“Can’t Get Enough: Goldman’s Profit is Citi’s Pain?”

By Thomas Adams, at Paykin Krieg and Adams, LLP, and a former managing director at Ambac and FGIC.

Many thanks for the thoughtful comments on my earlier post. If you can take a little more on the subject, I thought I would add some clarification to some of the issues raised.

First, on the merits of a monoline vs. AIG bailout, consider a case of counterparty compare and contrast, using Goldman Sachs and Citigroup as examples.

The popular wisdom in the aftermath of the crisis is that Citigroup is the sick man of the banking world: they lacked sufficient controls to protect against unwise exposures to CDOs and other structures, they are still alive only due to massive government loans, etc. Goldman, in contrast, has been praised for their superior risk management and their shrewdness in avoiding the worst aspects of the crisis.

In light of the benefits Goldman received through the bailout of AIG, are these interpretations still accurate?

Citi had massive exposure to the monolines due, in part to their unique history together. Way back at the time of their first bailout around 1990, Citi owned two bond insurers: Ambac and Capmac. At the strong suggestion of the government, Citi unloaded Ambac and Capmac through initial public offerings in the companies. Capmac was subsequently acquired by MBIA. Though Citi sold off their interests in Ambac and Capmac, the companies have long been in bed with Citi. The senior management of both companies consisted of many former Citi executives. Both Ambac and MBIA were very active insurers for Citi’s asset backed commercial paper programs and for a variety of other structured finance assets.

Over the course of late 2007 and early 2008, as the bond insurers faced pressure and eventually downgrades due to their CDO exposures, the stock market would swing wildly around based on news of possible bond insurer bailouts. At times, these previously obscure companies seemed to hold the fate of the market in their hands. Despite widespread concerns about the impact monoline insolvency might have on counterparties, municipalities and investors, various commentators and bankers suggested that a bailout for the monolines would be inappropriate or might create the risk of moral hazard. Goldman Sachs, back in January of 2008, suggested that a bailout of the monolines would be ineffective and that putting the companies into run-off made more sense. As hedge fund manager Whitney Tilson (who was gleefully shorting the insurers) helpfully points out in the same article, a bailout of the monolines would have helped banks like Citi and Merrill who had been foolishly writing dozens of CDOs, but would not be in Goldman’s interest, since Goldman had avoided such risks. The monoline bailout never arrived.

It is strange then, after months of debate about the market-wide risk presented by monolines and the apparent government decision not to rescue them, that the Treasury and Fed suddenly discovered systemic risk when AIG faced a potential failure. This discovery coincided with AIG’s massive new collateral posting requirements after the company’s ratings were downgraded in September 2008. As it turned out, this posted collateral eventually flowed to the benefit of Goldman, among others. As it also turned out, the transactions for which Goldman received the collateral revealed that Goldman had not entirely been avoiding CDOs after all. They just had a different counterparty for their trades than Citi or Merrill.

Had the government bailed out the monolines, rather than AIG, Citi might have been in much better shape than they are now. The status of Citi’s huge off-balance sheet risk, some of which received enhancement from Ambac and MBIA, might be materially different. Today, Citi might be the bank being hailed for navigating the crisis successfully and paying impressive 2009 bonuses. In addition, had the Fed bailed out the monolines, no collateral posting would have been required and cash would not have flowed directly into Citi’s pockets.

Goldman, which had argued against a monoline bailout, was a major beneficiary of the bailout of AIG. In the absence of an AIG bailout, Goldman might now be the bank propped up by huge government loans. For this, Goldman can be credited for being a better political operator in a time of crisis than Citi. Or maybe they just managed to hide their bailout better.

Next, I would like to add a few clarifications.

AIG’s “regulatory capital trades” have been the subject of some confusion in the comments to my prior post and elsewhere. I believe that this phrase is just another name for “negative basis trades” which is just another way of describing collateralized debt obligations (CLOs) which were insured by AIG and the monolines via CDS. AIG had a massive portfolio of insured CLOs but, in aggregate, the monolines did as well. Some of the monolines who avoided real-estate related CDOS (such as FSA and Assured) had very large insured exposure to CLOs. In fact, all of the insurers had much bigger exposures to CLOs than to those CDOs.

As the crisis was emerging, the insurers sought to distinguish CDOs backed by subprime and mortgage collateral from CLOs backed by high yield corporate debt. However, these two asset classes were just offshoots of the same business. Like CDOs, the insurers would insure AAA rated bonds on a “secondary” basis by delivering credit default swaps to the protection buyer. Because both CDOs and CLOs were insured via CDS, they were both subject to mark to market accounting, whereas traditional insurance was not. In the wake of the financial crisis, the insurers experienced mark to market losses on both CDOs and CLOs.

