Dum Da Dum Dum - My Stint As A Goldman Apologist

Bloomberg runs an article about the liquidation of some AIG credit derivatives at par, claiming it was a windfall for Goldman Sachs and others.  The most credulous blog response I have noticed is at 'naked capitalism':

It had generally been assumed that the AIG payouts of 100% on credit swaps (when the insurer was under water and bankrupt companies do not satisfy their obligations in full) was the result of some gap in oversight plus traders at AIG exercising discretion (they were unhappy about bonus rows and had reason to curry favor with dealers, who were potential employers).

The article makes clear that AIG had been negotiating to settle on the swaps prior to getting aid from the government, and was seeking a 40% discount. The Fed might not have gotten that much of a discount, but there was clearly no need to pay out at par.

Generally assumed by whom?  Did anybody think these multi-billion dollar liquidations and financing vehicles were created without the Fed's knowledge?

As to what people assumed, I assumed that when the government took a 79.9% stake in AIG in order to assure the world that its obligations would be honored, there was a pretty explicit intention to honor their obligations and avoid a worldwide meltdown as creditors, policy holders and local regulators attempted to seize AIG assets.

That commitment to avoiding a nasty reorganization more or less eliminated the bargaining position of "Take 60 cents on the dollar now or try your luck in a reorganization."

As to whether the payments represented a giveaway to Goldman Sachs - who knows?  I belabored this months ago, but the gist is this - Goldman claims they had previously bought credit default swaps against AIG, so they would have been protected in the event of an AIG default.  If AIG had actually defaulted, these unnamed third parties would have been on the hook for Goldman's losses (although whether they could have paid, who knows?).  It was these third parties that benefited from the settlement between AIG and Goldman at par.

As a bonus puzzle, it also means that the Fed was negotiating with the wrong people.  Goldman had no financial incentive to agree to accept a discount on its swaps with AIG unless that also triggered an offsetting  payment on its credit protection swaps (which it probably did not not since Goldman would have been a volunteer and the entire Fed exercise was meant to avoid formal defaults).

Maybe, maybe, maybe the Fed could have extracted something from the counterparties providing default protection to Goldman.  But since the default threat was not credible there, either, probably not.

The lesson is, if a government that values its credibility and hopes to avoid a panic promises to protect creditors, it pretty much has to do just that.  Quel surprise.  The same logic - a deal is a deal and contracts count - led to the government paying out on the controversial AIG bonuses.  It is easy enough not to like that outcome, but having a government that could tear up contracts at random would probably be worse.

Comments

[sbw]

Ooh! Left brain cramp.

[Thomas Collins]

See LUN for a summary of the movie that explains all of this.

If only clones of the Eddie Murphy character were at Treasury and the Fed during 2008.

[narciso]

"Where is Beaks"

[Melinda Romanoff]

Or, unless your branch office in the Old Executive Office building facilitates a bit of assistance in making the trades "good" for GS.

But of course that wouldn't happen...

[Rick Ballard]

TC,

The Eddie Murphy bit is good but I believe that Cleavon Little as Bart may better capture the essence of Dimon, Blankfein &c. Especially that first vignette.

[Rick Ballard]

TC,

The Eddie Murphy bit is good but I believe that Cleavon Little as Bart (especially that first vignette) may better capture the essence of Dimon, Blankfein &c.

[clarice]

Between Animal House and Blazing Saddles everything you need to know about the USA is explained.

[Gregory Koster]

Trouble is, however legal these settlements are, they are 100 octane for lefty populism, with much justice. The answer should be systematically breaking up the "too big to fail" gang of zombie banks, but that doesn't seem likely. The Left's answer will be to howl for more regulation e.g. interest rate ceilings on credit cards,or executive pay ceilings. This bunk will a) have doubtful relevance to the past difficulties and b) will likely cause a talent flight. b) may cause a second failure of the zombies, in which case poetic justice and a few more trillions on the national debt will have been served.

