Collateral calls and other dilemmas February 17, 2011 at 3:32 pm
William Cohen has done a nice piece of journalism for the New York Times on Goldman’s collateral calls vs. AIG. Unfortunately it is mixed in with a good deal of opinion, unjustified assertion, and spin. Let’s try to separate out the pieces.
The trades concerned was protection on various ABS written by AIG to Goldman. Goldman had the right to call collateral under certain circumstances, and this it did. I have edited Cohen’s text slightly to remove the invective:
On July 27, 2007, Goldman sent a $1.81 billion collateral call to A.I.G. Financial Products to make up for what Goldman thought represented the decline in the value of the securities [underlying the CDS written by AIG].
AIG disputed this call and Cohen reports that Goldman backed down:
During that time, Goldman reduced the collateral call to $1.6 billion, then to $1.2 billion and then to $600 million.
Apparently the two firms settled on $450M.
Things then quietened down between Goldman and A.I.G. Financial Products until Sept. 11, when Goldman asked for another $1.5 billion in collateral based on its marks. This was the beginning of the end. On Nov. 2, [AIG FP’s] Cassano said, [Goldman’s] Sherwood gave him a “heads up” that Goldman was increasing its collateral call to $2.8 billion, in addition to the $450 million it already had.
Various other banks who AIG had also written protection to also joined in at this point. This was close to the tipping point, and pretty soon multiple collateral calls had used up all of AIG’s available liquidity and more.
So, what do we know?
- Goldman was presumably the calculation agent for the trades. That means that AIG had explicitly agreed to accept Goldman’s marks for collateral purposes, albeit likely with some language that it had to be ‘commercially reasonable’ or similar.
- The trade concerned was on an underlying that had become massively illiquid. Neither Goldman nor AIG could point to trades evidencing fair value. Therefore the right CDS value – and hence the right collateral call – were subject to considerable doubt.
- Goldman, as anyone would rationally have expected them to do, made conservative (from the point of view of their credit risk) collateral calls. AIG disputed them. Goldman negotiated the amounts in what looks like good faith.
- Other firms in a similar position took similar action, albeit slightly less fast.
For me, it is difficult to see any malpractice from Goldman here. Goldman acted to protect itself, as it had every right to do. If AIG did not want to have to accept Goldman’s valuations, it could have negotiated a different valuation procedure for the trades. Instead it left itself open to massive liquidity risk by agreeing to the collateral arrangements that it did. AIG never considered the consequences were the underlyings to its trades to become illiquid, nor where it would find the collateral were the trades to go against them. I think that that is by far the worst of the behaviour seen here.