Yesterday’s release of detailed information regarding with whom AIG settled in full on credit default swaps (CDS) at the end of 2008 was helpful. We learned a great deal about the precise nature of transactions and the exact composition of counterparties involved.
We already knew, of course, that this “close out” at full price was partly about Goldman Sachs – and that SocGen was involved. There was also, it turns out, some Merrill Lynch exposure (affecting Bank of America, which was in the process of buying Merrill). Still, it’s striking that no other major banks had apparently much of this kind of insurance from AIG against their losses – Citi, Morgan Stanley, and JPMorgan, for example, are not on the list.
This information is useful because it will help the House Oversight and Government Reform Committee structure a follow up subpeona to be served on Goldman Sachs with the following purpose:
- Did Goldman actually deliver the security that was insured? Ordinarily when you close out a contract of this nature – particularly at par – you turn over the insured security in return for the payment. The insurer pays in full but is left holding a security; if this recovers in price, the insurer recoups some of the loss. But if Goldman was using AIG as reinsurance, which is what some news reports suggst, it did not have any security to turn over. (Remember that with CDS – unlike cars – you can insure something that you don’t own).
- If Goldman did not turn over a security, then how was it determined that the security had esssentially zero value – which was the rationale for the payment really being made at par? Was this assessment provided by Goldman or by some independent third party? These were highly illiquid markets, so there was generally no widely quoted price that could be used.
- How did this valuation process differ from standard practice among market participants – when close out under such conditions is typically not at par? If the Fed effectively allowed Goldman unilaterally to declare a security worthless and to demand payment in full, we have a major problem.
- Secretary Geithner claimed yesterday that, if payment had not been made in full, the economic consequences would have been dramatic. To assess this claim, we need to see the value of these claims on Goldman’s books prior to this bailout transaction. Best practice would suggest that Goldman was not carrying this asset at face value – as it is an articulate proponent of mark-to-market and there must have been a reasonable expectation that AIG would not pay off in full. Therefore the transaction represented a windfall gain for Goldman shareholders and insiders – rather than something that in any sense “saved the day” for the financial system.
- As the evidence stands currently, the entire AIG transaction therefore appears to have been structured in such a way as to benefit primarily Goldman – although, for fair comparisons, we should obtain parallel details from other counterparties. What was the entire timing and content of interactions between Goldman and the Fed on this matter? Who exactly designed the deal and with which advisers?
The House Oversight and Government Reform Committee has done an extraordinary job peeling back several layers of a potentially rotten onion. They need to follow the lead provided by this evidence and ask the next hard round of questions.
Some of these issues are rather technical but evidence either way will speak directly to accusations of favoritism and unreasonable government behavior. It is time to get fully to the bottom of this matter.
By Simon Johnson