The Media is Wrong about Goldman Sachs, AIG

This week brings us a joint effort from the New York Times and Reuters, reminding us all that Goldman Sachs is the devil incarnate and without the generous AIG bailout, they'd be just as hosed as their more earthly competitors:

Goldman Sachs Group Inc could have suffered dramatic losses if the federal government had not intervened to prop up American International Group Inc , according to a government report..n>.n>

It was revealed in March that Goldman received $12.9 billion in payments and collateral from AIG. (emphasis mine)

Well, nothing to really hammer home your agenda like rank speculation and utterly horrific summation. The TARP report (or SIGTARP) is 32 pages long, and traces the AIG bailout/credit default swap settlement from start to finish. The NYT article, at 350 words, focuses on a very small, cherry-picked section of the report's contents, and it ignores what I believe is the far more important point: Government (Treasury, Fed) officials failed to embrace their duty to the American people with hasty, and not particularly well-thought-out decision-making. That's right folks, I am defending not just Goldman, but the other banks that were paid "effectively par" (which is the report's language) on their credit default swaps with AIG as well.

From where do I draw this conclusion? From the actual report, which I read, carefully, in its entirety. Now, let me be clear: I fully understand the fear and uncertainty that motivated regulators to act quickly last autumn. But as the adage goes, "haste makes waste," and unfortunately that's exactly what happened with AIG. The following are pulled directly from the report filed by the Special Inspector General for the Troubled Asset Relief Program, issued yesterday, with page numbers for each quote, lest anyone doubt my integrity.

On September 15th, 2008, AIG's long-term credit rating was downgrades, and, without some kind of assistance, the company faced bankruptcy. FRBNY [Federal Reserve Bank of New York] believed that a consortium of private banks would be able to offer assistance to AIG. The consortium, however, believed AIG's liquidity needs exceeded the value of the company's assets, and the private sector solution failed in the wake of the bankruptcy of Lehman Brothers (pp. 6)

The next day, scared to the gills of having another Lehman (my thoughts on the handling of that case notwithstanding), the Powers That Be decided to extend an $85 billion revolving credit facility to AIG. That's all well and good - we were all afraid of collapse then - but in their haste, said Powers failed to analyze the terms attached to the facility, a decision which would come back to haunt them only a short time later.

In a rush to take action quickly, FRBNY did not craft its own terms and instead simply adopted in substantial part the economic terms of a draft term sheet under consideration by a consortium of private banks, which included a very high interest rate. The terms of this agreement, including the substantial increase in the amount of AIG debt and the substantial interest rate, would later put AIG's credit rating in jeopardy once again, requiring additional Government action. (ibid)

So the consortium, which actually put some (although its not clear how much) time/effort into analyzing an emergency credit facility for AIG came back with a firm "No way, Jose," but the Fed gave it the green light, anyway. Huh.

The group (consortium) developed a loan term sheet, but an analysis of AIG's financial condition revealed that liquidity needs exceeded the valuation of the company's assets, thus making the private participants unwilling to fund the transaction. FRBNY officials told SIGTARP that, in their view, the private participants declined to provide funding not because AIG's assets were insufficient to meet its needs, but because AIG's liquidity needs quickly mounted in the wake of the Lehman bankruptcy and the other major banks decided they needed to conserve capital to deal with adverse market conditions. (pp. 8)

Terrified of repeating history, the feds went too far in the opposite direction. Immediately realizing their mistake in letting Lehman fail, the Fed decided the best course of action was to do the complete opposite with AIG and hastily throw money at the problem.

In the final analysis, the Federal Reserve and Treasury believed that the risks of not rescuing AIG outweighed the risks associated with rescuing the troubled insurance company, and on September 16th, 2008, the Federal Reserve Board authorized an $85 billion credit facility for AIG. (pp. 11)

And so it went, which was all well and good, except, as previously mentioned (again, emphasis mine):

FRBNY did not develop a contingency plan in the event that the private financing did not go through and did not conduct an independent analysis regarding the appropriate terms for Government assistance to AIG; instead it used in substantial part the economic terms of the private sector deal, albeit for $85 billion instead of the $75 billion prepared by JPMorgan Chase for the unsuccessful private sector solution. (pp. 11)

So the NY Fed floated a loan to a company spiraling into the abyss that pushed them even further into it. Brilliant. This was supposed to be emergency rescue financing, not LBO debt on a junk-rated company! Did anyone at the Fed bother to actually read the term sheet before they gave it their John Hancock?

