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Initial Thoughts on AIG

posted by Stephen Lubben

This part of today's AIG deal confuses me:

To offset the dilution of A.I.G.’s current common shareholders, the company said it would issue up to 75 million warrants, which would allow those non-government shareholders to buy more common stock in the future, for $45 a share.

First off, this only "offsets the dilution" for those shareholders willing to sink more money into AIG. If you are cash constrained or don't think AIG is a good investment any more, maybe you can sell the warrants.  Even that will have some cost, especially for small shareholders.

Bfm3C But what is the value of these warrants anyway? Initially they'll have some option value, but they will only "offset the
dilution" if AIG's share price goes above 45. As shown, the shares are currently trading at about 39 or 40. In the coming months (or years) Treasury hopes to sell 92% of AIG's shares. And AIG will become a much smaller company, by selling off pieces of itself to pay off the government. And I suspect AIG wont' be making money the same way it did before, at least not without some government objections.

So there will be a huge seller in the market and the company will shrink, but the share price is going to go $6 higher. Count me skeptical.

But maybe the warrants will have a very, very long expiration date. And there is bound to some inflation in the future . . . 

Comments

CS, wondering what your thoughts are on the Ally/JP morgan foreclosure issue that recently came up? I think that's a huge story not so much about the impact on the housing market but more about due diligence and regulatory liability. Is it too far fetched to call their actions predatory? In other words, some of these lenders engaged in predatory lending and now are engaging in predatory servicing or predatory foreclosures. Thoughts?

Stephen,

I must be missing something, but you're reasoning seems, well, really crazy.

AIG stock has bounced around a 100% over the past year. You could easily have made the same argument last February. The government's selling isn't the ultimate determinant of share values: the strength of the business is, but that's very uncertain and includes a lot of contingent transfers, including transfers from the state. Surely you don't think you know the medium-term market value of AIG to within 15%? If you do, I want you as my stock picker!

In practical terms, it takes no money for ordinary investors to exercise an in-the-money option or warrant: if you have a margin account, your broker will be happy to exercise and let you take your profit, contingent on your immediately liquidating the shares if holding them would violate a margin requirement. For very large holders, where the exercise and sale makes the ex-post stock price indeterminate, financing the exercise can be an issue. But mot for myriad small investors all holding warrants and exercising them independently.

May 2011 AIG call options @ 45 currently trade for $2.25. That's about 6% of AIG's value. The warrants, as you suggest, probably don't expire so quickly, and may well be perpetual. So they would be much more valuable. 6% of the value of the stock is a minimum bound on the warrants, if they were distributed one warrant per share. We have no idea how many warrants AIG intends to provide as part of this "antidilution" provision. Given the very large stake Treasury is taking, I suspect it will be more than one warrant per share.

If Treasury exchanges preferred stock at par for AIG stock at market while the market value of the shares includes a promise of warrants that Treasury will not receive, it will be the most blatant direct transfer if wealth from taxpayers to bailout firm shareholders since the beginning of the crisis. I am hoping this is not what Treasury intends, but that sure is the impression one gets from the New York Times story.

I think a lot of this depends on whether you think the market for the traded bit of AIG is relatively efficient. My comments are bottomed on my skepticism on that point. But even then, you are right that the warrant holders might win the lottery, so long as they exit before the market rights itself. We'll see.

Stephen,

Reading the press release, rather than the Times story...

http://online.wsj.com/public/resources/documents/AIGAnnouncesPlantoRepayUS30Sept2010.pdf

They say "up to 75M" options may be issued. There are roughly 668M shares of AIG outstanding. If "one warrant" means "a right to buy 1 share @ 45" and conversion is at market, then the subsidy to shareholders implicit in the arrangement is around 0.7% -- still outrageous, but not drive me batsXt insane outrageous.

I certainly wouldn't claim that the market for traded AIG is efficient! But I would claim it to be volatile, which gives options on the firm a high value.

Given that options already trade on AIG, we don't need to concern ourselves with lotteries: we can compute an ex ante subsidy to AIG shareholders, given the share price, the conversion price, and the warrant grant. Arbitrageurs should be able to realize the value of the subsidy immediately, depending on the specific structure of the deal.

Of course, if the conversion price is determined by the share price and the share price is, as you suspect, inflated, then the subsidy is much larger, as the government's new stake will serve to dilute that would otherwise accrue only to existing shareholders. (In reality, much of this subsidy may have already been made though, if the losses due the firm would have erases common share values entirely and eaten into the govts preferred stake even without conversion.)

Steve, that shares outstanding number already takes into account the government's rather large stake. Only existing holders of common stock will be getting these warrants. There's approximately 135 million outstanding shares of common stock that will qualify so it's about 1/2 a warrant per share. Each warrant is good for 10 years as well.

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