In all likelihood, the proximate cause of the US Government coming in and seizing AIG last year was it became all too apparent to AIG’s management, and that of its counterparts, that AIG could not post the increasing variation margin (collateral) required to sustain its derivatives positions. Absent a posting of such collateral, AIG would have been declared in default. The amount of collateral AIG would have to post as the marks started going against it — if the media numbers of $2.3 Trillion of notional exposure in CDS are correct — would have completely overwhelmed AIG. The only balance sheet capable of supporting such exposure was that of the US government. Unwinding these risk positions also would have overwhelmed the traded markets for AIG CDS and the different positions counterparties had on with the firm. All of the former investment banks (FIBs) and banks that sold protection on the AIG name would also have been overwhelmed, including those who provided hedges to GS et al.

So, Uncle Sam had to come to GS’s and the other FIBs’ rescue. Following the US’s seizure, the collateral AIG posted on the derivatives was from the federal government, and the payouts on the CDS derivs were from the federal government. Without the US Treasury’s balance sheet, or the Fed’s willingness to step in to the breach, AIG most likely would have been vaporized within hours of telling its counterparties it could not post margin to cover its open position. One can almost see the bug-eyed desperation of the credit and risk personnel as they delivered this news to the senior management at the FIBs and banks.

At that point, Treasury Secretary Hank Paulson probably was notified by his former colleagues that they and his alma mater were in dire straits. As was the rest of the financial market. Having just sent Lehman to non-performance Hell, and seeing the markets seize up, Hank did not want to visit this fate on his former colleagues and friends. They likely did not want to go thru this either. This undoubtedly was conveyed in the strongest of terms by GS’s management to Hank and his Goldman alums at Treasury often and loudly. Along with the senior managements of the other FIBs and banks.

Things never should have gone this far at the FIBs. Long before it became necessary for the federal government to seize AIG, abrogate its contracts, and assume complete responsibility for contract performance — everything from the posting of margin to counterparts to the payoff on the CDS contracts — the SEC et al should have seen the problem developing and taken preemptive action to keep the entire financial system from melting down. The FIBs — led by none other than Hank Paulson when he was CEO at GS — lobbied for and ultimately were allowed to lever their balance sheets up to 30: and 40:1, as long as they could demonstrate via their precise calculations (one imagines Wiley E. Coyote, “super genius” at the whiteboard) that they understood the risk and had it fully contained. Here’s the summary of the dispensation in the 2004 amendments contained in the SEC’s “Final Rule:
Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities,” received by the FIBs (GS, MS, MER, and LEH):

“SUMMARY: We are adopting rule amendments under the Securities Exchange Act of 1934 that establish a voluntary, alternative method of computing deductions to net capital for certain broker-dealers. This alternative method permits a broker-dealer to use mathematical models to calculate net capital requirements for market and derivatives-related credit risk. A broker-dealer using the alternative method of computing net capital is subject to enhanced net capital, early warning, recordkeeping, reporting, and certain other requirements, and must implement and document an internal risk management system. Furthermore, as a condition to its use of the alternative method, a broker-dealer’s ultimate holding company and affiliates (referred to collectively as a consolidated supervised entity, or “CSE”) must consent to group-wide Commission supervision. This supervision would impose reporting (including reporting of a capital adequacy measurement consistent with the standards adopted by the Basel Committee on Banking Supervision), recordkeeping, and notification requirements on the ultimate holding company. The ultimate holding company (other than an “ultimate holding company that has a principal regulator”) and its affiliates also would be subject to examination by the Commission. In addition, we have modified the proposed rule amendments on Commission supervision of an “ultimate holding company that has a principal regulator” to avoid duplicative or inconsistent regulation. Finally, we are amending the risk assessment rules to exempt a broker-dealer using the alternative method of computing net capital from those rules if its ultimate holding company does not have a principal regulator. The rule amendments are intended to improve our oversight of broker-dealers and their ultimate holding companies.” (http://www.sec.gov/rules/final/34-49830.htm)

The whole SEC Final Rule thing above makes for really good reading. Reading it also explains what Lloyd Blankfein was trying to do in his FT op-ed 8 Feb 09 (http://www.ft.com/cms/s/0/0a0f1132-f600-11dd-a9ed-0000779fd2ac.html): He wanted to inoculate himself and GS against the likely line of questioning that’s going to come out once everyone sobers up and realizes GS, MS, MER, LEH, and probably Bear were continually reporting their risk positions, providing precise calculations on these positions, and demonstrating — every month for the 4 years leading up to the meltdown — they were behaving prudently and not abusing the amended rules they’d worked so hard to secure.

