Multi-sector CDOs and AIGFP

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Multi-sector CDOs and AIGFP

AIGFP was not regulated by any financial oversight agency. It didn’t even have to keep reserves on potential payouts on these CDSs, and even if it did, it has stated that the reserve amount would have been very small because it did not anticipate significant losses on the underlying debt instruments it was insuring. What AIGFP had going for it, and what the banks liked, was that it was a wholly-owned subsidiary of AIG, which carried a Aaa rating in its own name for everything it did. By virtue of this rating, AIG was viewed as one of the highest quality companies in the financial world – almost as safe and sound as a government.

The most common type of CDOs brought to AIGFP were called multi-sector: they had a little bit of everything mixed into them – loans, bonds, mortgage-backed securities on sub-prime mortgages as well as higher-quality instruments like prime mortgages. As long as none of these different types of instruments experienced unusual rates of default, the entire CDO would be traded on the market at a price close to par, and the ratings agencies would have no cause to downgrade the security.

What began to cause AIGFP trouble with its portfolio of credit default swaps backing up about $72 billion of multi-sector CDOs, was not that there were so many defaults on the CDOS that AIGFP had to make large payments under the swaps. The real problem was a series of collateral obligations AIGFP undertook every time it entered into a CDS, and the collateral conditions varied from one swap to the next.

There were three possible triggers for a collateral payment from AIGFP to the banks that bought insurance in the form of CDSs. The first occurred if the underlying CDOs being insured in the swap experienced a drop in price on the market – say from par value to 48 cents. The second occurred if the ratings given by Moody’s or some other agency on the CDOs were downgraded. The third occurred if AIG’s Aaa rating itself was downgraded.

You can now begin to see the sequence of liquidity disasters that befell AIGFP, and soon engulfed its parent AIG, starting in the summer of 2007 and extending until September 16, 2008 when AIG was near death. First, as the market realized that the US sub-prime mortgage business was experiencing very high and unexpected defaults, everyone looked at multi-sector CDOs that carried a significant percentage of these debt instruments in the security. These CDOs began to trade at lower and lower levels in the market as no one was sure just how impaired they would become.

Second, the ratings agencies began to downgrade dozens of CDOs because of the heightened default risk, and the lower prices in the market.

Third, the ratings agencies realized by 2008 that AIG stood behind the CDO market as insurer for the tune of $72 billion. At first, the long term rating of AIG was lowered, and this began a series of collateral calls from AIGFP’s swap customers. Then, by the summer of 2008, the ratings agencies were looking at downgrading AIG’s short term ratings, and doing so by several notches, which brought into question whether AIG could meet all of its obligations under these swaps. This accelerated the demands for collateral on AIG, which was experiencing a very unexpected triple whammy of collateral calls. By September, 2008, AIG had already coughed up an astounding $30 billion in collateral, and was really only half way through what ultimately it would need to satisfy contractual demands for collateral from the market. It simply ran out of resources to raise any more liquidity, and it faced inevitable default under its swap contracts, which would have led to bankruptcy.

This was the situation facing the Fed by the second week of September, 2008.

The Fed Steps In

The Fed already had its hands full in the summer and fall of 2008. First, Bear Stearns collapsed and was thrown into the arms of JP Morgan Chase, but only after the Fed agreed to take over the Bear Stearns real estate portfolio worth $30 billion in dodgy real estate assets. The quasi-government giants Fannie Mae and Freddie Mac had to be taken over by the government, then Countrywide Financial collapsed and also was pushed into a forced sale to a bank.

There was so much criticism directed at the government for the way in which these rescues were being done, and the amount of taxpayer money spent in the process, that when it came time to deal with the collapse of Lehman Brothers, the Treasury and the Fed threw this firm to the wolves on September 15, 2008. It received no help from the government and was thrown into the bankruptcy courts. This precipitated a global market meltdown.

The trigger for this meltdown occurred at the oldest mutual fund in the US, American Reserve Fund, which took a writedown of $785 million on Lehman Bros. bonds it held in its money market fund. This was announced on the afternoon of September 15, and by the close of business that day massive amounts of withdrawals were taking place at American Reserve since no money market fund had ever experienced such a loss (money market funds were supposed to be as safe as checking accounts).

When the market opened the next morning, mutual funds everywhere couldn’t cope with the withdrawals. The commercial paper market ground to a halt, as did the Eurodollar market for short term loans in London. Stock markets around the globe tanked. The global financial system was nearly paralyzed.

The US government stepped in and guaranteed the safety of all money market funds. It allowed Goldman Sachs and Morgan Stanley, the last two surviving old-line investment banks, to become commercial banks and enjoy the benefits of Fed liquidity. The Fed had been working since the previous week on the dire liquidity situation at AIG, and it had asked JP Morgan Chase and Goldman Sachs to form a bank syndicate to provide AIG with a massive $75 billion loan to solve its liquidity problem.

JP Morgan Chase came up with a package that charged AIG an onerous 11.3% on the $75 billion loan – a full $9 billion a year in interest alone. The banks would take an 80% ownership interest in AIG’s assets. This loan package was also intended to stop the ratings agencies from yet again lowering AIG’s ratings, which would have cost the company yet another round of collateral calls from the market.

There was one big problem, though. When the banks looked at AIGFP’s portfolio of swaps, and the potential collateral demands that could still occur, they realized that AIG, if it could sell all of its assets at decent market prices, still wouldn’t be able to meet the liquidity demands. In other words, the way the market was developing, AIG was headed straight towards default and the bankruptcy courts. Making this situation even worse was the global market collapse occurring at the same time as the result of the Lehman bankruptcy. The banks told the Fed that the loan package had collapsed. The banks effectively threw the AIG problem on to the laps of the regulators, none of whom by the way had any legal responsibility, regulatory oversight, or historical familiarity with AIG. It was an insurance company that had somehow become bigger and more important than even the biggest banks.

