Thursday, October 29, 2009

Janet Tavakoli: All Bark, No Bite

Janet Tavakoli has always been more bark than bite. Being provocative is part of her shtick.

In her latest commentary, she accuses Goldman CFO David Viniar of lying about Goldman's exposure to AIG on a September 16, 2008 earnings call (the AIG bailout was negotiated later that day). This ridiculous conspiracy about Goldman and AIG just won't die, apparently.

On the call, Viniar said: "I would expect the direct impact of our credit exposure to [AIG] to be immaterial to our results." As Tavakoli acknowledges, it's a strong statement to say that a CFO lied to the public. It's also a patently absurd statement in this case. Yes, I know, Goldman is evil, Goldman owns the government, yada yada yada. Anyway, back in the real world, Goldman's exposure to AIG almost certainly was immaterial.

Let's go over this again. The total notional amount of CDS protection that Goldman bought from AIG was roughly $20 billion. But "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 this way: if you buy a $300,000 homeowners' insurance policy on your house, and your insurer goes bust, you're not out $300,000. The cost to you is simply the cost of buying another insurance policy to replace the first one. In Goldman's case, the cost of replacing its trades with AIG was about $10 billion. Against that $10 billion, Goldman held $7.5 billion in cash collateral. It then hedged the remaining $2.5 billion of exposure with CDS on AIG. This is why Viniar said that Goldman's direct exposure to AIG was immaterial.

So what are Tavakoli's arguments? One is the Immaculate Negotiation argument:

The government could have stepped in and renegotiated its contracts. ... Goldman Sachs would have been out billions of dollars in collateral had a bankruptcy‐like settlement been negotiated with AIG, and that is material.
Saying that Goldman would've taken a material loss if "a bankruptcy‐like settlement been negotiated with AIG" is the equivalent of saying that Goldman would've taken a material loss if they'd agreed to take a material loss. It's true, but there's no way Goldman would ever have agreed to a "bankruptcy-like settlement" — why would they? As someone who has actually been involved in these kinds of negotiations, let me explain how the AIG/Goldman negotiations would have played out:
AIG: Would you be willing to accept, say, 70 cents on the dollar?
Goldman: No.

THE END
Seriously, what could AIG have threatened Goldman with? If they didn't accept a haircut, AIG would file for bankruptcy? Fine, Goldman would've just seized the $7.5 billion in cash collateral, and collected the remaining $2.5 billion from its counterparties on the now-triggered CDS on AIG (on which more below), covering Goldman's full bilateral exposure to AIG. That's what it means to be "hedged."

(This is also why the Fed paid Goldman and the other counterparties 100 cents on the dollar to terminate their CDS contracts with AIG, which this Bloomberg article portrays as some sort of gift to the banks. But the Bloomberg article also relies on the Immaculate Negotiation argument — how, exactly, was the Fed supposed to get the counterparties to agree to take a haircut? The Fed had just demonstrated to the entire world that it wasn't willing to let AIG file for Chapter 11. How do you suppose those negotiations would have gone? The Fed couldn't say, "You can either take a haircut to 70 cents or AIG will file for bankruptcy and you'll only get 50 cents," because everyone knew the Fed wasn't willing to put AIG in bankruptcy.)

Now, with regard to that $2.5 billion in CDS on AIG, Tavakoli argues that "It is never a given that hedges will pay off when the chips are down." That's true, and there's no guarantee that the counterparties who sold CDS on AIG to Goldman would've been able to make the payouts. But these CDS trades, like most standard single-name CDS trades, were margined daily. At the close on September 16, the CDS spread on AIG was 53 percent upfront and 500bps running, which means that the counterparties who sold Goldman CDS on AIG would have already posted around $1.4 million in collateral (excluding Independent Amounts). So the maximum potential shortfall to Goldman was about $1.1 billion — and the only way they'd lose that amount is if the counterparties they bought CDS on AIG from all somehow couldn't pay. Viniar was entirely justified in assuming that these counterparties would've paid the remaining $1.1 billion.

