBS in the portfolio of securities subjected to the roll rate analysis and have introduced analytics to capture the potential effects, both positive and negative, of the cash flow waterfall.

  • This quarter we include two stress scenarios of potential realized credit losses, each of which incorporate more highly stressed assumptions than used in previous scenarios.

  • The underlying roll rate and severity assumptions used in these scenarios are available for your review in the conference call credit presentation slide posted to our website.

  • The potential realized credit losses resulting from the two scenarios would produce losses of $5 billion and $8.5 billion, respectively.

  • To put the $8.5 billion scenario into perspective, if we look at the assumptions used regarding subprime mortgages, which represent a significant component of our collateral, the scenario assumes that currently delinquent mortgages will default at percentages approaching 96% and that the net recoveries upon foreclosure will only be $0.28 on the dollar compared to average nationwide recoveries currently of about $0.50 on the dollar.

  • Of course the collateral pools underlying be CDOs contain other classes of RMBS and other securities of various vintages which are also incorporated in the model.

  • However, this example may help to show that these scenarios are conservative and provide comfort to AIG that the potential ultimate credit losses, which may be incurred from the portfolio, are substantially less than the $24.8 billion of fair valuation losses we've recorded to date.

  • Turning to slide 13.

  • Back to the shareholders equity roll forward and the effects of impairment charges and the change in unrealized losses on available for sale investments.

  • I spoke earlier about the impairment charge of over $4 billion and will now focus on the change in the unrealized losses in our equity.

  • The net decline for the second quarter of $2.6 billion is principally driven by declines in market prices on foreign investments held in Japan, Taiwan, Thailand and other Asian countries due to rising interest rates.

  • While such movements in interest rates result in a decline in shareholders' equity, the economic effects are actually quite positive for the fundamental performance of the business.

  • Because we don't mark the liabilities to fair value rising interest rates are not reflected in the valuation of the corresponding liabilities under current accounting standards.

  • Turning to slide 14.

  • Within our insurance investment portfolios our total exposure to RMBS at amortized cost is $77.5 billion and has declined by a net $4.8 billion in the quarter, primarily as a result of payments of principal and charge-offs taken for other than temporary impairment charges.

  • The only purchases have been of agency pass-through certificates.

  • The difference in our holdings of $87.8 billion at par value and the $77.5 billion of amortized cost represents the other than temporary impairment charges already taken against these securities.

  • Of the OTTI charges taken year to date, 87% of them represent severity charges.

  • The underlying securities have retained their investment grade rating and virtually all are paying principal and interest.

  • However, in consideration of the rapid and severe market valuation decline AIG could not reasonably assert that the recovery period would be temporary.

  • The entire portfolio, including agency pass through certificate, is marked at approximately $0.77 on the dollar.

  • Let's go to slide 15.

  • And as you can see, despite continued rating agency actions taken in this sector our holdings are performing and are still almost 95% rated AAA and AA.

  • Slide 16 highlights the remaining changes in shareholders equity for the quarter.

  • I won't go through all of them in detail, but the principal point that you see is the affect of our capital raised in May.

  • Now I'll turn the call back over to Bob.

  • Bob Willumstad - Chairman, CEO

  • Thanks, Steve.

  • As I indicated at the outset, our second-quarter results are not indicative of the performance AIG can deliver.

  • And I know many of you have questions about what we're doing to get the Company back on track.

  • There are no quick fixes.

  • In uncertain times like these we will continue to make every effort to protect our capital, reduce risk and strengthen our balance sheet.

  • One of the ways to strengthen our balance sheet is to improve the profitability of our operating businesses.

  • This company has seen significant growth in operating expenses over the past three years.

  • We are working across all our businesses to reduce expense growth.

  • There will be some areas where we'll continue to spend heavily, such as financial reporting and controls, as well as risk management systems.

  • But we need to improve our expense management across all of our businesses.

  • I'm not in a position today to give you definitive targets for expense reduction.

  • We will, however, identify those opportunities in our September strategic review.

  • In the meantime, we've curtailed the expansion of capital intensive businesses and would not consider any major acquisitions at this time.

  • Once we complete our review we will act quickly to implement the necessary and appropriate changes to our businesses.

  • I have already spent significant time visiting our US operations and will do the same in Asia later this month.

  • I've also met with some of our key regulators and plan to meet with more of them soon.

  • Our goal is straightforward -- to define AIG's vision and determine the optimal portfolio of businesses based on where our true competitive advantages lie.

  • We will also change AIG's risk profile and sharpen our risk management and capital allocation process in addition to strengthening our accounting and reporting infrastructure, a less complex AIG will be a better competitor.

  • These actions will result in significant changes, but conditions demand it and we are moving forward with focus and a sense of urgency.

  • We've already reached one conclusion, that we should retain ILFC.

  • This is a strong market leading business and we determined it is best both for ILFC and AIG to stay together.

  • I'm not prepared to disclose any other strategic conclusions today; however, we will report to you the results of our review at an investor meeting on September 25th, details of that meeting will be provided to you.

  • It's clear from second-quarter results we have a lot of work to do to restore AIG's profitability to where it should be.

  • However, we understand the challenges ahead of us and we are developing a game plan to see AIG through these difficult times and rebuild shareholder value.

  • Before taking your questions I'd like to offer a general observation after being AIG's chief executive officer for nearly 2 months.

  • I'm convinced that AIG is a great company, but, as you can see from our results, we are facing some serious challenges.

  • I know there is more than a little frustration with our performance and that shareholders understandably want a clearer picture of our business outlook and whether the worst is over.