An FRBNY official told SIGTARP that, by September 17, 2008 - the day after FRBNY provided initial assistance to AIG and two days after AIG's Ratings downgrades - it was clear that the rating agencies were planning another downgrade of AIG because of the deteriorating financial condition of the company and the impact of the $85 billion FRBNY loan could have on AIG's capital structure, including the high interest rate payments AIG would have to make to FRBNY. (ibid)

Well, if there's a silver lining at least they realized their mistakes almost immediately! Wait. It took them almost two months to do something about it? Well, at least they used that time to roll up their sleeves and use their negotiating leverage to pressure counterparties into cooperating, right? Wait again. After retaining Blackrock to advise on possible solutions, the Fed chose not to apply pressure to AIG's counterparties, but actually did the opposite, selecting the option lease likely to require negotiation, and most likely, in their eyes, of being accepted ASAP.

The third option, which FRBNY eventually selected, was to create a SPV to purchase the underlying CDOs from AIGFP's counterparties, in connection with a termination of the related CDS. Within this option, BRS noted that counterparties could receive effectively par value or FRBNY could seek a reduction in the amount that counterparties would receive - otherwise know as concessions or a "haircut" - for the total of the CDOs and related swaps held by each of AIGFP's counterparties. FRBNY's AIG monitoring team explained that this structure had the benefit of minimizing valuation disputes with counterparties, because combining the payment by Maiden Lane III for the CDO's and the offset of collateral for the tear-up of the CDS contracts eliminated the need to agree with counterparties separately on the market price of the CDOs and the value of the CDS contracts. Blackrock assessed this option as having a "high certainty of execution" and the "simplest structure." FRBNY officials told SIGTARP that this structure was also attractive because it fit within the legal authorities of the Federal Reserve to lend against collateral. (pp.14)

So, despite having what most sane, reasonable people would consider significant negotiating leverage with AIG's counterparties (given the various Fed programs keeping banks afloat), the brain trust at the Fed decided to go with "simple" and "easy." In fairness to the staff at the Fed, they did actually "try" to negotiate haircuts on the CDS, but to no avail. Maybe their lack of success had something to do with the fact that from the get-go, they called AIG's eight largest counterparties - SocGen, Goldman, Merrill, Deutsch Bank, UBS, Caylon, Barclays, and BofA - on the phone (strike one), and stressed that any concessions were voluntary (strikes two and three, in my book). Seven of eight refused any concessions, and the only bank to budge, UBS, conceded to only a 2% haircut if and only if all the other banks agreed to the same.

By this time, Fed officials were worried about further ratings downgrades if they could get the counterparties to agree to reductions in payments. Interestingly, it doesn't appear anyone from the Fed actually spoke to any of the ratings agencies to let them know what was going on.

So, why, exactly, did AIG's counterparties think they could stand tall against the Fed, given their seemingly inferior negotiating position?

· They had collateral already posted by AIG to protect against the risk of AIG default. That, plus the fair market value of the underlying CDOs equaled par value of the CDS. Thus, from the counterparties perspective, offering a concession would mean giving away value and voluntarily taking a loss, in contravention of their fiduciary duty to their shareholders.

· In addition to the collateral, they had a reasonable expectation that AIG would not default on any further obligations under the CDS because the U.S. Government had already demonstrated that it would not allow AIG to go bankrupt.

· They had already incurred costs to mitigate the risk of an AIG default on its obligations that would be exacerbated if they were paid less than par value.

· They were contractually entitled to the par value of the CDS (pp. 16)

As I've written previously and above, the counterparties presented a pretty strong case as to why they were entitled to par on their CDS contracts. Also, the above bullet points - notably the first two - show, the Fed was severely outmatched at the negotiation table. It seems each time they showed up to the table they were fantastically unprepared for what they encountered, suggesting that they should have consulted, or heeded the advice of professionals more experienced with such negotiations.

Many observers (like derivatives expert Janet Tavakoli) have pointed an irate finger specifically at Goldman Sachs, as if

1. They were the only bank that was paid at effectively par,


2. They were lying about the extent, magnitude, and degree of their exposure to AIG on the CDS.

Again, as I've said in the past, the only way for her - or anyone else for that matter - to make such a ridiculous statement would be if they'd seen Goldman's trading book when this all went down, which, as far as I know, no one outside Goldman has.

Until now. SIGTARP actually went to the source and asked Goldman to defend themselves against such criticisms. To summarize the Masters of the Universe from 85 Broad:

· Goldman did NOT own the underlying CDOs; on the contrary, they'd sold equivalent protection on CDOs owned by its clients, and hedged its exposure by buying protection from AIG. If Goldman conceded to the Fed's request for a haircut, they would have taken a loss on their obligations to their clients.

