Rescuing Goldman Sachs - The Truth

Reservoir Gods

US Treasury Secretary Tim Geithner came under fire again last week over the bailout of AIG (he was a key player in that saga in his previous position as President of the New York Federal Reserve).

Geithner has been criticized, in the main, for providing the money to enable AIG to pay out, in full, tens of billions due under credit default swap agreements. And a major recipient of these payments was Goldman Sachs, which bagged $12.9bn. Without this money, many are saying, Goldman would have been forced to declare bankruptcy. Fast forward 10 months, the financial system has recovered and Goldman Sachs is contemplating paying out record bonuses to its staff. And, understandably, there's a lot of anger out there because of the perception of largesse on the part of the government. But is perception reality ? Did Goldman Sachs actually need the AIG money to survive ? This issue is a complicated one, but nevertheless worth examining.

It was September 2008, and Morgan Stanley was on the ropes. The firm was leaking cash and was in real danger of running out. Over at Goldman Sachs, CEO Lloyd Blankfein was watching the situation carefully. He knew that, if Morgan Stanley failed, his own firm most certainly would come under even greater pressure. But was Goldman in any imminent danger, and would a subsequent bankruptcy of AIG have been enough to push Goldman over the edge ?

The problem with the old broker / dealer model was that firms like Morgan Stanley (and Bear and Lehman before them) relied on overnight money for their funding. Unlike their big commercial banking rivals, these broker / dealers didn't have a large customer deposit base to finance their activities. So, after the fall of Lehman Brothers in September 2008, when the credit markets effectively dried up, Morgan Stanley was haemorrhaging cash, and finding it difficult to replace it. Although Goldman and Morgan Stanley were both being squeezed at that time, Goldman, however, was in a slightly better position than its rival.

Unlike Morgan Stanley (which predominantly relied on overnight funds for its borrowing requirements), Goldman had more long-term funding in place - in fact, the average term of even its short-term debt was 100 days. So although Blankfein and Co were concerned about the fate of Morgan Stanley, Goldman itself was in no immediate danger of running out of cash. (In the event, Morgan Stanley stemmed the tide by raising $9bn from Japan's Mitsubishi UFJ Group in exchange for an equity stake in the firm).

Furthermore, to calm the markets and prevent financial armageddon, the US authorities did a number of things to shore up the financial system: they encouraged Bank of America to acquire Merrill Lynch; they bailed out Fannie Mae and Freddie Mac; they injected funds directly into the nation's largest banks to beef up their capital positions; they allowed Goldman and Morgan Stanley to become bank holding companies in order to officially access the Fed's discount window (and increase liquidity), and they provided billions to AIG to stop it from failing. (A point worth noting is that since being given access to the Fed's Discount Window, Goldman has only used the facility once - and that was just to test it).

And it is also important to understand that the US government took these actions not just to save Goldman Sachs (which would ultimately have failed along with every other financial institution if the authorities hadn't acted as they did), but to protect the average man in the street. The government moved in for the benefit of us all. No one in their right mind believes that the collapse of the financial system would have been anything but disastrous for every single one of us.

So, given all this, why is Goldman Sachs taking so much heat ? Why is this firm in particular the subject of such ire ? In essence, of course, it is because Goldman is the poster child for the financial markets - this highly successful firm is full of rich bankers who, on the face of it, benefited tremendously from the bailout of the entire banking system and, while 'the little people' continue to suffer, the Goldman few have ended up even better off.

The truth, of course, is not that simple. Yes, Goldman received a $10bn TARP payment to strengthen its balance sheet. But this money was imposed on the firm by the US government, which was anxious to give money to all nine of the so-called systemically important firms (Bank of America, Bank of New York Mellon, Citi, Goldman, JPMorgan Chase, Merrill Lynch, Morgan Stanley, State Street and Wells Fargo), in order to avoid the appearance that some firms were better capitalized than others. Goldman took the money (it had no other option), but repaid it at the first opportunity - with interest. 

But the crux of the matter, and the reason for much of the anger focused on Goldman, relates to the bailout of AIG. Goldman received an additional $12.9bn from AIG after the government came in and took control. Was this really just a back door bailout of Goldman Sachs, a firm that many feel was in dire need of the funds after getting itself in trouble for excessive risk-taking ? 

Well, starting in the mid-1990's, Goldman bought 'insurance', in the form of credit default swaps, from AIG to protect the firm from the risk that other parties, with whom it did business, defaulted and caused Goldman to suffer financial loss. But that's not all. Goldman even spent another $100m buying additional 'insurance' protection from parties other than AIG to cover the very same risks. So far, so good.

But when the US Government decided that a failure of AIG posed a risk to the stability of the entire financial system, it stepped in to bailout the company. By definition, that meant bailout funds would be used to allow AIG to meet its obligations, which included obligations to Goldman. However, had AIG failed, Goldman's direct exposure to loss was actually close to zero - because of the cash collateral the firm already held against the credit default swaps, and the additional hedging provisions it had made.

When the US government decided to step in and make all counterparties whole, Goldman received the $12.9bn that was properly due to it. It is also worth mentioning that $4.8bn of the $12.9bn was handed to Goldman in exchange for highly marketable US Government Agency securities that AIG had pledged to Goldman in return for a loan of the same amount. AIG gave Goldman the cash, and Goldman returned the securities back to AIG. If AIG hadn't repaid the loan, Goldman would simply have sold the securities.

So, in summary, the bailout of AIG did not directly save Goldman Sachs, as the firm would undoubtedly have survived AIG's failure. However, even though Goldman would possibly have been the last man standing (or at least among that group), there is little doubt that the collective actions of the US government helped it survive in its present form.

What is also clear, however, is that all this noise about Goldman being rewarded for undue risk taking is pure nonsense. Goldman Sachs is no angel, but neither is it the sinner it is made out to be. Its risk management procedures are / were among the best on the Street (ironically as demonstrated by how it managed its exposure to AIG). The firm did not suffer the writedowns and losses sustained by many of its rivals. Unlike many, Goldman also managed its funding risks more prudently - as mentioned above, it didn't heavily rely on the overnight market for its borrowing requirements, and therefore would not have run into liquidity problems as fast as its peers.

And is it fair to blame Goldman, as some are doing, for the financial crisis ? Well, there are many who can be held responsible for this mess (mortgage borrowers, real estate brokers, irresponsible lenders, rating agencies, bond insurers, lawmakers, government departments and agencies, investment banks, hedge funds, etc), but Goldman is not chief among them. Yes, the firm (by its own admission) did some things that certainly didn't help prevent the financial crisis from unfolding, but Goldman is primarily getting it in the neck today because it has emerged from the crisis in far better shape than anyone else. But it has done so only because it is better managed and more prudent than most of its rivals. 

In truth, Goldman is an easy and popular target, but that doesn't make it the right one.

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