  • While I cannot provide all those answers for you today, we are committed to being an as open and candid as we can be.

  • We will now take your questions.

  • Operator, can we open the line for questions?

  • Operator

  • (OPERATOR INSTRUCTIONS).

  • Jimmy Buehler, JPMorgan.

  • Jimmy Bhullar - Analyst

  • Thank you.

  • Good morning.

  • I have a couple of questions.

  • The first one is on your capital position, if you could talk about under what scenario do you foresee -- or do you foresee a scenario in which you'd have to raise equity capital again if results don't improve or continue at this pace?

  • And then secondly, you've had several -- or a couple of quarters at least of DAC benefits in your life business because of realized losses.

  • And if you believe that we're in a period of a secular decline in investment returns, especially if you include the realized losses along with the portfolio yields and the returns don't improve could you have a DAC recoverability issue in the domestic life business at some point?

  • Bob Willumstad - Chairman, CEO

  • Thank you.

  • Jimmy, as it relates to capital, obviously it's a question that we focus on on a regular basis.

  • As I said before, we're doing our best to preserve as much capital as we can.

  • It's very hard to predict right now when and if we'll need more capital.

  • Our current position we think is satisfactory.

  • Future losses obviously can change that assumption and we're obviously dependent on the condition of the US housing market and how those will affect the securities that we hold.

  • But I would say right now we feel comfortable with the amount of capital that we do have, there's just no way of predicting the future at the moment.

  • I think on the second question about DAC --.

  • Chris Swift - VP, CFO Life & Retirement

  • Jimmy, it's Chris Swift.

  • I can maybe comment from a global life and retirement services side.

  • As you know, our practice is to review our DAC assumptions and do any formal unlockings in the fourth quarter.

  • That is on track.

  • I can tell you our early thinking right now is in the domestic markets, particularly in the variable annuity product line, we are on the high-end of our reversion to mean range.

  • So if the equity markets particularly continue to decline in the third and fourth quarter, that could potentially necessitate an unlocking.

  • In conjunction then with our normal fourth-quarter reviews we'll look at the other global markets and our long-term assumptions on market performance and asset performance.

  • And as Bob has indicated, if we need to derisk and change assumptions we will, but right now it's too early to say what that global review will predict in the fourth quarter.

  • Jimmy Bhullar - Analyst

  • Thank you.

  • Operator

  • Dan Johnson, Citadel Investment.

  • Dan Johnson - Analyst

  • Thank you very much.

  • Would you folks mind giving us a little bit more of a tutorial around the issues referred to as 2A7 puts?

  • I believe it's on page 87 of the Q.

  • Just basically trying to understand how many more I guess clients could I guess put this business back to you that would cause you to generate more CDOs as we did in the second quarter?

  • Unidentified Company Representative

  • Dan, it's (inaudible).

  • With respect to the 2A7, at this point we have written all the 2A7s we're committed to write.

  • So that's the maximum amount of 2A7 puts that we have outstanding.

  • The way those work is that if there's a sale remarketing then we would have potentially an obligation to buy the CDO back and -- or the underlying security back.

  • And on most of them we do have backstop liquidity lines in the event those bonds have been put back to us.

  • Dan Johnson - Analyst

  • And is it that we don't have any more exposure to this because there's been no failed remarketings or even that whole issue is basically there are no more 2A7s that we would be potentially on risk for?

  • Unidentified Company Representative

  • No, we do have outstanding 2A7 puts that continue to be outstanding, and given the current state of the market we would be expecting to be buying back those underlying reference obligations.

  • Dan Johnson - Analyst

  • Any sense on what that means from capital consumption?

  • Unidentified Company Representative

  • Not at this point.

  • Dan Johnson - Analyst

  • Okay.

  • Moving over to the MI business, can we talk a little bit about the captive benefits that we probably are receiving by now?

  • And importantly, do we have any captive counterparties that have put their captives into runoff?

  • Billy Nutt - President, CEO

  • Dan, this is Billy Nutt at UGC.

  • We've got approximately 65 captives that we're ceding incurred losses to.

  • So far this year we have ceded, through 6/30 we have ceded $255 million in ceded incurred losses.

  • We expect to cede about $460 million this full year.

  • Leakage, potential leakage from captives that would exhaust their trust accounts would be a modest, right now we're estimating about $25 million.

  • There have been some captives that have decided to get out of the mortgage guaranty reinsurance business and have notified us as such.

  • But of course they're still obligated for any books of business that we currently have on our books at this time.

  • Dan Johnson - Analyst

  • The obligation refers to the amount of money that is already in the trust?

  • Billy Nutt - President, CEO

  • That is correct.

  • We've got currently right now $1.1 billion of monies in the trust accounts in these 65 captives.

  • Dan Johnson - Analyst

  • Great.

  • And your $25 million of leakage, that was for this year?

  • Billy Nutt - President, CEO

  • That is for this year.

  • That's our estimate for this year.

  • Dan Johnson - Analyst

  • When we think about next year's performance, are we going to get most of the benefit from the captives in this year and potentially be on the outside next year or -- maybe just a little color there?

  • Billy Nutt - President, CEO

  • Well, right now we're estimating that most of the benefit will come through this year as losses accelerate due to the dislocation, the increasing dislocation in the housing market.

  • We will receive benefits next year, though it's a little too early to estimate that but we think it will be somewhat less than the benefit that we're estimating for this year of $460 million.

  • Dan Johnson - Analyst

  • Great.

  • And finally, sir, Mr.

