Goldman's Price of Protection

By PETER EAVIS What would have happened to Goldman Sachs Group Inc. if American International Group Inc. had gone bankrupt last September? From the time of the government's AIG rescue on Sept. 16, Goldman's position has been consistent: It wouldn't have been hurt. This isn't just relevant for the political debate, it also matters for investors. If Goldman were able to withstand the bankruptcy of a large counterparty like AIG without material hits, it would bolster the view that Goldman is a savvy risk manager, and that its stock deserves to trade at a premium to other banks to reflect that. This week, AIG released new data that might help investors assess the extent to which Goldman protected itself. In particular, the new information included details of payments made to Goldman after the government rescue. Goldman owned securities called collateralized debt obligations. To protect itself against value declines on these, Goldman wrote bets with AIG, using credit-default swaps. Monday, AIG said it provided protection on $13.98 billion of "multisector" CDOs with Goldman. As the CDOs declined in value, AIG posted collateral with Goldman that the firm could keep if AIG failed. Goldman declines to give specific numbers, but said: "The majority of our exposure to AIG at the time of the bailout was collateralized, with the rest covered by hedges." So what happened to this CDO exposure after the rescue? This week, AIG said Goldman received $2.5 billion of collateral between Sept. 16 and the end of 2008. And it got $5.6 billion in cash from a joint Federal Reserve-AIG entity set up to buy underlying CDOs from AIG's counterparties. That $5.6 billion represents the difference between collateral Goldman already held and the CDOs' par value. An AIG failure likely would have prevented Goldman from receiving the $2.5 billion of collateral, and the cash payments. Instead, Goldman would have been exposed to further declines in the value of the CDOs. This could have hurt Goldman's $37.3 billion of tangible common equity. And an AIG failure could have led to losses on other trades. AIG had about $20 billion of total swaps with Goldman, substantially more than the $13.98 billion on the multisector CDOs. Goldman's defense: It had protected itself against that outcome by acquiring swaps protection against a default by AIG itself. Hedging large exposures can be expensive, especially when others are trying to do the same. Goldman declined to say when it made these hedges. But it added: "We purchased the hedges when we believed that the collateral we received from AIG was inadequate to cover our notional exposure." If it got in before the swaps prices for AIG ballooned to expensive levels, it would count as one of the canniest trades of the credit crisis. Write to Peter Eavis at peter.eavis@wsj.com