What would happen to investment banks in a crisis?

By Felix Salmon
March 16, 2012
Sheila Bair has put her finger on the fundamental weakness of this week's stress tests with a single statement:

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Sheila Bair has put her finger on the fundamental weakness of this week’s stress tests with a single statement:

“No distribution should have been approved that would bring the leverage ratio below 4 percent,” Bair, the former chairman of the Federal Deposit Insurance Corp., said yesterday in an interview. “With leverage of 25-to-1, during a crisis, these banks would likely suffer a run.”

Essentially, the stress tests model what might happen to bank balance sheets in the event of a major crisis — one which includes a peak unemployment rate of 13 percent, a 50 percent drop in equity prices, and a 21 percent decline in housing prices. The Fed wanted to make sure that all big banks would still have a capital base of at least 5% of their assets in that scenario, which is why it barred Citigroup from returning capital to shareholders. Citi comes out at 5.9% “assuming no capital actions after Q1 2012″, but that number drops to 4.9% “with all proposed capital actions through Q4 2013″.

But capital levels are only half of the equation; the other half is leverage. And look at the Tier 1 leverage ratio for the different banks under the stressed scenario, on page 27 of the PDF. Citigroup plunges from 7.0% now to just 2.9% after the stress, while Bank of America is much more robust, dropping from 7.1% to 5.3%. And here’s the scary thing: of all the big banks, it’s the ones with investment banking arms which fare the worst. There are 19 different banks listed; seven of them end up with a leverage ratio under 5% in a stressed scenario. Citi’s one; the others include Goldman Sachs (4.5%), Morgan Stanley (4.5%) and JP Morgan Chase (4.0%), its “fortress balance sheet” notwithstanding.

Now, picture yourself in the kind of crisis where stocks are down 50% and unemployment is up to 13%. And imagine that you discover that the counterparty you use for all your financial transactions is levered 25-to-1. You will change your counterparty. That’s known as a run on the bank, and it’s fatal.

In other words, banks don’t need to just survive the stress test; they need to be able to keep their customers in a stressed situation as well. If a bank comes near to insolvency, it will go bust, as its customers rush for the exits.

As Bair says, bank counterparties don’t look at sophisticated risk-based metrics in a crisis: they look at headline numbers like the leverage ratio.

“This underscores another weakness of the tests: They didn’t really stress liquidity,” said Bair, now a senior adviser at Pew Charitable Trusts, a Washington-based nonprofit. “The investment banks are particularly vulnerable to liquidity failures because they don’t have a large, core deposit base.”

Investment-bank counterparties can flee in a matter of hours; old-fashioned deposit runs tend to take a lot longer. Which means that investment banks should be held to a higher standard than commercial banks when it comes to the stress tests. Instead, they just need to show a liquidity ratio of more than 3%. That number’s too low.

94 comments

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And, KenG, let’s suppose the Fed decided to buy up every underwater mortgage in the country at full nominal value. Brushing aside the question of whether that is or isn’t within their mandate, they could certainly create the cash to do so (and would have plenty of willing sellers).

If they were to make that bet, don’t you think they have the power to be CERTAIN that it pays off? Might destroy the economy in the process, but they could if they wanted to.

The intervention necessary to turn a profit on the GS stuff was far less severe, and it was going to happen anyways.

Posted by TFF | Report as abusive

TFF: GS was forced to sell, regardless of the outcome. They needed the liquidity. In theory, they could have sold something else. But the Fed offered them a pretty good deal on assets that the market was punishing.

Lots of people were forced to sell assets in 2008, that’s why the stock market crashed, as people were forced to sell stocks to pay off short term debts. GS was “lucky” that the Fed was willing to buy, at full price, assets they wanted to sell.

Then you say:

“Look at the deals that Buffett got from GS and BAC. Those are a sign of banks desperate for cash at any price.”

You’re making the case for ME.

I don’t think the fed should buy every underwater mortgage, but they did buy GS’s assets at a time when others weren’t as willing to pay the same price (I think if there were other buyers for those assets, the Fed would have gladly stepped aside, and avoided the harsh negative glare they received for those actions).

nivdeitas, I didn’t say the govt bailed out AIG, I said it was a hostile takeover, and it greatly benefitted GS. The government definitely needed to do something, but they didn’t negotiate a great deal with Goldman.