  • Swift, just the market assumption underlying the DAC market growth assumption I guess I'd say that underlies the DAC calculation?

  • Chris Swift - VP, CFO Life & Retirement

  • The domestic one is roughly 10%.

  • Dan Johnson - Analyst

  • Inclusive of dividends?

  • Chris Swift - VP, CFO Life & Retirement

  • Yes.

  • Dan Johnson - Analyst

  • Great.

  • Thank you very much for taking the questions.

  • Operator

  • Josh Shanker, Citi.

  • Josh Shanker - Analyst

  • Thank you.

  • Good morning.

  • I have two questions.

  • The first, I would like to understand in retrospect when you thought one year ago or one quarter ago that $1.2 billion to $2.4 billion would be the realistic stress case for the portfolio.

  • Obviously you increased that to 5 to 8.5 billion.

  • Looking back on it, what was wrong with the stress test that you did at that time and what makes you more comfortable with the ones that you're using today?

  • Bob Willumstad - Chairman, CEO

  • We'll have Kevin McGinn, our Chief Risk Officer, Josh, address that point.

  • Kevin McGinn - CCO

  • Hi, Josh.

  • Good morning.

  • The major change that we made was simply because of deteriorating market conditions.

  • We felt we needed to move our loss severity down, real estate values have obviously been declining even more sharply than we thought.

  • And so we took our loss severities in our delinquency pipeline up, especially on the '05 vintage.

  • Which of course, because we have so much '05, has a significant impact on the number.

  • The other significant change this quarter was we had a much better estimate of what we might experience in leakage in the CDOs themselves in terms of the principal payments that are coming down to the lower rated tranches.

  • We made a strong estimate of that.

  • And as you can see in the conference slides, that was almost a $1 billion difference in the quarter.

  • There were a few other issues that are explained in one of the conference slides.

  • Another significant impact was because we haircut the CDOs using current ratings and because the rating agencies are continuing to downgrade CDOs we've been using current ratings as opposed to original ratings to give ourselves some buffer there.

  • Josh Shanker - Analyst

  • And is that $5 billion to $8.5 billion a likely worst-case or a realistic case given the way you're looking at things right now?

  • Kevin McGinn - CCO

  • We think if you look at our assumptions, especially in our rolls and our loss severities, we think right now the $5 billion is -- probably is a very, very conservative estimate and the $8.5 billion would be even much more stressed.

  • So we don't think we're going to get to those numbers, but they are there to give you some indication of what could happen.

  • Josh Shanker - Analyst

  • If the deterioration of the marketplace were to freeze right now, things didn't get better but they didn't further deteriorate, of the $26 billion that you've marked in losses what actual loss would the portfolio take?

  • Kevin McGinn - CCO

  • That's a very good question.

  • We haven't really taken any credit losses to date as we've paid nothing out.

  • I would think that it's hard to really give you an accurate answer on that because there are so many moving parts.

  • But I think it would be something less than the $5 billion number that we've published.

  • Josh Shanker - Analyst

  • Okay.

  • And just a quick numbers question.

  • You said something interesting -- that two thirds of the OTTI losses were already reflected in book value as unrealized losses from prior quarters.

  • Is there any way that we can understand the trend?

  • What was the cumulative unrealized credit losses plus OTTI for the last three quarters, can we see a trend in that?

  • Kevin McGinn - CCO

  • The trend -- I think you have to look at the trend in the total valuations of the portfolio, not just what's other than temporary impairment charges, but also including what comes through on the balance sheet.

  • And if you look, for example, at the change in other comprehensive income for this quarter versus last quarter, you see about a $7 billion improvement in the change in OCI which is principally driven by the -- principally driven by unrealized appreciation or depreciation.

  • So that's $7 billion pretax, about $4 billion or so after tax.

  • So we've certainly seen a moderation, a significant moderation in the second quarter of the overall pace of decline in those valuations.

  • Josh Shanker - Analyst

  • And then am I more or less somewhat justified in assuming that the first quarter of this year and the fourth quarter of last year the OTTI losses were not taken from the AOCI calculation, but they were really sort of emergent losses at that time?

  • Kevin McGinn - CCO

  • Yes, that's the big difference.

  • This quarter the OTTI was very significantly offset, effectively a lot of it moved from the balance sheet to the income statement, where certainly in the previous quarter and the fourth quarter it was more additive.

  • Josh Shanker - Analyst

  • Okay, thank you very much.

  • Operator

  • Andrew Kligerman, UBS.

  • Andrew Kligerman - Analyst

  • Thank you.

  • First question comes back to the excess capital issue.

  • I know you've refrained from providing an excess economic capital number, but you are saying, at least as I read in the 10-Q that you have 99.95% confidence that your capital is commensurate with a AA range rating.

  • If I go back to your previous metrics for estimating excess economic capital I come up with a number of $13 billion to $19 billion.

  • So the first question -- is the $13 billion to $19 billion even in the ballpark with reality?

  • And secondly, maybe just a little more clarity on why you're so confident?

  • Steve Bensinger - CFO, EVP

  • Okay, Andrew, it's Steve.

  • It's a very good question.

  • I'm going to refrain from either affirming or denying your quantitative assessment because that's not something we really want to do at this point in time.

  • You can do your own math and come up with your numbers which you've done.

  • The reason that we have not quantified it as we have in the past is it's pretty clear to us that at this point in time in this environment the ultimate governors of capital are not solely our point of view, which we've said all along, on economic capital, but the points of view of the rating agencies, the points of view of the regulators and other market participants.

