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Wednesday, February 24, 2010

L. Randal Wray: Is this the worst scandal in US history? To ask the question is to answer it.

Worst Revelation Yet in the On-going Goldman-AIG-NYFed Scandal
By L. Randall Wray
Tuesday, February 23, 2010
Economic Perspectives from Kansas City

Richard Teitelbaum reported today (here) that Timothy Geitner's New York Fed hid the smoking gun that proves Goldman played the key role in bringing down AIG. The only plausible explanation for hiding the document is that Geithner et.al. were protecting Goldman. Is this the worst scandal in US history? To ask the question is to answer it.

In brief, here is the story. Recall that securitization of mortgages was supposed to be a risk-reducing innovation that would move mortgages off the books of banks and into well-diversified portfolios of those better able to absorb risks. Mortgage originators would do the underwriting (verify credit-worthiness), securitizers would do the packaging, credit raters would do the rating, and investors would buy the securities and take the risks. Ah, but Wall Street was too clever for all that. So here is how it really worked. Banks owned mortgage lenders who made NINJA loans (no income, no job, no assets), then worked with credit raters to get the ratings desired. The raters did not actually examine any of the loans because the banks bought Credit Default Swap (CDS) "insurance" from AIG to guarantee safety of the Collateralized Debt Obligation (CDO) issued against the mortgages. Goldman and other banks would then either sell the CDO while using a CDS to bet on default; or they would hold the CDO and use the CDS bet against it to hedge risk. Of course, since Goldman had securitized toxic waste, the bet was not a gamble at all. It knew the CDOs would fail. But meanwhile, it got to book all sorts of fees and income so that it could reward its management with outsized bonuses.

As the subprime market began to crater—due to "unexpected" delinquencies and defaults on mortgages—AIG's own financial situation was down-graded. This led Goldman and other banks to demand collateral from AIG against their CDS bets. Goldman, in particular, played hardball with AIG—ensuring it would fail.

Here is how bad those CDOs were: losses are running as high as 78% on the toxic waste underwritten by Goldman. No wonder the firm bet against it! Yet, when Geithner's NYFed intervened to rescue AIG, it demanded that AIG pay Goldman 100 cents on the dollar—for the "insurance" AIG provided on the toxic waste created by—you betcha—Goldman. Timmy's office then ordered AIG to engage in a cover-up—telling it in November and in December 2008 to keep bank names out of documents filed. As late as January 27 2010 "the New York Fed was still arguing that the contents of Schedule A shouldn't be fully disclosed", Teitelbaum reports. Schedule A is the damning document that not only names names but also details the CDO deals.

It shows that Goldman underwrote $17.2 billion of the $62.1 billion in CDOs that AIG "insured"—the most of any bank. Goldman, in turn, received $14 billion from AIG as its share of the settlement (second only to Societe Generale, which got $16.5 billion). If you do the math, Goldman was paid over 80 cents for every dollar of CDO it wrote that got AIG insurance ($14B/$17.2B). The government has poured $182 billion into the rescue to date and now holds much of the toxic waste created by Goldman and others.

Why did Timmy do it? Why does the NY Fed still insist on secrecy? "They must have been trying to shield Goldman" says Professor James Cox of Duke.

And here is the most outrageous part of the story. As Marshall Auerback and I wrote (here) Goldman's top management was not only betting against the toxic waste they created, they also bet against Goldman:

top management unloaded their Goldman stocks in March 2008 when Bear crashed, and again when Lehman collapsed in September 2008. Why? Quite simple: they knew the firm was full of toxic waste that it would not be able to continue to unload on suckers—and the only protection it had came from AIG, which it knew to be a bad counterparty. Hence on March 19, Jack Levy (co-chair of M&As) sold over $5 million of Goldman's stock and bet against 60,000 more shares; Gerald Corrigan (former head of the NY Fed who was rewarded for that tenure with a position as managing director of Goldman) sold 15,000 shares in March; Jon Winkelried (Goldman's co-president) sold 20,000 shares. After the Lehman fiasco, Levy sold over $6 million of Goldman shares and Masanori Mochida (head of Goldman in Japan) sold $56 million worth. The bloodletting by top management only stopped when Goldman got Geithner's NYFed to produce a bail-out for AIG, which of course turned around and funneled government money to Goldman. With the government rescue, the control frauds decided it was safe to stop betting against their firm.
Goldman appears to be the classic case of what my colleague Bill Black calls a "control fraud". But the NY Fed and by implication the US Treasury (which is also captured by Goldman) is involved in the cover-up of the frauds perpetrated by Goldman's top executives—those "savvy businessmen" President Obama has praised. And that, dear reader, is what makes this rank among the worst scandals in US history.


  1. As much as US criminal investigations against Goldman and others would be a good thing I cannot see anything coming of such a venture. Too many high officials in the Obama administration would be tarnished. I expect a cover up or any attempt to throw any investigation into the long grass where it will fail. This has already started with Geithner starting an "investigation".

    A European investigation could be much more effective but you would need British backing for such an idea, and I fear that Goldman's have as much influence in the UK government as they do in the US one.

  2. Always good to get your comments. We suspect a Goldman investigation will continue apace as the financial system continues to come under stress. Pretty soon we're going to need some big names to blame. Goldman's fingers are in so many games...

    Can you imagine, for example, if they come to AIG for payouts on Greek debt CDS's? The ex-Enron traders there have no concern for the company as well. It is a house of looters. Hard to see how it can stand.