Posted by KenG_CA | Report as abusive

Danny Black: thanks for your detailed exposition of the GS/AIG alleged “bailout”….the confusion on this point and on TARP is rampant….I share your view of the journalists whose attempts to grasp complex finance are usually pathetic.

Posted by NotoriousBOB | Report as abusive

KenG_CA, the fed/treasury had to rescue AIG to save the insurance market. Once AIG’s not going bankrupt, they don’t have the right to unilaterally tear up legal contracts, and they had no leverage to negotiate — what could they offer in return? Your fantasy view of the fed negotiating a tough deal with AIG’s counterparties is basically all those banks voluntarily agree to hand over money to the US gov at the same time that they’re fighting to survive.

GS didn’t need to sell their exposure, unless AIG went bankrupt and the CDS got torn up, in which case they would have to decide whether to hold on to the exposure and hope the market would recover, or sell to get rid of the risk — and this is just market risk, not liquidity.

It’s quite well-known that GS didn’t directly own the assets in question, but had offsetting derivative trades with other parties. They didn’t actually receive any liquidity benefit from selling the assets to the Maiden Lane vehicle, that money was passed on to the client on the other side. If the government had decided to let the trades continue to run, there would have been no change to GS other than a little operational burden of passing collateral it collected from one side to the other.

Posted by niveditas | Report as abusive

niveditas, the insurance subs of AIG were plenty healthy, and were sold off. They were in no danger of failing.

The Fed had leverage with Goldman – they could have offered 70 cents on the dollar, and let GS take it or try their luck with bankruptcy courts.

“GS didn’t need to sell their exposure, unless AIG went bankrupt “. Wasn’t there a good chance of AIG going bankrupt? Basically, that’s what the fed prevented from happening.

GS offloaded all risk to the Fed and the treasury, and was made whole at a time when most firms and people were failing.

Posted by KenG_CA | Report as abusive

niveditas, the market price to novate those exact same swaps at the time of Maiden Lane 3 creation was 50 cents on the dollar. Why would GS accept less than 50 cents on the dollar when they could sell it to someone else for more? On top of that it was holding 50c in cash. 50c + 50c is 100c. It is not “complex finance” merely simple arithmetic. Ken’s claim that there were no writers of credit insurance for these tranches AT THE TIME is a flat out untruth – I won’t call it a lie because he clearly has absolutely no idea what he is talking about. What I don’t get is why he is so utterly desparate to believe something that is so clearly untrue.

TFF, GS taking money from Buffet was not a sign of a bank needing cash at any price. It was a sign of a bank needing a public show of faith that having an “investment genius” would give them. By the time Maiden Lane 3 was created, the cash crunch crisis had passed and the commerical paper market had unlocked. Anyone who says GS was “forced to sell” their swaps is flat out wrong. It is like claiming that TARP investments were a sign of a company needing cash when we know that the government man-handled the stronger banks into taking it, so the weaker ones would not be stigmatised.

KenG_CA, again… market price of replacing those CDSes was 50c. GS had 50c cash. They had no significant exposure on those swaps to AIG going under. I know it is an article of faith that GS somehow controls the US government, that AIG was rescued simply to “bail out” GS, that GS would have gone bankrupt if AIG had not been able to pay out on the swaps, that despite ALL the evidence to the contrary that what GS was holding was somehow worthless and the babe in the woods in the government were duped into paying more than then were worth but as I have painfully tried to explain to you, none a single one of those statements is true. Now it is clearly important to you that you keep believing a lie despite the fact have had it explained to you why that statement is untrue. Personally I prefer the truth.

Posted by Danny_Black | Report as abusive

KenG_CA, I mean this statement is yet another example of how you clearly don’t understand what you are writing:

“In November of 2008, LIBOR may have been low, but nobody was lending to banks, especially to cover derivatives”. LIBOR being lower is EXACTLY a sign that banks were increasingly lending to each other. Thats what a lower offer rate means. It is an uncollateralised loan so the lender is not in a position to say I’ll cover your APPL exposure but not your interest rate swaps. The freezing up of the CP market was in Sept and beginning of Oct by Nov it was unfreezing and GS could tap the Fed collateralised loan facility in Oct. Seriously, you seem to be completely out of your depth even on the simplest matters.