  • So while we certainly have a point of view based on what we think is rigorous analysis, that's not a prevailing point of view in this marketplace and we have to be realistic about what's really driving our capital needs.

  • And hence, while he have a point of view and we have a confidence level associated with that and we communicate that it's not the driving factor in this environment.

  • Bob Willumstad - Chairman, CEO

  • I think obviously Steve said it correctly.

  • The rating agencies today are the governor of how much capital we have and how much capital we need.

  • Andrew Kligerman - Analyst

  • If you had to assess your level of concern that you're going to need to raise capital in the next six months, how would you rank it, low, medium or high?

  • Bob Willumstad - Chairman, CEO

  • Again, similar question as before.

  • The real question is what's the level of future losses and that's going to be dependent on the capital markets.

  • And I just don't think that we're prepared to make that forecast right now.

  • We've shown you our stress analysis, but obviously as an issue of timing -- so right now our efforts are to protect our capital bases as much as we can to go through a difficult (multiple speakers).

  • Andrew Kligerman - Analyst

  • Fair enough.

  • And then just sort of shifting over to the Super Senior CDS losses, Steve talked a bit about the roll forward and some of the conservative assumptions going on in that new $5 billion to $8.5 billion number, but now you've got an aggregate loss of about $25 billion.

  • Could you give us a sense, one or two big data points that drove the $25 billion -- that's in that $25 billion loss I think out of $80 billion in initial securities or insurance?

  • What's in that number, what are the assessments there that are driving that and what do you think the likelihood is that we're going to see another $5 billion or $10 billion hit next quarter?

  • Bob Willumstad - Chairman, CEO

  • Maybe I'll just comment on an overall basis and if Elias wants to add anything I'll certainly open the mic to him.

  • The principal driver of the fair value marks that we're taking on our GAAP financials is based upon market pricing.

  • Market prices for both underlying collateral with any mortgage type exposure or structured securities continues to be very adverse in today's marketplace.

  • You have a market that's, first of all, adverse to these types of risk; secondly, illiquid, there's very little trading going on and you also have sales of securities that are done on a for-sale or on fire sale type of basis that also drive the entire market down.

  • There's also (technical difficulty) to be very little distinguishing characteristic in the market today in pricing between different vintages.

  • Our portfolio is principally 2005 and prior, as we've highlighted before, but the pricing in the market of CDOs and underlying collateral is really not distinguishing properly, in our view, between different performance characteristics of those vintages.

  • Elias, do you have anything further on that?

  • Elias Habayeb - SVP, CFO

  • Yes, a couple quick points.

  • From an accounting perspective the fair value we reflect what's the exit price or liquidation price of the transaction today in the current market.

  • And the way we value this portfolio is it came to us holding the actual CDO security.

  • So there's a hefty liquidity premium that's going in the valuation.

  • On the stress analysis, what that stress analysis is looking at, if we hold the position until maturity, how much cash do we expect to lose from today through the maturity of that position?

  • And so that's going to have to highlight the difference between our credit analysis estimate and the valuations that we're using from a financial reporting perspective.

  • Andrew Kligerman - Analyst

  • So can you give a blunt number around an average recovery expectation or something like that to just kind of get a flavor for what you're thinking?

  • Elias Habayeb - SVP, CFO

  • In the valuations itself?

  • Andrew Kligerman - Analyst

  • Yes.

  • Bob Willumstad - Chairman, CEO

  • The recovery expectation would be the difference between the stressed scenarios that we show and the mark that's been taken.

  • And again, those are not expected losses, those are stress case analyses.

  • So we're not giving expected loss mark because we really have no way to base that.

  • We can use scenarios and I would suggest you take a look in the larger presentation that we posted last night, the credit presentation, pages 14 through 23 I think give you a lot of information about first of all how the stress test move from last quarter's number to where they are now, and secondly, the underlying assumptions around frequency and severity associated with those two different stress analyses.

  • And you'll see, as I noted in my remarks, that there are some pretty conservative assumptions than those.

  • Andrew Kligerman - Analyst

  • Okay, I'll check that out.

  • And then just lastly, Bob, with regard to your conversations with Hank Greenberg, has there been any progress on that front?

  • Bob Willumstad - Chairman, CEO

  • Well, we continue to talk; I've spoken to him as recently as a few days ago.

  • I'm not going to disclose the progress or the nature of the conversations, but we continue to talk to each other.

  • Andrew Kligerman - Analyst

  • Thanks a lot.

  • Operator

  • Andy Dunn, RBC.

  • Andy Dunn - Analyst

  • Good morning.

  • Could you give us some more color on the securities lending losses?

  • Steve Bensinger - CFO, EVP

  • Yes, maybe we'll give that one to Richard Scott.

  • Richard Scott - SVP Investments

  • The securities involved are primarily direct securitizations of mortgage loans of various types, but primarily subprime and Alt-A.

  • They were initially AAA in the mark to market which is what's flowing through the OTTD calculation is just that, it's taking the market price of those securities as they're currently trading and marking it through our income statement.

  • Andy Dunn - Analyst

  • So the securities you held that were downgraded (multiple speakers)?

  • Richard Scott - SVP Investments

  • Actually most of them have not been downgraded, the bulk of them are AAA floaters.

  • Unidentified Company Representative

  • It's a function of pricing again it is the same explanation I just gave to Andrew on the CDO it is the same market price phenomenon that is driving the price valuations are in the RMBS collateral that backs the securities lending pool.

  • Andy Dunn - Analyst

  • And was any of it due to a mismatch in the duration of the financing?

