How Goldman's Counterparty Valuation Adjustment (CVA) Desk Saved The Firm From An AIG Blow Up (And Opens Up A Whole New Can Of Wormy Questions)

Tyler Durden's picture

In today's NYT, Gretchen Morgenson does a good summary of how Goldman was demonstratively net short AIG (or net long its CDS, depending how you look at it) via nearly 100 counterparties to the tune of just over $1.7 billion in net notional, after Chuck Grassley released several previously classified documents disclosing Goldman's CDS position as of September 15, 2008, the day of Lehman's bankruptcy. As Gretchen summarizes: "According to the document, Goldman held a total of $1.7 billion in insurance on A.I.G. from almost 90 institutions. Its exposure to A.I.G. at that time was $2.6 billion. Goldman bought most of the insurance from large foreign and domestic banks, including Credit Suisse ($310 million), Morgan Stanley ($243 million) and JPMorgan Chase ($216 million). Goldman also bought $223 million in insurance on A.I.G. from a variety of funds overseen by Pimco, the money management firm." While the topic of how the world's biggest asset management firm in the face of Pimco (and specifically its massive Total Return Fund) could have a net short CDS position (i.e., unlimited downside exposure), and how this is supposed to demonstrate prudent capital management, is ripe for evisceration, we will leave it for another day, as there is something more notable in the Grassley disclosure that has to be discussed. While Gretchen is correct that the external position of Goldman's exposure vis-a-vis AIG is indeed a total of $1.7 billion in long CDS, if one were to actually present the gross number, the truth would be starker: as the Grassley document reveals, the firm's gross exposure for its IG flow and structured finance desks goes from a positive $1.7 billion net exposure, to a ($2.9) billion net exposure, a massive $4.8 billion swing! What is it that in one fell swoop moved the firm from having a huge long bet on AIG, to a major short CDS position, one that nearly entirely covered the firm's $2.6 billion in legacy risk exposure? Enter Goldman's Counterparty Valuation Adjustment desk.

The Counterparty Valuation Adjustment desk at most "commercial banks" has operated in the shadows long enough. Perhaps this latest disclosure by Grassley will finally push it into the light. But just what is a CVA? Conveniently, the Bank of England just released its quarterly bulletin, in which it dedicates 9 pages to just this topic (granted in the context of sovereign defaults swaps, but the principles are identical). To wit:

The role of CVA desks

A commercial bank’s CVA desk centralises the institution’s control of counterparty risks by managing counterparty exposures incurred by other parts of the bank. For example, a CVA desk typically manages the counterparty risk resulting from a derivative transaction with another financial institution (such as entering an interest rate swap agreement). The main role of the CVA desk is to consolidate credit risk management within the company. This can improve risk control procedures, including taking account of any offsetting positions with the same counterparty (which can reduce the need to hedge). CVA desks will charge a fee for managing these risks to the trading desk, which then typically tries to pass this on to the counterparty  through the terms and conditions of the trading contract. But CVA desks are not typically mandated to maximise profits, focusing instead on risk management.

CVA desks’ hedging of derivatives exposures In a derivative transaction, a bank may incur a loss if its counterparty defaults. Specifically, if the bank’s derivative position has a positive marked-to-market (MTM) value (calculated for the remaining life of the trade) when the counterparty defaults this is the bank’s ‘expected positive exposure’. These potential losses are asymmetric. If the value of a bank’s derivative position increases (ie the bank is likely to be owed money by its counterparty), the potential loss in the event of default of the counterparty will rise. In contrast, if the value of the bank’s derivative position falls such that it is more likely to owe its counterparty when the contract matures then the potential loss on the transaction is zero.

Having aggregated the risks, CVA desks often buy CDS contracts to gain protection against counterparty default. If liquid CDS contracts are not available for a particular counterparty, the desk may enter into an approximate hedge by purchasing credit protection via a CDS index and increase the fee charged to the trading desk to reflect the imperfect nature of the hedge. On occasion, when CDS contracts do not exist, CVA desks may try  to short sell securities issued by the counterparty (ie borrow and then sell the securities) but this is rare.

Another way to mitigate counterparty risk is for parties to a derivative trade to exchange collateral when there are changes in the MTM value of the derivative contract. The terms of the collateral agreements between the counterparties (detailed in the credit support annex in the derivative  documentation) include details such as frequency of remargining. Since MTM exposure for the bank is greatest if counterparties do not post collateral, CVA desks have reportedly been influential in promoting better risk management via tighter collateral agreements in order to reduce the CVA charge.