Posted by Danny_Black | Report as abusive

Danny, Lehman and Bear Stearns collapsed because nobody would lend to them. Once they died, banks didn’t trust anybody, and the credit markets froze. If you don’t think that happened, then you’re in denial. It was called the credit crisis because credit dried up. It wasn’t a matter of interest rates, it was because nobody could gauge risk, so they stopped lending.

Danny, you keep bringing up irrelevant information. You talk about the market price of the CDSes as if there was a liquid market for it, but if there was a liquid market for the swaps that GS held, then they would have sold them there, instead of selling them to the Fed. TFF says that only the Fed could afford to buy GS’s assets, and if that’s the case, then there wasn’t a market for them. Why would the Fed insist on buying those assets from GS, if there were other buyers available? Answer that question.

And when did I say there were no writers of credit insurance? I said nothing even close to that.

Posted by KenG_CA | Report as abusive

Danny, don’t know what you’re asking? I agree with you — exactly why I said the fed/treasury had no leverage with the AIGFP counterparties, and I would say esp not with GS that was fully collateralized and hedged.

KenG_CA, are you really stupid or are you just playing stupid? AIG had leverage to renegotiate their swaps with counterparties that were not collateralized (i.e. other than GS) IF they were going bankrupt, which they were not, because that would have caused catastrophic consequences to the insurance market. Your statement about insurance subs of AIG getting sold off later has a cognitic dissonance with your inability to grasp that the fed actually made money on these bonds later.

In either case, they had NO leverage to regenotiate with counterparties like GS which was fully hedged. If they went bankrupt, GS would get long exposure at call it 35c on the dollar, which is what GS thought the bid in the market was for the bonds underlying their trades. If AIG is bankrupt and GS has no net exposure to speak off, there is nothing AIG can do about it. The only thing that the fed/treasury could have offered here, IF GS actually owned the bonds, is to say “look, you own bonds that you say are worth 35c, we know this is an illiquid market and those bonds are pretty risky, we’ll bid 25c cash to take them off your hands”, and GS might accept a 10c mtm loss in return for 25c cash, as opposed to 35c in illiquid bond exposure. BUT, they weren’t actually the owners, so their calculation is, “we can get long this exposure for 35c, and maybe the bonds will realize 40c, OR we can take the fed/treasury bid at 25c and take a 10c mtm loss AND a 10c out of pocket cash cost to make our client no the other side whole. Err, no thanks”.

Posted by niveditas | Report as abusive

And KenG_CA, the mark that GS had on the bonds was based on the cash market bid for those CDO tranches, albeit probably not in a 12bn notional size, probably more like 1-2bn — it was conservative wrt to CDS protection. It was more than likely that someone would have been willing to go long those bonds at 35c on the dollar if they didn’t actually have to fund the bonds.

Posted by niveditas | Report as abusive

And KenG_CA, your latest post is self-contradictory, where you argue that there was no market for CDS’s at the same time as saying that you claim you said nothing about there being no writers for CDS.

If you don’t understand that that doesn’t make any sense, no-one can help you.

Posted by niveditas | Report as abusive

KenG_CA, no no no. I keep bringing up market QUOTES. GS had live QUOTES on protection on those tranches. Please god tell me I don’t now have to explain what a quote is to you.

Also if AIG goes into bankruptcy then under UK law they are being liquidated. No money goes out without the administrator personally signing off on it, everyone is fired, contracts are terminated etc. Remember more countries use UK law than US law – for instance HK and Singapore which were where AIA was based.

As for why the Fed would insist on buying the tranches is almost certainly for transactional and adinistrative ease. What I can 100% guarantee it was not for was to save GS an insignificant mark to market loss.

Posted by Danny_Black | Report as abusive

niveditas, I think I am going to leave this one to you if you don’t mind. At the end of the day nothing we are going to say is going to convince this guy that the entire AIG rescue was not some cunning plot to save GS a possible temporary tiny MtoM loss.

Posted by Danny_Black | Report as abusive

nvideas, I didn’t say AIG had leverage, I said the treasury/Fed had leverage with GS. The government took over AIG, and bought back the swaps AIG sold to GS. I think your entire rant is based on your assumption that I said AIG had leverage, which I certainly did not say or imply.