  • Richard Scott - SVP Investments

  • The duration is primarily -- they're floating rate to floating rate.

  • So no, I would not characterize it as a duration mismatch.

  • Andy Dunn - Analyst

  • Okay, thank you very much.

  • Operator

  • Tom Cholnoky, Goldman Sachs.

  • Tom Cholnoky - Analyst

  • I've got two questions.

  • Bob, if you look back historically at AIG, one of the hallmarks of the Company was its willingness and ability to take risk and generate returns that were clearly in excess of what other companies were able to do.

  • And given the underlying trends in your core businesses and your focus on what appears to be de-risking the businesses, how would you really assess the core earnings power of the Company, especially in light of previous management's target of a 15% ROE over the next five years?

  • And then I've got a follow-up.

  • Bob Willumstad - Chairman, CEO

  • I think the hallmark of AIG historically has been its ability and willingness to take risks and I will say prudent risks, in my judgment anyway, largely in its core business of property and casualty and life underwriting.

  • I think as you look now you see, again in retrospect, much of the problems that have come about have been a concentration of risk in the US housing market both in the investment portfolio and the credit default swap book.

  • My own view is lowering the level of risk will be making sure that we're getting paid adequately for the risk that we take.

  • If you look at the impact in the financial products area, these are relatively narrow margins for what's now turned out to be a much greater amount of risk than I think anybody anticipated.

  • So I think we will stick to where we have competitive advantages which is essentially in our core insurance business.

  • And I think as we go through this review process we need to better understand the amount of risk that we take and whether we're going to get adequately compensated for it.

  • Many of these businesses that have performed quite well in the past have been a byproduct of a company that was AAA rated which we don't now have.

  • So I think the environment has changed and the competitive landscape has changed and obviously the ratings of the Company have changed and I think we have to factor that into our judgments.

  • Tom Cholnoky - Analyst

  • Does that mean that a 15% return is no longer something that makes sense in the current environment?

  • Bob Willumstad - Chairman, CEO

  • Certainly in the current environment it would be hard to put your finger on any return.

  • I think as we go through this evaluation and hopefully in September we'll be able to talk about what we think the returns will be as we kind of look at the composition of the portfolio of businesses going forward.

  • But I'd be hesitant to put a number on it right now.

  • Tom Cholnoky - Analyst

  • How do you think or what are the rating agencies saying to you currently?

  • I haven't seen any of them come out to make any pronouncements, but given your most recent results do you foresee any changes in the way that they are viewing the Company?

  • Bob Willumstad - Chairman, CEO

  • We've spent time with the rating agencies, we just haven't heard back from them, they haven't made any public statements so we're waiting to hear.

  • Tom Cholnoky - Analyst

  • Sorry, one last question, if I can, on ILFC real quickly.

  • There's been a lot of speculation in the market if oil tends to trade back up to 140 that the global airline industry will start to have some significant problems in terms of being able to keep airplanes in the air.

  • And is there any risk that you could envision where perhaps the residual values is that of your fleets could be impaired?

  • If somebody could comment on that.

  • Bob Willumstad - Chairman, CEO

  • I'll make one comment and maybe turn it over to Alan Lund.

  • Our most recent review of that business is that all of those planes have been put out on lease.

  • And while I think everybody understands that there's a potential for some risk going forward in the airline business, I think ILFC really is a premier company with a market leadership position and has proven very adept at dealing with a lot of these problems ensuring that these aircraft are leased.

  • But Alan, maybe you want to comment?

  • Alan Lund - Vice Chair, CFO

  • I think what I would add to that is that we have by far the most fuel-efficient fleet that's out there in general.

  • And so where there are airlines now that will be trying to get less fuel-efficient airplanes out of their fleet and in the current financing environment where they're having problems taking on incremental airplanes that they would be looking to leasing and we've got the right product for what they need to deal with the higher cost of fuel.

  • Tom Cholnoky - Analyst

  • Okay, great.

  • Thank you.

  • Operator

  • Tom Gallagher, Credit Suisse.

  • Tom Gallagher - Analyst

  • A few questions.

  • First, for Bob.

  • Just broadly speaking, and I know you're not really prepared to go into specifics, but broadly speaking, when you mention risk reduction as a strategy, does that contemplate a meaningful reduction of housing-related exposure or do you still think that's too cost prohibitive based on illiquidity?

  • That's question number one.

  • Related question, is there a consideration here to reducing the types of assets that you invest in including private equity and hedge funds, a potential reduction in allocation to those asset classes?

  • And then -- why don't I start with those and I have a few follow-ups?

  • Bob Willumstad - Chairman, CEO

  • Your comment about cost prohibitive on housing obviously is the challenge we face.

  • We continue to look at any number of options, again given the analysis that we've shown around the stress testing, most everything we think that might be available in the marketplace would be cost prohibitive.

  • But we're going to continue to look at all of those things.

  • Obviously any effort to derisk that part of the business would be an important decision for us and obviously we'd have to look at the cost implications of that.

  • I think on the second question, obviously investment performance and investment income is down considerably against the high water mark last year, much of it driven by private equity and alternatives.

  • Again, we think that that business for the long term has good returns attached to it.

  • I don't think it's a question of risk, it's a timing of question of timing and obviously it will create more lumpy, if you will, investment returns.

  • But I think over the long term that's a decent asset class for us to be in.

  • Tom Gallagher - Analyst

  • Okay.

  • And then just a couple of other questions.

  • One on some disclosure you have on [VIEs].

  • I believe there's $38 billion of worst-case losses, at least as indicated in your 10-Q.