In deciding what to do, the Fed had about 24 hours from September 15 to 16 to analyze with the Treasury the AIG situation. They discovered that AIG would default on $103 billion in loans from state and local governments, $50 billion in bank loans and derivatives, $20 billion in commercial paper, and $40 billion in insurance covering 401k retirement packages across the US.

The problems ranged from the horrendous to the horrific. The municipal bond market stood to be devastated by state and municipal loan losses. The Lehman bankruptcy involved $8 billion in commercial paper losses, which led to the Reserve Primary Fund disaster, but AIG’s commercial paper losses were much bigger at $20 billion. The 401k losses would affect tens of millions of Americans. AIG’s loan losses spread to banks all around the world.

The Fed and Treasury, standing in the middle of a global financial collapse the day after the Lehman Brothers bankruptcy, felt they had no choice but to save AIG, a much bigger player with far greater reach and implications for economic and financial disaster. The Treasury authorized an $85 billion line of credit at the Federal Reserve NY for the purpose of lending to AIG the amounts needed to post collateral behind its swaps at AIGFP. The Fed had no plan in place on how to do this, so it simply lifted the term sheet conditions from the JP Morgan failed loan package, and used those terms to lend to AIG.

From September 16 through October, the Fed lent $61 billion to AIG, over half of which found its way into the market as collateral to support its swaps. At the same time, AIG was instructed to begin reducing its swap book. This required AIG to turn to all the big banks with which it had a swap portfolio, and ask to close out, or abrogate the swap contracts. The banks would consider doing this, but would not want to be then left with the CDO risk that caused it to enter into the swaps in the first place. There was some talk of AIG therefore taking over the CDOs as well, which had sunk substantially in value because of the default risk, but it was very difficult to agree with each bank on what these CDOs were worth. In fact, the banks weren’t willing to sell these CDOs at any discount whatsoever, despite what the market said they were worth, so AIG turned to the Fed for help, and authorized the Fed to negotiate on their behalf.

Here is where we come to the gist of the Barofsky report and the criticisms of the Fed. But let us recap two critical facts up to this point. As of September 15, AIG was certainly heading for bankruptcy, within a manner of days. The banks stood to lose billions on their swaps with AIG, because they would be under-collateralized if the CDOs fell further in value, and because they could not easily all at once get replacement CDS coverage for their CDOs.

Second, shortly after September 16, the banks began receiving collateral from AIG, courtesy of the Fed via the $85 billion loan authorization. For the next two months, the banks were made whole as necessary whenever their CDOs fell in value. The banks could look at their portfolio with AIGFP and consider it safe and secure because of the collateral, and as important, because of the guaranty of more collateral to come as necessary, courtesy of the federal government.

The Fed Tries Its Hand at Negotiating

In early November the Fed assigned a team of managers to begin negotiating for the abrogation of the CDSs. They chose the eight largest bank counterparties to talk to, including Goldman Sachs, BOA, JP Morgan Chase, Deutsche Bank, UBS, and top of the list was Societe Generale in Paris. The plan was to ask the banks to tear up the CDS contracts through a legal abrogation agreement. It was common for banks to do this in the derivatives market from time to time, though never before on a large scale. The banks always required the customer to pay them for any potential real market losses they may incur in abrogating the contract, plus interest and a bit of a fee for all the trouble. Abrogations have never been cheap, especially if the customer was desperate to get out of a deal.

What would the banks want? Collectively, they held CDOs worth a face value of $62.1 billion, and these were the underlying CDOs behind the swaps bought from AIGFP. The banks wanted to give these over to the Fed and get $62.1 billion back, because otherwise the banks would be stuck with CDOs that were unhedged for further default problems.

The market price for this collective group of CDOs was in early November $29.6 billion, which tells you just how badly the market had trashed these instruments. But the banks held cash collateral of $35.0 billion to protect against just this contingency, and if you add the two numbers up, you come to a bit over the $62.1 billion in face value. In other words, the banks were sitting pretty. They were 100% covered for the existing market losses on these CDOs, and the market pricing was beginning to stabilize.

Remember that all this collateral came from the Fed on behalf of the now moribund AIG. The banks wanted to do a simple deal. They would give the Fed all the CDOs in exchange for $29.6 billion in cash – their current market value. They would keep all the existing cash collateral, so they would be perfectly whole. They would then abrogate the CDSs and have no further claim on AIGFP, as if the whole mess never occurred. The Fed, meaning the taxpayers, would be out $62.1 billion in cash to clean this mess up.

In preparing talking points for the negotiations, the Fed reminded each bank that it would be appropriate to give back some of the collateral to the Fed rather than keep it all. The Fed, by stepping in a month earlier, had saved the banks from billions of losses had AIG gone into bankruptcy, and these losses might have included a systemic crisis in which a few other banks went under and couldn’t pay their obligations as well. “”Be nice to us, given all that we have done for you,” was the Fed motto.

The Fed then tied the hands of their negotiators in several ways. First, the Fed would not threaten to throw AIG into bankruptcy if they didn’t get a “haircut” on the $35 billion in collateral. This would be unethical because the Fed had no plan to put AIG into bankruptcy and everybody knew it. Second, the Fed negotiators would have to do the same haircut deal with everybody. If Goldman Sachs agreed to return 30% of the collateral, JP Morgan Chase would have to agree to the same thing. Third, the banks were told up front that their participation in the negotiations was entirely “voluntary”; nobody was going to be forced to do anything or accept any haircut.

You should not be surprised that seven of the eight banks refused to take any haircut on the collateral and would therefore return none of it. They argued the cash was theirs, not the Fed’s, and they owned it by the sanctity of a legal contract that the Fed was proposing to violate. Second, AIGFP was not in default and there was no bankruptcy, and there wouldn’t be any, so giving back collateral when there was no legal requirement would constitute a breach of fiduciary duty that the banks had to their shareholders. Unstated in all this was the fact that the Fed wasn’t threatening any consequences if the banks refused to give back any of the collateral.