As for whether there was a market for the swaps that GS held, I am only saying that if there was a market, then the Fed did not need to buy them. Why would the Fed step in when there were other willing buyers?

When I said there was no market for CDS’s, I meant there was no market for GS to sell the swaps they bought from AIG. That is not the same as there being nobody to write new swaps.

Danny, AIG wasn’t “rescued”, at least not from the perspective of their former shareholders. And if my memory is correct, they transferred $13 billion in cash to GS in late 2008. I guess $13 billion is relatively insignificant.

So how can you guarantee 100% what the Fed action was for? Were you part of the non-bailout?

Posted by KenG_CA | Report as abusive

“And if my memory is correct, they transferred $13 billion in cash to GS in late 2008.”

The “they” was not AIG, but the Fed.

Posted by KenG_CA | Report as abusive

Guys, I’m sorry, I was on a different planet in 2008. On the planet I lived on then, there was this incredible credit crisis, where banks were afraid to lend to almost everybody, and the economy was grinding to a halt. It wasn’t like where you lived, where debt was freely traded, and the market was completely liquid. Of course, on my planet, there was no Goldman Sachs around to do God’s work, so people and companies were forced to sell assets at huge discounts, because they had no place to borrow money.

So how did that all work out for you guys on your planet? Did those folks at Goldman Sachs save your financial system, and restore stability to your economy? Does everybody love them now, because hardly anyone lost money?

Posted by KenG_CA | Report as abusive

Here’s the left wing WSJ on Goldman and AIG and the Fed:

http://online.wsj.com/article/SB10001424 052748704201404574590453176996032.html

You claim to have worked in the financial industry, and that makes sense, seeing how incredibly screwed-up and self-serving it is.

You spend a lot of time talking about how I don’t know anything about a bunch of things that I’m not talking about – my claims were that Goldman changed to a bank holding company so it could borrow cheaply from the Fed, got a cash infusion from Warren Buffet, and then got a sweet deal from the government, one that is not offered to other companies in trouble, and you respond with a litany of insults and nonsense about what I don’t know.

I know it’s late, so read this after you wake up in the morning, before you start drinking again.

Posted by KenG_CA | Report as abusive

ok so on crazy world, Hank Paulson is ignoring the ongoing liquidity issues in AIG.

“Sir, AIG is in trouble. 75million insurance policies are at risk.”.
” dont care”.
“Sir, over a trillion dollars in assets are at risk of being locked up indefinitely”.
“dont care”
“Sir, a major player in the lending market is at risk of defaulting”
“dont care”
“Sir, a major player in cp market is at risk of defaulting”
“dont care”
suddenly blankfein calls
“hank, there is a tiny chance of a small temp mark to market loss. sure we are collaterised up to market quotes for novation and on top of that have cds against aig AND got collateral for that protection too. there is basically a zero chance of a cash loss and we can tap the fed for collateralised loans”
“whoah!! mtm loss of a few milion. hold the line whilst we arrange a 180bn rescue to prevent that”

this basically what u are claiming and only a retard would believe that. a category that clearly includes u.

Posted by Danny_Black | Report as abusive

” got a sweet deal from the government, one that is not offered to other companies in trouble”

this is also untrue. the other counterparties got the same deal.

Posted by Danny_Black | Report as abusive

niveditas, you might be new here so probably be best to aware of some of the “tricks of the trade”:

1) Quote from http://www.IhateGS.com or if talking about “foreclosure fraud” from someone who is offering to help the “victims” – for a fee of course….

2) If that fails, post a link that has no relationship to the topic at hand

3) and my personal fave, post a link that makes the polar opposite case whilst claiming it doesn’t. For instance if one looks at Ken’s WSJ link it mentions what we said which is that 8.4bn of the 13bn “gift” to GS from rescued AIG was cash GS ALREADY had as collateral. Throw in the 1.4bn it was holding in collateral on the protection that AIG would pay up and we have a much less impressive “gift” of less than 4bn which is what the tranches quotes were. I always wonder whether people like Ken are too stupid to realise what they post makes the opposite case or whether they think other people are too stupid to realise ( My money is on the former… )

Posted by Danny_Black | Report as abusive

“And KenG_CA, the mark that GS had on the bonds was based on the cash market bid for those CDO tranches, albeit probably not in a 12bn notional size, probably more like 1-2bn”

Isn’t this pretty much what I was saying? Finding a buyer for a LARGE position is never easy. And while the lending markets may have opened up by then, $12B is a serious chunk to swallow.