  • Can you comment a little bit about how much of this should we think about being first loss or subordinated positions versus being more of a pari passu investor with collateral pools that you've originated?

  • So that's a question on the VIE.

  • And a question I had on the regulatory capital CDS, on the mark you took.

  • Steve, if I understood you correctly you said it was a $125 million mark related to one contract for $1.6 billion that you had expected to mature that didn't.

  • And that looks to be, if I'm right, about an 8% mark.

  • How should we think about as that relates to the remaining $307 billion of notional [classes]?

  • Should we think about all of that being assumed to run off and that which does not run off would have a similar mark or maybe you could help us think through that?

  • Thanks.

  • Steve Bensinger - CFO, EVP

  • Let me take that question and then we'll go to the VIEs in a second.

  • This particular trade -- and again, I'll let Elias amplify on it -- had different characteristics in terms of the underlying reference pools than the rest of the regulatory capital and relief book.

  • So the reason we separated it out is because we don't see that as being indicative of valuation of the remainder of that portfolio.

  • The remainder of that portfolio continues to show terminations, many of them earlier than we expect, at either no cost or sometimes with a payment to AIG for termination as the regulatory capital relief is no longer provided to the counter party as they implement Basel II.

  • This particular one had different features and maybe, Elias, you can just explain that?

  • Elias Habayeb - SVP, CFO

  • I'd be happy to.

  • In this one transaction -- the difference in this transaction is we wrapped a security that was backed by mortgages, while in the rest of the regulatory capital portfolio we entered into a derivative with the bank on loans that sit on their balance sheet.

  • And in this case through our surveillance and monitoring we understood that the counter party's motivation has gone beyond capital relief for other purposes.

  • And we continue to monitor, as we've said before, the portfolio very closely and stay very close to our counterparties.

  • We educate ourselves from the $18 billion plus in transactions that have already been terminated early during the year which have told us that for those types of derivatives, that they're used for capital management purposes.

  • The value propositions that our counterparties are seeing isn't sensitive to what's happening to spreads in the marketplace.

  • And we continue to believe at this point, based on the data that's available for us, that the rest of the portfolio is being used for capital management purposes and once that benefit disappears the intent of the counter party is to unwind the transaction.

  • And therefore we believe the mark we have on those today on the balance sheet as of June 30, is the right mark for that portfolio.

  • Steve Bensinger - CFO, EVP

  • I would also point out, Tom, that if you have a chance take a look at page 9 of the credit presentation.

  • That shows the reference pool losses to date against the weighted average detachment points on these different pools and I think you'll see that they're extremely low.

  • Tom Gallagher - Analyst

  • So just a follow-up on that.

  • So is it fair to say this was more of a one-off transaction embedded within the pool where the risk or the equality of the collateral was not nearly as good as what's left?

  • My only concern here would be if we roll forward several quarters and we keep thinking about the embedded assumptions for how fast this runs off and maybe some of it doesn't run off, would we use marks that are somewhat similar, even considering the fact that losses may be way away from attachments?

  • I'm just worried more about the marks that we might see on this.

  • Steve Bensinger - CFO, EVP

  • I'll let Elias or Andy Forster talk.

  • But it's not equality of collateral issue.

  • It's more the form of the underlying collateral.

  • Andy, do you want to just talk about that on this transaction?

  • Andy Forster - EVP, Asset Trading & Credit Products

  • Sure.

  • I think the quality of this transaction is indicative of the transactions we have, there's no change there, as Steve mentioned.

  • And going forward, as Elias said, we will continue to monitor the transactions and ensure that the motivations remain consistent with our current beliefs.

  • Tom Gallagher - Analyst

  • Okay, thanks.

  • And then on the VIEs?

  • Steve Bensinger - CFO, EVP

  • I'll let David Herzog, our Chief Accounting Officer, talk about that one.

  • David Herzog - CAO

  • Hi, Tom.

  • It's David.

  • The vast preponderance of that exposure we are indeed pari passu with the other equity holders.

  • Tom Gallagher - Analyst

  • And David, is there an equity first loss position content there if we were to say starting with the $38 billion?

  • David Herzog - CAO

  • Tom, no.

  • These investments are recorded on our -- most of them are consolidated or included on our balance sheet -- not consolidated but included on our balance sheet.

  • And again, it's not a first loss.

  • Tom Gallagher - Analyst

  • Got it.

  • So the full 38 is pari passu?

  • David Herzog - CAO

  • That's correct -- the vast preponderance of it is pari passu.

  • Tom Gallagher - Analyst

  • Thanks a lot.

  • Operator

  • Jay Gelb, Lehman Brothers.

  • Jay Gelb - Analyst

  • Thank you.

  • I was hoping you could give us a sense of what your minimum target ratings would be for AIG at the corporate level for financial strength as well as senior long-term debt?

  • Steve Bensinger - CFO, EVP

  • Jay, it's Steve.

  • I think our target is to maintain our current rating levels.

  • I don't think we have a minimum target level that we're shooting for here.

  • That's a tough question to answer beyond that.

  • Jay Gelb - Analyst

  • Okay, that's fair.

  • Then as we get closer to the results of the strategic review should investors be prepared for earnings or balance sheet charges related to that?

  • Bob Willumstad - Chairman, CEO

  • That would be premature to say.

  • I don't think that that's necessarily part of any expectation.

  • Obviously if we were to decide to divest of assets there, I suppose, could be some charges to that.

  • But that's not the thought process I think right now.

  • Jay Gelb - Analyst

  • Will there be a reserve review on the property-casualty business as part of the strategic review or might that come later?