I know, I know---the sharks had contracts guaranteeing them bonuses. Even so, I think an interesting experiment for the zombie banks would be to refuse payment of the bonuses, and say, Sue us. How many AIGers say, would want to sue in the full glare of publicity, showing everyone what they did to earn their dough? Given that corporate HR departments are always bawling at the small fry about behaving ethically, not stealing company secrets or using insider info, why not let the millionaires dance to that piper's tune instead of "My God How The Money Keeps Rollin' In." Meanwhile, let us praise for a change, Ron Paul in his efforts of audit the Fed and its remoras.

[Thomas Collins]

Ah, Rick, thanks for bringing back memories of another "many belly-laughs" movie. Clarice, I think Senator Blutarsky is a cut above many in the US Senate today.

[Greg Ransom]

Recommended: Russ Robert at Econtalk this week. Great podcast on how Wall Street got the pathological regulations they wanted.

[Rick Ballard]

GK,

Dimon, Blankfein &c have the keys to the Dow bubble machine. They're pretty much untouchable until the market corrects as Grantham explains in detail. I lean towards Rosenberg and Grantham's probable outcome scenarios above any others currently on display.

My preference would be to watch Act II through the Hubble telescope - from Mars. My current position on the sidelines is still too damn close to the game.

[Theaetetus]

"these multi-billion dollar liquidations and financing vehicles were created without the Fed's knowledge?"

The culture of rape and pillage with short-sells and next quarter long-term vision
has not changed for Wall St or the Banks.

If the Fed, like the FDA, is the watchdog that needs watching, perhaps it's time to reassess the autonomy it holds. Yes, I'm afraid more regulation for economic serial-killers and Fiscal Pedophiles is the logical transition for this overly powerful friend of the Financial Markets.

[Charlie (Colorado)]

Even so, I think an interesting experiment for the zombie banks would be to refuse payment of the bonuses, and say, Sue us. How many AIGers say, would want to sue in the full glare of publicity, showing everyone what they did to earn their dough?

Yeah? And then what if AIG won? Do you really want to establish that contracts are only good if you have the better PR?

On the other hand, could someone who is owed a $30 million bonus force AIG into bankruptcy after all? Personally, I'd probably put up wih a fair bit of snark in the Times for thirty mil, and as I recall we concluded that these bonuses were pay, and so liable for treble damages. How much would they be willing to put up with for another $60 mil? They might be saying "Make us sue. Make our day."

[Andy Freeman]

> If AIG had actually defaulted, these unnamed third parties would have been on the hook for Goldman's losses (although whether they could have paid, who knows?). It was these third parties that benefited from the settlement between AIG and Goldman at par.

Not so fast. If those third parties couldn't have paid, Goldman et al would have been left holding the bag.

Yes, it's a bigger subsidy to those counter-parties but it's still a subsidy to Goldman et al.

Those counter-parties were paid for assuming risk. Since they did so on Goldman's behalf, Goldman should be doing the collecting. As it is, we won't even try.
> I assumed that when the government took a 79.9% stake in AIG in order to assure the world that its obligations would be honored, there was a pretty explicit intention to honor their obligations and avoid a worldwide meltdown as creditors, policy holders and local regulators attempted to seize AIG assets.

In other words, you assumed that the govt buying AIG was an obligation to keep Goldman from losing money.

We're pointing out how the govt protected Goldman and that doing so was a bad thing.

Me - I assumed that the govt bought AIG to do a orderly shut-down, with folks losing money.

Goldman et al SHOULD lose money when their risk analysis goes wrong. That's the price that they pay for getting to keep the profits when it goes right.

[Rick Ballard]

Goldman et al SHOULD lose money when their risk analysis goes wrong. That's the price that they pay for getting to keep the profits when it goes right.

Agreed, but the "heads I win, tails you lose" provisions in their rent-a-pol contracts seem to supercede all other factors. Has the inventory of AIG CDS positions ever been made public? After all, the major players have had a year now to sweep all the nasty stuff under the carpet (and into the Fed/Treasury), surely whatever remains is of pristine purity.

[Old Lurker]

"Goldman et al SHOULD lose money when their risk analysis goes wrong. That's the price that they pay for getting to keep the profits when it goes right."

How very...quaint, Andy. These days "we're gonna take those profits and invest them better for the public good".