The kicker that destroyed any possibility of the Fed getting some of the collateral back occurred with the French bank. They told the Fed that it was not simply a fiduciary responsibility they had to follow in keeping cash that was rightfully theirs – it was decidedly against French law to give back the collateral because there was no bankruptcy. The French regulators confirmed this in no uncertain terms to the Fed, with the implication that if the Fed pushed on this point relationships with the French government would be damaged. Remember that all the banks had to agree to the same deal, so each bank had a veto power over any deal, and the French bank had the ultimate veto – it was illegal for them to give back the collateral.

The negotiating team reported all this back to Timothy Geithner, and recommended that the Fed settle all the swap abrogations by allowing the banks to keep all the collateral and thereby effectively receive par value on contracts that in the market were worth less than half that. Geithner agreed and the deal was done. The Fed then promptly kept all these details secret, including the names of the banks involved, and even went to court to maintain this secrecy under the financial equivalent of a “state secret” argument. They recently lost this argument on appeal to a higher court, and the Barofsky report severely berated the Fed for this because no terrible consequences have occurred now that the details are known.

What Went Wrong Here?

The Barofsky report lays a pretty heavy blanket of criticism on the Fed for not just the secrecy of their actions, but the actions themselves. The Fed didn’t have to treat everyone all the same. It could have accepted different levels of haircuts. It didn’t have to put so much faith in the sanctity of contracts when AIG was in virtual suspended animation – bankruptcy in all but name.

These criticisms do not show an understanding of how the Fed works. Like any large American organization, it pays considerable attention to the law. Timothy Geithner had a high powered, high-priced General Counsel sitting as his right side all the way. Geithner was told clearly that as long as AIG was not in bankruptcy, the Fed might damage its reputation by violating the terms of perfectly sound legal contracts and insisting on repayment of collateral when it was not legally required. He was also told the Fed had no ethical right to threaten bankruptcy when the threat could not be backed up later in court with proof it was real. He was probably told – though there is no proof of this in the report – that giving any bank preferential treatment on haircuts exposed the Fed later to lawsuits of unfair treatment.

Timothy Geithner is like most American executives – he is a technocrat. He respects technical advice, especially of the legal kind, and he abides by it. Past presidents of the NY Fed might be different – Gerald Corrigan comes to mind during the Drexel Burnham bankruptcy. He would bang some heads together to get an outcome that satisfied the political pressure on the Fed, even if it meant overriding legal advice. Gerald Corrigan, by the way, now works for Goldman Sachs. He might have in this situation taken Goldman Sachs and JP Morgan Chase aside and said, “I want you guys to get your consortium of banks to agree on a haircut – something like 30% would be nice – and I want all of you to come back and voluntarily request that the CDS collateral provisions be waived in favor of paying back to the Fed some amount of the collateral. I don’t care how you do this, and it is not going to be the Fed asking for it – it is going to be voluntarily offered to us.” The banks would not need to be told that there was a steel hand underneath the Fed’s velvet glove.

Maybe Timothy Geithner would have done this, technocrat though he is, if there were enough political pressure on him to save the taxpayers billions of dollars, but there wasn’t. No one in the Bush administration – certainly not Henry Paulson at Treasury – was demanding fairness for the taxpayers. There was public disgust over the whole bailout process, but this disgust got bottled up in a Congress paid for by the financial industry. Barofsky might have mentioned that lack of political pressure, and the consequent insensitivity to taxpayer needs that the Fed and the Treasury displayed, but he didn’t, maybe because his current paymaster, the Obama administration, isn’t showing any such sensitivity either.

Which brings us to the crux of the problem, only hinted at in the Barofsky report. The real problem for the taxpayers didn’t occur when the NY Fed failed to negotiate the return of some of the collateral in November, 2008. The problem occurred on September 16, when the Fed and the Treasury were suddenly faced with a collapsing AIG. Had there been any forethought and planning for such an event, the reaction could have been very different and far less panicky.

The first response should have been: ”Financial markets worldwide are frozen, and they are going to stay frozen for a long time no matter what we do with AIG." In hindsight, this is exactly what happened. The commercial paper market has taken nearly a year to recover a fraction of its previous activity, and this was only after the Fed had to guarantee transactions. Credit spreads took nine months to begin coming down to normal levels. Banks are lending to each other only because governments around the world now guarantee their bank activity, but banks are still not lending to corporations, small businesses, or individuals.

The housing market in the US exists entirely on the generosity of Federally-managed firms like Fannie Mae, Freddie Mac, and FHA. In other words, the disaster that the Fed faced on September 16 rolled on despite the rescue of AIG.

If AIG had been allowed to fail, the market would have learned a serious lesson about dealing with companies that act like banks but really have no controls or regulatory oversight like banks. The pain would have been greatest at the banks themselves. Some banks like Citigroup and Bank of America would have been even more crippled than they are now, but their current status as zombie banks would not be any different. The damage done to 401ks could have been mitigated by additional federal government guaranties, but even here the cost while enormous would have been less than what was spent paying off AIGFP’s credit default swaps at par.

Suppose you say that it is impossible to expect government bureaucrats to react on September 16 in any different manner. You can argue that any normal person would have panicked too, and that tough-nosed regulators like Gerald Corrigan don’t come around all that often – in fact these days they are all working for Goldman Sachs. Fine. Where, then, was the prudential planning for this catastrophe. All it would have taken is someone in advance of the crisis – a clever lawyer for example – inserting one clause in the agreements with banks before any collateral was posted with them. It would have said “The Federal Reserve Bank of New York reserves the right at any time to demand immediate repayment of any or all amounts of collateral posted with Bank X, with no compensation required to be paid to Bank X in any form by the Federal Reserve Bank of New York, and Bank X hereby waives all rights to petition for a legal stay of said repayment.” If the banks didn’t like this clause, they wouldn’t get their collateral. They could go ahead and sue the government for breach of contract, but in the meantime they would be experiencing real pain with their CDO portfolio and the pressure would be on them to settle. Once the collateral was out the door, the Fed lost all leverage with the banks, and this is why the November negotiations were a foregone conclusion and a waste of time.

