Should Goldman Have Been Nicer to AIG?

The Financial Crisis Inquiry Commission grilled Goldman Sachs bankers again this week. Some commissioners appeared to believe that the bank acted improperly by aggressively demanding collateral on derivatives AIG had insured which had lost value. This, however, was a legitimate action, since these assets actually were worth as little as Goldman thought -- if not less. Consequently, I argued that Goldman was right to demand this capital, so the FCIC's time could be better spent searching for more blameworthy causes of the crisis.

Felix Salmon defends the FCIC on this one, saying that this is a worthy investigation:

The fact is that the financial crisis had many moving parts, all of which were interwoven with each other, and one of the central ones was the collapse of AIG. It's reasonable to say that if AIG had not collapsed, then the crisis would not have been as bad as it was -- and it certainly wouldn't have been nearly as expensive as it turned out to be for the US government.

Was Goldman only doing its job when it started demanding ever-increasing amounts of collateral from AIG? Certainly, yes. But in doing so, it helped to bring down a venerable insurance company, and cost the US taxpayer the best part of $100 billion in bailout funds. Some of that money will end up being repaid, with interest; the chances are that much of it won't be. So this is a perfectly legitimate subject for the FCIC to investigate.

Certainly, the failure of AIG had a lot to do with the crisis. But the question to ask is: did Goldman cause AIG to fail, or did AIG do so by making incredibly poor bets on its derivatives? Many other banks demanded more collateral from AIG as well once they realized, as Goldman did, that the mortgage market had collapsed. Goldman just did so earlier and more aggressively.

The way to determine whether or not the inquiry is legitimate is to wonder whether AIG would have had a different fate if Goldman hadn't been so aggressive. Of course, it wouldn't have. Even more modest collateral calls would still have eventually eaten through its capital. Salmon continues:

If the AIG insurance contracts had simply been allowed to stand and slowly unwind, rather than being torn up at great expense to the government and concomitant benefit to Goldman Sachs, the amount of damage done would have been much smaller.

This sounds like an argument to suspend realistic valuations of assets based on new assumptions as the market changes and rating agency downgrades until you know the economy is back to normal again, whenever that may be. That's an interesting idea, but it certainly wasn't within the power of regulators, without some aggressive new rulemaking. Such a move, however, would seriously undermine markets, since it would mean that contracts wouldn't reflect market realities, but the regulators' whims.

In the meantime, within the market where we actually lived, Goldman was acting rationally and on the behalf of its shareholders. The idea that banks aren't profit maximizing, and merely benevolent firms looking out for the interest of counterparties that make stupid decisions might be a pleasant fantasy for frustrated regulators. But that's not how the real world works. The contracts demanded collateral, so Goldman requested it. If AIG didn't want Goldman to have as much discretion on naming the value of the insured assets, then it should have been smart enough to request a 3rd party calculation agent, which isn't uncommon.

The underlying argument that Goldman behaved badly also implies that panic played a major part in AIG's undoing. It certainly helped, but there was more than simply panic at play: there was legitimate deterioration in the market that majorly affected the firm's capital and liquidity. Even though panic certainly made matters a little worse for AIG, it would have failed anyway due to insufficient capital and the market realities at the time. As a result, it's hard to understand how there is any blame to be placed on Goldman for putting pressure on a domino of the financial crisis that had already begun to fall.

AIG failed because it bet badly and didn't have the capital to back up its poor decisions. Goldman was just on the other side of some of those bets. If AIG can prove that it would have survived without Goldman's demands, but with the demands of other banks in conjunction with the market realities at the time, then I will agree that Goldman should be blamed for single-handedly bringing down AIG.