· The Maiden Lane III settlement with Goldman covered $13.9 billion of swaps, however on that portfolio, Goldman already had $8.4 billion of collateral from AIG to cover a drop in value of the underlying to that point based upon AIG's calculations. However, Goldman calculated the loss was actually $9.6 billion, and had purchased additional protection to cover the difference. Thus, the $8.4 billion in collateral, the $1.2 billion in additional protection, and their calculated FMV of the underlying at that point of $4.3 billion meant Goldman would have been made-whole (received par) if AIG defaulted.

· Goldman had collected collateral on other hedges, and they claim that even if AIG had defaulted (gone bankrupt), they would have been "ok." (pps. 16-17)

I find it relatively unlikely we'll get much more detail out of Goldman, for what its worth, to judge how true such claims are or may have been at the time.

Interestingly enough, while it seems to me (and several other observers) that the Fed should have had the upper hand in its negotiations, its employees and officials believed otherwise. Reasons given:

· The greatest leverage that FRBNY might have had - the threat of default and an associated AIG bankruptcy - was effectively removed by FRBNY's intervention in September, and intervention that the counterparties understood to mean that the U.S. government would not permit an AIG failure. The officials stated that ethical constraints prevented FRBNY from even suggesting that it would allow bankruptcy when it in fact would not do so.

· In addition, FRBNY was concerned that its use of a threat of an AIG default might introduce doubt into the marketplace about the resolve of the U.S. Government in following through on its commitments in support of financial stability. FRBNY officials felt the introduction of such uncertainty might have been dangerous and potentially expensive for the U.S. economy in light of the precarious market conditions in November, 2008 and the extraordinary official efforts that had been taken to support market functioning.

· FRBNY was further concerned - as it was throughout the AIG rescue - about the reaction of the ratings agencies. While threatening not to support AIG might have been useful for purposes of forcing concessions by the counterparties, it could also have been viewed by the credit rating agencies as an indication that the FRBNY and the U.S. Government was not standing fully behind AIG, which could have had a negative impact on AIG's credit rating.

· As a policy matter, FRBNY was unwilling to use its leverage as the regulator for several of the counterparties to compel concessions, in part because in the negotiations it was acting as a creditor of AIG and not as the counterparties' primary regulator.

· Also as a policy matter, FRBNY was uncomfortable with violating the principle of sanctity of contract.

· The refusal of the French Banks to negotiate concessions played a significant role in complicating FRBNY's efforts. FRBNY views treating all parties equally as one of its "core values," and it did not want to be perceived as making a more favorable deal with the French institutions than with the domestic institutions. Indeed, FRBNY recently suggested that the requiring concessions from some banks while not requiring concessions of others was not consistent with the principles found in Section 4 of the Federal Reserve Act (requiring the Federal Reserve to treat member banks and banks equally) and the principles of national treatment and equality of competitive opportunity in the International Banking Act (requiring that domestic banks and branches of foreign banks be treated equally). (pps. 18-19)

While I sympathize with the no-doubt difficult, if not unprecedented, position in which the staff of the Fed found themselves last fall, I don't agree with their rationale for not pushing harder in negotiations with AIG's counterparties. By the time the Fed asked (why they didn't "tell" or "strongly suggest" is beyond me) the counterparties to take a haircut on the CDS, they'd already ceded the top position at the negotiating table, but instead of standing tall, they folded like a lawn chair.

Could Goldman (and to a lesser extent, the other counterparties) have been more grateful for the Fed's intervention? Absolutely. But that's another story of horrendous public relations, and doesn't materially affect the facts relating to the transactions themselves.

If the American people have any rightful anger, and deserved ire about the AIG swaps "bailout," it should be directed at the AIG and AIGFP employees and executives who were directly responsible for the risk management regime predicated on foolish risks, the Ratings Agencies who didn't recognize the risks until it was too late, and the U.S. representatives from the Fed, Treasury, etc who - as the last line of defense - failed to exercise prudent banking practices in their rush to avert possible catastrophe.

Contrary to some other relatively extreme observers, I've yet to find evidence of any conspiracy here, especially since Occam's Razor indicates there's a much simpler explanation: We're all human, and we all make mistakes, or decisions we wish, with the benefit of hindsight, that we'd made better or differently. The Fed found itself at each step of the way in an unenviable position between a rock (likely AIG bankruptcy) and a hard place (being perceived to funnel bailout funds to the banks through AIG). If they'd gone the other direction, they'd no doubt be suffering similar - or worse - criticism for their actions. All things considered, and all things equal, I think there's far more important things for all of us - taxpayers, Wall Streeters, politicians and regulators, - on which to focus our time and energy.

Presented by

Jordan Terry

Jordan S. Terry is Founder & Managing Director of Stone Street Advisors LLC, which provides independent financial research & analysis services to institutional investors.

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