market folly

Bruce Berkowitz's Fairholme Capital has filed a 13D on shares of American International Group (AIG). Due to activity on September 16th, Fairholme has disclosed a 24.4% ownership stake in AIG with 32,909,500 shares. This is a very slight increase over Fairholme's previous AIG position. Berkowitz's most recent purchase came on September 15th, buying 1,000 shares at $36.04.

What's interesting here is that he had previously filed a 13G indicating a passive stake. With the filing of a 13D, he has signaled activist intent. Yet within the filing itself, he did not necessarily lay out a tentative plan of action. Typically, an investor filing a 13D will try to shake up the board, consult with management regarding strategy, or take some sort of action in an attempt to generate shareholder value.

Fairholme originally started an AIG position back in March of this year. He initiated his stake with 20% of some tranches of convertible debt, other AIG bonds, as well as 13 million shares of common stock. In other ownership, David Tepper's hedge fund Appaloosa Management had previously bet on AIG's 8.175 junior subordinated debt. Tepper argued that there was a mis-pricing due to a misunderstanding of AIG's capital structure. Berkowitz's credit positions give him additional layers of protection, but his equity stake is harder to fully understand. Some analysts have likened shares of AIG to spinning the roulette wheel while others have found value and believe AIG can earn $8 billion or so in 2011.

So, what's Berkowitz's investment thesis? He has previously argued that the government's involvement has 'cleansed' the company and that AIG can move forward as a free entity in 2011. In the past, Berkowitz opined that the company has the ability to pay back taxpayers and the Treasury, emerging as a smaller organization by selling off assets such as AIA and Alico. The overriding thesis in Berkowitz's portfolio overall has been 'recovery.' In terms of his firm's other positions, we've detailed Fairholme's MBIA stake, as well as their new position in Morgan Stanley (MS).

Berkowitz's investment could possibly be best served if AIG could offload AIA for more than 1x book value somehow down the road. In recent developments, it appears as though AIA will raise up to $15 billion in a Hong Kong IPO. Additionally, the troubled firm has neared a deal to sell two of its Japanese life insurance companies to Prudential for $4-5 billion combined. Selling assets and raising capital to payback taxpayers has been the CEO's number one priority. Also, AIG is said to be evaluating options regarding its Nan Shan Life Insurance ownership stake.

As if AIG wasn't a complicated mess to start with, you can't forget the fact that the government also has a massive stake in the company (ya know, from when they saved them). Apparently, AIG and the government are in talks to speedup the repayment of US taxpayers, allowing the company to gain independence again. This plan essentially converts the government's $49 billion worth of preferred shares into common shares. Such a scenario means that the government would own over 90% of the company (up from its current almost 80% stake). These common shares would then eventually be sold off to private investors.

Breaking down what is owed to taxpayers, it's clear there's still plenty of work ahead. The Federal Reserve of New York owns $26 billion worth of preferred interests in AIA and Alico. This amount is most likely to be repaid by the sale of the units. Further AIG asset sales will be required to pay back the $20 billion in secured debt owed to the New York Fed. Also, don't forget the $29 billion from Maiden Lane II and Maiden Lane III (financed by the New York Fed). This figure will most likely be repaid via the securities those companies own. Lastly (as mentioned above), the Treasury Department owns $49 billion worth of preferred shares, likely to be converted into common and then sold.

Keep in mind that this is by no means guaranteed as there are a lot of moving parts involved and it could take years to complete. This is obviously quite a large overhang but something that needs to be done in order for the company to fully recover. AIG seeks to simplify its capital structure for the future, allowing investors more clarity in valuing the company. The government will be more willing to reduce its ownership stake as long as AIG is able to raise new capital, most likely via issuing new stock.

Unfortunately, Berkowitz's most recent full portfolio disclosure is only as recent as May 31st, 2010. Back then, AIG was Fairholme Fund's second largest position at 6.86% of the portfolio. Given that this position is so large for him, one shouldn't necessarily be surprised that he wants to take a more hands-on approach with the 13D. While AIG's roadmap to recovery is essentially mapped out, it's unclear how Berkowitz plans to pave the road with his activist stake.

For an in-depth look at Fairholme's portfolio as well as the investments of top hedge funds, check out our new publication: Hedge Fund Wisdom.