Overview of Goldman Sachs’ Interaction with AIG and Goldman Sachs’ Approach to Risk Management
We have consistently said that we had no material direct economic exposure to AIG. As is our standard practice, we marked to market (assigned current values to financial assets and liabilities on a daily basis) the assets on which we had purchased protection with AIG. Per the terms of our specific trading arrangements with AIG, the company was contractually required to give us collateral to cover any fall in asset value. Because there were periods when AIG didn't provide enough collateral, we hedged ourselves against the then seemingly unlikely event that AIG might default through primarily credit default swaps (CDS). The cost of this hedging was over $100 million. If AIG had failed, we would have had both the collateral and the proceeds from the CDS protection we purchased and therefore would not have incurred any material economic loss.
In order to collect under a credit default swap, there has to be an event of default. No event of default means no payout. By supporting AIG, the US government prevented AIG from defaulting. Some have questioned whether, if AIG had defaulted, we would have received the money owed to us under the credit default swap arrangements. Because these CDS contracts were written by large financial institutions that mark to market and net their positions every day, we exchanged collateral with the CDS providers on a daily basis. This protected us from the risk that those counterparties would not be able to fulfill their commitments in the event AIG failed.
Finally, others have asked why Goldman Sachs didn't take a "haircut," – that is, accept less money than we were owed. We had taken great care and incurred considerable expense to protect our shareholders. We believe it would have been irresponsible for them to suffer an unnecessary loss.
We did not take the creditworthiness of AIG for granted. On the contrary, our actions in the case of AIG are a good example of responsible risk management.
Since the mid-1990s, Goldman Sachs has had a significant trading relationship with AIG. Our business with them spanned a number of their entities, including many of their insurance subsidiaries, and it included multiple activities such as stock lending, foreign exchange, fixed income, futures and mortgage trading.
AIG was a AAA-rated company, one of the largest and considered one of the most sophisticated trading counterparts in the world. Goldman Sachs established credit terms with them commensurate with those extended to other major counterparts including a willingness to do substantial trading volumes, but subject to collateral arrangements that were tightly managed. These arrangements included the requirement that AIG give Goldman Sachs collateral to protect us against possible future loss on the securities protected.
Risk Management Approach
As the firm does with many other counterpart relationships, we limited our overall credit exposure to AIG through a combination of collateral and market hedges in order to protect ourselves against the potential inability of AIG to make good on its commitments. We established a predetermined hedging program which provided that if aggregate exposure moved above a certain threshold, credit default swaps and other credit hedges would be obtained. This hedging is designed to keep our overall risk to manageable levels.
As part of our trading with AIG, we largely acted as an intermediary between clients and AIG related to certain bond risk, such as Super Senior Collateralized Debt Obligation (CDO) risk. The net risk we were exposed to was consistent with our role as a market intermediary rather than a proprietary market participant.
Timeline of Events Related to AIG
In July 2007, we began to significantly mark down the value of our Super Senior CDO risk. Our rigorous commitment to mark-to-market accounting prompted us to do so in a way which we believe was more conservative than other institutions and consequently resulted in collateral disputes with AIG. Over subsequent weeks and months, we continued to make collateral calls as the market deteriorated. While we collected significant amounts of collateral, there still remained material gaps between what we were paid and what we believed we were owed. As we have stated on multiple occasions, these gaps were hedged in full by the purchase of CDS and other risk mitigants such that we had no material risk.
In mid-September of 2008, prior to the government's action to save AIG, a majority of Goldman Sachs’ exposure to AIG was collateralized and the rest was covered through various risk mitigants. Our total exposure was roughly $10 billion, which predominantly included AIG FP but also a number of other AIG legal entities. Against this, we held roughly $7.5 billion in collateral. The remainder was fully covered through hedges we purchased, primarily CDS. We had no material economic exposure to AIG.
In the middle of September, it was clear that AIG would either be supported by the government and meet its obligations by making payments or posting collateral, or it would fail. In the case of the latter, we would have collected on our hedges and retained the collateral posted by AIG. That is why we are able to say that whether it failed or not, AIG would have had no material direct impact on Goldman Sachs.
Cash Flows with AIG
Goldman Sachs has stated consistently that the firm did not have a significant economic exposure to AIG. AIG's disclosure of cash flows to counterparties does not in any way contradict that statement.
In this regard, a list of AIG's cash flows to counterparties indicates little about each bank's credit exposure to the company.
The three buckets AIG identified in which cash flowed to counterparties are the following:
- The first represented $2.6 billion in additional collateral that was called as markets continued to deteriorate. This posting of collateral was consistent with the agreements we entered into with AIG.
- The second bucket was the $5.6 billion associated with Maiden Lane III. In mid-November, the Federal Reserve established this financing entity to purchase the securities underlying certain CDS contracts and effect the cancellation of those contracts between AIG and its counterparties. The Federal Reserve required that the counterparties deliver the cash bonds to Maiden Lane in order to settle the CDS contracts and avoid any further collateral risk. Consequently, the cash flow of $5.6 billion between Maiden Lane and Goldman Sachs reflected the Federal Reserve paying Goldman Sachs the face value of the securities less the collateral held on those securities. Goldman Sachs then spent the vast majority of the money we received to buy the cash bonds from our counterparties in order to complete the settlement as required by the Federal Reserve.
- The third bucket AIG identified involved $4.8 billion related to securities lending. Financial institutions regularly exchange securities for cash to facilitate their liquidity needs. In this case, AIG gave Goldman Sachs $4.8 billion in securities which were largely the highest quality very liquid agency securities. Goldman Sachs in return gave $4.8 billion in cash to AIG. The $4.8 billion referenced in AIG's disclosure was simply the return of cash to Goldman Sachs in exchange for the return of securities AIG had posted. Since these securities were highly liquid and marked to market, had AIG not returned the cash, we would have sold the securities for the roughly $4.8 billion.