One of the most frequent complaints leveled against Timothy Geithner is that he let Goldman get away with murder when he allowed AIG to pay off its CDS counterparties at 100 cents on the dollar. Economics of Contempt, one of my favorite bloggers, had a great post on this a while back, dubbing this the "Immaculate Negotiation" theory of the crisis:
Let's go over this again. (The numbers are from a conference call that Goldman held in March to discuss this very issue.) The total notional amount of CDS protection that Goldman bought from AIG was roughly $20 billion. But "exposure" in credit derivatives is equal to the cost of replacing a credit derivative in the market, not the notional amount of the transaction. Think about it this way: if you buy a $300,000 homeowners' insurance policy on your house, and your insurer goes bust, you're not out $300,000. The cost to you is simply the cost of buying another insurance policy to replace the first one. In Goldman's case, the cost of replacing its trades with AIG was about $10 billion. Against that $10 billion, Goldman held $7.5 billion in cash collateral. It then hedged the remaining $2.5 billion of exposure with CDS on AIG. This is why Viniar said that Goldman's direct exposure to AIG was immaterial.
So what are Tavakoli's arguments? One is the Immaculate Negotiation argument:The government could have stepped in and renegotiated its contracts. ... Goldman Sachs would have been out billions of dollars in collateral had a bankruptcy‐like settlement been negotiated with AIG, and that is material.Saying that Goldman would've taken a material loss if "a bankruptcy‐like settlement been negotiated with AIG" is the equivalent of saying that Goldman would've taken a material loss if they'd agreed to take a material loss. It's true, but there's no way Goldman would ever have agreed to a "bankruptcy-like settlement" -- why would they? As someone who has actually been involved in these kinds of negotiations, let me explain how the AIG/Goldman negotiations would have played out:AIG: Would you be willing to accept, say, 70 cents on the dollar?Seriously, what could AIG have threatened Goldman with? If they didn't accept a haircut, AIG would file for bankruptcy? Fine, Goldman would've just seized the $7.5 billion in cash collateral, and collected the remaining $2.5 billion from its counterparties on the now-triggered CDS on AIG (on which more below), covering Goldman's full bilateral exposure to AIG. That's what it means to be "hedged."
(This is also why the Fed paid Goldman and the other counterparties 100 cents on the dollar to terminate their CDS contracts with AIG, which this Bloomberg article portrays as some sort of gift to the banks. But the Bloomberg article also relies on the Immaculate Negotiation argument -- how, exactly, was the Fed supposed to get the counterparties to agree to take a haircut? The Fed had just demonstrated to the entire world that it wasn't willing to let AIG file for Chapter 11. How do you suppose those negotiations would have gone? The Fed couldn't say, "You can either take a haircut to 70 cents or AIG will file for bankruptcy and you'll only get 50 cents," because everyone knew the Fed wasn't willing to put AIG in bankruptcy.)
Today he reads the TARP watchdog report and pronounces himself vindicated:
Despite the overtly political "conclusions" and "lessons learned" sections (sadly, the only sections journalists read), the SIGTARP report (finally) gets a lot of the real facts out in the public domain, so we can finally talk about them now. The SIGTARP report confirms that:
1. First, AIG tried to negotiate haircuts on its CDS contracts, but counterpar
ties refused (as was their right):AIG was attempting to resolve its liquidity crisis caused by the collateral posting requirements by negotiating a cash payment to the counterparties in return for terminating the credit default swaps. ... While FRBNY was conducting analysis on alternative solutions, AIG's attempts to negotiate the termination of its multi-sector credit default swap book with its counterparties were failing. AIG requested FRBNY's assistance in securing these terminations.2. Contrary to the constant claims of ill-informed pundits, the NY Fed did try to negotiate haircuts with AIG's counterparties:On November 6 and 7, 2008, FRBNY assistant vice presidents, vice presidents, senior vice presidents, and executive vice presidents contacted eight of AIGFP's largest counterparties (Société Générale, Goldman Sachs, Merrill Lynch, Deutsche Bank, UBS, Calyon, Barclays and Bank of America) by telephone. They described a proposal under which each counterparty was asked to accept a haircut from par. Seven of the eight counterparties told FRBNY officials that they would not voluntarily agree to a haircut. The eighth counterparty, UBS, said that it would accept a haircut of 2 percent as long as the other counterparties also granted a similar concession to FRBNY. FRBNY officials told SIGTARP that their concerns about credit rating downgrades limited the time available for negotiation about reductions in payments.3. The NY Fed tried to get the French bank regulators to help them negotiate haircuts with SocGen and Calyon--two of AIG's biggest counterparties--but not only did the French regulators refuse to help, they specifically instructed SocGen and Calyon not to agree to any haircuts (rendering UBS's conditional acceptance of a 2% haircut moot). From the report:During these negotiations, an FRBNY executive vice president and senior vice president contacted the Commission Bancaire to inform them that the FRBNY was conducting negotiations with Société Générale and Calyon, two of the counterparties with the largest credit default swap contracts with AIG, and was requesting their support. The Commission Bancaire then contacted the firms. The Commission Bancaire spoke again with FRBNY and forcefully asserted that, under French law, absent an AIG bankruptcy, the banks could not voluntarily agree to less than par value for the underlying securities in exchange for terminating the swap contracts. Thus, the French banks claimed they were precluded by law from making concessions and could face potential criminal liability for failing to comply with their duties to shareholders.
What could the Fed have done? It could have abused its regulatory authority: threatened the banks that wouldn't play ball with some sort of retaliation. But this would probablyhave created deep problems with the French. It would also have further devastated a shaken banking sector. Leaving aside the morality of using regulatory authority for unauthorized purposes, countries where the regulator arbitrarily uses its authority to secure sweetheart deals for the government do not have robust, thriving financial sectors.
Yes, yes, I know--ours isn't so hot either. It's pretty galling how little pain the remaining banks have suffered as a result of the crisis.
But really, you'd like living with a third world banking system, and the slow economic growth it tends to generate, even less. Banking, more than any other industry, is built on trust in the future. If people think their savings can at any time be diverted into government coffers by the will of the regulator, they move them elsewhere, or stop saving entirely.
This article available online at: