On Conservation of Risk, Poor Risk Management & Government Intervention- Part 1

Over the weekend, I had an extensive discussion with my business partner on the topics of financial risk, Goldman Sachs, AIG, and the federal government and Federal Reserve's payment of AIG's credit derivatives obligations amidst its takeover of the insurer.

The reason for our renewed discussion was a Wall Street Journal piece over the weekend which cited several new sources that again called into question Goldman's management's assertions, which continue to this day, that it was adequately hedged and in possession of sufficient collateral, which would not have lost value, such that they were really indifferent to AIG's survival or bankruptcy.

The Journal's own staffers, the TARP's inspector general, and a private risk analyst from Chicago, retained by CBS to review and comment on an internal AIG memo, all have disputed Goldman's assertions.

The details contained in the Journal's weekend story, entitled "Goldman Fueled AIG Gambles," were somewhat shocking. At least, to me.

The investment bank, according to the Journal piece, was ultimately repaid for "trades with AIG covering a total of $22 billion in assets."

Elsewhere in the article, it is stated that Goldman intermediated $14B of CDO deals, to Merrill's $6B, and that AIG ultimately insured some $80B of CDOs with credit derivatives.

As my partner and I talked about Goldman's strong-arming of the Fed and Treasury to repay 100% of AIG's credit derivatives obligations, despite being effectively, but, thanks to government intervention, not technically bankrupt, he contended that one should credit Goldman for its cleverness and alacrity.

I disagreed, and continue to do so. Here's why.

First, Goldman's insistence on being repaid in full, rather than accept an AIG bankruptcy, and, indeed, argue for it, has fatally undermined the Constitutionally-enshrined, normal bankruptcy process. I believe the unintended consequences of this act will reverberate globally, to the ultimate detriment of faith in the US dollar and Treasury obligations.

Second, given that the preponderance of evidence points to Goldman now misrepresenting how vulnerable it was to bankruptcy from the losses it would have taken on its AIG transactions, it doesn't actually appear to be the same Goldman Sachs of, say, John Whitehead's reign as CEO.

In fact, the AIG debacle exposes Goldman for being just another financial services firm which mismanaged risk to a degree that should have caused its failure. A failure that is vital to terminating the control of assets by inept management.

True, Goldman Sachs weathered 2007 and part of 2008 by betting against the residential finance boom. But, in the end, it was undone by the simplest of risk management mistakes.

Goldman Sachs' management forgot that, until an actual financial loss, total risk in the financial system cannot be eliminated. It is conserved, and transferred via transactions such as credit derivatives.

But that does not eliminate it from the financial system. In fact, to the contrary, due to a hoary technical term known as "counterparty risk," a firm can sell its risk to another party, perhaps even at what seems to be an attractive price, only to find, later, it still owns the risk, when the counterparty fails.

Thus, when you examine the details of AIG's CDO credit derivatives book, you see that Goldman was in for about 25% of it.

Further, according to the Journal article, Goldman was securitizing mortgage pools that were no better in quality than others. They contained subprime mortgages, loans from Countrywide, known for pioneering low- and no-doc loans. In effect, Goldman's brand, in this case, carried no actual expectation of higher quality mortgages.

Nothing that Goldman did involving its underwriting of CDOs or trading credit derivatives on them with the intent of transferring the risk to AIG would seem to actually connote superior skills or value provided to its clients.

If anything, Goldman Sachs traded on its image by extracting value from everyone else in the deals in which it participated.

But it made one really big mistake. It's management overlooked the risk to its own firm of piling on too much risk with one other player, AIG. Goldman's risk managers apparently disregarded the likely outcome of one insurer, AIG, assuming far too much CDO valuation risk, for, as it turned out, prices which were much too low.

When all of that risk became concentrated in AIG, and then became realized with the bursting of the housing bubble, that risk went back to those firms which had attempted to sell it to AIG.

Unlike many other observers of last year's financial crisis, I have never believed that the government intervention embodied in the TARP and the Federal Reserve's liquidity creation was necessary to avert some sort of 'systemic meltdown,' or a 'plunge into a financial abyss.'

I continue to believe that Anna Kagan Schwartz was correct in her contentions in an interview with the Wall Street Journal last fall. She diagnosed the late 2008 financial crisis as one of institutional solvency, not liquidity.

As such, she opined, crippled, insolvent institutions should have been closed, with the excess financial capacity allowed to disappear. If the US financial system truly needed added capacity, there are plenty of private equity and hedge funds ready to move in and seize the opportunities thus presented.

The dirty little secret of US banking in the past two decades has not been a lack of capacity, but an overabundance. That's why so many exotic instruments were created. Because the basic equities and debt products became so marginally profitable.

Just when the US financial system had a chance to clean out poor financial risk management in a Schumpeterian wave of failures of credit providers, the government foolishly caved in to the affected, about-to-fail institutions and ran the monetary printing presses to bail them out.

How are the risk managers at Goldman Sachs and its ilk to learn from their mistakes if those gargantuan mistakes were simply erased?

Unfortunately, the damage has and will spread beyond just those institutions, as I'll discuss in the next post on this topic later this week.

to be continued.....