Their Own Private Bailout: More On Goldman And AIG

Have I been going too easy on Goldman? One reader wrote yesterday to take me to task for turning a blind eye to Goldman's "double dealing." In his view, it's scandalous that Goldman was at one and the same time packaging mortgage backed derivates (CDOs) and betting on a crash through CDS contracts made with AIG. If  Goldman thought mortgage backed derivates were a bad deal, why were they selling them to clients? And if they didn't, why were they betting against them?

I don't think this is fair. Goldman wasn't one of the biggest CDO players by any means. This reader forwarded a column by Ben Stein that cited Goldman as one of the "top ten" issuers of these derivatives. But Goldman is one of the world's biggest investment banks; its rankings in these areas are far lower than Goldman's rankings in other areas of finance. I don't think you can say that if anybody at an investment bank sold a certain kind of instrument, then nobody else there can bet against it. That's not double dealing. That's hedging risk, and it's what an investment bank is supposed to do. There's a gray area here. If a bank systematically promotes bad products to clients, that is indeed a meaningful issue. But we don't have nearly enough insight into Goldman's workings to say that (by contrast, I think we can say that about Bear, Stearns, which seemed to have taken its worst, least sellable CDOs and dumped them in to Ralph Cioffi's funds).

It's also worth noting that some of the criticism of Goldman really puts any investment bank in an unwinnable position. If they hedge their exposure, they're "double dealing." But if they don't have lots of exposure to mortgage bonds, and are simply making bets on the derivatives market through its AIG contracts, they're "speculating." Either way, the investment bank is somehow supposed to be culpable. You can see the irony of this if you look over the broader landscape. The banks that lost money are supposed to have been criminally negligent because they didn't see where the market was going. Now it seems Goldman, one of the few banks that made money in all this, is supposed to be slimy because they did.

PS: Should we stop trading in the kinds of derivatives that AIG dealt in, as George Soros advocates? Yes. But that doesn't mean we should criticize and/or punish Goldman for having been on the right side of the trades when no one saw just how stupid and destabilizing AIG's business was.

Bad Asset Math, Bonus Edition

On Monday, writing about the Geithner asset purchase plan, I wrote that you should put your money on the pessimists and bet that the asset purchase plan will cost the government a bundle. I think I could have done a better job of explaining why. In general, you'll find a lot of people who will assume that "if Wall Street and private equity likes it, it's a bad idea." The thinking is that the sharpies on Wall Street will always get a good deal. I'm suspicious of that knee jerk response. The experience of the last year has shown that's not true: investment banks have shown themselves very capable of making horrendous bets in markets they designed themselves . The fact that private equity is willing to play with Geithner doesn't in itself mean we're getting ripped off.

But there's still reason to be skeptical that the government will get off pain-free. Supporters of the Geithner plan think we're using the power of the communal mind to come up with the right price. The private equity folks want to make money on this deal, and the temptation is to think that if they make money, the government does well, too. The only thing the government gives up is the notional value of its loan guarantees, and it even gets to share in the profits.

However, it doesn't work quite like that. The problem is that how the private equity players do in aggregate isn't what matters. It's how they do on each deal. Let's say they buy three batches of CDOs; we'll call these CDO Larry, CDO Moe, and CDO Curly. If CDO Larry turns out to be a good deal, while CDO Moe and CDO Curly are worthless, the investors can do quite well. The private equity investors can make a profit on Larry, but still call in the government's loan guarantees on Moe and Curly. You might say, hey, that's not fair. Shouldn't they have to cover the loss on Moe and Curly if they made a lot of money on Larry? Well, no. Not as the plan stands now if I understand it correctly. Maybe over the next weeks the plan will develop further. If Geithner & Co. can find a way around this problem, then this could turn out to be a much better deal for the government. But so far, I don't see what that way would be.