Yet again, from the arguments I’m hearing on both sides, it seems to come down to:
(1) The price was reasonable at the time, perhaps even a bargain for the Fed. Nor was it a wild gamble that just happened to work out well.

(2) At the time, finding a buyer for a trade of that size would have been tricky/impossible (except perhaps at fire sale prices).

I imagine there was also a reason for GS to sell? Usually the reason to sell an asset is the desire for liquidity. I guess it is possible that they were strong-armed into a sale that they didn’t want to make, but absent evidence to the contrary then I assume the liquidity argument holds up. Their assets were worth something, but they had no ready way to convert them to cash — and cash was at a premium.

Posted by TFF | Report as abusive

“For instance if one looks at Ken’s WSJ link it mentions what we said which is that 8.4bn of the 13bn “gift” to GS from rescued AIG was cash GS ALREADY had as collateral.”

Danny_Black, a quick question on this…

If you are holding collateral on an open contract, are there restrictions on how you can use it? I know that if I give a realtor a deposit on a purchase agreement, I expect that money to be kept securely and not spent or “reinvested”. In this instance, I imagine the collateral held might change daily with the market conditions — which would require holding sufficient liquidity to cover price swings.

Seems to be that cash on a closed position would be more flexible than collateral on an open position, no?

Posted by TFF | Report as abusive

danny, you continue to ignore the main point that I keep repeating, but I will try one more time: GS wanted to sell some positions, and the only buyer was the Fed. GS obviously wanted liquidity, as they gave Buffet a great deal for the preferred shares he bought, they converted to a bank holding company so they could borrow from the Fed, and they sold additional common shares to raise more capital. They really wanted to sell their AIG assets, for it was obvious to even morons like me that AIG was in deep trouble, and GS was repeatedly asking AIG for more cash. They were a very motivated seller, and there was only one buyer. That makes it a buyer’s market. If I’m buying tens of billions of dollars worth of paper goods (from GS and the other AIG counterparties with the sense to demand collateral for their AIG-sourced insurance), I should be able to get a discount, especially considering the atmosphere of FUD that was enveloping the world.But the Fed got no discount, it paid full price. That was not a deal everyone got, only Goldman and a handful of other firms.

Posted by KenG_CA | Report as abusive

TFF, I cannot imagine there was any reason in the world for GS to sell at a loss. They could repo those tranches if they needed the cash. As has painstakingly been pointed out to Ken, despite he absolute refusal to accept the facts, GS was simply not at risk of taking a material cash loss on those tranches. Hence why when the Fed bought out GS – and all the other counterparties – it was at fair value. I strongly suspect that it was the Fed who initiated the solution of terminating the swaps and taking into the Maiden Lane 3 SPV the underlying. From an administrative perspective it would be simpler – there is an upfront loan for a set amount and it gets paid back, with the existing arrangement there is collateral payments back and forth, maybe cash has to sit in the SPV to accomodate possible payment whilst accruing interest payments or there needs to be a credit line etc. Simpler to buy out the tranches, have one loan at the beginning and my P&L is tranche performance minus loan. As I said before, given the FACT that GS stood to make no material loss on those swaps I can guarantee it was not to save GS from those non-existent losses.

As for the collateral, I believe that there are “safe harbour” provisions that allow you to seize that collateral if the counterparty defaults. Certainly in cases I know about possession was at least 9/10s of the law. I also believe that it can be considered as part of your liquidity pool. But you may want to hear from an expert on that.

KenG, no I have dealt with it repeatedly. You are asserting GS wanted or needed to sell. You are asserting the Fed was the only buyer. You are asserting that the price the Fed paid was not a fair price. NONE OF THESE STATMENTS ARE TRUE. I repeat,
************NONE OF THESE STATMENTS ARE TRUE****************. Repeating them over and over doesn’t make them true.

GS gave a great deal to Buffet because it was buying a Buffet seal of approval. You think KenG Capital would have got the same deal? It was also over a month before Maiden Lane 3 in the midst of the turmoil post LEH bankruptcy. I find it hard to believe you are this stupid.

