Opinion

Felix Salmon

Goldman’s collateral demands and the financial crisis

By Felix Salmon
July 1, 2010

Daniel Indiviglio is coming over all faux-naive with respect to the FCIC’s grilling of Goldman executives over its aggressive demands for collateral from AIG:

The FCIC’s decision to waste its time investigating this question is troubling, because it has nothing to do with its mission of determining what caused the financial crisis. Goldman demanded collateral from AIG because it’s the job of an investment bank to demand cash from a derivative’s counterparty when asset deterioration occurs. The only explanation for spending two days questioning the bank about this issue is a desire to mimic other politicized pursuits of using Goldman as Washington’s favorite punching bag. The commission should focus on real causes of the crisis, not convenient targets.

The fact is that the financial crisis had many moving parts, all of which were interwoven with each other, and one of the central ones was the collapse of AIG. It’s reasonable to say that if AIG had not collapsed, then the crisis would not have been as bad as it was — and it certainly wouldn’t have been nearly as expensive as it turned out to be for the US government.

Was Goldman only doing its job when it started demanding ever-increasing amounts of collateral from AIG? Certainly, yes. But in doing so, it helped to bring down a venerable insurance company, and cost the US taxpayer the best part of $100 billion in bailout funds. Some of that money will end up being repaid, with interest; the chances are that much of it won’t be. So this is a perfectly legitimate subject for the FCIC to investigate.

Essentially what happened at AIG was that it bought subprime assets high and was forced, by the government, to sell those same assets low. In doing so, it lost so much money that it had to get bailed out by the government.

Now if the government was going to put up all that money anyway, why not simply lend it to AIG and then let AIG post it as collateral? Or better yet, just provide a government guarantee on AIG’s CDS exposures, in return for a fee, which in turn would keep AIG’s counterparty risk at AAA levels, and would mean that AIG didn’t need to post any collateral at all.

Eventually, AIG would probably lose money on its CDS exposure — but as we’ve seen, those positions haven’t lost money yet. And losing money at some point in 2011 or 2012 or later is vastly preferable to panic-selling at the height of the crisis, which is what we ended up doing.

Goldman Sachs, of course, was on the opposite side of these trades to AIG, and if AIG bought high and sold low, then Goldman bought low and sold high. The credit protection Goldman bought from AIG was dirt cheap, when the deals were initially entered into. And then, at the height of the crisis, Goldman unwound all of those CDS deals for cash, at valuations which were extremely attractive to Goldman Sachs and extremely unpleasant for AIG. Absent that deal, Goldman could have gone to the open market and tried to sell credit protection on those assets in order to lock in its gains, but it’s far from clear that it could have found enough willing buyers to be able to do so.

Meanwhile, of course, a key Goldman alumnus, Dan Jester, was in charge of the AIG problem at Treasury, while his boss, Hank Paulson, was a former Goldman CEO. As they watched Goldman apply ever-increasing amounts of pressure to AIG, in the form of collateral demands, their solution was for AIG to give in to all of those demands, and eventually for the US government to end up writing an enormous check to Goldman Sachs, in the knowledge that AIG would be unlikely to repay the money.

Yes, in a capitalist system it makes sense that Goldman would push hard for as much money as it could get its hands on. But its actions undoubtedly exacerbated both the financial crisis generally and the cost to taxpayers specifically. If the AIG insurance contracts had simply been allowed to stand and slowly unwind, rather than being torn up at great expense to the government and concomitant benefit to Goldman Sachs, the amount of damage done would have been much smaller.

And indeed, the biggest weakness of AIGFP’s CDS operation, as explained by Joe Cassano, was that it only ever concerned itself with total eventual possible losses, rather than with the path that asset values might take along the way. If there was a panic big enough to justify a downgrade of AIG’s triple-A credit rating, that could drain the company of vital liquidity even if the CDS insurance policies weren’t paying out any money at all. Cassano’s failure to model or worry about such matters is inexcusable. But once the government ended up being responsible for AIG, it had every opportunity to help AIG retain its triple-A rating and thereby deny Goldman its collateral, putting off any possible losses until years into the future.

So it does make sense to say that Goldman’s demands for collateral — along with the government’s acquiescence to those demands — were a central part of the narrative of the financial crisis. I’m glad that the FCIC is looking into them, and I trust that it’s thinking carefully about ways in which they could have been dealt with better.

Update: Indiviglio responds, and as far as I can tell essentially concedes the point, retreating to a position which involves saying no more than that Goldman didn’t “single-handedly bring down AIG.” He seems to think that if Goldman didn’t single-handedly bring down AIG, and if it acted legally, then the FCIC has no business looking at what it did. Which is ridiculous on its face.