Finally, what is fundamentally missing at the Fed and the Treasury, and certainly now with two successive administrations and almost all 535 public servants in Congress, is the sense that the big financial institutions which have created this monstrous mess are dispensible. The problems that have arisen due to their avarice and misjudgments are only going to be solved over time, and are best solved in bankruptcy courts or through FDIC closure processes, not by making these institutions wards of the state until 10 or so years later they are nursed back to health. The public can and has been protected through deposit insurance, but the collapse of lending and credit in general has not been mitigated one whit by anything done so far to rescue these institutions. Let them die a merciful, quick death if death is their fate anyway. We will all of us individually benefit from such mercy as well.

Additional bailouts of 2008

On October 9, 2008, the company borrowed an additional $37.8 billion via a second secured asset credit facility created by the Federal Reserve Bank of New York (FRBNY).[1]

From mid September till early November, AIG's credit-default spreads were steadily rising, implying the company was heading for default.[2]

On November 10, 2008, the U.S. Treasury announced it would purchase $40 billion in newly issued AIG senior preferred stock, under the authority of the Emergency Economic Stabilization Act's Troubled Asset Relief Program.[3] [4]

The FRBNY announced that it would modify the September 16th secured credit facility; the Treasury investment would permit a reduction in its size from $85 billion to $60 billion, and that the FRBNY would extend the life of the facility from three to five years, and change the interest rate from 8.5% plus the three-month London interbank offered rate (LIBOR) for the total credit facility, to 3% plus LIBOR for funds drawn down, and 0.75% plus LIBOR for funds not drawn, and that AIG would create two off- balance-sheet Limited Liability Companies (LLC) to hold AIG assets: one will act as an AIG Residential Mortgage-Backed Securities Facility and the second to act as an AIG Collateralized Debt Obligations Facility.[5]

Publicly Federal officials said the $40 billion investment would ultimately permit the government to reduce the total exposure to AIG to $112 billion from $152 billion.

Privately "[t]he U.S. Treasury said in a draft of a presentation that its $40 billion investment in the American International Group Inc. bailout was “highly speculative.”

A slide with the phrase was included in documents obtained in a Freedom of Information Act request by Judicial Watch, a group that advocates government transparency. The sentence was omitted from another version of the slide in a presentation describing the November revision to AIG’s rescue in which the insurer got $40 billion from the Treasury.

“The prospects of recovery of capital and a return on the equity investment to the taxpayer are highly speculative,” according to the first of the two Treasury slides."[6]

On December 15, 2008, the Thomas More Law Center filed suit to challenge the Emergency Economic Stabilization Act of 2008, alleging that it unconstitutionally promotes Islamic law (Sharia) and religion. The lawsuit was filed because AIG provides Takaful Insurance Plans, which, according to the company, avoid investments and transactions that are"un-Islamic". [7] [8]

Counterparty controversy

AIG was required to post additional collateral with many creditors and counter-parties, touching off controversy when over $100 billion dollars were paid out to major global financial institutions that had previously received Troubled Asset Relief Program money.[9]

While this money was legally owed to the banks by AIG (under agreements made via credit default swaps purchased from AIG by the institutions), a number of Congressmen and media members expressed outrage that "taxpayer" money was going to these banks through AIG. [10]

Post-bailout expenditures

The following week (of September bailout), AIG executives participated in a lavish California retreat which cost $444,000 and featured spa treatments, banquets, and golf outings.[11]

It was reported that the trip was a reward for top-performing life-insurance agents planned before the bailout.[12]

Less than 24 hours after the news of the party was first reported by the media, it was reported that the Federal Reserve had agreed to give AIG an additional loan of up to $37.8 billion.[13]

AP reported on October 17 that AIG executives spent $86,000 on a previously scheduled English hunting trip. News of the lavish spending came just days after AIG received an additional $37.8 billion loan from the Federal Reserve, on top of a previous $85 billion emergency loan granted the month before. Regarding the hunting trip, the company responded, "We regret that this event was not canceled."[14]

An October 30, 2008 article from CNBC reported that AIG had already drawn upon $90 billion of the $123 billion allocated for loans.[15]

On November 10, 2008, just a few days before renegotiating another bailout with the US Government for $40 billion, ABC News reported that AIG spent $343,000 on a trip to a lavish resort in Phoenix, Arizona.[16]

Settlement of credit default swaps

During December 2008, AIG paid $18.7 billion to various financial institutions, including Goldman Sachs and Société Générale to retire obligations related to credit default swaps (CDS). As much as $53.5 billion related to swap payouts are part of the bailout.[17]

On March 15, 2009, under mounting pressure from Congress and after consultation with the Federal Reserve, AIG disclosed a list of major recipients of collateral postings and payments under credit default swaps, guaranteed investment plans, and securities lending agreements. [18]

Goldman Sachs, CDOs and credit default swaps

Goldman Sachs Group Inc. played a bigger role than has been publicly disclosed in fueling the mortgage bets that nearly felled American International Group Inc.

Goldman was one of 16 banks paid off when the U.S. government last year spent billions closing out soured trades that AIG made with the financial firms.

A Wall Street Journal analysis of AIG's trades, which were on pools of mortgage debt, shows that Goldman was a key player in many of them, even the ones involving other banks.

Goldman as Middleman

Goldman originated or bought protection from AIG on about $33 billion of the $80 billion of U.S. mortgage assets that AIG insured during the housing boom. That is roughly twice as much as Société Générale and Merrill Lynch, the banks with the biggest exposure to AIG after Goldman, according an analysis of ratings-firm reports and an internal AIG document that details several financial firms' roles in the transactions.