  • Steve Bensinger - CFO, EVP

  • I don't know that that's necessarily a strategic issue, I think that goes on on a regular basis.

  • Frank Douglas - SVP, Casualty Actuary

  • This is Frank Douglas.

  • Many different sets of eyes review our reserves every quarter.

  • We do a fairly complete update of the reserves for each profit center each quarter, that's what you see in the results.

  • We have outside eyes also look at the numbers on a regular basis.

  • So we're pretty comfortable that as many folks as need to are already reviewing the results.

  • Jay Gelb - Analyst

  • Okay.

  • Thank you very much.

  • Operator

  • Alain Karaoglan, Banc of America Securities.

  • Alain Karaoglan - Analyst

  • Good morning.

  • I have several questions.

  • The first one relates to the $20 billion in capital that was raised already.

  • Where have you allocated the -- to which segments of the business has it found a home?

  • And do you have any left or has it been all allocated or do you expect to allocate it in the third quarter?

  • Steve Bensinger - CFO, EVP

  • Alain, it's Steve.

  • No, it has not been all allocated.

  • There's a large sum of it left.

  • The allocation that's been made so far has been some of it to the Domestic Life and Retirement Services companies for capital purposes and the most of it I would say has been used for AIGFP purposes in terms of collateral.

  • Alain Karaoglan - Analyst

  • Okay.

  • In terms of the de-risking of the Company, I assume if you're going to derisk that means you're going to lower the risk on the investment portfolio.

  • And the question that I have is should you be selling so much in fixed annuities outside of the US which is a spread business or is that going to force you to maintain a riskier portfolio, Bob, than you would like because you've sold these annuities on which you're crediting a minimum rate?

  • And related to that, on the partnership income really the issue is not one of volatility and whether you should have any at all, but isn't it more the size of the partnership investments compared to other companies that is more significant?

  • So while you might still have some that you're going to derisk you should have less of it?

  • Bob Willumstad - Chairman, CEO

  • Let me respond to the last question in terms of partnership income.

  • I'm not sure, again, I haven't looked at it from a competitive point of view very closely, but given the size of our balance sheet the 3%, 4% that we have it seems to me is not unreasonable given, again, the size of this balance sheet.

  • I think to try and respond to your first question, when I think about derisking I think about businesses that I'll say are not necessarily core to our overall franchise.

  • I think there are a lot of components both for the property and casualty as well as the life business that we need to look at carefully.

  • But again, I think there's a certain amount of risk one has to take to be in these businesses and to be a leading player in the industry.

  • So again, all of those things are certainly going to be part of the review process, but we'll look at the investment portfolio as well.

  • Alain Karaoglan - Analyst

  • And could you update us on the CFO search and what your expectations are?

  • Bob Willumstad - Chairman, CEO

  • Well, the process is ongoing.

  • I've met with a number of potential candidates, very attractive and I expect over the course of the next six to eight weeks to have that resolved if not sooner.

  • Alain Karaoglan - Analyst

  • Thank you very much.

  • Operator

  • Jay Cohen, Merrill Lynch.

  • Jay Cohen - Analyst

  • Thank you.

  • Just some unrelated questions.

  • First is, on the domestic retirement, the fixed annuities, individual fixed annuities, it looked like on a consecutive quarter basis not only did the base yield go down, that it looked like the cost of funds went up.

  • So I guess that the crediting rate went up.

  • Why would that occur when base yields are coming down?

  • Jay Wintrob - EVP of Retirement Services

  • This is Jay Wintrob.

  • Good morning.

  • Just a couple of comments, if I can just backtrack on Alain's earlier question.

  • I don't if you were connecting partnerships with fixed annuity crediting rates, but for our pricing purposes the returns on partnership investments are not factored into the pricing we use on our credited interest rates as an aside.

  • The reason cost of funds went up is pretty straightforward.

  • In the quarter you had along the yield curve the treasury curve shifting up at the longer durations.

  • By way of example, two-year T was up 103 basis, five-year T was up 89 basis points, 10-year T was up 56.

  • So it's logical that some of that increase would be reflected as we adjust our credit and interest rate on new business.

  • Not all of it of course because new business is just a component of the overall block.

  • And the primary reason I think was mentioned earlier on the decline in the base yield was directly related to what Steve mentioned which was the prudent build up of liquidity in those portfolios.

  • Jay Cohen - Analyst

  • That makes sense, thanks.

  • Second question, this is probably a quick one.

  • In the other income, the other unallocated expenses were up quite a bit and there was something discussed, a charge for a settlement of dispute.

  • I'm wondering if you can quantify that that was a material reason why those expenses went up?

  • Steve Bensinger - CFO, EVP

  • That was $100 million, Jay.

  • Jay Cohen - Analyst

  • Oh, pretty material.

  • Can you talk about the dispute that was settled?

  • Steve Bensinger - CFO, EVP

  • It was relating to our buyout of the remaining interest in Ascott in London and it's fully resolved.

  • Jay Cohen - Analyst

  • Okay, that's great.

  • Thanks, Steve.

  • And the last question, on UGC, I guess the losses have just been so astronomical, it's really mind-boggling.

  • When do these losses peak?

  • Can you look out at all and give us any sense of when these losses will at least peak and level off?

  • Billy Nutt - President, CEO

  • Jay, this is Billy Nutt.

  • Good morning.

  • Obviously the ongoing disruption and the deepening disruption in the housing market is placing pressure on our first and second lien losses as well as those of the rest of our industry.

