This is the clearest account we’ve heard of the complex relationship between Goldman Sachs and AIG. Basically, Goldman argues in a letter to the editor printed in the Wall Street Journal today that it had hedges and collateral that effectively reduced its exposure to AIG to zero.This has a couple of interesting implications.
- If AIG couldn’t pay out on the CDS contracts it had made with Goldman, Goldman’s hedges would have meant that Goldman would have not lost anything.
- Because the government bailed out AIG, Goldman never got to collect on those AIG hedges it had placed with other financial institutions. That means the bailout meant that Goldman spent $100 million on hedging contracts that it didn’t need and probably wouldn’t have bought if it could have anticipated the bailout of AIG.
- Goldman was, then, effectively, economically neutral when it came to the AIG bailout. AIG fails, Goldman gets paid by other counter-parties. AIG is bailed out, Goldman gets paid by AIG.
- Goldman was doing something everyone else should have been doing: reducing systemic risk from AIG’s failure by eliminating that risk through hedges.
Here’s the letter from Goldman:
Prof. Amar Bhidé does his readers a disservice when he asserts that Goldman Sachs miscalculated the creditworthiness of AIG and was “made whole” by a government bailout of the company (“You Can’t Rush a Recovery,” op-ed, April 9).
These are the facts: Goldman Sachs is in the business of acting as an intermediary for numerous clients and often assumes risk on their behalf. Our normal protocols require that we protect our shareholders from loss associated with our incurring these positions through rigorous risk management. This includes buying credit insurance which, in the matter at hand, we did from AIG, then one of the world’s largest insurance companies. The terms of this insurance included a requirement that AIG give us enough cash collateral to protect us against possible future loss.
We have consistently said that we had no direct economic exposure to AIG. We marked to market the risk we had insured with AIG, and AIG was contractually required to give us collateral to cover any diminution in value. Because there were periods when AIG didn’t provide enough collateral, we hedged ourselves against the then seemingly unlikely event that AIG might default. The cost of this hedging was over $100 million. If AIG had failed, we would have had both the collateral and the proceeds from the credit default swaps and therefore would not have incurred any economic loss.
In order to collect under a credit default swap, there has to be an event of default. No event of default means no payout. By supporting AIG, the government prevented the company from defaulting. Some have questioned whether, if AIG had defaulted, we would have received the money owed to us under the credit default swap arrangements. Because these swaps were written by large financial institutions which mark to market their obligations to each other and net their positions at the close of business every day, we exchanged collateral with the CDS providers on a daily basis. This protected us from the risk of any knock-on defaults.
Finally, others have asked why Goldman Sachs didn’t take a “haircut,” in other words, less money than we were owed. We had taken great care and incurred considerable expense to protect our shareholders. Why would it have been appropriate for them to have suffered a loss when they didn’t need to?
Far from miscalculating the creditworthiness of AIG, we acted in a way which most people would think of as a good example of responsible risk management.
Lucas van Praag
Goldman Sachs & Co.
The spokesman for Goldman Sachs, Lucas van Praag, may be the best in the business. He’s certainly one of the only flacks to be elevated to the heights he has acheived as a partner managing-director at Goldman.