In Goldman's biggest deal, it acted as a middleman between AIG and banks, taking on the risk of as much as $14 billion of mortgage-related investments. Then Goldman insured that risk with one trading partner—AIG, according to the Journal's analysis and people familiar with the trades.

The trades yielded Goldman less than $50 million in profits, which were mostly booked from 2004 to 2006, according to a person familiar with the matter. But they piled risks onto AIG's books, which later came to haunt the insurer and Goldman. The trades also gave Goldman a unique window into AIG's exposure to losses on securities linked to mortgages.

When the federal government bailed out the insurer, Goldman avoided losses on its trades with AIG covering a total of $22 billion in assets.

A Goldman spokesman says that up until AIG was rescued by the government, the insurer "was viewed as one of the most sophisticated financial counterparties in the world. It wasn't until the government intervened in September 2008 that the full extent of AIG's problems became apparent."

"What is lost in the discussion is that AIG assumed billions of dollars in risk it was unable to manage," the Goldman spokesman added.

An AIG spokesman declined to comment on the firm's trades with Goldman.

More clarity has emerged recently over the roles that firms such as Goldman played, as complex deals carried out by banks are now being untangled in legal and regulatory inquiries. Last month a government audit of part of the AIG bailout described Goldman's middleman role.

One of Goldman's trades with AIG involved a financial vehicle called South Coast Funding VIII. South Coast was one of many pools of bonds backed by individual homeowners' mortgage payments that Wall Street turned into collateralized debt obligations or CDOs.

Merrill Lynch, now part of Bank of America Corp., underwrote the South Coast CDO in January 2006 by stuffing it with packages of home loans originated by firms such as Countrywide Financial Corp., the big California lender.

Once a CDO debt pool is assembled, it is sliced into layers based on risk and return. Merrill sold the safest, or top layer, of deals like South Coast to large banks, including in Europe and Canada.

An auction sign for a property is seen at the front garden of a foreclosed house in Miami Gardens, Fla., in September. The banks wanted protection in case the housing market tanked. Many turned to Goldman, which effectively insured the securities against losses. Then, to cover its own potential losses, Goldman bought protection from AIG, in the form of credit-default swaps.

Goldman charged more than AIG for the protection, so it was able to pocket the difference, making millions while moving the default risks to AIG, according to people familiar with the trades.

The banks eventually realized they didn't need to use Goldman as a middleman.

The trades seemed prudent at the time given AIG's strong credit rating and the fact that AIG agreed to make payments to Goldman, known as collateral, if the value of the CDOs declined. The trades were also low risk for Goldman as long as AIG stayed afloat.

Other banks also acted as middlemen, including Merrill Lynch, which did roughly $6 billion of these deals compared to $14 billion for Goldman, according to people familiar with the trades and the analysis of banks' exposures to AIG.

"It seems shocking to me that Goldman would become so exposed to AIG and kept doing deals with them and laying on the risk," says Tom Savage, a former chief executive of AIG's financial products unit who left in 2001 before the explosive growth of insuring mortgage-debt pools.

The middleman trades began to unravel in mid 2007 when the U.S. mortgage market started slumping. Goldman was the first of AIG's trading partners to notify AIG that the CDOs were losing value and demand collateral. Other banks including Société Générale and a unit of Credit Agricole that had bought insurance from AIG eventually did the same.

A Goldman spokesman said that between mid-2007 and early 2008, Goldman showed AIG "market price levels" at which trades could be undone, allowing AIG to decrease its risk, but "AIG refused to accept that the market was deteriorating."

When Goldman didn't get as much collateral as it wanted from AIG, in 2007 and 2008 it bought protection against a default of AIG itself from other banks.

AIG officials were skeptical of the prices Goldman presented, according to the minutes of a February 2008 AIG audit committee meeting, which noted that Goldman was "unwilling or unable to provide any sources for their determination of market prices."

Additional calls for collateral from Goldman and other banks eventually led to AIG's September 2008 bailout and led the New York Federal Reserve two months later to fully cover $62 billion of insurance contracts Goldman and 15 other banks had with the financial products unit of AIG.

Goldman's other big role in the CDO business that few of its competitors appreciated at the time was as an originator of CDOs that other banks invested in and that ended up being insured by AIG, a role recently highlighted by Chicago credit consultant Janet Tavakoli. Ms. Tavakoli reviewed an internal AIG document written in late 2007 listing the CDOs that AIG had insured, a document obtained earlier this year by CBS News.

The Journal analysis of that document in conjunction with ratings-firm reports shows that Goldman underwrote roughly $23 billion of the $80 billion in mortgage-linked CDOs that AIG agreed to insure.

One such deal was called Davis Square Funding VI. That CDO, assembled by Goldman in March 2006, contained mortgage securities underpinned by subprime home loans originated by firms such as Countrywide and New Century Mortgage Corp., one of the first subprime lenders to fail in 2007.

A big investor in Davis Square's top layer was Société Générale, which bought protection on it from AIG, according to the internal memo. The French bank was the largest beneficiary of the New York Fed's Nov. 2008 move to pay off banks in full on their AIG insurance contracts.

A company financed largely by the New York Fed ended up owning both the Davis Square and South Coast CDOs. Société Générale received payments from AIG and the New York Fed totaling $16.5 billion.

Goldman received $14 billion for its trades that were torn up, including $8.4 billion in collateral from AIG.

A representative of Société Générale declined to comment.

The special inspector general for the Troubled Asset Relief Program, which recently reviewed the New York Fed's effort to stanch collateral calls last year, said Goldman officials said the company believed it would have been fully protected had AIG been allowed to fail because of collateral it had amassed and the additional insurance it had bought against an AIG default.