  • We anticipate that the housing market is not going to stabilize until the second half of next year.

  • Combine that with weakening in the economy, ongoing weakening in the economic environment, that it's going to continue to challenge our domestic businesses.

  • And therefore we expect losses to continue at their current levels for the next several quarters and we think that 2009 is going to be a challenging year as well.

  • Jay Cohen - Analyst

  • Is it fair to say that the loss in 2009 might be smaller than 2008?

  • Billy Nutt - President, CEO

  • It's hard to tell at this point in time.

  • It should not be any worse than 2008.

  • But again, that depends upon how much further this housing market deteriorates and whether we go into a rather strong economic recession.

  • Jay Cohen - Analyst

  • Billy, have you made any management changes at the Company?

  • Billy Nutt - President, CEO

  • I don't anticipate any management changes, perhaps I should defer that to Bob.

  • Jay Cohen - Analyst

  • But I'm saying have you made management changes for your rank and file?

  • Billy Nutt - President, CEO

  • Yes, we've done some restructuring within our domestic group and we have made some management changes in order to consolidate some businesses.

  • As you know, we have significantly contracted our second lien business, we've reengineered that business and we've made some management changes and some in force reductions as a result of those changes.

  • Jay Cohen - Analyst

  • All right, thanks for the answers.

  • Operator

  • Larry Greenberg, Langen McAlenney.

  • Larry Greenberg - Analyst

  • Thank you very much and good morning.

  • Just back to CDOs for a moment.

  • I'm wondering if you have an opinion on the argument that some people have made that some underlying trends in the collateral backing these instruments have actually improved?

  • Specifically that the inflow of new problem subprime loans has slowed and there's a lower roll rate into late delinquency buckets?

  • Kevin McGinn - CCO

  • Larry, good morning, this is Kevin McGinn.

  • As you know, the CDO collateral that the subprime and Alt-A collateral that backs our CDOs is heavily from the 2005 vintage -- in fact about 71% of it is from the first half of '05 and before.

  • And yes, there's definitely been a slowdown, especially in the last three months we've seen early indications that the pipeline is definitely is slowing down.

  • And that is as we expected because as the adjustable rate mortgages flow through the pipeline we did expect to see as those things reset the data to improve and it is slightly improving.

  • The rate of growth has definitely slowed dramatically.

  • The '06 and '07 though continues to not show any appreciable decline.

  • We don't have a lot of that in the CDO pools, as you know, it's only a small component of it.

  • But we're encouraged obviously by the '05 development.

  • Larry Greenberg - Analyst

  • Okay, great.

  • And then can you give us an update on the material weakness as it relates to CDS valuation?

  • Steve Bensinger - CFO, EVP

  • Yes, we can do that.

  • I think we're continuing to make the necessary investments in people and process and automation around that whole area, so I would say that we're hopefully on track to meet our objectives for remediation by the end of the year.

  • That's our objective.

  • Larry Greenberg - Analyst

  • Would part of the conclusion of that be your ability to move away from valuing the portfolio as if you own the underlying CDO and go back to some sort of CDS valuation negative basis adjustment?

  • Is that part of the thinking?

  • Bob Willumstad - Chairman, CEO

  • No, that's really not.

  • The market observability will dictate any changes in methodology.

  • As of right now we don't see anything that would lead us to believe that the observability of negative spread is anywhere near on the horizon.

  • Larry Greenberg - Analyst

  • Great.

  • And then just switching gears a little bit on property casualty loss reserves.

  • I know it's been discussed in past quarters, but the persistence of problems with the 2001 and prior business in the face of most of the industry recognizing pretty consistent redundancies in their loss reserves, I recognize the challenges of excess casualty on some long tail lines.

  • But I mean there has to be some urgency to put this issue behind the Company and I'm just wondering if you could elaborate a little bit more on that?

  • Frank Douglas.

  • This is Frank Douglas.

  • I guess just to recap briefly, what we generally do to set all reserves, as you probably know, we rely on historical loss emergence patterns.

  • We do the same thing for excess casualty.

  • When you get reported emergence, as we have in the past couple of years, that has exceeded that historical norm, you're going to get adverse development.

  • So simplistically that's what's been occurring for excess casualty including many kinds of latent claims which we describe for you in the 10-Q in some be detail.

  • Why are we seeing that more than other companies?

  • I think a simple answer is no other company that I think you're probably comparing us to had anywhere near the market share of excess casualty that we did.

  • We had a very large share of the market in the late 1990s.

  • As you know, that's turned out to be a very unprofitable time, particularly for excess casualty, and we're still, despite the very adverse results we've recognized through the years, we're still seeing higher than expected emergence patterns coming from those years.

  • The good news is that the more recent years, even for excess casualty, continue to develop favorably.

  • So as we're concerned about those older years, the overall active book, certainly the last three or four accident years, five accident years has developed very favorably and I'd say very comparable to the other companies you're comparing us to who don't have an excess casualty book the size of what we had.

  • And I'll just add, we have added $3 billion to our reserves year to date and I don't think the competition has increased reserves significantly, at least much of it.

  • So I think that's partly the result of our quarterly updates where we're telling you what we're seeing.

  • And if we're seeing a need to increase reserves that's what we're reflecting.

  • Larry Greenberg - Analyst

  • Thank you.

  • Bob Willumstad - Chairman, CEO

  • Okay.

  • Again, I want to thank everybody for taking the time and we look forward to seeing you in September.

  • Thank you.

  • Operator

  • That concludes today's conference.

  • Thank you for participating.

  • You may disconnect at this time.