GS had all the liquidity it needed from the Fed collateralised loan program.

As has been repeatedly pointed out to you, despite your refusal to accept simple arithmetic, GS had no credit exposure to AIG on those swaps. It had collateral to cover a default by AIG, it had extra CDS to cover the cost of replacing those swaps and collateral to cover if THOSE CDSes didn’t pay out. It was covered, unlike the other banks who also got 100c on the dollar. Every single counterparty of AIG got that deal. Every single one, even the ones that were not as well covered as GS.

Posted by Danny_Black | Report as abusive

Danny, I think I’ll stop too.. too hard to argue with a guy who doesn’t even think AIG was actually bailed out/rescued.

Posted by niveditas | Report as abusive

Danny, your analogy, while humorous and more welcome than your usual admittedly rude discourse, wasn’t quite valid. Nevertheless, I think our entire disagreement, the thread of your anger/alcohol-fueled stream of incoherence and general obnoxiousness, and my futile attempts to get you to answer a direct question, can be reduced to one simple question: what do you think would have happened to GS if AIG had been allowed to go bankrupt?

I fully appreciate that would have been a bad thing for the economy, so the government through its various appendages would have great incentive to avoid that catastrophe. But I also think it just wouldn’t have been no big deal to GS. They would have been impacted, either directly or indirectly, and had also ample incentive to prevent an AIG bankruptcy. But if you can only answer one question directly, without expressing your frustration at the inability of financial industry outsiders (victims is more appropriate) to speak your language of Wall Street shorthand, what do you think the net effect of an AIG bankruptcy would have been on GS?

And niveditas, it all comes down to your definition of who AIG is. I am talking about their shareholders, and they were definitely not rescued or bailed out, as they pretty much lost everything. But maybe you can tell me how that was wrong, and how someone holding shares of AIG in January of 2008 is better off at any time since the “bailout”.

Posted by KenG_CA | Report as abusive

niveditas, what is extraordinary is this focus on GS. Of virtually ALL the swap counterparties GS was the one with the LEAST credit exposure.

What is also insane is this focus on banks when there was and is a cash drain called Frannie. This IS a place where profits – sorry “profits” – were privatised and losses socialised. This IS a place were one can legitimately argue banks got an indirect subsidy – and mortgage holders a much much much more direct one. I can even understand people making this “privatised gains, socialised losses” up to the end of 2009 but now it is simply false and diverts attention from where the real problems are. And that is probably not a coincidence.

Posted by Danny_Black | Report as abusive

“In November of 2008, [...] LIBOR being lower is EXACTLY a sign that banks were increasingly lending to each other

That’s just not true. For a man who makes such a big deal about the difference between capitalised QUOTES and transactions to make a statement like this about LIBOR in November 2008 … unbelievable, but I suppose that it explains the statement that “they could repo those tranches if [if!] they needed the cash”.

Posted by dsquared | Report as abusive

dsquared, you might be right and my recollection of the timeframe may be hazy. From recollection, all hell broke loose in Sept and by end of Oct time it was starting to recover from crisis mode after the money markets were guaranteed.

Does it change anything?

Posted by Danny_Black | Report as abusive

Apparently wasnt that hazy:

http://papers.ssrn.com/sol3/papers.cfm?a bstract_id=1329903

Posted by Danny_Black | Report as abusive

No, I’m looking at (because I happen to have it open on my desk rather than out of any great claim of representativeness) the Euribor/EONIA swap spread and it confirms my impression – the LIBOR market basically didn’t exist between Sept 08 and March 09 (when QE1 was launched). LIBOR wasn’t actually lower in November 08 as far as I can see – policy rates were lower.

Also, you couldn’t repo CDO tranches at any price from about June of 2008. If you could, Peloton Partners (closedin Feb 08) would still have a fund.

Posted by dsquared | Report as abusive

i dont have access to data so will stand corrected

Posted by Danny_Black | Report as abusive

u have access to us data?

