Moral Hazard Defined; Goldman's Response To The FRBNY On AIG: "Let It Fail, We Are Insured"

Courtesy of the SIGTARP's latest report, the events on November 6 and 7th, when Wall Street lackey extraordinaire Tim Geithner decided to pay $27.1 billion to make all of AIG's counterparties whole, have attained even more granularity. The main thing disclosed is just how willing Geithner was to extract absolutely no concessions from AIG's counterparties, and how after putting in a token effort, the best he could do was to just get UBS to agree to a contingent 2% haircut, which would only be effective if all the other counterparties agreed to the same. Of course, this approach failed, and the final "make whole" bailout was a foregone conclusion from the beginning. That Tim Geithner approached his duty of "preserving" taxpayer capital with such disdain, would be grounds for immediately termination for cause in any normal, non-banana society. Alas, America has long ceased being representative of one.

First, here is a reminder of the full exposure that AIG's 16 counterparties had with AIG on the night of November 7th when the FRBNY was "trying" to extract some concessions on behalf of taxpayers, instead of merely making its true "masters" whole.

As the table highlights, AIG had already posted $35 billion in collateral due to a decline in the underlying value of sold CDOs which had a total par market value of $62.1 billion. At this point AIG was running out of cash, which is why it came to the Fed for a rescue attempt. If any additional deterioration in the credit markets or in the actual CDO securities were to occur, AIG would be unable to post any incremental collateral when requested (or demanded). The balance that counterparties were on the hook for was $27.1 billion, of which SocGen and Goldman had the greatest exposure of $6.9 and $5.6 billion respectively.

So how did these negotiations transpire? We present the example of Goldman, which is likely sufficiently indicative.

When Geithner spoke to Lloyd Blankfein, it was immediately made clear to him that any haircut discussions were doomed for two reasons. First: Goldman claimed that all of the CDOs it had purchased from AIG had subsequently been long sold off to greater fools. In essence, Goldman had taken on AIG's counterparty risk with regards to the CDO assets it had bought, and then sold, from AIG. What Goldman claims is that had AIG defaulted, Goldman would have been stuck with making its counterparties whole for the difference. This makes sense. What does not make sense, is why Goldman bought protection from AIG on the balance. As the report states: "Goldman Sachs then purchased the corresponding value in protection from AIG to hedge against its own exposure in the event of a default of the refernce CDOs." It is thus unclear how exactly Goldman would have been impaired, absent the assumption that because the counterparty on the bought protection, was AIG, any possibility on collecting on what would soon become a general unsecured claim, would be eliminated. In effect, Goldman was acting as a mere pass through for roughly $28 billion ($14 billion x2) in gross notional.

Yet where it gets scandalous, is that Goldman had estimated the fair market value of the AIG CDOs at $4.3 billion: a $1.2 billion haircut on what was still owed to it. Of course, this FMV estimation could have been astronomically wrong, and could have had a value as low as $0.01 (and had AIG actually filed for bankruptcy, not only would $0.01 be a conservative estimate, but it is what Goldman's stock would be trading at as well). So what does Goldman do: it spends $100 million to purchase $1.2 billion in net AIG CDS exposure. Basically Goldman had insured itself against AIG's bankruptcy, not merely using CDS as a pass through for net exposure. So when Geithner and Goldman were discussing haircuts, Goldman said that even if AIG were to file, and GS was able to extract the $4.3 billion in purported liquidation value for it CDO holdings, it would still be made whole courtesy of its AIG bankruptcy insurance. The irony is that the $1.2 billion in protection was purely a strawman. There is no chance in hell Goldman would have been able to collect on that contract had AIG really filed. Not only that, but virtually every single other CDS contract would have been torn up. And the supremely ironic thing is that both Blankfein and Geithner were fully aware of this! Yet this is precisely the strawman that Goldman used to negotiate with Tim Geithner, who of course was not trying to extract any haircuts, but was merely trying to enforce moral hazard without it becoming too obvious.

Alas, reading further down Barofsky's report, it becomes all too obvious that moral hazard is all the AIG bail out was really about.

As SIGTARP points out:

The greatest leverage that FRBNY might have had - the threat of default and an associated AIG bankruptcy - was effectively removed by FRBNY's intervention in September, an intervention that the counterparties understood to mean that the US government would not permit an AIG failure. The officials stated that ethical constraints prevented FRBNY from even suggesting that it would allow bankruptcy when it in fact would not do so.

So there you have it: the FRBNY's actions were motivated from the very beginning by "ethical constraints" - alas, none of these constraints had the taxpayer even remotely in consideration. The core premise is that had Goldman and the other 15 counterparties of AIG disappeared, it would have been the end of the world, end of story. That there is no way to test this null hypothesis is irrelevant. After all, Geithner (and Bernanke) said so, and so it must be.

And the biggest irony of all comes from this blurb: "Sec. Geithner further explained to Congress that "we explored at that time every possible means to reduce the drain on their resources including what you referred to. But again, because we have no legal mechanism in place for dealing with this, like we deal with banks, we did not have the ability to selectively impose looses on their counterparties."

This, Mr. Geithner, is what moral hazard is all about. Thanks to your actions you have doomed the U.S.'s formerly free and efficient equity markets to the biggest capital market bubble in history, which, like any ponzi, has only two outcomes: it either keeps growing in perpetuity as greater fools crawl out of the woodwork to keep it growing, albeit at ever slower marginal rates (note, this did not work out too well for Madoff), or it eventually pops. And the longer it takes to pop, the greater the ultimate loss of value: one day Madoff's business was worth $50 billion, the next day it was $0. And that is precisely the same fate that American capital markets will have at some point in the upcoming months or years. When future historians look back at what specific action caused the biggest crash in U.S. capital markets history, Mr. Geithner's cataclysmally botched negotiation of the AIG counterparty bailout will undoubtedly be at the very top of the list. In the meantime, just like in the Madoff case where the trustee is trying hard to trace where any stolen money may have been transferred to, to see the fund flows in our ongoing "ponzi in progress", look no further than the bank accounts of Goldman bankers as they receive their biggest ever bonus this year (and, by many indications, last).