The plot thickens: the table below demonstrates the external (net of CVA netting), and internal (gross up) exposure to AIG by Goldman Sachs. As is glaringly obvious, the two actual trading groups within Goldman, the IG Flow and Structure Credit, experience a miraculous transformation when moving from internal to external exposure, as noted above. In fact, this transformation is so big that had it not been for the extremely beneficial impact from the CVA internal-to-external adjustment, the firm would have in fact been short not only residual CDO exposure, but would have found itself net short AIG CDS as well, further increasing the motivation to tear up contracts, in the least, as is what ended up happening post Maiden Lane III, and to push outright for the prevention of an AIG bankruptcy (which also happened). It also puts into doubt the veracity of all those statements by Messrs Viniar and Blankfein that Goldman was "hedged" to an AIG collapse, and in fact did not need the government bail out.

Another observation: Goldman's flow operations once again demonstrate that they in no way take a hedged position against order flow, yet merely execute alongside (or just ahead of) the whales. It is, however the prop desk, or in the CVA case, the prop's prop trading desk, that ends up bailing out the firm (time after time). Indeed, in this particular case, the prop side of Goldman's operations is responsible for not only all the revenue associated with any selling of AIG CDS, but with initiating the positions in the first place, and furthermore, eliminating any and all massive losses that would have been borne out of the firm's flow traders, had nature runs it course. In other words Goldman's claim that prop accounts for just 10% of revenues is patently false, or true only in the case where the balance of the firm consistently generate negative revenues, with the delta a plug coming out of David Copperfield's hat.

So just what is the basis of the CVA intervention: did the trading desk merely buy massive amounts of AIG CDS with the same counterparties (with CVA listed on the trade ticket instead of IGF or Structured Credit as the executor) and netting all at the end of the day, or, in yet another fractal bifurcation, merely buy protection of the  secondary counterparties (to AIG as primary), thereby offsetting secondary risk. Or, as the BOE suggests, did the CVA merely double count hedged risk exposure: "Another way to mitigate counterparty risk is for parties to a derivative trade to exchange collateral when there are changes in the MTM value of the derivative contract." In other words, while Goldman was collecting excess collateral via aggressive EOD variation margin collection, did the CVA also book this as an actual trading offset? If so, the firm has been lying about its net exposure to AIG via CDS all along.

To get to the bottom of this, Senator Grassley needs to immediately get not only the cost basis and trade dates of every single trade ticket that comprises the alleged $1.7 billion in net exposure, but also explicit details on the activity of Goldman's CVA desk as pertain to AIG risk mitigation, and how precisely that shadowy group within Goldman decides which counterparty requires such massive risk margin contrary to exposure produced by the firm's flow traders. After all, flow was and always is actively aware of unbalance risk well pre-CVA (which is really just a glorified middle office) intervention. Why is it that the flow desk was so comfortable with a huge bullish exposure on AIG, while the CVA had a mandate to be so very bearish? Since Goldman has indicated it is willing to cooperate with regulators and politicians, we are confident this minor additional data hunting expedition will be in no way unfeasible to 200 West risk mavens. And while at it, the Senator should also request the actual P&L per trade, and the actual unwind or novation date per ticket. In the case of novations, as we have speculated previously, if Goldman was merely offloading its short-risk exposure to an unwitting market maker or hedge fund, while AIG's CDS were trading tens of points upfront, even as the firm knew full well the FRBNY would not let it fail, this would constitute trading on material insider information, as we have demonstrated previously. If indeed Goldman was selling its AIG CDS at the very top of the market, that would open up an entirely whole new regulatory can of worms, one that we are confident all the pent up class action lawsuits and David Cuomo would be more than interested to tap into.

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Village Idiot's picture

I apologize in advance for adding worthless drivel to what is certainly a serious post, but my child just came home with two "Lego" characters - "Clutch Powers" and "P-Squiddy." Swedish comedy or political statement?

piceridu's picture

Friggin money is on political statement
..oh yeah, great CVA post!


Oh regional Indian's picture

VI, loaded omens!!!

And these Gold Men. Hate them but doff a hat at their single-pointed focus.

Squeeze every penny from any transaction. Take some going take some coming, shaft the customer, take down a country, take done a company... all in a day's work.

Just squeeze that last penny.

Exposes like the above are going to start coming out of the woodwork now though.

Gold man just might be getting a not so golden finger.


SteveNYC's picture

I don't have any real "wants" in life, but I would enjoy seeing that firm collapse during my current manifestation. A few trials and jailings would be nice too......

Waterfallsparkles's picture

Are the Senators actually getting educated enough to truly understand what actually went on.  Maybe there is hope.

Vampyroteuthis infernalis's picture

The Senators know what is going on. They just leave the dirty work to their industry cronies and benefit immensely. Who do you think turns a blind eye?

bingocat's picture

Exposes like the above?

