AIG's Failure Is So Much Bigger Than Enron

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By Andrew Sullivan, CFA

Enron -- reviled, fraudulent Enron -- destroyed more than $60 billion of shareholder value.

AIG (NYSE: AIG), which the government just took over, has destroyed $180 billion already -- and it almost brought down our entire financial system.

We don't know money
Which is ironic, given AIG's old television commercials, in which the giant letters "A I G" displayed on the screen while text flashed underneath that culminated in the following phrase -- all in capital letters:

WE KNOW MONEY

There were no smiling couples, young children at play, or lounging retirees. No, AIG was above that -- it was better than that.

But here's a news flash, AIG: You don't know money.

If you did, you'd have realized a few things. Insurance is terribly simple, as long as you follow the Three Rules:

1. Price your risk correctly.
2. Invest conservatively so you can pay out claims when they come due.
3. Don't do anything else.

Sit back and collect the spread. That's it, folks.

Seriously, that is it. Ask Warren Buffett, and he'll probably tell you that if you follow those three rules, you'll be fine. You won't be the biggest or fastest grower, but you'll be absolutely fine.

The problems come when you get greedy and aren't satisfied with the spread. And your greed can lead to certain actions that aren't stated anywhere in the rules, including:

1. Diversifying into fast-money proprietary trading.
2. Leveraging your company 11-to-1.

Neither of these is a goal of a well-run insurance company, yet AIG embraced both with open arms.

Diworsifying
But AIG self-destructed not because it screwed up in its insurance business. It didn't fall into the trap of mispricing risk, as so many other insurers over the years have done. It also invested premiums fairly conservatively. So it followed Rules 1 and 2.

Where it slipped up was in Rule 3. See, the folks at AIG thought they were so smart at insurance that they could start other capital-markets businesses ... including proprietary asset management in things such as commodities, currencies, energy, interest rates, and the selling of default swaps on collateralized debt obligations (CDOs).

This strategy worked beautifully -- for a while. AIG created a separate business segment called Financial Services to trade in the aforementioned assets. This business had $204 billion in assets at year-end 2007, up from $60 billion in 1998.

Operating income surged from $900 million in 1998 to $4.4 billion in 2005. Some of the moves it made were brilliant, such as the purchase of ILFC, an aircraft-leasing business. But the other trading businesses were the Medusa that turned the whole company to stone.

Let me make one thing clear: Proprietary trading isn't bad, in and of itself. Warren Buffett engages in it. But just like atomic weapons in the wrong hands, proprietary trading can do a lot of damage. The problem is when you start to get aggressive and don't heed proper risk -- when you start to speculate instead of invest.

And there's one other critical ingredient for disaster.

The "L" word
As in "leverage," the sharp knife in corporate seppuku dramas. Leverage is, by my estimation, the No. 1 reason why companies fail.

And compared with its peers, AIG had one of the sharpest knives around. Here's how its leverage (assets to equity) stacked up against other insurance operations as of December 2007:

• AIG: 11 to 1.
• Markel (NYSE: MKL): 4 to 1.
• Berkshire Hathaway (NYSE: BRK-B): 2 to 1.
• Montpelier Re (NYSE: MRH): 2 to 1.
• Travelers (NYSE: TRV): 4 to 1.
• White Mountains Insurance (NYSE: WTM): 4 to 1.
• Chubb (NYSE: CB): 4 to 1.