Cutting risk down to size
To be fair, the firm has already slashed its risk, reducing its positions from a notional value of over $2 trillion in May 2008 to $940 billion at the end of 2009. The reductions will continue, but management wants to keep positions worth between $300 billion and $500 billion in order to benefit from improving credit markets.
That could work out for AIG: The prices of even the highest quality (AAA-rated) mortgage securities are still substantially below their highs; if they continue to improve, derivatives written on these securities will gain in value. Similarly, investors still require above-average incremental yield over Treasury bond yields to own highly rated corporate bonds. That premium could come down, too, which would push bond prices up.
Limited upside, downside remains
If AIG reduces its portfolio to between $300 billion and $500 billion, it will have shrunk its derivatives holdings by 75% to 85%. There may be the opportunity for gains on remaining positions, but my guess is that they are limited. Furthermore, one can't rule out the possibility of further losses: In an environment in which investors are beginning to take a hard look at sovereigns' creditworthiness (Greek tragedy or the tale of 1,000 skyscrapers in Dubai, it's your choice), it's easy enough to imagine a broad reversal in sentiment with respect to the credit risk of nongovernment debt. That would hurt a firm like AIG that wrote insurance on that risk by selling credit derivatives.
More than a speculation?
Let's be clear: The risks contained in AIG's derivatives portfolio are difficult or impossible to assess from the outside. Which is why -- among other reasons -- I don't understand why one would own AIG shares except as an outright speculation. I feel much the same way about Fannie Mae
If you believe that owning AIG shares is, in fact, an investment rather than a speculation, I'd be curious to hear your rationale -- you can lay it out in the comments section below.
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Fool contributor Alex Dumortier loves macro-themed investing; you can follow him on Twitter. Berkshire Hathaway is a Motley Fool Inside Value selection. Berkshire Hathaway is a Motley Fool Stock Advisor pick. The Fool owns shares of Berkshire Hathaway. Try any of our Foolish newsletters today, free for 30 days. Motley Fool has a disclosure policy.