The fact that these firms — GS, MS, MER, LEH — no longer exist as investment banks does not obviate the need to go back into these reports and forensically reconstruct the past as best as can be done to see exactly what these former IBs thought they were doing, and whether they were deliberately misleading their regulator. That ought to keep a lot of folks busy for the next few years. A good starting point would be a detailed public accounting of the total risk position, and how much taxpayer money was allocated to posting of margin and paying off on the CDS. Tracking all of these funds down and fully — and publicly — accounting for them would seem to be an absolute necessity to restoring taxpayers’ faith in their Treasury and the folks running it.

Davos provided a flashpoint for a profound change in global leadership. The whimpering US-UK-EU bankers have been shamed. Then after the finger pointing, insults, hand wringing, and gut wrenching, Putin rode in on a white horse carrying a banner. Chinese Premier Wen Jiabao provided the confirmation to what Putin laid out, like a second of a formal motion. Wen Jiabao proceeded from the Davos stage to four European capitals to seal the new path and its legitimacy. The barter system has been launched in quiet, while the Western press continues not to comprehend a ruptured status quo limping along. It cannot; it will not; the transition is on.

http://www.marketoracle.co.uk/Article8986.html

cont.
There is a brand new system being designed that will borrow from the past and apply 21st century tools for barter / counter trade / excess capacity etc. An Exchange Platform will cut out the banks altogether � [Chinese Premier] Wen delivered his speech in Davos and went straight to Berlin where they put the final touch on the new world currency basket , sponsored by Berlin-Moscow-Beijing-Tokyo-Riyadh. Moscow and Berlin already have a massive counter trade / barter trade agreement in place, and Beijing was eager to joint that platform as well.” The new global currencies are planned for launch in January 2010. They will be launched amidst growing chaos. Events up to that time will be tumultuous.

In May 2003, at a workshop on risk management for some hundreds of financial regulators, invited as an executive director of the World Bank to say some words, I said the following:

“A regulation that regulates less, but is more active and trigger-happy, and treats a bank failure as something normal, as it should be, could be a much more effective regulation. The avoidance of a crisis, by any means, might strangely lead us to the one and only bank, therefore setting us up for the mother of all moral hazards—just to proceed later to the mother of all bank crises.

Knowing that “the larger they are, the harder they fall”, if I were regulator, I would be thinking about a progressive tax on size.”

You can find the rest I said at http://subprimeregulations.blogspot.com/2007/06/some-comments-made-at-risk-management.html

But since I never heard anyone else at the World Bank or much less the IMF saying something to that effect, I must make clear that many of those quarter-backing on Monday morning or kicking some banks now, when they´re down, have not earned my respect either.

Make them an offer they can’t refuse: Either they downsize themselves to a reasonnable level, (we’ll decide what’s reasonnable, not the banks) or the go-vermin will introduce all sorts of very nasty requirements that will make banking a much less profitable business without the casino-like attitude and insane risk-taking that has prevailed thus far.

Examples?
1) Shareholders must approve by a LEGALLY BINDING VOTE from a simple majority, any executive compensation scheme, that’ll be written in plain english, shall be accessible to shareholders 45 days in advance and where every perk, money, options, stocks of all kinds, pension benefits are clearly listed. Of course, ditto for bonuses doled out to this very special marvel of genetic engineering called “the best and the brightest”. I’m trying to avoid the dirty paws of Congress here and leave the interested parties decide what’s good for them.

I love the smell of capitalism in the morning!

2) Fractional reserve lending just got less fractional. 10% would become the minimal norm, no exceptions.

3) Banks have no right to own proprietary trading desks. Wanna be a trading jock? Open a hedge fund and be gone already.

I could go on and on, but the gist of it is simple. You can either be a smaller, very entrepreneurial bank with fairly good latitude to innovate (and not put everyone at risk while doing so) or, you can be a BIG bank reduced to be a Utility and regulated as such.

Please run for National Political Office. We need your clear thinking.

Thanks,

Bill

Yes, absolutely, though let us not forget that exactly the same goes for the clean-up that is needed in banking regulations.

There are plenty of those currently involved in destructive criticism that over the last decade occupied high places from where they could have provided a lot of constructive criticism but kept total silence.

Vichy collaborators selling themselves as Free French, no matter how much they repent, are not those we could trust to speak out next time it is needed either.

In any case, as to conspiracy theories – I generally think the stupidity we observe among large companies is just that: stupidity (rather than ingeniously disguised brilliance).

However, Hank Paulson’s very dramatic turnabout after the fall of Lehman Bros was rather dramatic.

I truly have to ask myself whether Hank would have been so cavalier about letting a big investment bank just to prove a point if that bank had been Goldman Sachs – his own baby (which still employed many of his friends and former co-workers).

That’s not a conspiracy theory at all – that’s simply coarse observation of well known facts, and a basic understanding of human nature.