Tavakoli also argues that Goldman had exposure because AIG's failure would have caused a system-wide meltdown:
If AIG had gone under, the already illiquid market would have frozen. Collateral requirements for all trading would have increased (just as they did the week Bear imploded), and Goldman would have had problems collecting from many trading counterparties.
That may be true, but not only is that not the issue, there's also no way Viniar could possibly have known how the mayhem following an AIG default would have affected Goldman. It's not like he could've said, "Yes, our exposure is material because an AIG default will cause hedge fund clients A, B, and C to withdraw their prime brokerage accounts, initial margins to rise by X, and 2-year swap spreads to fall Y basis points." No one knew what would happen if AIG was allowed to file for Chapter 11 — not even the Great Janet Tavakoli. Remember also that what Viniar said was that he expected "the direct impact of [Goldman's] credit exposure" to be immaterial. He wasn't talking about Goldman's exposure to a broad systemic meltdown, and no one thought he was either.

Finally, Tavakoli argues that Goldman's exposure to AIG included "reputation risk." Yes, I'm sure that if AIG had failed, Goldman's reputation for having prudently managed its counterparty risk would've been devastating.

I own all 4 of Tavakoli's books, and it's undeniable that she's extremely smart. But like I said before, in her public commentary, she's all bark and no bite.

24 comments:

Tom Rush said...

Great review!

Michael Hunt said...

Excellent reasoned commentary! Janet is certainly a colorful and smart industry gadfly. I think in this particular case, as you have correctly pointed out, her animosity (toward high profile, highly paid IBs) exceeds her analysis. At times she seems to border on irrational when critiquing individuals in the business. She seems a woman scorned. I am sure there is some untold back-story to her career.

Anonymous said...

Devastating.

The Saddam Sachs hysteria is hysterical. Unfortunately, a huge number of people have fallen for it. Scary.

Sean Foster said...

Good call on Tavakoli! I think she works hard at being "provocative", perhaps too hard as shown by your analysis. "Provocative" may be a kind word to describe her attempts at pr at the expense of others. Her Buffett book was certainly a pr piggyback attempt. No doubt she is a smart person driven by some underlying hatred of--- well, who knows? I am glad you took the time to breakdown her faulty analysis. I have no particular love for GS, they are a big player and clearly open to deserved criticism-- but not in this particular case.

Anonymous said...

"if you buy a $300,000 homeowners' insurance policy on your house, and your insurer goes bust, you're not out $300,000."
True, but if your house is on fire when your insurerer goes bust, you are out $300,000 because the next insurance company is going to charge you $300,000 for your new $300,000 policy, if they give you a policy at all.

It is a pretty commonly held assumption that many CDS were mispriced - and with AIG no longer writing CDS, the actual liquidity grew rather thin (and pricing questionable in any size and counterparty risk still an issue) so replacing the notional protection at $10bn is questionable. You are right that GS could seize the cash collateral it was holding. As to the rest of the exposure, GS had risk. The materiality seems open to interpretation.

Having had a counterparty fall down on my firm's trades, I have witnessed firsthand the pain of losing billions of dollars on perceived a firm's "hedged" positions (our credit rating was downgraded when we did not get paid and when we paid out to our counterparties - luckily it was not simply coming from my wallet).

Still, to say that GS was lying here is rather provocative.

anne said...

"Of you buy a $300,000 homeowners' insurance policy on your house, and your insurer goes bust, you're not out $300,000."

First of all, AIG failed. That it was propped up by the government does not change the fact that the company failed dramatically.

Goldman Sachs didn't just hold insurance policies with a company that went belly up - they happened to be holding insurance policies with a belly up company right at the moment the Great Fire commenced.

So all those people - like GS - who had policies with the bankrupt insurance company happened to be holding them just as their house went up in flames.

So to use your analogy, if you're house burns done the day your insurance company goes belly up, you're really SOL.

Second, I don't know if you realize this, being a structured finance lawyer, but for most people outside of the weedy patch known as Wall Street, it's odd to claim for GS to claim they were protected from AIG's failure, but then turn around and take $12 billion from the feds. That they took the money gives the appearance that they needed it. Intuitively, their decision to take money they claim they didn't need does not make sense.

It is also suspect when at a time when the economy of the nation is collapsing as dramatically as the business of AIG collapsed, the person in most frequent contact with the Treasury Secretary was the CEO of GS. Yes, former colleagues, I realize. Friends, probably. Golfing buddies. But in that a bankrupt company, thanks to the largess of the US government, paid out 100 percent on the dollar (unusual in bankruptcy cases, right?) to one of (if not the) biggest clients - that also happened to be former employer of Paulson does tarnish the deal in the eyes of the public.

It is illuminating to realize that in bankruptcy, GS would be empowered to go in and seize what it wanted from a bankrupt firm. That's not how I understood how bankruptcy worked. I have a feeling that when Viniar was on that call, he knew the feds would not let GS fail.

