Submitted by Janet Tavakoli of Tavakoli Structured Finance

I Retract My Apology and Call for More Regulation of Goldman Sachs

TSF – Opinion Commentary – November 22, 2009 (see also Apology)

According to SIGTARP1, both the Federal Reserve and Treasury agreed that an AIG failure posed unacceptable risk to the global financial system and the U.S. economy. On March 24, 2009, Fed Chairman Ben Bernanke testified before the House Financial Services Committee [P.9]:

[C]onceivably, its failure could have resulted in a 1930’s-style global financial and economic meltdown, with catastrophic implication[s].

From July 2007, AIG’s financial situation deteriorated while so-called “AAA” collateralized debt obligations (CDOs) dropped in value. AIG sold credit default swaps (CDSs) on these CDOs and had to post more collateral, as the prices plummeted.

Goldman Sachs was AIGFP’s (UK-based AIG Financial Products) largest CDS counterparty with around $22.1 billion, or about one-third of the problematic trades. Goldman underwrote some of the CDOs underlying its own CDSs, and also underwrote a large portion of the CDOs against which French banks SocGen, Calyon, Bank of Montreal, and Wachovia bought CDS protection. Goldman provided pricing on these CDOs to SocGen and Calyon. Goldman was a key contributor to AIG’s liquidity strain and the resulting systemic risk. (See “Goldman’s Undisclosed Role in AIG’s Distress”)

Apocalypse AIG

By mid September 2008, AIG’s long-term credit rating was downgraded, its stock price plummeted, and AIG couldn’t meet its borrowing needs in the short-term credit markets. According to SIGTARP, “without outside intervention, the company faced bankruptcy, as it simply did not have the cash that was required to provide to AIGFP’s counterparties as collateral.” [P.9] The Federal Reserve Board with Treasury’s encouragement authorized a bailout. 2

The Federal Reserve Bank of New York (FRBNY) extended an $85 billion revolving credit facility, so AIG could make its collateral payments to Goldman and some of its CDO buyers. AIG also met other obligations, such as payments under its securities lending programs owed to Goldman and some of its CDO buyers. (See also: “AIG Discloses Counterparties to CDS, GIA, and Securities Lending Transactions.”)

Goldman “Would Have Realized a Loss”

Fed Chairman Bernanke said AIG’s crisis put the world at risk for a global financial meltdown. Goldman purchased little credit default protection3 against an AIG collapse. Even if Goldman escaped a collateral clawback of the billions it held from AIG4, the underlying CDOs posed substantial market value risk (SIGTARP P. 17). As for systemic risk, Goldman CEO Lloyd Blankfein worried about untold billions in losses. (Too Big to Fail, P. 382.)

On September 16, 2008, as the FRBNY arranged AIG’s $85 billion credit line, Goldman CFO David Viniar said whatever the outcome, he would expect the direct impact of credit exposure to be “immaterial to [Goldman’s] results.” The CDOs’ ($22.1 billion) value was down around $10 billion, and AIG still owed Goldman $2.5 billion in collateral (hedged and partly collateralized by CDSs on AIG). SIGTARP shows the CDOs’ value fell another $2.5 billion in two months, and AIG’s new credit line provided more collateral. The CDOs were losing market value. If AIG had collapsed, the value drop would have been swift and brutal with new protection either unavailable or too expensive, if past CDS market mayhem provided any information. As the Wall Street Journal put it, SIGTARP “throws cold water on [Goldman’s] claim.”

