Was the AIG bailout a Goldman bailout by proxy?

By Felix Salmon
July 27, 2009
Joe Hagan has a big story on Goldman Sachs in this week's New York, and Moe Tkacik and Matt Taibbi both pick up on the way that Hagan deals with Goldman's share of the AIG bailout funds. It's worth quoting at some length:

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Joe Hagan has a big story on Goldman Sachs in this week’s New York, and Moe Tkacik and Matt Taibbi both pick up on the way that Hagan deals with Goldman’s share of the AIG bailout funds. It’s worth quoting at some length:

Goldman Sachs was AIG’s biggest banking client, having bought $20 billion in credit-default swaps from the insurer back in 2005…

By that weekend in September, Goldman Sachs had collected $7.5 billion from its AIG credit-default swaps but had an additional $13 billion at risk—money AIG could no longer pay. In an age in which we’ve become numb to such astronomical figures, it’s easy to forget that $13 billion was a loss that could have destroyed Goldman at that moment.

Hank Paulson and then–New York Fed chief Tim Geithner called an emergency meeting for the following Monday morning…

At the meeting, it was hard to discern where concerns over AIG’s collapse ended and concern for Goldman Sachs began: Among the 40 or so people in attendance, Goldman Sachs was on every side of the large conference table, with “triple” the number of representatives as other banks, says another person who was there. The entourage was led by the bank’s top brass: CEO Blankfein, co-chief operating officer Jon Winkelried, investment-banking head David Solomon, and its top merchant-banking executive Richard Friedman—all of whom had worked closely with Hank Paulson two years prior…

On the government side, Goldman was also well represented: Geithner himself had never worked for Goldman, but he was an acolyte of former Goldman co-chairman and Clinton Treasury secretary Robert Rubin. Former Goldman vice-president Dan Jester served as Paulson’s representative from the Treasury. And though Paulson himself wasn’t present, he didn’t need to be: He was intimately aware of Goldman’s historical relationship with AIG, since the original AIG swaps were acquired on his watch at Goldman.

The Goldman domination of the meetings might not have raised eyebrows if a private solution had been forthcoming. But on Tuesday, Paulson reversed course and announced that the government would step in and save AIG, spending $85 billion in government money to buy a majority stake…

Of the $52 billion paid to AIG’s counterparties, Goldman Sachs was the biggest recipient: $13 billion, the entire balance of its claim. The amount was surprising: Banks like Merrill Lynch that had bought credit-default swaps from failed insurers other than AIG were paid 13 cents on the dollar in deals moderated by New York’s insurance regulator. Eric Dinallo, the former New York State insurance commissioner, who was at the AIG meetings, characterizes the decision this way: AIG’s counterparties, Goldman being the most prominent, “got to collect on an insurance policy without having the loss.”

Over time, it would appear to many that Goldman Sachs had received a backdoor bailout from a Treasury Department run by the firm’s former CEO. Why did Paulson bail out the banks that did business with AIG, critics have demanded ever since, and not Lehman Brothers? Certainly executives at Lehman want to know. (As one former Lehman managing director there puts it, “The consensus is that we were deliberately fucked.”)

The first thing worth noting here, beyond Hagan’s clearly prosecutorial stance, is that he’s got Eric Dinallo on the record criticizing the AIG bailout on the grounds that it was a backdoor Goldman Sachs bailout. That’s an important development, I think. Dinallo knows what he’s talking about, and he’s clearly not scared of annoying Goldman.

As Hagan notes, Dinallo was the person who orchestrated the unwind of smaller monolines’ positions; I believe that the 13-cents-on-the-dollar deal with Merrill Lynch was over CDS sold by ACA. I believe that ACA was rare in that it never had a triple-A rating to start with; Merrill was buying insurance from a single-A-rated insurer, which means that it had every reason to assiduously hedge its counterparty risk there.

I don’t think, in all fairness, that ACA ever provided all that much of a precedent for AIG. ACA was small enough that it could fail without much in the way of systemic consequences; it also had no consumer-facing obligations which it might default on. Even Taibbi seems to concede that if AIG had been allowed to fail, the entire financial system would have come down with it:

I was on a radio show a few weeks back with a hedge-fund manager, a Goldman apologist, who insisted on the air that Goldman would actually have made more money if AIG hadn’t been rescued, because the bank was properly hedged against AIG’s collapse… it wasn’t until the show was over that I realized the proper response to that argument was just, “Bullshit!” Goldman has been making that argument ever since the AIG bailout, but it has never come out and identified that magical counterparty or counterparties who’d have been able to come up with $20 billion after a system-wide financial collapse.

I think this is true. Yes, Goldman had as much counterparty hedging as it could, with respect to AIG, but counterparty hedging, like all hedging, is imperfect. For a detailed explanation of how Goldman hedged its counterparty risk, go here. But here’s the conclusion:

Ultimately, you try to hedge what you can hedge; what you can’t hedge, you try to quantify; what you can’t quantify, you try to understand; and what you can’t understand, you keep small enough not to sink the firm.

According to Hagan, Goldman failed on the last front: a loss of $13 billion on its AIG exposures would, he says, have sunk the firm. But then again, a loss of $13 billion on its AIG exposures would only have happened in the context of what Hagan calls “an overall collapse of the financial system” — and no investment bank is set up to survive that.

So yes, the AIG bailout was, to some degree, a Goldman bailout. But really the AIG bailout was a bailout of the entire financial system. Goldman was a beneficiary of that, to be sure, but so was every other financial company in existence.

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