When news of the first A.I.G. bailout broke last fall, New York Times analyst Gretchen Morgenson reported that Goldman Sachs was A.I.G.’s largest trading partner, with some $20 billion of exposure to the insurance giant. Goldman subsequently said its exposure to risk from A.I.G. was hedged by other investments.
Can we ask a simple question: can anybody tell us how Goldman could hedge $20 billion of exposure to AIG? Keep in mind that this seems to be an extremely difficult thing to do. After all, the whole reason for the AIG bailout is supposedly to prevent a systemic catastrophe that would supposedly result from AIG’s bankruptcy. But if Goldman found some easy way to hedge the risk from AIG, why couldn’t this be done by others? Why couldn’t the Treasury or the Fed help facilitate offsets that would prevent an AIG collapse from endangering the financial system?
Off the top of our heads, we can think of four ways Goldman could have hedged against AIG’s collapse.
- Short AIG. Masively shorting the shares of AIG would certainly have limited exposure to AIG’s bankruptcy. This trade would have had to been put an early enough to avoid AIGs share price collapse. With a market cap of just $1.24 billion, there’s no much left to short.
- Short insured bonds. Exposure to AIG being unable to pay on credit default swaps could also be reduced by shorting a portion of the the bond portfolio that was insured by AIG.
- Sell the bonds. Goldman could have just exited the positions it had insured, although this probably would have entailed huge losses we haven’t seen them take.
- Short other banks with AIG exposure. Goldman could have also made bets against the equity or debt of other banks, particularly banks in Europe, with exposure to AIG. If AIG failed, causing a systemic crisis, this trade would pay.
Notice that none of these scenarios indicates that Goldman doesn’t stand to make massive gains from AIG’s bailout. Just because a $20 billion exposure is hedged, doesn’t mean Goldman cannot continue to profit from AIG’s ability to keep making good on it’s credit default swap obligations. In this sense, people may have been deeply misled by Goldman’s denial. The right question to ask isn’t will Goldman go broke if AIG does but how much will Goldman benefit if it doesn’t.
We labour under the confidence that our readers are far smarter than we are, so perhaps you can provide insight into how Goldman could have hedged the AIG exposure. Please leave a comment or send an email to [email protected] Thanks!