Last Updated: May 9, 2008: 2:22 PM EDT
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AIG chief under siege

Martin Sullivan's credibility takes another hit even as he boasts the insurer is building a 'fortress balance sheet.'

By Colin Barr, Fortune senior writer

NEW YORK (Fortune) -- Martin Sullivan, the chief executive of American International Group, picked the right time to build what he calls a "fortress balance sheet," because bad bets in the mortgage markets have him and his board under siege.

AIG (AIG, Fortune 500) shares tumbled 9% Friday after the insurance giant posted a $7.8 billion first-quarter loss that was driven by another round of mark-to-market writedowns of mortgage-related positions. AIG said the latest quarter included a $5.9 billion pretax writedown of the value of the credit default swap portfolio held by its AIG Financial Products unit, and a $3.6 billion impairment of its mortgage-backed securities holdings.

"While we anticipated a difficult trading environment, the severity of the unrealized valuation losses and decline in value of our investments were beyond our expectations," Sullivan said.

This isn't the first time AIG's expectations have proven less than reliable. In December, in a gaffe that brings fallen Citi (C, Fortune 500) chief Chuck Prince to mind, Sullivan told investors that AIG's exposure to mortgage-related losses was manageable. "We can't predict the future," Sullivan said, "but we have a high degree of certainty in our businesses."

As Friday's selloff shows, AIG's top management has a serious credibility problem. The first-quarter loss follows a poor showing in the fourth quarter, when AIG lost $5.3 billion, or $2.08 a share. Housing-related markdowns have now reached almost $20 billion. But the company argues that those markdowns vastly overstate the extent of the losses it will have to recognize when the investments mature. AIG estimates actual losses will range from $1.2 billion to $2.4 billion.

Unfortunately for AIG, the market is taking a different view. While Citi analysts agreed on Friday that $20 billion is probably too large, they wrote to investors: "We also believe that a risk book of $470 billion bears more worst case risk than just $1 billion to $2 billion." Meanwhile, ratings agency Fitch estimated losses of between $1.6 billion and $5 billion.

AIG execs say they have confidence in their loss estimates because they stopped playing the riskiest part of the CDO game in early 2006 - before the worst of Wall Street's underwriting excesses took place. AIG's decision to exit the business of insuring CDOs - debt securities chopped up and packaged in a way that supposedly reduced their risk - offers some insight into the root of the current credit crisis.

In late 2005, AIG decided to stop selling insurance policies on CDOs that were being structured and underwritten by investment banks like Merrill Lynch (MER, Fortune 500) and Citi. Merrill and others, in turn, sought out guarantees from bond insurers, such as ACA Capital Holdings, in the hopes of holding onto a lucrative revenue stream.

The problem was that insurers like ACA had much less capital than AIG, so when the credit deterioration in the securities underlying these CDOs began in earnest in late 2006, their balance sheets were devastated. Both Merrill and Canada's CIBC were forced to take charges to write down the value of their exposure to ACA, which is now in bankruptcy.

Eventually, the mania for CDO underwriting became so intense that, when even the lower-tier guarantors pulled out of the business, Merrill and Citi took these CDOs onto their balance sheets. Swiss banking giant UBS (UBS) responded by providing unlimited capital to its CDO-issuing clients. That's how Merrill, Citi and UBS ended up with nearly $100 billion in writedowns on mortgage-related securities.

But even if AIG has avoided the worst of the CDO fallout, it's still bleeding. The first-quarter losses are forcing AIG to raise $12.5 billion in new capital - a move that Sullivan said will allow AIG to maintain its "fortress balance sheet," a phrase he used repeatedly during Friday's conference call. Strangely, execs also made a point of saying they decided to raise new capital without any prompting from the rating agencies.

S&P and Fitch cut their ratings on AIG anyway, citing the latest quarter's bigger-than-expected losses. And while Sullivan called the downgrades "manageable," he conceded that the downgrades will raise funding costs. AIG will also have to post $1.6 billion in additional collateral on its swap contracts.

With costs rising and the company's insurance business posting weak results, AIG's decision to boost its quarterly dividend by 10% raised some eyebrows. While analysts wanted Sullivan to defend the dividend boost, which will cost the company $200 million annually, he would only say that it demonstrated AIG's financial strength.

But AIG stock has lost 44% of its value over the past year, and nearly a quarter of the firm's net worth as measured by shareholders' equity has vanished since Sept. 30. Sullivan's going to have to do better than a 2-cent dividend boost if he wants to avoid going the way of Chuck Prince. To top of page