Goldman Sachs's AIG Double Dip?

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As it turns out Goldman Sachs tops the list of financial institutions the Fed paid on behalf of AIG. Of the original $85 billion bailout loan, Goldman Sachs received $12.9 billion, the largest amount. The outrage over AIG FP’s bonus payments seems misplaced. Even if we could claw back bonus money, bonuses represent less than one tenth of one percent of the total AIG bailout. Goldman’s bailout payment is real money, and by their own admission they didn’t need it.

The arguments made for waiting 6 months to reveal the names of the financial institutions bailed out were always weak. As recently as March 5th, Federal Reserve Vice Chairman Donald Kohn was still claiming that revealing the names would “undermine the stability” of AIG and create uncertainty in the financial markets. More likely, taxpayers would have much more quickly reached a very disturbing conclusion. Namely, former Treasury Secretary Paulson was committing taxpayer funds to bail out Goldman Sachs, the firm he once ran. A firm that has publicly claimed it had little exposure to AIG.

On the surface, this bailout has always looked unseemly. As we dig deeper, it appears downright scandalous. First we must follow the money. Starting last September, the New York Federal Reserve, with now Treasury Secretary Geithner at the helm, paid the collateral calls that AIG was facing directly to AIG’s counterparties. The largest recipient was Goldman Sachs.

We know that these collateral calls arose because AIG FP had written insurance, or Sold Protection, on a variety of mortgage related Collateralized Debt Obligations. The typical trade for a large bank would have been something like the following: A large Bank might buy the super-senior tranche of a mortgage CDO. This security would likely have a triple-A rating from two major rating agencies. The security itself was at the time of its pricing considered very low risk. Its spread to Libor in 2006 might have been 30 basis points.

The next leg of the trade is where AIG comes in. The bank or brokerage owning the AAA security then went and bought an additional layer of protection from AIG FP. On the surface, this made the trade even safer, because AIG was also AAA. So the bank owned a AAA asset, protected by a AAA insurance company. A belt and suspenders approach.

Not really, because the likelihood of AIG being able to pay off this claim was low. The risk of losses was then considered miniscule, but they were no further reduced by the purchase of an additional layer of protection from AIG. The reason for this is that AIG, through the process of writing hundreds of billions of this protection, became perfectly correlated with the assets it was insuring.

The analogy of a passenger on the Titanic buying life insurance from another passenger on the Titanic is apt. It doesn’t make much sense, but the Titanic is unsinkable. And home prices never decline.

Why would banks buy protection they knew was unlikely ever to pay off? Because traders had an enormous incentive to do so, even knowing the value of the protection would likely never be realized.

In our example, the bank owns the asset and earns 30 basis points, assuming it funds itself at Libor. On a $1 billion CDO tranche, the trader would earn about $3MM per year on this position. Not bad, but a clever trader can do better.

If the trader pays 10 basis points to AIG FP for protection on the asset, the net spread falls to 20 basis points. But by hedging the asset with AIG he or she could capture the full present value of that 20 basis point stream into current income. So on the same $1 billion CDO tranche, with an average life of 10 years, the trader might recognize close to $20MM immediately. From the bonus-minded trader’s perspective, making $20MM today is far better than making $3MM per year for 10 years.

This explains why a banker might buy insurance from an entity whose very existence is so highly correlated with the risk he is insuring. Not so much greed, or the lack of regulations, but the presence of bizarre regulations. This also explains why firms such as Goldman Sachs and Bank of America found themselves so heavily exposed to AIG.

But why was Goldman Sachs first in line at the bailout parade? Goldman Sachs representatives have alternatively said their exposure to AIG was “immaterial” or “hedged.” Goldman Sachs spokesman Michael DuVally recently told Bloomberg that “Goldman Sachs would have been unaffected by the failure of AIG.” Well, $12.9 billion is not immaterial, so the only reasonable explanation is that their net exposure to AIG was immaterial because they had hedged.

Which would mean that when the government paid AIG’s claims, Goldman Sachs had something like a $12.9 billion windfall gain on its hedges. We know Goldman Sachs is populated with smart traders, so it is perfectly believable that they had taken precautionary measures to protect themselves against an AIG payment failure. They may have hedged with Credit Default Swaps or some other instrument. It does not really matter, because, taken at its word, Goldman did not need the government bailout money.

Given how unseemly it is for Goldman to have taken this taxpayer money, which it didn’t need, while their former chairman was running the Treasury Department, one might expect, or even demand, that they pay it back. In the scheme of things, the bonus payments the Obama administration is so fussed about are a pittance compared to Goldman’s apparent double dip.

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