[bad]

Rick, Stupid here. (raises her hand and waves it about)

I know I've asked this before but please let me ask again without getting THWACKED...

Is there a rundown of pension funds that got screwed by AIG's CDS position?

[d finch]

"having a government that could tear up contracts at random would probably be worse."

Tell it to the GM bondholders.

[Melinda Romanoff]

Oooh, loaded question Ms. bad. (Hope all is well!)

The losses at AIG would be eaten, ostensibly, by the "general fund" of the insurance giant, that's the pile of cash/assets that the schlubs in London using for their bets. So, round abouts, the investors in AIG were the ones who were "hosed", they didn't off-load as much on others, hence the size of what they paid GS, et al.

The pension exposure is primarily in owning the CDO (collateralized debt obligations), CLO (insert "loan", and those various, other instruments that mashed credit card debt with car loans, and called them AAA. (Thanks, Moody's, Fitch, and S&P!!)

JD Rockfeller once said chasing yield is a fool's errand.

He was right, in spades.

[Gregory Koster]

Chaco, d finch and the GM bondholders have a fine point. You are right, my suggestion has more than the Recommended Daily Allowance of demagoguery. But which is worse:

a) tearing up contracts just because one side has the worse PR or
b) gold standard contracts for the big guys, the rack for the small fry

in the notoriously political environment that The Once has instituted for contract law? The discovery process of a lawsuit by the bonus creditors would enable facts for more than "thirty years of TIMES snark."

My scheme is a poor idea. I don't much like the "there's nothing you can do about it because we're rich," alternative. It is way too late for a real bankruptcy that would have stuffed all those hogs onto the conveyor belt.

Rick, I'm sorry you linked Grantham's piece. I alternated between laughing like hell and kicking my (metaphorical) dog. He does seem to have a good take on the consequences. The worst effect of the Blankfein boom is that it will only confirm The Once's idiotic bigotry about how capitalism works, and make him even more ready to stick his finger in all of our eyes, for our own good, of course.

[Rick Ballard]

Bad,

I'm pretty sure that the answer to your question will remain a puzzle inside a riddle wrapped in an enigma for the foreseeable future. As Mel notes, pension funds are being clobbered due to slight miscalculations in presumed risk factors underlying the ABS/CDO instruments (and where would we be without them?). The final size of the crater won't be known for another 4-6 years but the degree of inflation explicit in current long term budget forecasts suggests that 'large' would be an understatement. Of course, that's if we get through the current deflationary period with any jobs left.

It' going to be a much more interesting decade than I would ever have considered wishing to see.

[sbw]

Once contracts have been GMified, how can one put Humpty together again? 'Now contracts are really going to be sacrosanct. Really."

[d finch]

Rick Ballard-

Bingo.

[Rick Ballard]

Bad,

Upon reflection - most pension funds publish lists of their holdings as well as quarterly status reports. AFAIK, they do not necessarily have to use 'mark to market' accounting so a careful review of footnotes is warranted. There is also a layer of federal insurance which guarantees a fairly high percentage of benefit payouts (80% is not uncommon).

[Melinda Romanoff]

bad-

To follow up Rick, here's the PBGC guarantees for 2010 (LUN).

Any guesses as to who actually pays for those guarantees?

And, of course, they have funding issues.

You can take comfort in knowing that places like Harvard Endowment, Calpers, and Calters actively traded the CDS market. In the case of Harvard, they actually bet the farm with their daily operating funds. That sort of "wisdom" cost them almost 60% of the "grocery money".

Corporate pensions have to "show their work", state and locals? not so much.

It's depressing stuff, and has been building for years. I think it's why no one wants to bring it up. It'll be solved in a very messy fashion, where everyone walks away unhappy.

[Melinda Romanoff]

Ooops. (LUN here!)

[Melinda Romanoff]

And the ABS (Asset Backed Securities) are being reset right now, with the revaluations of Stuyvesant Town and the NYC Four Seasons Hotel. They might have been leveraged just a tad bit better than the cash flow generated.

Ooops.