Comments
8 comments so far | RSS Comments RSS

We have certainly heard much about the role of GS alumni in government, and in particular during the meltdown. I doubt that Paulson did anything demonstrably wrong, even as his former firm profited from the venture. And I doubt that we should deny government the ability to take advantage of business expertise in making policy. But should Paulson and others have stood down during the crisis, due to at the very least the perception of a monumental conflict of interest? Or was their expertise of greater value than the conflict?

Posted by Curmudgeon | Report as abusive
 

I normally have very little sympathy for Goldman, but it couldn’t have been the only one demanding collateral. Knowing that my debtor would go spectacularly bust one way or another, I would fight for what’s mine. All the better that I have clout to pull off a full recovery for my shareholders.

Posted by aosika | Report as abusive
 

It may come as no surprise to haughty Mr. Inviglio that Goldman got cashed out by their ex-employees for $100B twenty times faster than he could get an insurance agent to even pick up the phone about assessing routine valet-parking damage to his Gremlin. But to everyone else, it looks suspicious.

Actually, more than suspicious. It looks a lot like Grand Theft Treasury. There really has to be a better or at least less conspicuous way of doing government than neutering the FCIC.

Posted by HBC | Report as abusive
 

aosika: Of course you’re right, if we take the our current state of crony capitalism where no financial company is allowed to go bankrupt as an immutable given. However, the fact is that we have pretty well-developed systems for handling the division of scarce debtor resources: contract law and, if necessary, bankruptcy.

The #1 problem with the AIG bailout is that it went around both of these systems in order to pay some creditors in full according to a function of their aggressiveness and political influence. The unpredictability, distrust, and unjust distribution of the spoils generated by these actions far outweigh any conceivable benefit that could be derived by auctioning off AIG’s assets slowly under a bizarre amalgam of old management, new management, and arbitrary ad hoc government oversight that makes up rules as it goes along.

Posted by najdorf | Report as abusive
 

Cassano/AIG come off as, say, a flood insurer who claims they should still be in business… if it weren’t for floods.

Posted by aosika | Report as abusive
 

“Yes, in a capitalist system it makes sense that Goldman would push hard for as much money as it could get its hands on. But its actions undoubtedly exacerbated both the financial crisis generally and the cost to taxpayers specifically. If the AIG insurance contracts had simply been allowed to stand and slowly unwind, rather than being torn up at great expense to the government and concomitant benefit to Goldman Sachs, the amount of damage done would have been much smaller.”

I’ll let Adam Smith answer for me:

http://econlib.org/library/Smith/smWN7.h tml#II.2.94

“But those exertions of the natural liberty of a few individuals, which might endanger the security of the whole society, are, and ought to be, restrained by the laws of all governments, of the most free as well as of the most despotical. The obligation of building party walls, in order to prevent the communication of fire, is a violation of natural liberty exactly of the same kind with the regulations of the banking trade which are here proposed.”

Posted by DonthelibertDem | Report as abusive
 

The FCIC is engaged in shameless posturing and you miss the point. You write that:
“Essentially what happened at AIG was that it bought subprime assets high and was forced, by the government, to sell those same assets low. In doing so, it lost so much money that it had to get bailed out by the government.”

But that is not “essentially” correct. The government got involved with AIG late, when the values of those assets had fell so far it was about to go bankrupt. That was no because of GS but because by then everyone thought CDO’s were toxic. AIG came to the government for a bailout the day after Lehman failed.

Moreover, it is funny how the same people who blame GS now blame the other banks for holding too much of CDO’s on their books. That is how Lehman, Merrill, BA, Citigroup, WAMU, failed. So GS is blamed for not doing what the other guys did. And the other guys are blamed for not doing what GS did.

Focus on GS by the FCIC is insurance that we will not learn from them anything about what caused the crisis.

Posted by bwickes | Report as abusive
 

HBC, GS never got even close to 100 billion from the government via AIG. I know facts mean zip to you but on the off hand chance you feel like not embarassing yourself in the future:

Par value of CDOs insured by AIG for GS and GS clients:
roughly 20billionUSD

Market Value of CDOs at time of AIG collapse:
roughly 10billion USD

Collateral held against the CDSes before the collapse:
7.5billion.

Direct counterparty exposure to AIG:
2.5billion USD

At the most aggressive valuation GS got a grand total of 12.5billion – assuming their CDOs went to zero which they didn’t – which whilst it is not peanuts is nowhere near 100 billion but why confuse a rant with facts?

Posted by Danny_Black | Report as abusive
 

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