RAG Perspective: An American Pro-Liberty Conservative: Miscellany: 4/25/10

Sunday, April 25, 2010

Miscellany: 4/25/10

Quote of the Day
Never miss a chance to keep your mouth shut.
Robert Newton Peck

AIG and Things That Make You Go 'Hmmm'

As Dodd, Lincoln and other Senate Democrats try this week to push us to a dubious financial overhaul "reform" bill, in particular, the regulation of derivatives, The position of this blog has been that there should be increased transparency of derivative transactions through clearinghouses, but I oppose picking market winners and losers (e.g., commercial trading desks versus banks), restrictions on transaction participation which adversely affect liquidity, and costly changes to the nature and extent of collateralization (beyond some current financial baseline).

The Wall Street Journal last fall commented on a telling revelation that did not get widespread discussion. The conventional thesis behind the AIG bailout was that AIG's failure constituted a systemic risk, i.e., its failure in the derivatives business (its credit default swaps, a form of mortgage-related insurance) would have resulted in cascading bank failures. [Note here that I am not attempting to justify AIG's failure to collateralize and/or hedge against its risk exposure to the swaps; as one of the largest insurance companies in the world and subject in other lines of business to high regulation, reserve requirements, etc., and reasonably predictable (e.g., 18 year) cycles in the real estate market, it had to be aware of a downside risk. In essence, if it had to collateralize against the CDS being written and properly priced its swaps, that would have limited the number of swaps sold.]

It turns out the New York Fed (which at the time was being headed by current Treasury Secretary Geithner) was not concerned about the solvency of counterparties of AIG swaps. In fact, CDS settlements in the aftermath of the Lehman failure failed to validate the similar Chicken Little claims. In fact, Geithner seemed to be more concerned about AIG's other insurance businesses. But, as the WSJ notes, those insurance businesses were segregated into regulated subsidiaries, and hence the CDS counterparties did not have claims against those assets.

Instead, Goldman Sachs and other counterparties were made whole after the AIG failure by the government. What about the moral hazard by the federal government interceding? What about Goldman Sach's responsibility to ensure that AIG had reserves to back up the CDS it was writing? Why didn't it hedge against the volume of business it was doing with AIG? The only reasonable response seems to be that Goldman Sachs thought AIG was "too big to fail".

WSJ seems to suggest that the real story of these claims of systemic risk of AIG is to underscore the financial overhaul reform legislation. The fact that progressives have been exaggerating the risks of derivatives and its role during the economic tsunami is disingenuous smoke-and-mirrors politics as usual.

The Goldman Sachs Kerfuffle Weekend Update

Over the weekend, the Senate permanent subcommittee on investigations released selected Goldman Sachs internal emails, including a late 2007 note from the Goldman CEO suggesting they probably made more money than they lost in the mortgage securities business because of their short positions. (A short is a bet that a security will lose value in the future from current prices.) Goldman responded by releasing internal documents showing that it did take hedge against its MBS risk by taking short positions but argued that it did not short for speculative purposes, i.e., as a significant, consistent, standalone investment objective.

This blog is hardly a shill for Goldman Sachs; for instance, I opposed full-value settlement of the AIG swaps, and I've been critical of its heavy political contributions to Dodd and Obama. However, I lean towards Goldman's side on this question, and I am very concerned about the relative timing of recent SEC charges against Goldman and these documents over the weekend as questionably close to coming Senate votes on financial overhaul reform.

There was also an interesting post in Newsweek suggesting the Goldman/Paulson relationship behind recent SEC securities fraud allegations is not necessarily unique--that similar relationships occurred elsewhere in the industry. [In fact, Goldman claims it lost $100M on the Abacus securities Paulson shorted (although it did hedge against its loss and its stake had more to do with an expected buyer falling through).] I am somewhat skeptical of the government's case; all of the buyers knew about risks/rewards associated with subprime mortgage notes, were investment professionals, and were given financial information relevant to the securities. The fact that Goldman had difficulty selling off the remainder of its Abacus position, presumably without the potential deal partners knowing of the Paulson short position, seems to put into question the saliency of the Paulson position. If the housing market had bounced back, Paulson would have been left scrambling to cover its position. When the partners took the position, they ultimately believed that the securities would, at minimum, not lose money from their original purchase price, or they would have argued for a better price from the get-go.

Political Cartoon

Glenn Foden points out in a globally competitive financial market, the current financial overhead reform legislation is an overly expensive, counterproductive, heavy-handed effort which unnecessarily pushes many strings, addresses the symptoms instead of the fundamental causes of financial risk mismanagement, and raises the cost of doing financial transactions in the US. We need true leadership, not some sort of public relations stunt by a progressive Congress and President to provide cover that it addressed the problems underlying the 2008 economic tsunami.