Four Seasons story LUN, CRE= commercial Real Estate

[Melinda Romanoff]

(Oscar Peterson-Mas Qui Nada (LUN))

[Tom Maguire]

Not so fast. If those third parties couldn't have paid, Goldman et al would have been left holding the bag.

Yeah, but those deals are generally collateralized (it was collateral calls triggered by a ratings downgrade that staggered AIG). Goldman may not have had all the collateral they wanted, of course. And an AIG default may have triggered so dramatic an apocalypse that no one survived. But that was why the Fed was not allowing it.

Me - I assumed that the govt bought AIG to do a orderly shut-down, with folks losing money.

Goldman et al SHOULD lose money when their risk analysis goes wrong. That's the price that they pay for getting to keep the profits when it goes right.

I don't see how AIG can force Goldman to agree to a loss on an early settlement of their swaps, other than default. I suppose AIG/the Fed could have taken the position that Goldman could try to ride the swaps out for their remaining life and test whether the Fed would tolerate a default few years down the road.

Well. Part of Goldman's risk analysis may have been that AIG was too big to fail. An accurate assessment, perhaps made easier by having ex-Goldman people in power everywhere.

[bad]

I guess I need to get my mom to give me more details of her pension before I can chase down her exposure.

Thanks very much for your help.

[jimmyk]

Uh-oh, our fearless leader left us in italics.

This was a big game of chicken, and Bernanke/Geithner/Paulson blinked. They could have extracted something from GS and the other big counterparties if they threatened to let that first domino topple.

[jimmyk]

Hey, I fixed it. (At least on my browser.)

[Melinda Romanoff]

TM-

Now yer catchin' on, but...

Collateralized? Really?

You should know better than that.

AIG thought it was selling insurance. It wasn't, and everyone on "The Street" knew it. They were the suckers at the table, and, of course, everyone loaded them up. What they thought they were selling was actually long maturity options on various company's debt, and, more dumberer, other country's debt. They had to pay up if and when it turned south.

Here's the twist, as more and more parties bought the insurance, driving the price up, the only way the risk desk could hedge the position was to sell short the company's stock, forcing a default scenario. Now who would short more to help out a CDS trade, going in their favor? Hmmm.

They screwed themselves, and sold all AIG's underlying asset pool (It's only strength) right down the river.

Third parties had little, or nothing, to do with what they were doing. Totally different type of trade. It's not nearly as simple as that. You have to understand the type of trade taking place. AIG, and certainly not the press, never really understood what they did to themselves.

It's actually a shame.

Horse. Barn, and all that.

/rant off.

[glasater]

Melinda-

Didn't what you wrote about AIG happen after Hand Greenberg was booted?

[Melinda Romanoff]

glasater-

A bit before, but most of it was after Hank was tossed. Not that he understood this stuff in the first place.

[glasater]

Thank you Melinda--

Have an interview with Charlie Rose with Hank:-) Greenberg in the LUN.
Charlie did many interviews on the financial crisis a little more than a year ago and two were with Mr. Greenberg. And again in the early part of this year.
And as you most likely are aware, Mr Greenberg is hiring former AIG personnel for his present firm.

[spongeworthy]

I'd just add a clarification to what our host has posted. Negotiating a discount at that point was meaningless once the Feds had decided we were backstopping AIG. We could either let them negotitate a discount and settle their trades and then backtrack to fill in the missing funds or we could do it the easy way and guarantee it up front.

The idea was to prevent a credit meltdown NOW, not when we get around to paying your claims.

[Andy Freeman]

> Yeah, but those deals are generally collateralized (it was collateral calls triggered by a ratings downgrade that staggered AIG). Goldman may not have had all the collateral they wanted, of course.

The point is that Goldman et al had the collateral that they thought appropriate. They made the deals that they wanted to make.

Goldman et all should live with the consequences of those deals. If they made arrangements to be made whole and those work, great. If not, well that's why they make the big bucks.

And yes, it's okay if the result is that Goldman ends up owning a town in Australia or that town loses its pension fund. (One of the sob stories was that some town in Oz had gotten money from Goldman to provide collateral for an AIG contract.) If that's a problem for the folks in said town, they can juxtapose their representatives and their lamp posts.

