Insurer AIG seen posting gloomy 2nd quarter

A sign on an office building for AIG, American International Group, is pictured in Los Angeles, California May 8, 2008.

NEW YORK (Reuters) - The clouds hanging over American International Group Inc (AIG.N) are likely to linger after the insurer's second-quarter earnings report on Wednesday.

"It is not going to be a pretty quarter," said Keefe Bruyette & Woods analyst Clifford Gallant, who predicts the world's largest insurer will be hit for the third consecutive quarter by losses on derivatives linked to subprime mortgages.

Also darkening the horizon are fears that AIG's investment income could disappoint, and that its insurance businesses will post lackluster earnings.

AIG, which sells insurance across the world and other services including asset management, has over the past two quarters recorded more than $20 billion in losses from credit default swaps -- a type of guarantee on debt collateralized with a range of assets, including subprime mortgages.

Swaps written by AIG Financial Products, a unit separate from its main insurance businesses, have had to be written down as underlying subprime mortgage investments have fallen steeply in value.

CREDIT LOSSES

Analysts are divided on how much AIG will be hit by credit swap losses in the quarter. Gallant sees $3 billion in losses, while analysts at Wachovia predict up to $7 billion.

To be sure, AIG has recorded little in the way of realized, or actual, losses from the swaps. But the fact that it has been badly hit by unrealized mark-to-market losses has unnerved investors. Until February, management predicted no significant losses from the swaps, which would leave AIG on the hook in the event of a default on the underlying bonds.

Citigroup analyst Joshua Shanker, in a note late on Monday, predicted investors have already priced more write-downs into the stock. "We believe that shares would rally on credit losses below $5 billion," Shanker said.

And on Tuesday, UBS analyst Andrew Kligerman upgraded the stock to "buy" but cautioned it was not for the "light-hearted," citing AIG's "heightened sensitivity to volatile credit markets, and many operating headwinds."

Kligerman, who sees as little as $1.4 billion in credit swap write-downs in the second quarter, set a 12-month price for the shares of $41. AIG shares, halved from the beginning of the year, were trading up $1.87 or 7 percent at $28.56 on Tuesday.

Analysts polled by Reuters Estimates on average expect second-quarter operating earnings, including credit default swap losses but not realized gains or losses, of 46 cents a share -- about one-quarter the operating income AIG reported in the year-ago period.

END IN SIGHT?

Investors hopeful that AIG will get all the bad news out of the way in the second quarter may be disappointed.

"When people say 'kitchen sink,' they mean it is done. I'm not sure that's going to be the case," said KBW's Gallant.

Robert Willumstad, who was named AIG chief executive on June 15, has vowed to address the problems that have dogged AIG in recent quarters. But he has said he may need until September to finalize a plan for sweeping changes, including slashing jobs and parts of AIG's sprawling network of businesses.

It is also not clear how readily AIG will be able to rid itself of its thorniest problem, the credit default swaps. Some analysts say the best thing for AIG to do would be to hold on, as it could see some of its write-downs reverse as market conditions improve.

UBS' Kligerman, for one, sees as much as $11 billion in eventual gains from the $20 billion the company has already written down.

Some bond insurers which wrote credit swaps, such as Security Capital Assurance Ltd and Ambac Financial Group Inc (ABK.N), have in recent weeks been able to negotiate their way out of contracts, but at a cost.

OTHER ISSUES

AIG investors are girding for some disappointing investment results as well. Insurance earnings are further expected to be weak, with rate pricing having fallen for many types of coverage over the past two years.

AIG's results have typically gotten a big boost from hedge fund returns. The company, based on figures disclosed in June, had nearly $30 billion invested in hedge funds and private equity firms.

But returns have been in a slump in the months since the credit crisis set in. Industry tracker Hedge Fund Research's multi-strategy index posted losses of 2.5 percent in the first half of the year, while a fund of funds composite index was down by 2.3 percent.

Citigroup's Shanker said AIG, which earned $700 million from these investments last year, is unlikely to see any income from hedge funds or private equity in the second quarter. "We believe that such a disappointment could prove concerning to investors."

Still, there are those who believe that AIG's woes may only be temporary, and are buying shares. Last week, Fidelity Investments' flagship Magellan stock fund reported that it had significantly boosted its holdings. The $37.6 billion Magellan held $865.1 million of AIG at the end of June, up from $475 million in May.

Others, including Fifth Third Asset Management and Microsoft Corp (MSFT.O) founder Bill Gates' charitable foundation, have also bought AIG shares in recent months.

(Editing by Gerald E. McCormick)