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:

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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.

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