The auditor, however, questioned that conclusion. The report said Goldman would have had a difficult time selling the collateral and that the firm might have been unable to actually collect on the additional insurance.

Goldman created CDOs, bet against then and won

"In late October 2007, as the financial markets were starting to come unglued, a Goldman Sachs trader, Jonathan M. Egol, received very good news. At 37, he was named a managing director at the firm.

Mr. Egol, a Princeton graduate, had risen to prominence inside the bank by creating mortgage-related securities, named Abacus, that were at first intended to protect Goldman from investment losses if the housing market collapsed. As the market soured, Goldman created even more of these securities, enabling it to pocket huge profits.

Goldman’s own clients who bought them, however, were less fortunate.

Pension funds and insurance companies lost billions of dollars on securities that they believed were solid investments, according to former Goldman employees with direct knowledge of the deals who asked not to be identified because they have confidentiality agreements with the firm.

Goldman was not the only firm that peddled these complex securities — known as synthetic collateralized debt obligations, or C.D.O.’s — and then made financial bets against them, called selling short in Wall Street parlance. Others that created similar securities and then bet they would fail, according to Wall Street traders, include Deutsche Bank and Morgan Stanley, as well as smaller firms like Tricadia Inc., an investment company whose parent firm was overseen by Lewis A. Sachs, who this year became a special counselor to Treasury Secretary Timothy F. Geithner.

How these disastrously performing securities were devised is now the subject of scrutiny by investigators in Congress, at the Securities and Exchange Commission and at the Financial Industry Regulatory Authority, Wall Street’s self-regulatory organization, according to people briefed on the investigations. Those involved with the inquiries declined to comment.

While the investigations are in the early phases, authorities appear to be looking at whether securities laws or rules of fair dealing were violated by firms that created and sold these mortgage-linked debt instruments and then bet against the clients who purchased them, people briefed on the matter say.

One focus of the inquiry is whether the firms creating the securities purposely helped to select especially risky mortgage-linked assets that would be most likely to crater, setting their clients up to lose billions of dollars if the housing market imploded.

Some securities packaged by Goldman and Tricadia ended up being so vulnerable that they soured within months of being created.

Goldman and other Wall Street firms maintain there is nothing improper about synthetic C.D.O.’s, saying that they typically employ many trading techniques to hedge investments and protect against losses. They add that many prudent investors often do the same. Goldman used these securities initially to offset any potential losses stemming from its positive bets on mortgage securities.

But Goldman and other firms eventually used the C.D.O.’s to place unusually large negative bets that were not mainly for hedging purposes, and investors and industry experts say that put the firms at odds with their own clients’ interests.

“The simultaneous selling of securities to customers and shorting them because they believed they were going to default is the most cynical use of credit information that I have ever seen,” said Sylvain R. Raynes, an expert in structured finance at R & R Consulting in New York. “When you buy protection against an event that you have a hand in causing, you are buying fire insurance on someone else’s house and then committing arson.”

Investment banks were not alone in reaping rich rewards by placing trades against synthetic C.D.O.’s. Some hedge funds also benefited, including Paulson & Company, according to former Goldman workers and people at other banks familiar with that firm’s trading.

Michael DuVally, a Goldman Sachs spokesman, declined to make Mr. Egol available for comment. But Mr. DuVally said many of the C.D.O.’s created by Wall Street were made to satisfy client demand for such products, which the clients thought would produce profits because they had an optimistic view of the housing market. In addition, he said that clients knew Goldman might be betting against mortgages linked to the securities, and that the buyers of synthetic mortgage C.D.O.’s were large, sophisticated investors, he said.

The creation and sale of synthetic C.D.O.’s helped make the financial crisis worse than it might otherwise have been, effectively multiplying losses by providing more securities to bet against. Some $8 billion in these securities remain on the books at American International Group, the giant insurer rescued by the government in September 2008.

From 2005 through 2007, at least $108 billion in these securities was issued, according to Dealogic, a financial data firm. And the actual volume was much higher because synthetic C.D.O.’s and other customized trades are unregulated and often not reported to any financial exchange or market.

Goldman Saw It Coming

Before the financial crisis, many investors — large American and European banks, pension funds, insurance companies and even some hedge funds — failed to recognize that overextended borrowers would default on their mortgages, and they kept increasing their investments in mortgage-related securities. As the mortgage market collapsed, they suffered steep losses..."

To read the rest of the article... Banks Bundled Bad Debt, Bet Against It and Won

Goldman used AIG to profit by shorting CDOs

Obviously, the people at AIG never figured out what was going on until it was too late. But there's a mountain of circumstantial evidence that the people at Goldman had a keen grasp of the fatal flaws of these CDOs, which they structured. The Times piece is a major addition to that mountain of evidence:

[Former AIG executive Alan] Frost cut many of his deals with two Goldman traders, Jonathan Egol and Ram Sundaram, who had negative views of the housing market. They had made A.I.G. a central part of some of their trading strategies.

Mr. Egol structured a group of deals -- known as Abacus -- so that Goldman could benefit from a housing collapse. Many of them were actually packages of A.I.G. insurance written against mortgage bonds, indicating that Mr. Egol and Goldman believed that A.I.G. would have to make large payments if the housing market ran aground. About $5.5 billion of Mr. Egol's deals still sat on A.I.G.'s books when the insurer was bailed out.

"Al probably did not know it, but he was working with the bears of Goldman," a former Goldman salesman, who requested anonymity so he would not jeopardize his business relationships, said of Mr. Frost. "He was signing A.I.G. up to insure trades made by people with really very negative views" of the housing market.

As further evidence that Goldman used AIG to profit by shorting CDOs, rather than to manage its preexisting risk exposure:

[N]egotiating with Goldman to void the A.I.G. insurance was especially difficult, Federal Reserve Board documents show, because the firm did not own the underlying bonds. As a result, Goldman had little incentive to compromise.