However, by mid-2008, while no CDO had resulted in an actual claim yet, the insurers could no longer credibly argue that they would not incur real losses on the CDOs (though they tried). In contrast, CLOs, while suffering from impaired pricing, were still rated AAA and looked like they might survive without any losses. CLOs were still considered “safe” and therefore not a significant source of future insured losses. Thus, the impact from AIG’s and the monoline’s downgrades was much less for holders of insured CLOs. The regulatory arbitrage that the European banks had played with the CDS might be unwound, but the underlying bonds were still AAA, whereas the insured bonds in the many CDOs were worth pennies on the dollar.

With respect to questions regarding Goldman’s security in the collateral posted by AIG: this was no sure thing for Goldman. Had AIG gone bankrupt, the bankruptcy trustee could have tied the money up for years, as has happened in the UK to hedge funds exposed to Lehman. If Goldman had a pressing need for this cash, such a tie-up might have been a real problem. In addition, as the Skeptical CPA pointed out in a series of excellent posts some time ago (http://skepticaltexascpa.blogspot.com/2009/05/goldman-aig-and-18-usc-152.html,http://skepticaltexascpa.blogspot.com/2008/11/bust-outs-and-paulson-mob.html, andhttp://skepticaltexascpa.blogspot.com/2008/12/deprizio-doctrine-and-aig.html), the posted collateral could be subject to claw back, or worse, by a bankruptcy judge, depending on whether AIG was determined to be “insolvent” at the time of the posting. Had the deals that lead to AIG’s dire straits been examined in detail by a bankruptcy judge, Goldman might have faced questions about their own culpability in their AIG’s demise.

Goldman has made it clear that they are upset and concerned about all of the media attention on their role in the bailout. In my view, they should really turn their gaze inward and be angry at the people who put them in a position of massive exposure to AIG. Instead, they (and their friends such as John Paulson) boasted about how much smarter they were than everyone else by profiting from the market downturn and having superior risk management. As we know now, some of these claims turned out to be an exaggeration.

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18 comments

  1. J Ram

    Make the connection. Hank Paulson was the one to put on the $20B exposure on Goldman’s books insured by AIG. Paulson bailed himself out.

  2. DownSouth

    @”…Goldman can be credited for being a better political operator in a time of crisis than Citi.”

    The words “merit,” “talent” and “ability” take on new meaning in our newly minted Banana Republic.

    Paulson, Geithner and Pandit should be stripped of all their wealth, dressed in bright orange, shackled and paraded around in public before being marched off to a life behind bars.

    They are traitors to the American people. Econo-terrorists.

    They deserve no better treatment than the terrorists who flew the airplanes into the World Trade Center.

    1. DownSouth

      Arianna Huffington appeared on Charlie Rose with several other pudints yesterday.

      I find it amazing that Huffington is the only one of the bunch who grasps the damage being inflicted upon the body politic and the civil society by Obama’s failure to punish the perpetrators of these heinous crimes.

  3. kievite

    I do not think that Goldman bailout was something extraordinary taking into account general context that existed during the last year of Bush administration.

    I think it it would be more constructive to view Goldman as the major beneficiary of the theological belief in self-regulating market which shackled regulators and made public just a shipple in the hands of unscrupulous gamblers with good government connections. Resulting fleecing of taxpayers, economic damage and the destruction of the “moral compass” of the society are natural results Goldman or no Goldman.

    But the problem is that any ideology after becoming dominant has a lock-in effect on the society. And what is the key question is whether the society will be able peacefully to transform without some kind of direct uprising aka revolution (which might take new forms as the direct confrontation with police forces now is pretty dangerous).

    While the buildup of this pressure might take years, it looks like Goldman now became a catalyst for public anger against the existing regime. I think that at some point the elite might realize that it can serve as a sacrificial lamb to dissipate some of the tension.

    1. Robespierre

      Call it for what they are:
      unscrupulous gamblers: Calling them gambler implies some modicum of randomness. There was no gambling here there was pure an simply the systematic application of fraudulent transactions to collect millions of dollars in bonuses. To call them gambler is equivalent to call Al Capone an unscrupulous gambler because he bet on the distribution of alcohol during prohibition. Society MUST recognize that these people are just as criminal as organize crime, drug cartels and terrorist even when their crimes are implemented in a different way. BTW what you call self-regulation believes I called systemic bribery of elected officials to undermine supervision so that crimes can be committed with impunity.

  4. jdmckay

    Very good article Thomas, thanks.

    (…)It is strange then, after months of debate about the market-wide risk presented by monolines and the apparent government decision not to rescue them, that the Treasury and Fed suddenly discovered systemic risk when AIG faced a potential failure.

    You’re much too kind… strange is not the word I’d use. strange is the bearded lady in a circus.

