What Did Paulson Know, When Did Geithner Know It?

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“Net-net, I would think we had a gain over the time. I don't think it was particularly material to Goldman Sachs, but net-net, I think we had a gain.” -David Viniar, Goldman Sachs CFO, March 20, 2009

On March 18th, I wrote in “Goldman Sachs’ AIG Double Dip?” that, since Goldman Sachs claimed to have no material unhedged exposure to AIG, the government bailout must have represented a windfall to Goldman. They got the collateral they needed from the government, and they “double dipped” because their hedges made money. Goldman CFO Viniar has now admitted as much, although he claims the amount is not material.

Now, what is material to you and me might not be material to Goldman Sachs. But I would wager that if we were to define “material” as “more than the $165 million AIG bonus pool everyone is so excited about”, then the windfall was probably material.

Still, our quibble must not be with AIG employees who had the bad taste to accept their contractual compensation. It is not really with Goldman, for being clever enough to get paid twice for the same risk. Our outrage must be directed at those who made AIG’s mess the public’s mess. Those who put the U.S. taxpayer at risk under the questionable threat of systemic collapse. The focus should be on Treasury secretary Timothy Geithner and his predecessor Hank Paulson.

It is not surprising that Goldman Sachs hedged itself against AIG’s collapse. Since Goldman bought insurance on CDOs from AIG, and probably knew they weren’t alone in this trade, they certainly realized that AIG was heavily exposed to the impending housing correction. It was back in 2007 that the super-senior tranche of the ABX index started to explode in spread, and this is about the same time, according to Viniar, that Goldman began hedging their AIG exposure.

Good risk management, apparently. So Goldman, at the top of the list of those bailed out in the AIG debacle, did not need the money. Who did? Were Citibank, Merrill and Bank of America completely unhedged? If they were hedged, even partially, did they really need the bailout funds? If domestic banks were hedged, how was it that the collapse of AIG would lead to an implosion of the world financial system?

What really needs to be clarified is why Paulson and Geithner started us down this path. How did they become convinced that AIG’s demise would lead to the end of our financial system? Did they ask if the main counterparties to AIG had, like Goldman, protected themselves? The question is not why an institution 80% owned by the government is paying bonuses; the question is why that institution came to be owned by the government in the first place.

It is time to clarify how we came to this pass. Congress must compel former Treasury secretary Paulson and current Treasury head Geithner to answer some questions about what happened last fall. Here is an initial list.

1) News reports have circulated stating that last fall bank executives met with both of you gentlemen to discuss a bailout of AIG. Mr. Paulson, Mr. Geithner, with whom on Wall Street did you discuss the travails at AIG over the last part of 2008? What was their advice?

2) The view that the failure of AIG would risk systemic collapse was apparently shared by both of you. How did you reach this conclusion? What specific evidence did you have that AIG’s failure would cascade through the system?

3) When did you realize that the largest beneficiary on the list, Goldman Sachs, had protected itself well enough that it had no material exposure to AIG?

4) Goldman Sachs had collateral and hedges to protect itself against AIG’s default. Which banks did not?

5) When did you realize that if the taxpayer were to fund a risk Goldman had already hedged, Goldman would receive a windfall gain?

6) Concerning the other U.S. banks on the list. Did they also hedge, in whole or in part, their AIG risk and thereby receive windfalls when the bailout funds came in?

7) We now know the original $85 billion was a very low estimate of the amount of money AIG would ultimately need. Did the $85 billion reflect the full expected-loss at the time? If not, why was Congress not told that the final bill was likely to be much higher?

8) When did you realize that almost two-thirds of the initial $85 billion was to go to non-U.S. banks? Did you feel it was relevant to Congress’ approval of this expenditure to know that most of the money would service non-U.S. institutions?

9) Mr. Geithner, in your March 2nd press release announcing further aid to AIG you mentioned the risks to the millions of policyholders of AIG in the U.S. Are not these policyholders protected by separate capital pools and therefore insulated from the woes of the holding company? Can you explain specifically how the problems within AIG FP affect the policyholders of the insurance companies?

10) Assuming there is some risk to policyholders, back in September, when AIG was first approaching us for aid, did you consider taking proactive measures to help protect AIG policyholders by placing AIG’s insurance subsidiaries in stronger hands? Were potential buyers of AIG’s insurance subsidiaries contacted?

Lately Congress has been far more insistent when it comes to seeking answers to tough questions. This is a welcome relief from last fall, when they seemed content to let experts dictate terms to them. We have allowed the threat of systemic failure to justify unlimited public expenditures, with very little evidence of how the dominoes supposedly might fall. The Goldman story shows a robust system, not a weak one. It’s time for our leadership to explain why they initiated this flawed bailout.

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