Image courtesy of flickr/John Wardell
AIG disclosed some of the firms that benefited from the government bailout. Essentially, the government money was largely used to pay off other firms. I have a few comments.
1. AIG’s customers were either using AIG for hedging positions or speculative positions. This was mainly done through Credit Default Swaps. These CDS essentially “insure” risky corporate debt – if the CDS is used along with a position in corporate debt. For example, you could buy Ford bonds and simultaneously protect against a default by purchasing CDS from someone like AIG. You are hedged but (and this is a big but) only fully hedged if AIG stays in business.
2. For the hedgers, they failed to properly take the risk of the insurer into account. Parties on the other side of these contracts need to share some of the responsibility. Goldman, for example, was not doing business with the U.S. government – they were doing business with a corporation. This is not the same thing as Goldman having a savings account where the FDIC is covering $250,000 – yet that is how we are treating it. The U.S. taxpayer should not be obligated to make whole all these counterparties who miscalculated the risk of AIG. We are bailing out bad risk management and it is not fair to the American taxpayer. As for the speculators, why should they be bailed out? It’s like bailing out someone who lost at the craps table.
3. It is not surprising that many of the counterparties are foreign. I don’t think the foreign firms should be treated differently. Domestic firms, foreign firms, municipalities, all failed in their risk management. They all should bear some of the cost.
4. From the AIG press release:
American International Group, Inc. (AIG) recognizes the importance of upholding a high degree of transparency with respect to the use of public funds. As a result, after close consultation with the Federal Reserve, AIG is disclosing information identifying certain credit default swap counterparties, municipal counterparties and securities lending counterparties.
What does “certain” mean? Does it mean “a select number”? Does it mean “”all”? If it was “all”, why didn’t they say “all”. How can they call this a “high degree of transparency”?
5. The real story here is for someone to figure out how much more the American taxpayer is potentially on the hook for. AIG has been to the trough four times and now has $180 billion of our money, roughly $1,200 for every working (and seeking work) American. It seems like there was little or no due diligence done on the original government dole out. Transparency to me implies a level of disclosure such that we can figure out the future obligations. How much more will they likely need? $50b, $100b, $300b? We have no way of determining this. This type of forward looking analysis needs to be done as a prerequisite for any future taxpayer money.
6. The other sub-story here is size. AIG has many good business units. However, because they were a conglomerate, the good businesses are being punished for the incompetence of a small number of their business units. With smaller specialized units, we would not be in this situation. AIG could not make the “systemic risk” AKA “too big to fail” argument (as they do on their website).
7. The final sub-story is the following. The U.S. taxpayer is “the” stakeholder in AIG. It is not clear to me that the corporate governance in AIG has shifted from maximize shareholder value to ‘do what’s best for the American economy’. For example, full transparency is necessary. Uncertainty about the future health of AIG and the size of future government obligations, works against the recovery of the U.S. economy.
Read the AIG release here.
AMEN! Keep telling the truth, Cam, sooner or later it will matter (I hope).
How is it possible to lose $40 billion doing securities lending. What were they doing with the collateral? I haven’t seen anything on this.
I agree with you, it is time for regulators to take a hatchet to financial institutions that are too big to fail and where a business miscalculation or venality leads to systemic risk. Big organisations are also more prone to the herd instinct.
As regards naivete by counterparties to AIG: it would appear from other commentary that Goldmans didn’t think AIG couldn’t fail, since they insured their exposure to CDS on AIG with other financial institutions! I don’t think many others did, though.
Here is the Reuters interview with key information:
A day ahead of the hearing, Reuters posed 10 questions to
Goldman about these issues. The following are the questions and
the answers from Goldman spokesman Michael DuVally:
QUESTION: If Goldman Sachs was collateralized and hedged on
its AIG positions, why did it take $12.9 billion of taxpayer
money?
ANSWER: “Goldman Sachs has maintained that its exposure to
AIG was collateralized and hedged. The majority of Goldman
Sachs’ CDS (credit default swap) exposure to AIG Financial
Group was collateralized. That means that Goldman Sachs had
collateral. To the extent it wasn’t collateralized, Goldman
Sachs hedged its exposure via the credit default swaps market.
