Hank Paulson, Goldman, and AIG (For Journalists)

I see that Gretchen Morgenson has another ridiculous article about Goldman's (mythical) involvement in the AIG bailout. The article focuses on the fact that Hank Paulson talked to Lloyd Blankfein more times than he talked to other CEOs in the week after Lehman failed. The article is misleading in extremis, and relies heavily on innuendo and misdirection. The clear suggestion is that Paulson bailed out AIG to save Goldman. The obvious problem with that argument is that AIG was bailed out by the Fed, not Treasury. But I want to address a premise of the article: that Goldman had substantial exposure to AIG.

Of course, Morgenson takes it as a given that Goldman had substantial exposure to AIG—since, hey, she's the one who started that rumor in the first place! Unfortunately, it's just not true: Goldman had hedged its exposure to AIG. But since there's apparently not a journalist in the country who understands what it means to be "hedged" (other than Shannon Harrington of Bloomberg, who is top-notch), I'm going to break down the Goldman-AIG trading relationship as clearly as I possibly can. Now, I've never had a talent for explaining complex issues in clear, easy-to-understand terms, so bear with me.

The most important thing to understand is this: "Exposure" in credit derivatives is equal to the cost of replacing a credit derivative in the market, not the notional amount of the transaction. Think about it: the total notional amount of CDS that Goldman bought from AIG was roughly $20 billion, but AIG didn't "owe" Goldman $20bn. It had merely promised to protect Goldman against future losses on certain CDOs up to $20 billion. If AIG had failed, Goldman would have lost that protection, and would have had to buy the same CDS contracts from someone else to replace the lost protection. Therefore, Goldman's "exposure" to AIG was equal to the cost of replacing the CDS trades it had on with AIG.

Now we can break down the Goldman-AIG trading relationship, which Goldman CFO David Viniar laid out in this conference call:

• Goldman bought roughly $20 billion of total CDS protection on various CDOs from AIG.


• In September 2008, the cost of replacing the CDS protection that Goldman had bought from AIG was $10 billion. [Direct exposure to AIG = $10 billion]


• Against this $10 billion, Goldman held $7.5 billion in collateral, the vast majority of which was in the form of cash. [Direct exposure to AIG = $2.5 billion]


• The remaining $2.5 billion was hedged via CDS on AIG—that is, Goldman bought CDS protection on AIG from a third party. [Direct exposure to AIG = $0]
  

Goldman's claim that it held $7.5 billion in collateral when AIG almost failed is supported by this 8-K filing by AIG, which shows that Goldman held $8.4 billion in collateral by late November 2008. Now, we can argue about whether the counterparties that sold Goldman CDS protection on AIG would have been able to pay if AIG had been allowed to fail—I'm perfectly willing to have that debate. Unfortunately, we don't know who those counterparties were. Standard single-name CDS are collateralized and marked-to-market every day, though, which means that as the CDS spread rises, the protection seller has to post more and more collateral. So it's likely that by the time AIG collapsed, Goldman's counterparties had already posted most of the $2.5 billion in collateral.

So there you go: $10 billion of exposure, hedged by $7.5 billion in collateral and $2.5 billion in CDS on AIG. I don't think I can make it any clearer than that.