A New Wrinkle In The Goldman-AIG CDO Mess

Bloomberg breaks more news today about the ongoing fiasco involving Collateralized Debt Obligations (CDOs), Goldman Sachs, AIG, the New York Fed and Rep. Darrell Issa (R-CA). Documents finally released from the NY Fed after about a year indicate that Goldman Sachs created more of the toxic CDOs insured by AIG than any other bank, which played a part in AIG's troubles and eventual bailout. Those securities were so bad that they sometimes had losses exceeding 75% of their notional value, according to Bloomberg. If Goldman and other banks knew these securities were garbage, should they explain why they asked AIG to insure them? Not necessarily.

First, let me summarize the situation, for those who haven't been following along. During the financial crisis AIG got an enormous bailout, to the tune of $180 billion. Several months later, it was learned that AIG's bailout led to a sort of backdoor bailout for some big investment banks like Goldman. Those banks received tens of billions of dollars in cash based on swaps and other obligations that they had with AIG. This angered many, especially in Washington, who believed that this fact was hidden when they approved the bailout.

More recently, in January, the NY Fed finally released some more documents about this debacle at the request of Rep. Issa. They appeared to indicate that the NY Fed was well aware of the fact that there would be a substantial backdoor bailout for banks when AIG got its government cash, but purposely hid that fact until after Congress provided the funding. At that time Treasury Secretary Timothy Geithner was the president of the NY Fed. Yet, he says he knew nothing about the AIG bailout, because he was already recused. But that didn't prevent Congress from ripping into him during a hearing on the matter last month.

The news today provides a little bit more detail on those CDOs that AIG insured. We learned that Goldman originated a huge number of them -- more than any other investment bank at $17.2 billion. Merrill Lynch (aka Bank of America) underwrote the second most at $13.2 billion. Germany's Deutsche Bank created the third most at $9.5 billion. We also learn that they were incredibly ugly, incurring enormous losses. That means AIG had to pay up to these banks, since the firm made the mistake of agreeing to insure the bonds.

The NY Fed hid this detail for a long time, and many are critical of that decision. They believe that it misled Congress and the public. While conspiracy theorists might believe that they were in cahoots with these banks. I suspect the answer is simpler: the NY Fed was trying to stabilize the financial industry, and this detail going public sooner would certainly not have helped its cause. This doesn't necessary absolve the Fed's actions, but it does explain them.

Next, there's the question of whether or not the banks should get in trouble for seeking insurance on what they may have known were poisonous securities. One Bloomberg source says:

The banks should have to explain how they managed to buy protection from AIG primarily on securities that fell so sharply in value, says Daniel Calacci, a former swaps trader and marketer who's now a structured-finance consultant in Warren, New Jersey. In some cases, banks also owned mortgage lenders, and they should be challenged to explain whether they gained any insider knowledge about the quality of the loans bundled into the CDOs, he says.

Not really. Assuming that AIG was not misled by the banks, then I'm not sure how the banks could be held blameworthy. These guys at AIG who decided to insure the bonds were not folding shirts at their local mall's GAP for a living, so knew little about CDOs: they were financial professionals who should have understood what they were getting their firm into. If the banks provided accurate and complete information for what they requested to perform their analysis, then AIG must be held responsible for its decision to insure the securities.

Of course, if it turns out that these banks did misrepresent the CDOs, then that's an entirely different matter. That's fraud. Sue away and ready the orange jumpsuits.

You could look at this like a situation sort of like where one financial professional sells another financial professional a security. In that case, the buyer can't blame the seller if it doesn't live up to the expectations of the buyer. If he could, then there wouldn't be much of a financial market. At its very heart is the spirit of transactions where one party believes a security is worth more than another party so a trade takes place. Whoever had a better prediction of the ultimate value of that security makes a profit; whoever misjudged the security probably wishes the transaction never occurred. This fiasco involving AIG is just an extreme example of a variation on that tune.

But don't get me wrong: knowingly selling very bad securities to other financial professionals is not an advisable practice. Surely, if AIG survives, it should think twice about buying securities so easily from those banks that sold them the worst junk. That's why there's a good reason not to take advantage of those you trade with. But if a bank is willing to jeopardize its reputational risk by selling trash to unsuspecting financial firms, then it can do so if those firms are dumb enough to buy that junk after obtaining accurate information about it.