Last week, Special Inspector for TARP Neil Barofsky made waves by accusing the Treasury of not being transparent enough when it comes to what AIG will cost taxpayers. After declaring a potential loss of around $45 billion last spring from AIG's bailout, Treasury revised that to a mere $5 billion loss. The new estimate came as a part of AIG revealing its planned exit strategy. Yet it's a little hard to swallow that the Treasury's AIG stake could have appreciated a whopping $40 billion in just six months. Is this new estimate a more accurate one, or will taxpayers still be losing tens of billions of dollars on the firm?

I spoke at length to a Treasury source about the AIG game plan. Let me begin by explaining the Treasury's old loss estimate. Then, I'll explain what the Treasury hopes to own when the exit strategy is realized and how that would change things. Finally, we'll get into obstacles that stand in its way.

The Treasury's Old Loss Estimate

The old loss estimate is based in part on the Treasury's preferred shares of AIG. They consist of around $47.5 billion of what the U.S. government is owed. In addition to that, AIG had a credit line with the government of around $22 billion. It had not drawn on that line.

According to the Treasury source I spoke with, that $22 billion line had always been considered to consist of approximately a full loss to taxpayers. The conservative accounting methodology view was that, as long as it was outstanding, the government might have to provide that money to AIG in full. And if they did, it probably means that AIG is having big problems, so we shouldn't expect to get any of it back.

Knowing that, you can approximately back into the loss on the $47.5 billion in preferred shares. Since they aren't particularly liquid, they were also valued at a significant loss, in this case of about $23 billion.

That gets you a $45 billion loss.

The Treasury's New Estimate

If the AIG strategy is fully realized, then the above scorecard changes considerable. First, that $47.5 billion in preferred stock will be converted to 1.66 billion common shares. As the Treasury noted today, at market prices on Friday, they would be worth $69.5 billion. Although AIG doesn't have a huge volume of trading at this time, simply determining the value of shares by using market value is a fairly common valuation method.

That other $22 billion will be drawn on by AIG in order to pay back the Federal Reserve. But in this case, that isn't because AIG is in worse trouble, as the accounting methodology assumed. For the cash, the Treasury will be provided special purpose vehicles backed by a number of assets held by AIG, which will be worth more than the $22 billion that the Treasury will be providing. According to the source I spoke with, the Treasury believes that these assets will easily provide proceeds for taxpayers to get that entire $22 billion back.

So the Treasury has essentially released another, even more optimistic, estimate of its AIG share valuation. According to the latest value of its presumed common share holdings, even if that entire $22 billion investment is lost, the Taxpayers will still break even on AIG. But if the Treasury gets that entire amount back, then it could be pure gravy for taxpayers, with a $22 billion gain.

But. . .

Is this new estimate a little too hopeful? It depends on your view of the future. There are essentially three assumptions being made for the Treasury to get to its new estimate. Most importantly, the AIG exit strategy must be completed. The time line currently set has that happening sometime in the first quarter of 2011. AIG's exit strategy being realized depends on two main factors.

First, the rating agencies have to agree to it. AIG will be spending lots of money to extinguish its debts to the Fed and Treasury. So the agencies need to view the firm as being adequately capitalized at the end of it all.

Second, several big asset sales have to close. A few already have, as we learned today that the AIA IPO raised $20.5 billion, and the firm's sale of its ALICO unit to MetLife brought in another $16.2 billion. So far so good, but a few sales still have to prove successful.

Third, the Treasury has to dispose of $1.66 billion in shares that it intends to own. That won't be a cinch. It's a lot of shares, and the Treasury will own 92.1% of the firm. So it's almost like an initial public offering, as nearly the entire company's equity will have to be sold over time. Similarly, the Treasury must sell shares of other assets in AIG special purpose vehicles

So will taxpayers be made whole? It does seem possible, but the book on AIG still has a few chapters left. Next year at this time, we should have a much better idea of how taxpayers will fare. But their fate certainly does look more hopeful than it did a year ago.

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