Why AIG's bailout was one giant mess

Allister Heath

TO say that Goldman Sachs is in the doghouse is something of an understatement. The firm has become the bank everybody loves to hate. The argument is familiar: Goldman benefited from the bailouts; it is about to pay huge bonuses again; no wonder the New York Times called this weekend on it to donate billions to help repay the national debt.

Neil Barofsky, the inspector general for the bailout, poured more oil on the fire last week. He correctly argues the Fed should have been tougher towards AIG’s counter-parties when the insurer was bailed out, forcing them to book some losses. Barofsky is also sceptical of Goldman’s claims that it didn’t stand to lose anything from a collapse of AIG because it had hedged itself against that risk with other financial institutions.

So who is right: Goldman’s critics, or the firm itself, which continues to argue that it was fully insured against AIG’s collapse? Neither. All of AIG’s counterparties should have put their hands in their pockets to help reduce the taxpayer’s contribution; however, there is no evidence to support the view that Goldman benefited disproportionately. Assuming the entire system hadn’t collapsed, there is equally no evidence that Goldman would have been brought down by AIG’s failure, though it would have suffered more than expected.

Other parts of the financial services industry had more to lose from AIG’s collapse, including money market funds, pension funds that had purchased vast amount of insurance from AIG and owners of the firm’s commercial paper. Goldman wasn’t even AIG’s biggest banking counter-party: Societe Generale had that dubious honour.

AIG provided insurance in the form of credit default swaps (CDSs) on collateralised debt obligations (CDOs), tradeable pools of mortgages. When the market value of the CDOs started to fall, AIG had to start making collateral payments to its customers, including Goldman. By September 2008 it was running out of money and was bailed-out. The cash was used in part to meet the payments. Then, to draw a line under AIG’s liabilities, the Fed bought out all the CDOs at their mark-to-market value, meaning that none of the counterparties lost a penny (collateral payments plus the market value of the CDOs summed to their face value). This was wrong: the banks should have been forced to take a haircut, accepting less for their CDOs.

Most of the banks rejected such a proposal, arguing that their contracts remained legally binding because AIG was still trading. The biggest stumbling block was the French government, which backed SocGen.

What about Goldman? Barofsky’s report says that the illiquidity of the market – which would have been exacerbated by AIG’s failure – means that “it is far from certain” the underlying CDOs could have easily been sold. Had AIG collapsed, the possible demise of other participants “might have made it difficult for Goldman to collect on the credit protection it had purchased against an AIG default, although Goldman stated that it had received collateral from its counterparties in those transactions”. Had AIG defaulted, Goldman would have had to bear the risk of further declines on $10bn in CDOs (though these have now gone up in value). There is no real smoking gun here. Nobody is denying that Goldman was hedged; nobody is sure what would have happened had AIG gone bust. Only one thing is certain: AIG’s bailout was disastrously mismanaged.