The AIG Gravy Train

One of the latest bailout memes going around is that maybe the government shouldn't have bailed out AIG, because an "AIG bailout" really means a bailout of the counter-parties, like Goldman Sachs, who were dumb enough to have AIG insure their transactions. Interestingly, one of the first people to voice this idea was none other than former AIG patriarch Hank Greenberg (whom I wrote about today), who's said that shareholders would have fared better in an AIG bankruptcy than in the federal bailout. Greenberg's take is odd--hey, wouldn't shareholders have been left with zip in a bankruptcy? But the more general complaint that about AIG--that it's not clear why the the government should be funding a $12-plus billion stealth bailout of Goldman--is understandable.

Understandable, but still wrong. One of the government's aims over the last months has been to separate toxic assets from good ones. If that's what you want to do, then AIG is by default a pretty good vehicle for doing it. It is in effect, a "bad bank"--one that has concentrated risk in bad CDOs that no one wanted. Backing AIG is in effect a way to get bad assets off other banks' balance sheets. It helps contain the cycle of failure.

Should AIG have been allowed to offer the derivatives that brought it down in the first place? Clearly, no. But they were. When it comes to insurance and bank deposits, the principle of caveat emptor is a bad one. Awful as the current crisis is, it would be worse if there was no assurance that the buck stopped somewhere. Take it away, and you simply create a world of ever more baroque transactions set up to deal with the uncertainty that insurance companies will pay out on their policy and banks will return money to depositors. The government's first job is to stop an insurer from writing hurricane policies if it would bankrupt it. But it's second is to backstop the insurance when it does.

The question of what would have happened if the government had not backstopped AIG, however, is an interesting one. Goldman says that their exposure to AIG was itself hedged . We don't know how effectively that could have been done--but we also have no reason to doubt it. If that is the case, then in fact we simply don't know who would have been on the hook if AIG failed. In effect, it might not be Goldman being bailed out, but still another set of banks and insurers. So that would add yet another "unknown unknown" to the crisis--reason enough to tread very carefully.

Tom Friedman Says It's August, 1914. Time To Buy?

At some point this, too, shall pass. I don't think we're at that point yet, despite the rise in the markets (and note the Dow's at 7,000--exactly where Nouriel Roubini said we'd be). However, there are some reasons out there for hope that we may not be at the threshold of a cataclysm that makes the world of Mad Max look like a luxury resort in Acapulco.

First, Citi seems to have indicated that it may have a profit this quarter. Now, this comes on top of close to $40 billion in losses, and who knows what kind of extraordinary special write downs there might be in addition to this profit. So it's a little like the guy in the burnt out butcher's shop saying, "Well, we did sell some kielbasa!" But the notion that, with government help, Citi could turn out to be solvent would be a dramatic boon to the markets. (Just don't count on it yet. We still have no idea of how to value all those zombie assets.)

Second, Goldman Sachs is talking seriously about returning the government's money (take a look at Stephen Labaton's interesting story in the Times). Ironically, the bailout was supposed to restore confidence in the markets. But it's hard to imagine anything that would be more encouraging right now than Goldman or Wells Fargo coming out and saying they don't need it. Goldman in particular, it seems to me, has been unfairly tarred here. Having read the mortgage market right, Goldman has still had the stigma (and boy, it has turned out to be a stigma) of taking taxpayer funds. They're very much in their rights to toss it back and not offer much in the way of a thank you. Then they can all go on some fancy junket.

The final reason for optimism? The chorus of doom saying has reached a crescendo. So far, the evidence of this crisis is that the conventional wisdom is consistently wrong. Miserably wrong. And there is no better barometer of the conventional wisdom than Thomas Friedman's column. Today, more finger wagging about the impending disaster. According to Friedman, we're at "9/12" or at "August, 1914". Umm, maybe. Or maybe we're at 1618, right before the 30 Years' War. Or maybe ... the sack of Carthage! Why look just a century back? Yes, those who forget history are condemned to repeat it. But those who who start volunteering historical analogies by the bushel in an effort to make up for failing to predict the last crisis by talking up the next one are ... I don't know. Maybe they are condemned to write books that sell millions of copies to folks who have no intention of ever reading them.