    When the federal gov dumps these guy’s mistakes on taxpayers while their remaining repub K-street lawmakers are decrying the evils of BO’s “socialism”, w/virtually no accountability for the entire bunch.

    A couple days after Mount blew I was flying over in a private plane w/several friends. We took several hours to circle, swoop in for close views. The swath of destruction from the lava flow was dramatic… hard to grasp w/out actually seeing it. “Devastation”, “anhilation” are words that come to mind which kind’a sorta approximate the reality.

    This financial thingie… I’m not sure our language has words to describe it’s swath of destruction.
    * Our institutions… banks, FED/Treasury, rating agencies, SEC, K-Street congress, investment houses, state fund managers… private & public institutions, utterly complicit.
    * Lawmakers the same… utterly complicit.
    * Nearly every professional I now, from mid-30’s through already retired… lost min. 30% of 401k to more than 60%. Yet, we hear little about this.
    * Perhaps most discouraging, a media invested in perpetuating bubble incubating conditions which describes to it’s viewership such causes as “predatory borrowing”, analysis such as “nobody saw it coming”, etc etc…
    * And for an encore, the public coffers are tapped to… replenish the crooks coifers. And this, we are told, is a RECOVERY.

    So anyway, great article. But strange it ain’t.

  5. Alfred

    ‘Trading assets at fair value’ in ‘cash flow from operating activities’. What is the meaning of it? Anybody cares to explain? Is it marked to market or not? I would like to understand- Thanks

  6. Allen C

    Where is the investigation?

    Again, the smartest guys on the Street knew AIGs capital limitations as their assets are regulated. I suspect the Armageddon scenario was planned as the default probability increased.

  7. Allen C

    Look for the planning evidence! It was a scam from the beginning. They all knew sufficient cash was unavailable. I suspect that planning began on or before June 2008.

  8. nivedita

    Not sure I get the first paragraph of the clarifications? I thought reg cap trades, negative basis trades and writing protection on CLOs are related, but different things.

    Reg cap trades refer to banks buying protection from AIG and the monolines, on assets they held on balance sheet (eg super-senior CDO and CLO tranches) in order to reduce their regulatory capital requirement, and allow them increased leverage.

    A negative basis trade is a trade where a bond can be purchased for a higher yield than the sum of the cost of funding and the cost of credit protection — i.e., buying the bond, funding it, and buying credit protection against it leaves you with a theoretically riskless positive cashflow. This is a trading position and doesn’t have anything to do with getting reg cap relief, you might want to do this with assets you don’t own if the price is right, and you might be willing to lose a small amount of money buying insurance if you can reduce your regulatory capital requirement enough.

    CLOs are collateralized LOAN obligations, btw, i.e. like CDOs but made out of bank loans.

    1. Yves Smith Post author

      The “reg cap” trades were also negative basis trades, and were widely described as such in the industry, and not as regulatory relief trades (I’ve never heard anyone in the industry call them that, that usage, which comes on blogs and in layperson discussions, seems to derive from the famed AIG footnote disclosing the dollar amount). For instance, a leaked AIG memo refers to these trades as negative basis trades, that was the industry nomenclature. The trading desks that booked them would have never entered into them if there was a negative carry (ie, the CDS spread more than the yield). So these particular negative basis trades were a subset of neg basis trades generally.

      I can assure you Tom is well aware of the difference between CLOs and ABS CDOs. I edited out “ABS” to make the piece a tad more reader friendly. But in general, when the media talks about CDOs, it mean ABS CDOs. And I do see ABS CDOs as being quite different than CLOs, beyond the difference in the ultimate borrower. CLOs are first gen securitizations, CDOs are resecuritizations.

  9. nivedita

    Also a question on the collateral being tied up and its relation to what happened in the Lehman bankruptcy. My understanding there was that hedge funds who had collateral posted to Lehman, or assets held by the bank got their money tied up. Do you have a reference for what you appear to be saying, that hedge funds that had collateral posted to them by Lehman also had problems?

    1. vender

      I’m pretty sure you’re right, and Lehman and HF were the other way around.

      CPA’s take on collateral is more interesting. If I read it right, it’s along the lines – we know AIG is insolvent and is not posting collateral right now. So we get our chums to stay the execution of AIG, and in meanwhile we persuade them to post the collateral.

      This would be something that is not nice, but I suspect happens more often than not and not only in finance. I know about a few companies that were technically insolvent but the bankruptcy was staved off for a while so some better connected parties could extract as much as they could before it all went into one pot.

      From that perspective I like the UK law better – if you trade insolvent, directors are personally criminally liable IIRC (mind you, sometimes it’s hard to show that you knowingly traded insolvent).

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  11. Kay4

    Looks like Goldman used all its connections and got a little lucky while everyone else especially the taxpayers got screwed.

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