Wednesday, April 15, 2009

The Goldman Sachs Three Card Monte Act

These guys never stop. Bob Murphy has pointed out to me a letter to the editor of WSJ written by Goldman Sachs managing director Lucas van Praag:

Prof. Amar Bhidé does his readers a disservice when he asserts that Goldman Sachs miscalculated the creditworthiness of AIG and was “made whole” by a government bailout of the company (”You Can’t Rush a Recovery,” op-ed, April 9).

These are the facts: Goldman Sachs is in the business of acting as an intermediary for numerous clients and often assumes risk on their behalf. Our normal protocols require that we protect our shareholders from loss associated with our incurring these positions through rigorous risk management. This includes buying credit insurance which, in the matter at hand, we did from AIG, then one of the world’s largest insurance companies. The terms of this insurance included a requirement that AIG give us enough cash collateral to protect us against possible future loss.

We have consistently said that we had no direct economic exposure to AIG. We marked to market the risk we had insured with AIG, and AIG was contractually required to give us collateral to cover any diminution in 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. 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 credit default swaps and therefore would not have incurred any 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 government prevented the company 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 swaps were written by large financial institutions which mark to market their obligations to each other and net their positions at the close of business every day, we exchanged collateral with the CDS providers on a daily basis. This protected us from the risk of any knock-on defaults.

Finally, others have asked why Goldman Sachs didn’t take a “haircut,” in other words, less money than we were owed. We had taken great care and incurred considerable expense to protect our shareholders. Why would it have been appropriate for them to have suffered a loss when they didn’t need to?

Far from miscalculating the creditworthiness of AIG, we acted in a way which most people would think of as a good example of responsible risk management.

Lucas van Praag
Managing Director
Goldman Sachs & Co.
New York
Bottom line, van Praag is saying, look we had insurance if AIG went bankrupt, but because the government propped up AIG, we couldn't exercise our credit default swaps (i.e. insurance), so that's why the government gave us money because they prevented the bankruptcy which we hedged against.

Was Goldman fully protected on their own? Maybe, maybe not, depending on how much insurance Goldman actually bought. But, what van Praag is doing is, like an expert three card monte shark, keeping you focused on the wrong card. While everyone is focused on the card van Praag is playing with, the real action is the card left over on the other side. That card is the wholesale liquidation of AIG portfolios at fire sale prices that Goldman and money center banks were able to flip for billions in profits at the expense of the taxpayer.

Unless those trades are analyzed, no one will really know what went down to make Goldman profitable in Q1. Further, I suspect Goldman, and others are gearing up for more of these wholesale liquidations. After the stress test results are released the government will force the sale of Private Eqiuty positions held by banks.

It is a three card monte act, but instead of ripping off NYC tourists on Broadway and Fifth Avenue for $20, it is ripping off taxpayers for billions without the taxpayers even getting to look at any of the cards. Only Timothy Geithner gets a peek.


  1. To further the analogy, instead of a disappearing card, we have a disappearing month as well. I thought it was just me when Christmas didn't feel real.

  2. So let me get this straight: Goldman Sachs was playing three card monte because they were smarter than the other guy? No, just better traders. Why should they have taken a haircut? They were smart enough to lay the risk off on others, and smart enough to bet the right way.

  3. @ Anonymous

    I think you need to re-read my post. You just got caught in the Goldman three card monte scam. The entire point of my post is that the focus on a "haircut" where they hedged is not the major problem. The problem comes in with the trades they made with AIG when AIG was blowing out their portfolios out at absurdly low prices.

    That was the scam.

    Always keep you eye on the red card, and it's never where the deal tries to make you think it is.