Before September 16, 2008, AIG tried to negotiate a settlement for forty cents on the dollar. Other insurers have negotiated even deeper discounts to settle their CDS contracts on CDOs. The SIGTARP report shows that the FRBNY’s decision to pay 100 cents on the dollar to resolve $13.9 billion (part of Goldman’s $22.1 billion) of credit default swaps by purchasing the underlying CDOs in Maiden Lane III was important to Goldman Sachs. “Goldman Sachs…did not agree to concessions, because it would have realized a loss if it had.” [P.16]

Treasury Secretary Timothy Geithner, then President of FRBNY, is revealed in this New York Times article with apparent Stockholm syndrome rivaled only by Patty Hearst. He seems to echo Goldman’s talking points after discussions with Goldman’s CFO. In the fall of 2008, Henry (“Hank”) Paulson was Treasury Secretary. Paulson was formerly CEO of Goldman Sachs and held that role when Goldman executed its trades with AIG. Stephen Friedman, a former Goldman Sachs co-chairman, was Chairman of FRBNY. Friedman owned shares of Goldman Sachs, and was a member of Goldman’s board, while he held his influential Fed position. He resigned the Fed position in May 2009, but not before purchasing 50,000 shares of Goldman Sachs, when the public was still in the dark about the terms of the bailout.

Goldman’s Turn to Apologize

In light of the SIGTARP report, I withdraw my earlier apology to Goldman. Public commitments to AIG are currently around $182 billion. If you wonder what Goldman CEO Lloyd Blankfein meant when he said: “[Goldman Sachs] participated in things that were clearly wrong and we have reason to regret and we apologize for them,” think of Goldman’s role in AIG’s crisis, Goldman’s bailout, and Goldman’s ongoing heavy taxpayer subsidies. That way, one of you will be genuinely sorry about it.

1 The November 17, 2009 report of the Office of the Special Inspector General for the Troubled Asset Relief Programs, “Factors Affecting Efforts to Limit Payments to AIG Counterparties.” The report does not address the risk of collateral clawbacks by authorities on behalf of AIG or the public, and it does not address the relative size of Goldman’s CDS positions and CDO underwriting activity related to AIG’s CDSs mentioned in the above commentary.



2 Fed and Treasury officials thought AIG’s derivatives were “more risky and unbalanced than Lehman’s.” They were concerned about loss of confidence in AIG’s subsidiaries, AIG’s failure to perform on annuities and wraps, losses to state and local governments, global banks and investment banks, losses to 401k plans, and the credit markets. The Reserve Primary Fund had fallen below $1.00 per share after it wrote off Lehman’s debt causing a run on the fund, and officials worried about an AIG failure causing further “breaking-of-the-buck.” (P. 10)

3 SIGTARP says Goldman would have trouble collecting on the credit default protection it bought to protect against an AIG collapse—which by deduction seems to only be around $2.5 billion. It is usual to have mark-to-market collateral, but it is unlikely this position was 100% collateralized. In November 2008, it seems $1.2 billion of this hedge was allocated for Maiden Lane III assets and $1.1 billion to another $8.2 billion position leaving an apparent slight excess notional amount. But even if it were 100% collateralized, that seeming advantage could quickly disappear in a volatile market when pricing discounted illiquid assets that lack transparency. [P. 16, 17]



4 According to SIGTARP, private participants felt AIG’s financial condition was so tenuous that on September 15, they refused to fund AIG making the Fed’s bailout necessary. Their analysis showed AIG’s liquidity needs exceeded the value of the company’s assets. [P.8] Goldman’s status in the event of an AIG collapse would have been that of a credit default swap counterparty during a global crisis with very special circumstances. Goldman thought it would get to keep the billions in dollars it received from AIG, if AIG collapsed. That would normally be the case, but these would have been extraordinary circumstances inflamed by value-destroying CDOs over which Goldman had pricing power, and Goldman had underwritten some of the CDOs. Authorities charged with resolving a collapse of AIG may have clawed back a substantial portion of the collateral.

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Janet Tavakoli is the president of Tavakoli Structured Finance, a Chicago-based consulting firm to financial institutions and institutional investors. She is the author of a book on the cause global financial meltdown: Dear Mr. Buffett: What an Investor Learns 1,269 Miles from Wall Street (Wiley, 2009), Structured Finance & Collateralized Debt Obligations (Wiley 2003, 2008), and Credit Derivatives & Synthetic Structures (Wiley 1999 and 2001).