If the government had allowed AIG to fail, Goldman Sachs would
have received its collateral. A credit event would be
triggered, and Goldman Sachs would receive a payout from the
credit default swap insurance that it had. This is from other
counterparties.”
Separating out the money Goldman received due to AIG’s
securities lending obligations, DuVally said: “AIG was not
allowed to fail. So there was no payout from the hedges.
Additionally after the bailout there was some additional
deterioration in AIG’s position. Under the terms of the
contracts that Goldman Sachs had with AIG, it was entitled to
collateral. We were always fully collateralized and hedged.”
QUESTION: Did then-U.S. Treasury Secretary Henry Paulson or
his aides discuss Goldman’s exposure to AIG with Goldman Chief
Executive Lloyd Blankfein or any other executive or director of
the bank? Also, if they did, what was the substance of the
conversations, and did Goldman Sachs take any position on
whether AIG should be saved?
ANSWER: “Goldman Sachs was not party to any discussions
about the bailout of AIG.”
QUESTION: Did Goldman do any due diligence on AIG before
buying credit default swaps (CDS) from it?
ANSWER: “We do extensive due diligence on all our
counterparties.”
QUESTION: From what other institutions did Goldman buy CDSs
to insure its collateralized debt obligations or other
securities?
ANSWER: “We do not disclose counterparty information.”
QUESTION: How did Goldman account for the counterparty risk
in its dealings with AIG?
ANSWER: “We made sure our positions with AIG were
collateralized and hedged.”
QUESTION: Did Goldman have more exposure to AIG through
CDSs than that disclosed by AIG on Sunday? If yes, how much
is/was that exposure?
ANSWER: “The disclosures by AIG encompass all the
collateral received by Goldman Sachs on its credit default swap
positions with AIG financial products for the period from
September through the end of the year.”
QUESTION: Why did Goldman decide to close its securities
lending transactions with AIG?
ANSWER: “AIG could not return the cash it owed to Goldman
Sachs under the terms of the transaction. It was the terms of
the agreement. Note that Goldman Sachs had the ability all
along if AIG could not honor its transaction to sell those
securities into the market. Note that those securities which
still had value went back to the government.”
QUESTION: Was the value of the securities returned to AIG
less than the cash received from AIG?
ANSWER: “They were equivalent. Under the terms of the
agreement if the securities Goldman Sachs borrowed had declined
in value, Goldman Sachs had the right to request that part of
the cash collateral it posted to AIG be returned.”
QUESTION: Has Goldman Sachs received more money from AIG to
satisfy counterparty obligations since the end of 2008, and
what did it receive before Sept. 16?
ANSWER: “We are not disclosing the amount of collateral we
received from AIG before the government bailout nor after the
end of 2008. We can say that our notional exposure to AIG is a
fraction of what it was at the time of the September bailout.
And as has been the case, our exposure remains collateralized
and hedged.”
The key is the answer to question 1:
If the government had allowed AIG to fail, Goldman Sachs would
have received its collateral. A credit event would be
triggered, and Goldman Sachs would receive a payout from the
credit default swap insurance that it had. This is from other
counterparties.
It is not clear to me what this collateral is and how much of the exposure the collateral covers. Second, it is not clear to me that receiving a payout on insurance it had from other counterparties was fully or partially hedging them. Finally, if AIG went down, it is possible that their other counterparties would go down too – leaving them with no insurance.
Cam:
G. Morgenson’s NYT article about the demise of Lehman would call into question Goldman’s answer to the question about discussions with Paulson about an AIG bail-out:
https://www.nytimes.com/2008/09/28/business/28melt.html?_r=2&hp&o
Can you explain how the CDS’s pay out. I have heard that it is not a lump sum in the event of a default, but some kind of payment stream (maybe to cover lost coupon payments). I have no idea if this is true, but if it is, it would seem that it would indeed be very difficult to calculate future taxpayer “obligations”.
Here’s a good primer on CDS
https://www.securitization.net/pdf/content/Nomura_CDS_Primer_12May04.pdf