In August 2007, the Wall Street Journal's David Reilly called for hot news.* I replied that AIG had material mark-to-market losses for the second quarter of 2007, yet it took no write-downs whatsoever for its credit default swaps on underlying mortgage related "super senior" collateralized debt obligations (CDOs). I looked at one aggregate position of credit default swaps (CDSs) amounting to more than $19 billion.** The mark-to-market losses were just one part of the problem. Since too many of the assets backing the position had high risk of severe principal losses, it also had a lot of "cliff risk," as in falling off of one. AIG had a grave problem just from this position alone, and AIG had other serious problems.
Initially, I agreed to talk to Reilly on background, but I didn't want to be named or quoted. AIG vigorously denied it would ever take a write-down or a loss on the CDSs, much less one that was material to its earnings statement. Reilly called me again asking if I were sure. I said I was positive. He called AIG again and then me, asking for a quote this time. I didn't want to get into a fight with AIG in the "Heard on the Street" column and reminded Reilly that I only agreed to talk to him on background. Reilly's editor called me and said that given that AIG's denial was so forceful, the paper needed me to go on the record. I know and trust this editor, so I agreed. Reilly quoted me but omitted that I said the difference was material. Even the Wall Street Journal hesitates to use the word "material" to describe an accounting misstatement. It guarantees a conference call with lawyers.
I called Warren Buffett about my concerns, but stuck to the public information already in the article. (Dear Mr. Buffett Pp. 164-165, 246).
I stuck my neck out and met with Jamie Dimon, CEO of JPMorgan Chase, adding that the difference was material. JPMorgan Chase's credit derivatives positions exceeded those of all other U.S. banks combined at the time. JPMorgan was not a participant in the problematic deals, and it was not a recipient of AIG's subsequent settlement payments, but stability in the credit derivatives markets was an important issue. Jamie dismissed my explanation of the looming cliff risk and said he understood CDOs. (Dimon later said he wished he had listened to me back then.) In August of 2007, he did not want to contemplate a potential implosion of AIG.
Goldman Knew (or Should Have Known) the Consequences
Unbeknownst to me at the time, in July 2007, Goldman Sachs and AIG began a prolonged battle over prices and collateral payments. In February 2008--six months after Reilly's Wall Street Journal article--PricewaterhouseCoopers (PWC) said it found "material weakness" in AIG's accounting. PWC was also Goldman Sachs's auditor. Goldman hedged against the possibility that AIG could go bankrupt and also extracted billions more in collateral from AIG before the crisis. By September 2008 initial bailout, Goldman Sachs had extracted $7.5 billion in collateral from AIG against these trades.
Goldman should have been well aware of the cliff risk posed by CDOs that it hedged with AIG. Moreover, Goldman created CDOs that other banks hedged with AIG, including some hedged by French banks Calyon and Societe Generale. In fact, Goldman Sachs was a key architect of AIG's crisis. (See details here).
If any of the assets backing the CDOs were as bad as Goldman Sachs Alternative Mortgage Products' GSAMP Trust 2006-S3, the BBB-rated tranches (and most of the higher rated tranches) would be worth zero today. Goldman itself created some assets that amounted mostly to hot air, so it was in a good position to know that the CDOs AIG hedged were "backed" by too many value-destroying "assets."
Details of AIG's Trades Were Kept Secret Even by the SEC
The government's 100% payout to AIG's counterparties was extraordinary under these circumstances, and the negotiations were done in secret. In September of 2008, the Fed agreed to the first AIG bailout rather than let it sink into bankruptcy. It was very much to the benefit of Goldman Sachs and the other recipients of bailout funds that the details of the CDOs and the assets backing them were kept secret. Some CDOs held up moderately well, but others looked so bad, a public view of details would have prompted an immediate investigation. There appears to be a cover-up, and even the SIGTARP report did not reveal key details. So much for Washington's "investigations."
Even the SEC allowed details to be suppressed until 2018. (Click here to see the redactions on the last four pages of the March 2009 SEC filing.)
In September 2008, a good negotiator would have insisted that the collateral already extracted from AIG by Goldman Sachs, Societe Generale and others should be recharacterized as a loan and paid back after the crisis. As for subsequent payments including those made in November 2008--if they were made at all--they would only have been made as a loan.
Goldman Sachs Worried About Billions in Crippling Losses
Public funds bailed out AIG in September 2008, and the public did not get transparency. The secrecy benefited those involved in the initial negotiations, those involved in subsequent negotiations, and the banks that received the payments.
Now that the crisis is over, this issue should be reopened, and billions in collateral should be clawed back to pay down public debt, before Goldman Sachs pays more than $16 billion in taxpayer subsidized bonuses to its employees.
Goldman's CEO Lloyd Blankfein knew that if AIG failed, Goldman's counterparties would suffer collateral damage (Dear Mr. Buffett P. 167), and if AIG failed in September 2008, Blankfein worried about billions in crippling losses for Goldman Sachs. Yet, in an October 2009 Wall Street Journal interview, Blankfein said he didn't suspect AIG had problems producing collateral: "I never had reason to suspect....[I]t never occurred to me."
* David Reilly is now with Bloomberg News.
** I gave Reilly an example of an aggregate position of AIG's credit default swaps (CDS) amounting to more than $19 billion. It was backed by BBB-rated tranches of residential mortgage backed securities (including some subprime loans) and other BBB-rated asset backed securities (auto loans, student loans, and more). Mark-to-market means one shows the market price, or if no market prices are available, one records a price based on a model that calculates a price at which one would expect to trade in the market. Given then market conditions, AIG's assertions were not plausible.
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