Tavakoli Structured Finance LLC

The Financial Report

By Janet Tavakoli

Congress Exposes Potential Profiteering, Cover-Up in AIG’s Deals

Yesterday the House released some missing details of the AIG bailout. (Click here to see the unredacted pages of the March 2009 SEC filing.) The public knew that the Fed paid 100 cents on the dollar to AIG’s trading counterparties to resolve its credit default swaps, but the details of the assets behind the trades were kept secret.

Plenty of Time to Renegotiate AIG’s Contracts

The first bailout of AIG occurred in September 2008 when the FRBNY extended an $85 billion credit line to AIG. By the September 2008 initial bailout, Goldman Sachs had extracted $7.5 billion in collateral from AIG, and other banks that bought Goldman’s CDOs also extracted billions from AIG (click here for details).

Goldman CEO Lloyd Blankfein claims he had no idea AIG had trouble producing collateral. I knew AIG was headed for grave trouble more than a year before the September 2008 bailout and raised the issue with both Warren Buffett and JPMorgan Chase CEO Jamie Dimon. Goldman Sachs claims to be a superior risk manager, yet asks the public to believe that it was clueless about AIG’s distress, even though Goldman itself was a key contributor to it.

Then Treasury Secretary Henry Paulson was CEO of Goldman Sachs at the time it put on these trades with AIG. Lloyd Blankfein was (and remains) CEO of Goldman and was the only Wall Street CEO at one of Paulson’s bailout discussions. Stephen Friedman, then Chairman of the NY Fed, also served on Goldman’s board.

Details That Could Anger the Public

An analysis of the previously secret details shows that at the time of the November 2008 buyout, some collateralized debt obligations (CDOs) had implied prices of around 60 cents on the dollar. Others had implied prices of around 20 cents on the dollar.

Not revealed by the new report is that many of the assets backing some of the CDOs have a high risk of severe or total principal loss (many have actual losses). These CDOs have “cliff risk,” as in falling off of one. (There is currently no reliable secondary market, and similar CDOs have traded as low as one penny.) One such CDO is Davis Square IV, a CDO on which French bank Societe Generale bought protection from AIG. The CDO is a poster child for Wall Street’s key contribution to a financial crisis that devastated the U.S. economy.

Goldman’s CDOs: Falling Off a Cliff Risk

Goldman Sachs created and closed Davis Square IV in April of 2005. The CDO was managed by Trust Company of the West (TCW). (Click here for a list of assets of Davis Square IV from the time period around January 2008). The original portfolio included mortgage-backed securities from Goldman Sachs Alternative Mortgage Products, Merrill, and problem mortgage lenders Countrywide, New Century, Novastar, First Franklin, and Fremont (among others). Assets include home equity loans, midprime loans, subprime loans, and adjustable rate mortgages. The CDO also includes other CDOs.

AIG’s Joe Cassano said AIG was basically out of the business of guaranteeing mortgage product at the end of 2005, yet the report shows around 14% of the CDOs on which AIG sold protection appear to be from 2006, 2007, or 2008 representing around 30% or $19 billion of the $62.13 billion notional amount purchased by the Fed.* Furthermore, CDOs from 2006 and 2007 are buried within the portfolios backing the original CDOs. For example, TCW traded mortgages from 2006 and 2007 vintages into the portfolio backing Davis Square IV. These “assets” are among the worst of the lot.

Goldman Sachs and TCW: Too Cozy for Investors’ Comfort

CDO managers may disclose conflicts of interest, but a conflict of interest shouldn’t mean that new assets “managed” into your portfolio are highly likely to do you harm. TCW and Goldman Sachs had a relationship that benefited TCW, which earned fees from deals like Davis Square IV. Davis Square IV included several tranches of Goldman’s Abacus deals, including $53.5 million from 2006. By September 2008, Goldman’s CDO, Abacus 2006-12, was already downgraded from AA2 to Ca, a junk rating–it means you are likely to lose your shirt. Another part of this CDO in Davis Square IV’s portfolio was downgraded from A3 to Ca. Three of Goldman’s slices of Abacus 2006-15 also made their way into Davis Square IV, and they were also all downgraded to Ca, a junk rating, by September 2008.

Blackrock’s Suspect 2007 CDO: Dumped by TCW into AIG Protected CDO

Among other eyebrow raising assets in Davis Square IV, one finds a CDO called Pinnacle Point Funding 2007-a. This CDO was managed by Blackrock. It closed June 7, 2007, and went into acceleration (not a good sign) on December 13, 2007. Davis Square IV’s “investment” was originally rated triple-A. By the time of AIG’s September 2008 bailout, it was already downgraded to C, a junk rating, by Moody’s. Yet the Fed awarded no-bid contracts to Blackrock to manage the assets it bought from AIG.

Profiteering and Cover-Up: Possible Reasons for Redaction

The financial windfall conferred by AIG’s bailout, the self-serving claim that the crisis prevented negotiation, and the subsequent cover-up of details were very much to the benefit of Goldman Sachs and its current and former officers involved in the bailout discussions

In the example above, I show the Davis Square IV portfolio as of January 2008. One would need similar snapshots of all the CDOs to figure out who did what to whom. The fact that the Fed and SEC suppressed potentially explosive facts is bad enough, but the delay in making the information public has given interested parties a window of opportunity to cover their tracks by dumping the worst of the assets, thus hiding them forever from public view.

Suppressing the details of AIG’s trades made it easier for AIG’s counterparties to cover-up profiteering and then exploit public funds. If details of these trades had been made public in September 2008, a reasonable negotiator would have demanded that the billions of dollars that had been extracted from AIG (including the $7.5 billion Goldman extracted by then) should be recharacterized as a loan.

Instead, the Fed gifted tens of billions of dollars to banks that supplied the financing for bad loans that damaged the U.S. economy. More than that, these banks engaged in suspect deals that covered up losses and allowed them to continue to report apparent “profits” and pay inflated bonuses. Meanwhile, their securitization activities continued to harm the economy during a period when the United States was at war.

Goldman is not solely responsible, but it had a large role in AIG’s crisis and a unique position of conflicted interest and influence over the terms of the bailout. 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.

*Figures updated January 29, 2010

See: “Goldman’s Undisclosed Role in AIG’s Distress” – November 10, 2009

Read more finance articles on this topic by Janet Tavakoli.

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