First off, at any given firm the CVA desk is the one which "insures" the firm. If the CVA desk makes a profit, that is not necessarily a good thing. It is the whole point to be "short" the main business. Nobody actively hopes that their insurance pays off, whether it be car insurance, fire insurance, flood insurance, etc). In finance, if you are marked to market AND you have risk appetite to take advantage of blood in the streets, times when lots of insurance pays off are opportunities to be taken advantage of when they arise. That said, if disaster does not occur, the cost of buying insurance in the middle of a panic can be prohibitively expensive and you will suffer for it if the world does not end.

Second, if you notice, the CVA desk did not actually buy the insurance from the Street. It forced the IG Flow desk to buy the insurance for itself, and asked them to buy CDS protection for its own purposes. The CVA desk simply acted as the accounting hub and risk manager. As to whether they were "over-insured", I think the point was that GS thought that AIG had not posted sufficient collateral (to the tune of $2bn+) so the $1.7bn of net external (because net external is the only one which matters) AIG CDS exposure and the other non-CDS short was probably about right (after taking into account the CDS haircut which would have been necessary). 


Au Member's picture

Tyler, nothing to do with your post but just seen that Wikileaks has releases a bombshell

Goldenballs's picture

Just confirms everyones worse fears war seems totally out of control with no effective overall command or direction.Just who is in charge of all these units,are they above the law and who are they accountable to.These questions need answering and fast.

Is this becoming a Vietnam.

sgt_doom's picture

I truly hate to disturb your very disturbed world view, Goldenballs, but everything is going according to plan.

Again, the copper is being mined in Afghanistan by Chinese companies, who are being protected by the US military.

The oil is flowing to China from southern Iraq, again according to the planning of the multinationals and transnationals to keep those factories and production facilities humming.

And eventually those pipelines will be completed to carry the gas and oil to India for similar reasons.

Now you understand the overall design.

MarketFox's picture

In addition ....this is just another example of how ineffective and basically useless the SEC really is.....

S ecure 

E mployment 

C ontracts


The revolving door from government to corporate just spins faster and faster....

And now that it is clear that there is no accountability....even after $Trillions have been will spin even faster.....


Goldenballs's picture

"Derivatives" a very dirty word,the truth of which will eventually come out but how much of this current crisis is down to derivatives.

RockyRacoon's picture

Nice sleuthing.  I hope the whole shebang goes down in flames with GS at the controls.

Ted K's picture

One of the better ZeroHedge posts. OUTSTANDING.

Droops's picture

For you to describe CVA desks as "glorified middle office" shows your basic misunderstanding of quite how important these issues have become in the modern investment bank. Au contraire - at any of the top tier firms, the CVA or DCEM area is probably amongst the most technically skilled and respected desks, particularly after the past 24 months.

Circumspice's picture

Yeah, where I worked CVA lost a modest amount of money consistently for several years, and then were just about the only profitable part (and massively so) of the company during the worst quarters. It's a good idea to pool the evaluation of counterparty risk in one part of the company rather than have each unit understand the exact legal liability and balance sheet strength of dozens of counterparties, just as it's good to manage interest rate risk at a total company level.

runforthehills's picture

couldn't agree more. CVA market makers deal with some of the most complex credit pricing problems.. really non trivial stuff

by the way ZH, the "c" in cva is short for "credit" not "counterparty"

Natural's picture

Perhaps I am thinking that the way GS manages risk is more savvy than it is, but in my opinion the CVA desk would identify that the firm holds exposure of suppose 1 billion to AIG.  The CVA desk could then call the IG flow desk and ask for a market on the AIG CDS and purchase protection, the flow desk then needs to manage that and trade out of it.  Now if this were too occur we would see CVA now long 1 billion in protection, IG Flow flat (short 1 billion to CVA and long 1 billion from a variety of counterparties).   I don't think there is anything wrong with this and I really don't see CVA as saving the firm by having on some speculative position.  They did their job which was to identify that the firm held credit exposure and that needed to be hedged.    

I also see a scenario where the CVA desk tells the flow desk they are looking to accumulate a long protection position and then the flow desk is in charge of doing it, then perhaps the position is crossed each evening resulting in the flow desk being flat.  


Also I believe you have pointed out that GS was long 1.7 billion in protection thru the CDS market, from my understanding they held an equivalent of 600 in protection through their structured products desk.  This is net 2.3 billion in "protection million" leaving them with net 300 million in exposure, yeah yeah I understand if AIG went under GS would have had a rather hard time collecting on their CDS...   What about their equity positions in AIG?   


I am actually surprised by their position.  I thought GS would have ended up having some position where they had predicted a bailout but where equity went to 0... short cds, short stock thru options or whatever.


*To be clear I trade solely cleared products and have no exposure to credit trading besides what I read in the news/here.