Goldman's seven Abacus deals [Abacus 2004-1, Abacus 2004-2, Abacus 2005-2, Abacus 2005-3, Abacus 2005-CB1, Abacus 2006-NS1, Abacus 2007-18] were unique among all the CDOs in AIG's portfolio. For all the other deals, the collateral manager, the entity that oversaw and managed the CDO after closing, was entirely independent from the bank that originally arranged and structured the transaction. For all the Abacus deals, Goldman acted both as both the arranging bank and the collateral manager. This is no small technicality. In other Abacus deals, Abacus 2006-13 and Abacus 2006-17, Goldman used its "sole discretion" to retire lower rated CDO tranches without regard to seniority. This approach, under documentation drafted by Goldman, upends the entire premise of structured finance.

Most importantly, the government never purchased the Abacus deals when it bought $62.1 billion other CDOs at par, back in November 2008. Why didn't the parties feel a need to take the Abacus deals off of AIG's balance sheet? It's an extremely important question, for which we will not have an adequate answer until we see the actual documentation, specifically: the offering memoranda, the performance reports and swap agreements.

Hiding Behind Societe Generale

The Times story also suggests that Goldman used Societe Generale as a front, to conceal from Frost and others the size of their cumulative bet against these CDOs.

Mr. Sundaram's trades represented another large part of Goldman's business with A.I.G. According to five former Goldman employees, Mr. Sundaram used financing from other banks like Societe Generale and Calyon to purchase less risky mortgage securities from competitors like Merrill Lynch and then insure the assets with A.I.G. -- helping fatten the mortgage pipeline that would prove so harmful to Wall Street, investors and taxpayers. In October 2008, just after A.I.G. collapsed, Goldman made Mr. Sundaram a partner.

Through Societe Generale, Goldman was also able to buy more insurance on mortgage securities from A.I.G., according to a former A.I.G. executive with direct knowledge of the deals. A spokesman for Societe Generale declined to comment.

It is unclear how much Goldman bought through the French bank, but A.I.G. documents show that Goldman was involved in pricing half of Societe Generale's $18.6 billion in trades with A.I.G. and that the insurer's executives believed that Goldman pressed Societe Generale to also demand payments...On Nov. 1, 2007, for example, an e-mail message from Mr. Cassano, the head of A.I.G. Financial Products, to Elias Habayeb, an A.I.G. accounting executive, said that a payment demand from Societe Generale had been "spurred by GS calling them."

As noted earlier in the story:

In addition, according to two people with knowledge of the positions, a portion of the $11 billion in taxpayer money that went to Societe Generale, a French bank that traded with A.I.G., was subsequently transferred to Goldman under a deal the two banks had struck.

See here for an analysis of the ten-figure purchases and sales between Goldman and SG.

The AAA Pyramid Scheme Embedded Inside AIG

The Times reports that Goldman tailored the terms of the swaps to exploit these defective credit ratings:

The terms, described by several A.I.G. trading partners, stated that A.I.G. would post payments under two or three circumstances: if mortgage bonds were downgraded, if they were deemed to have lost value, or if A.I.G.'s own credit rating was downgraded. If all of those things happened, A.I.G. would have to make even larger payments.

Here's an example of how terminology for a general news readership can lead to confusion. In the context of the story, the Times seems to be referencing the ratings of the CDOs, not the subprime bonds held by the CDOs. The distinction is critical because almost all subprime bonds were downgraded in 2007, whereas most of these CDOs were not downgraded prior to May 2008, when they received minor downgrades.

Most importantly, almost all these CDO tranches were rated AAA during November 2007, when, as the Times reports, Goldman was demanding billions in cash collateral. There is no way to reconcile a 40% diminution of value, which Goldman repeatedly asserted, with a AAA rating. It's like saying 2 + 2 = 11. In effect, Goldman was admitting that the CDOs' ratings were a joke.

It was an especially cruel joke on AIG and on the American taxpayer. If the ratings agencies had severely downgraded the CDOs in 2007 or earlier in 2008, AIG's day of reckoning would have come sooner. Instead, that day coincided with Lehman's bankruptcy. The ratings agencies announced their major downgrades of AIG after the close of business on September 15, 2008. Those downgrades triggered cash collateral calls and on AIG on September 16, 2008, the same day that a money market fund, which wrote down Lehman paper, broke the buck and triggered widespread panic in the money markets.

As noted before, the timing of the CDO downgrades looks suspicious. Eric Kolchinsky, a former managing director at Moody's, has alleged that the ratings agency deliberately and deceitfully delayed the announcements of downgrades of various CDOs. The House Oversight Committee is still investigating the matter.

Why Goldman Pressured AIG to Hand Over Cash

The thrust of the front-page Times article was that Goldman aggressively pressured AIG to hand over cash collateral beginning in 2007, Goldman asserted, because, the CDOs "were deemed to have lost value." But negotiations were always at an impasse, for an obvious reason. There was no way to settle on agreed-upon "market value" for the CDOs. These securities weren't bought or sold, like Treasuries or shares of IBM. Nor was there any market benchmark upon which the CDOs could be valued. The only way to set a price, according to auditors for AIG and the Federal Reserve, was according to internal valuation models.

The Times reports:

[D]ocuments show there were unusual aspects to the deals with Goldman. The bank resisted, for example, letting third parties value the securities as its contracts with A.I.G. required. And Goldman based some payment demands on lower-rated bonds that A.I.G.'s insurance did not even cover. A November 2008 analysis by BlackRock, a leading asset management firm, noted that Goldman's valuations of the securities that A.I.G. insured were "consistently lower than third-party prices."

The Times reporting suggests that Goldman wanted to control the dispute by using a nominally independent third party, PricewaterhouseCoopers, which had shifted into Goldman's camp:

Adding to the pressure on A.I.G., [David] Viniar, Goldman's chief financial officer, advised the insurer in the fall of 2007 that because the two companies shared the same auditor, PricewaterhouseCoopers, A.I.G. should accept Goldman's valuations, according to a person with knowledge of the discussions. Goldman declined to comment on this exchange.