Get Used To It: House Prices Won't Bounce Back. Ever.

Just how old is the idea that the price of real estate only goes up? Certainly at least several centuries. Call it Ricardo's Mistake, after the great economist and preeminent theorist of free trade David Ricardo. Ricardo believed that land was the one scarce economic resource, and that over the gains of a growing economy would accrue only to landowners, a situation he proposed to remedy by a system of land taxes.

A year and a half into this down market, the notion that things have to go back up is still with us. A few days ago I wrote about the Obama administration's foreclosure plan . I still think it is a good idea. But even in the rescue plan there is hiding a core of the same thinking that led us to where we are. One hope of the administration is that five years from now, home borrowers who are underwater will no longer be. Or at least that's the hope implied by the plan of letting folks refinance their mortgages up to 105% and/or get a five year interest rate break from the bank. Problem is, after those five years are up, many of the same people will still be facing foreclosure (not all).

And it's not just the administration. Consider the plan put forward in Slate that would give banks a share in the future appreciation of a house for which they agree to take a haircut on the mortgage--the idea that banks can cut mortgage principal by 20 percent and make up most of their loss with an option on the future appreciation (a plan, by the way, similar to one that Barney Frank proposed some time ago) is pure fantasy. But it's a fantasy that's attractive because even at this stage many people are not prepared to stomach the thought that housing prices will not rise, on an inflation adjusted basis, for many, many years. Like John Updike's Rabbit Angstrom in "Rabbit is Rich" with his pile of gold coins, we hold to the idea that tangible property like a house, is the a guarantee of future income.

Having written so much about mortgages in recent months, by the way, I wonder if some readers are asking if I own a house. The answer is no. My ex-wife and I bought a co-op apartment in New York in 2003. Even at that time, prices seemed out of line to me, and I bought with some trepidation. My wife got the apartment in the divorce, and since then it has been sold. At a profit, I'm pretty sure.

The Last Man Left To Defend Wall Street

The Dow's below 7,000 (as Nouriel Roubini--and Chumpchanger! --said it would be), the banks are about to be nationalized, and Chumpchanger has been ... close to AWOL for a month.

So there's some catching up to do, and I'll start with last week's story from Slate's The Big Money, Is Wall Street Evil? My editor for some reason preferred "evil" to "wicked"; I like the sound of "wicked" better, but maybe "evil" scores higher in the hit counts. One reader, Kim Elliot, took me to task for "a veiled attempt to excuse rich people while lecturing us folks who make an honest living, however delusional our choices." Obviously, I disagree. On two counts. First, I don't think I was lecturing. Second, heck, I thought it was pretty unveiled attempt to excuse rich people. I may well be one of the poorest men in history to take on the mantle of defending the prerogatives of the monied interests.

On investigating further, however, it turned out that Elliot and I agreed on more than we disagreed. Elliot's biggest issue with Wall Street was not the enormous amount of money reaped by the Street before and (in the case of Merrill, even during) the crash, but the smugness and sense of entitlement that persists despite the enormous evidence of Wall Street thorough going incompetence. On this I agree whole heartedly, except that I see this same smugness well beyond the boundaries of Wall Street. The builders and commercial bankers, the mortgage brokers and realtors, the journalists who believed the housing bubble would never burst and the builders of McMansions who to this day imagine that they made no mistakes and resent bailing out their neighbors--all of the other players who created the current mess all manage to smugly insist that the failings of character and of basic common sense all happened somewhere else. They resent bailing out their less fortunate neighbors and rant about the failings of Wall Street with the same smugness that Elliot (rightly!) criticizes Wall Street for. And that smugness drives Elliot and me equally crazy. Money does corrupt, and it corrupts in a particularly insidious way that makes those who have it believe that it is a justified reward for their own intellect and character. This is the case on Wall Street, and off it. And to this problem, I see no solution at all.