Posted by Danny_Black | Report as abusive

leaving aside the harshness of the back-and-forth, the substance of this is pretty important. seems to me that GS was well-hedged, so it’s pretty unfair that they keep getting singled out. why not focus on unhedged, desperate, foreign banks like soc gen et al who were exposed to aig and not appropriately protected by collateral or hedged?

that said, GS was certainly interested in access to liquidity; to deny it is silly. They were much too big in the trade—they couldn’t easily unwind it if they wanted to do so, and they surely wanted to do so to have unfettered access to liquidity at a time of great need. they were hedged, but stuck. after the fact it is easy to say they were smarter than the others in the exposure, but to deny their mistake is to think that only p&l matters, when in crisis liquidity matters even more.

the government’s decision to bail out aig creditors (not shareholders) certainly had to do with an interest in avoiding a lehman-like crisis (or making it worse). GS might have been hedged against their exposure to AIG bankruptcy per se, but not to the indirect impact of an AIG bankruptcy—GS, and everyone else for that matter, including the man on the street, would have suffered huge if AIG was permitted to fail.

The government could have gone to GS (and in fact would have been wise to start with all the foreign banks, and ended with GS, which was most intelligently hedged and therefore least desperate at that moment) and said, “accept 85 cents on the dollar.” if soc gen, gs, and the rest of them said no to this then there would be a game of chicken going on over the global economy between the us government, which was trying to solve a crisis, and a bunch of arrogant bankers. first call could have been us government to french government. i don’t think the us government tried very hard on this—but that’s probably because they were busy, in the midst of trying to save the world, exhausted, and constantly running out of time. also, i think most of them were bureaucrat/regulators, not traders who are trained to go for the jugular. with the benefit of hindsight i suspect that they wish they had done so, if only for appearance’s sake.

so i think the GS/AIG story is not really about GS, and the focus on GS to the exclusion of others is pretty darn unfair.

On the other hand, the government should have tried to negotiate a discount if only to avoid the conspiracy theories etc, which could ultimately lead to larger political, economic, and social risks.

Posted by beccanyc | Report as abusive

I didn’t focus on GS, I just gave them as an example of what an investment bank would do in a crisis. Which they did.

And in all my comments on this topic, over the last few years, I have never suggested any kind of conspiracy that drove the lack of negotiation, only incompetence. The government/Fed should have negotiated a discount, even if it was only 15%, for 15% of what they were risking was still a lot of money.

Posted by KenG_CA | Report as abusive

“so i think the GS/AIG story is not really about GS, and the focus on GS to the exclusion of others is pretty darn unfair”

I don’t think it’s particularly unfair. If there were dozens of Credit Suisse alumni working in the highest level of the US government, and if the Treasury Secretary who negotiated the deal was a former CEO of RBS, and if that Treasury Secretary had held unminuted, off-the-record meetings with Nomura, then there would be much less focus on GS in this case. What people are worried about here is a generally too close relationship between big investment banks and the state (which I think is what’s meant by “conspiracy theory” here, although IMO that’s a bit dismissive), and it’s not unreasonable that they focus these concerns on the big investment bank which seems to have the closest relationships with the state.

Posted by dsquared | Report as abusive

dsquared, you seriously think that if it has been loads of Standard Chartered alumni – am trying to think of a vaguely serious bank that was not on the AIGFP swap list – that they would or could have behaved differently vs AIG? You seriously suggesting that saving GS was even on Paulson’s reasons for intervening with AIG?

Posted by Danny_Black | Report as abusive

“You seriously suggesting that saving GS was even on Paulson’s reasons for intervening with AIG?” (D.B.)

Lovely to see you again, Mr. Black. No matter what self-serving, exculpatory assertions he makes, we’ll never actually know what was in Paulson’s mind, will we? He did have a clear conflict of interest though. That’s the beginning and the end of it, ethically speaking.

Posted by MrRFox | Report as abusive

Also I am moderately sure that in Sept TSLF was extended to include ABS of the sort GS had insured. In which case they would have been able to repo it. There used to be a spreadsheet of this sort of stuff floating around and it is possible I am confusing it with TALF which would be post Maiden Lane 3

Posted by Danny_Black | Report as abusive

MrRFox, good to see after a break that the brain trust is back.

Posted by Danny_Black | Report as abusive

“What people are worried about here is a generally too close relationship between big investment banks and the state (which I think is what’s meant by “conspiracy theory” here, although IMO that’s a bit dismissive), and it’s not unreasonable that they focus these concerns on the big investment bank which seems to have the closest relationships with the state.”

i think this is a pretty reasonable response to my posted comment. GS people are all over the place—not just Paulson, but also some of his support at Treasury, and now Dudley and Draghi. So if someone wants to investigate closely to decide if, based on facts, decisions were made during the crisis environment that were unfairly supporting GS economics, they should do so.