Stupidity should be painful.

[Andy Freeman]

> The idea was to prevent a credit meltdown NOW, not when we get around to paying your claims.

We understand the idea (the goal actually). We're pointing out flaws in the means used.

[glasater]

There was a demonstration about the 'terrible' bankers the other day. But no one wants to demonstrate against those idiots the credit ratings agencies.....

[Rick Ballard]

"Goldman claims they had previously bought credit default swaps against AIG, so they would have been protected in the event of an AIG default."

Uh huh. Here's a detailed piece showing how GS is backstopped by JPM which is insured through C which has layed off all risk to BAC which has negotiated a strict stop loss agreement with WFC (fully guaranteed by GS).

That's some fine cookin' from Uncle Ben's kitchen.

[Rick Ballard]

For the record GS pimps forecasters were first out with the reduction in GDP forecast, followed by Morgan Stanley and Merrill Lynch.

[Tom Maguire]

From Andy Freeman, Oct 28, 12:10 PM:

The point is that Goldman et al had the collateral that they thought appropriate. They made the deals that they wanted to make.

...If they made arrangements to be made whole and those work, great. If not, well that's why they make the big bucks.

There are two different collateral pools being discussed here.

1. Goldman was entitled to either hold collateral from AIG or declare a default on its mortgage related swaps with AIG, thereby activating the Credit Default swaps it claims it had as protection against an AIG default.

2. Goldman also had collateral from the third parties providing the AIG credit protection, which may or may not have been adequate to secure the value of the contract at the moment of an AIG default.

Goldman and others were insisting on more collateral from AIG following their credit downgrade. The Fed stepped in, took over AIG, and honored its obligation to post full collateral.

I don't see how the Fed could have stepped in and announced that they were going to honor AIG's contracts selectively - that would mean they were defaulting on some contracts, which would trigger the global scramble the Fed intended to avoid.

The point I was making was about the 2nd type of collateral securing Goldman's credit protection provided by third parties. Goldman claims they would have been made whole by third parties if AIG had defaulted. I say, that depends on how much of their third party's collateral they held at the moment AIG defaulted, and whether the third parties weathered the AIG default.

Maybe Goldman had plenty of excess collateral, or their third parties were rock solid - I don't know, but I doubt Andy does either.

But to say Goldman was stupid in their credit judgment is not consistent with the facts on offer. Their negotiating stance with the Fed may have been, fine, don't pay us, declare a default so we can collect from our third parties, and everyone goes home early.

The Fed says, gee, we don't want to default, we just don't want to pay you.

After Goldman finishes laughing they ask the Fed to choose. The Fed chooses not to default, and here we are.

Now, maybe Goldman was bluffing, or lying about their third party protection. Maybe the third parties were undercollateralized and could not have paid.

Or maybe not. The Fed could have found out the hard way, and chose (probably wisely) not to.

[spongeworthy]

We're pointing out flaws in the means used.

In view of the goal, I fail to see what better alternative was open to them at that time.

[Melinda Romanoff]

Counterparty risk was consideed a net-net at the time of the injection.

My opinion is that GS was a willing purchaser of AIG's CDS contracts, using woefully misquoted prices from AIG. Essentially a no-money-down transaction for the face value involved. The prop desk at GS knew it was mispriced, and was out to take AIG for what ever it would lay on the line. The second part of the trade was GS buying up all the CDS' they could get on AIG. Meaning, if AIG folded, one set of CDS' would pay off (probably multiples more than AIG wrote to GS in the first place), when the others were bust, but would leave GS as, at minimum, secondary creditors in Chap. 11. By the Feds making GS whole on the AIG CDS', they got paid on both sides of their trade.

And that's the last I'll write on this. It isn't simple stuff, and they Were out to screw everyone.

[Melinda Romanoff]

One thing I left out, as those other entities sold CDS' to GS, the only way they could hedge their position was to be short AIG stock. As the stock fell, they had to sell more. Since AIG was using their own stock as part of their capitalization, the death of AIG was, obviously, fait accompli. Just a matter of when.

I think that covers it. Let me know what I missed.