Pricewaterhouse had supported A.I.G.'s approach to valuing the securities throughout 2007, documents show. But at the end of 2007, the auditor began demanding that A.I.G. provide greater disclosure on the risks in the credit insurance it had written. Pricewaterhouse was expressing concern about the dispute.

The insurer disclosed in year-end regulatory filings that its auditor had found a "material weakness" in financial reporting related to valuations of the insurance, a troubling sign for investors.

Of course, a highly plausible explanation is that Pricewaterhouse, like AIG, had assumed that the CDOs' AAA ratings were credible, until Goldman set them straight. But again, this gets back to the issue of whether Goldman knew these deals were toxic from the start. Goldman opposed proposals that would have enabled it to make its case to others.

Goldman Sachs, Timberwolf and AIG

The blow-up of a $1 billion subprime mortgage-linked security called Timberwolf 1 may have provided Goldman Sachs Group with an early clue about trouble to come at insurance giant American International Group .

It may be just coincidence, but there is some overlap between the underlying subprime-backed securities the Timberwolf deal tracked and some of the toxic collateralized debt obligations that AIG had guaranteed payment by writing credit default swaps.

Critics have long complained that Goldman unfairly benefited from the federal government's $180 billion bailout of AIG because it was a major trading partner of the insurer.

This week the Timberwolf transaction gained a degree of infamy when a U.S. Senate subcommittee investigating Goldman's role in the mortgage mess released an email in which a former executive summed up the transaction as "one shitty deal."

A review of the so-called reference portfolio for Timberwolf finds that 25 percent of the 56 securities supporting that Goldman-backed transaction are pieces of the same CDOs on which AIG had written guarantees.

AIG's inability to make good on the nearly $70 billion in guarantees it had written on portions of 178 CDOs held by Goldman and 15 other big banks led the federal government to put together a $180 bailout for the insurer in September 2008. As part of the bailout, the New York Federal Reserve negotiated deals with the banks that enabled it to move the rotting CDOs off AIG's books and into a new entity called Maiden Lane III.

Goldman was the underwriter and sole marketer of the Timberwolf deal, which lost 80 percent of its value within five months of its March 2007 closing. The so-called hybrid collateralized debt obligation was liquidated in early 2008, months before the U.S. government averted an AIG bankruptcy.

AIG legal team studying CDOs

American International Group Inc.'s legal staff is scrutinizing complex mortgage deals the company insured before its government rescue, and will take action if it concludes the transactions wrongly harmed AIG, Chief Executive Robert Benmosche said at the company's annual meeting.

"We are looking at all activities from that period," Mr. Benmosche said. "To the extent we find something wrong that harmed AIG inappropriately, our legal staff will take appropriate action."

Mr. Benmosche made his remarks in response to a question from an investor about Goldman Sachs Group Inc., which is facing a civil suit by the Securities and Exchange Commission over a mortgage deal known as a collateralized debt obligation. That deal, dubbed Abacus 2007-AC1, wasn't insured by AIG, though the bailed-out insurer previously worked with Goldman on other "Abacus" transactions. Goldman has denied wrongdoing in the case.

AIG's chairman, Harvey Golub, said the company continues to do business with Goldman, which he called a "fine firm that does a lot of things extraordinarily well."

Still, the insurer recently picked Citigroup Inc. and Bank of America Corp. instead of Goldman to advise the company on a plan that would help it pay back the bailout it got from the federal government, according to people familiar with matter.

The giant insurer had considered Goldman for the job, but picked the other banks after the firm was sued by the SEC, the people said. Goldman advised AIG on its recent deals to sell two overseas life-insurance businesses for $51 billion.

Where Goldman "can serve the purposes of AIG we will continue to use them," Mr. Golub said. "Where we can get better service from other firms we will do that."

A Goldman spokesman declined to comment.

AIG's annual meeting, held in a company cafeteria in lower Manhattan, lasted less than half an hour and prompted just a handful of questions from the investors in attendance.

With board members sitting in the front row and officials from the Treasury Department in the audience, Mr. Golub said the company was "grateful" to U.S. taxpayers for the bailout of up to $182.3 billion. He then moved quickly through an agenda that included a shareholder vote on the company's bonus plan.

Mr. Golub said the company has made "substantial progress in addressing key issues" in the past year. During that time, AIG agreed to sell the two large life insurance operations to repay the Federal Reserve Bank of New York, and continued to wind down derivatives that were a major factor in its near-collapse. Mr. Benmosche said at the meeting that AIG's Financial Products unit, which sold the contracts, achieved a "dramatic reduction in risk" by unwinding many derivatives trades.

Some of AIG's Abacus deals were among those the unit exited last year. The agreements to unwind the contracts caused AIG to realize a loss of roughly $2 billion.

In the specific Abacus deal at the center of the SEC case, Goldman is accused of failing to tell investors that a hedge fund that wanted to bet against the deal had a hand in selecting mortgage assets that would determine how the security performed. Even before the SEC case made headlines, AIG had begun conducting reviews of the transactions arranged by its financial products unit for similar disclosure issues, according to people familiar with the effort.

Mr. Benmosche predicted "volatility" in AIG's earnings as it seeks to pay back the federal bailout that began in 2008 as AIG teetered on the brink of collapse. While Mr. Benmosche said the company's operating units "performed well" in the first quarter, when AIG swung to a $1.45 billion profit from a loss a year earlier, he said the company may take goodwill charges in the future.

AIG currently owes the Federal Reserve Bank of New York about $27 billion, including accrued interest and fees. The government-controlled insurance giant has also drawn about $49 billion in funds from the U.S. Treasury. The government owns just under 80% of AIG.

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