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.

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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