Personally, i think the AIG case is pretty clear—Paulson et al, in the midst of crisis made worse by the Lehman bankruptcy, did what they could to forestall an AIG bankruptcy. All market participants benefited, and in fact it’s at least likely that the economy was/is better off than it would have been without their actions. One can argue that the decision was made because of a desire to support GS—but given how little GS had to gain as an individual counterparty of AIG, and how much Paulson had to lose if in fact it was seen to be a GS-centric decision, that conclusion seems quite far-fetched.

If you were to argue that the lack of a ballsier approach by the government to negotiation was driven by a GS-centric view, again i’d disagree for the reasons stated in my original post.

but i believe that the negotiation should have happened, and GS and others should have suffered some direct economic damage from the unwind of the trade via the Treasury.

and with respect to the weekend during which GS and MS violently joined the community of institutions subject to Fed oversight and regulation in return for access to the discount window: Bernanke et al should have taken Mack and Blankfein to the cleaners on that one. getting 15c out of GS on the AIG book is nothing. Taking 49% of corporate equity in return for giving access to liquidity at the Fed….that would have taken balls, but it would have been a helluva show. I don’t know why Buffett got a better deal out of GS than Treasury/Fed did. I like to think i think it doesn’t have much to do with Paulson, who i think understood how dire the situation was generally and wanted more than anything for the country’s economic system to survive.

That said, Treasury took a bat to AIG shareholders’ heads, to Lehman shareholders’ heads, and to Bear shareholders’ heads. So i dunno.

One other thing: when GS leadership (Blankfein and Cohn), at the height of economic pain in our country, claimed that they never needed government support (Vanity Fair interview 3/09), they were lying in a way that was so bald-faced as to be insulting to anyone with a brain. Their lack of humility and gratitude is the key reason why they are now suffering reputational damage, and why GS won’t be able to get out of the way of this avalanche of bad PR until they’re gone.

In other words, GS might not have done anything so wrong during the crisis, and the facts don’t support the heavy criticism they are singled out for every day for years now……but arrogance kills. Every time.

Posted by beccanyc | Report as abusive

beccanyc, there is a fundamental difference between taking an investment from Buffet and taking from the gov in terms of signalling. An investment from the “world’s greatest investor(TM)” says we are a great bet and gonna be around a while, an investment from the government says we are on the way to nationalisation, sell now whilst the shares are not worth zero. Thats why when TARP rolled round the Treasury forced all the banks to take an investment on identical terms even the ones that arguably didn’t need it – Wells and JPM for instance.

There was an interesting article on the AIGFP negotiations. I am quoting from memory so the details may well be wrong but it is more or less correct. Two of the banks offered a 2% haircut if the others agreed but one of the two was French and the french regulator vetoed their offer. I guess they could have extra-legally enforced a writedown like they did with the bondholders of the auto firms but it is hard to see how that would have achieved anything except more uncertainty about bank futures.

As for the Vanity Fair article, it would be interesting to see what was actually said and in what context. If he was asked narrowly about TARP investments or these swaps then arguably he is correct. But any of the other interventions? GS would have survived the disappearance of the credit wrap for agency MBS? The sudden disappearance of the CP market? China making a cash loss of around 1/3 of its fx reserves, Russia something 1/4? The knock-on disruption to the housing and treasuries market? Hard to believe he would make that claim and harder to believe that a competent journalist would not press him on it.

As for Paulson, Geithner and their team, I think that under the circumstances they did the best they possibly could and a pretty good job at that. One only has to stare across the ocean at the job that the mafia of the mediocre did in the UK to see what could have been the result….

Posted by Danny_Black | Report as abusive

Um,… no, Mr. Black – a Northern Rock solution would have been more fair, and would have been seen to be so by the general population. But that would have meant the end of a lot of 8-digit annual paydays on Wall Street – and we can’t have that, can we?

Posted by MrRFox | Report as abusive

MrRFox, yeap because Northern Rock had done a great job for the UK.

Posted by Danny_Black | Report as abusive