I do not believe Viniar lied. But I don't believe it's as spanking clean as you assert....

Shelly Smith said...
This comment has been removed by a blog administrator.
Anonymous said...

GS sold a product to the European commercial banks, that enabled them to meet BASELII reserve requirements. It was, is essence, a piece of US mortgage paper, supported by an AIG insurance policy wrapped with a AAA-rating. At AIG's failure, French banks would have become severely capital constrained. Christine Legarde personally called Paulson to ask that AIG be saved. The reputational risk to GS of near-bankrupting all of Europe's major banks would have been devastating. Read the list of banks who received $ 10s of billions from the FED. Its the GS client list.

Anonymous said...

How likely is it that other AIG counterparties were similarly hedged against a potential AIG default? Some of them appear to be Saddam Sachs clients. Would Saddam Sachs have advised them to enter into CDS agreements to eliminate their exposure to an AIG default?

Anonymous said...

Well, you can only conjecture from the headlines...Swiss banks gave up names that the US Treasury has been after for years. Clearly, there was a quid pro quo. So I guess the Swiss banks, who were levered at 8x the national GDP owed something to the US Treasury. I guess they weren't hedged over at JPMorgan or Berkshire Hathaway. Seriously, who can write systemic risk insurance like this? The British banks are levered at 4x GDP. There is a reason why the G-7 meetings have become so collegial and have been expanded to included countries with funds to lend.

Economics of Contempt said...

Anonymous @ 5:45 PM:

Yeah, the $10bn number is still technically open to question. But I checked it against where the ABX was trading at the time (~50), so it seems legit.

Anonymous said...

EoC, Dyaln Ratigan is claiming that AIG counter parties, "such as Goldman Sachs...", had previously accepted 40 cents on the dollar.

Comments?

Anonymous said...

AIG: Would you be willing to accept, say, 70 cents on the dollar?
Goldman: No.

THE END

really? and would it have played out the same if it was USG instead of AIG (as it has been since then). why did this work out then?

Treasury: Do you want TARP money?
Goldman: No.
Treasury: Here is your $10. Next.

THE END

Anonymous said...

You are very confused. From GS's perspective the 12.9 billion had nothing to do with TARP. To them it was AIG's money, and it was owed to GS.

And they were correct. AIG owes the government 12.9 billion. GS does not owe the government 12.9 billions. Nowhere in the books of the United States government is there a receivable from GS for 12.9 billion.

HIs point on why GS would say no is simple. They had another place to go to get their "100" cents on the dollar. To get there, they had to say no to any AIG offer of less than 100 cents.

Anybody with a brain would say no to 70 cents if merely saying it, no, got them 100 cents.

Anonymous said...

i get that. and i see how my comments were confusing.

what i was trying to say: the treasury could have twisted GS's arms (like it was made to appear in the case of TARP) if it wanted to.

Anonymous said...

the treasury/fed/government nebula

Anonymous said...

"Anybody with a brain would say no to 70 cents if merely saying it, no, got them 100 cents."

not so fast. the "70 cents" is risk-less, being furnished up front in the form of cash (equivalent).

the "100 cents" is not -- if not any other risk, certainly the 100 cents embody counterparty risk.

so maybe on a risk-adjusted basis it would still be the case that the "100 cents" is worth more, but that is not necessarily true. certainly 100 cents in upfront collateral is more than any expected cash flow from the hedges for the 100 cents.

King of Ithaki said...

as an attorney who handles commercial transactions, surely you are aware that in a bankruptcy filing, the trustee would claw back all that "offset" and the counterparties would be "unsecured" creditors...so that these 'special people' were in fact given money they would never have seen in a bankruptcy, even worse, they probably would not even have been able to file a proper claim as has been noted by many in respect to documentation of these derivative transactions, many of them exist only in the minds of the purported parties, for bankruptcy purposes, these are not "secured" parties and would have their offsets ignored by a proper bankruptcy case...

tisk tisk for you to omit that obvious part of her argument...

doug-will said...

Why all this talk about house insurance or houses on fire? This was a casino on fire, with the all the rich players scrambling for as many of the chips they could get before the casino closed down. The problem, now that the fire is out and casino insurance has made everyone whole, is that the ins co, ie the gov, has allowed the casino to go back to biz as usual and refuses to take away matches from the players...

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