AIG May Capture Biggest Red Flag

This post first appeared on Minyanville.

If there was ever a Monday to skip that morning coffee and run on pure adrenaline, this is it.

As Lehman Brothers (LEH) and Merrill Lynch (MER) jockey for top placement in this morning’s headlines, American International Group (AIG) is dramatically staking a claim for the financial market’s biggest red flag.

Lehman and Merrill, already collapsed into the hands of bankruptcy courts and Bank of America (BAC), respectively, have well-publicized and largely understood troubles. Loaded up with securities tied to US mortgage debt, their capital bases have been eroded by losses and writedowns on bad assets.

Although losses have been hard to quantify -- due to obfuscation by management and underhanded accounting aimed at hiding the true extent of the damage -- most investors can at least wrap their heads around the issues.

The US’s largest insurer, on the other hand, is besieged by losses in its opaque credit products division and is rushing to sell assets and raise capital to stay alive. Professor Sedacca has been eyeing the firm as a potential cancer for weeks, in fear that its mammoth exposure to the credit markets may put the entire system at risk.

AIG has seen its balance sheet destroyed by losses on complex derivative instruments known as credit default swaps. The company sold these insurance contracts to other financial institutions that owned mortgage-backed securities, putting AIG on the hook for any losses that may occur. And they have indeed occurred.

Although many such obligations are yet to be paid out, the value of these assets have opened a gaping hole in AIG’s balance sheet.

The company, which has raised over $20 billion this year, is seeking another $40 billion. To that end, it's asked the Federal Reserve for a bridge loan to give it time to find the cash, according to the Wall Street Journal. AIG’s -- and indeed Wall Street’s -- concern is that ratings agencies Moody’s (MCO) and Standard and Poor’s may not wait around to downgrade the company's debt.

The New York Times reports the company may not last more than a couple days if such a downgrade were to occur.

AIG, and indeed all financial institutions, covet high credit ratings to keep their borrowing costs and capital requirements low.