How the feds and Goldman Sachs used AIG to hose U.S. taxpayers

A critical question in the U.S. government's 2008 rescue of AIG is whether the deal amounted to a "back-door" bailout of Goldman Sachs (GS). Increasingly, the answer appears to be a resounding "yes."

That's important for several reasons. First, the $182 billion taxpayers have injected into AIG was to prop up the insurance giant, not certain companies with which it did business. If the lifeline was for Goldman, then the bank owes us money. Second, the American public has a right to know which financial firms it saved, and why. Third, it's unfair for the government to favor one firm over other industry players. Fourth, this isn't how the free market -- or government -- is supposed to work.

For taxpayers, the issue comes down to this: Did we cover market losses Goldman would've suffered if not for the enormous, and highly unusual, pressure the feds put on AIG to pay its credit default obligations to the bank in full? Goldman got 100 cents on the dollar for distressed mortgage debt in the government-brokered deal; in the secondary market at the time, private investors were paying an average of 48 cents on the dollar.

Members of the Financial Crisis Inquiry Commission zeroed in on this issue Thursday in pressing Goldman CFO David Viniar on whether the investment bank would've lost money if AIG had gone bust. Goldman has long maintained that it was in no danger, saying that it hedged both against potential losses on its mortgage securities deals with AIG and on the possibility that the insurer itself would collapse and fail to pay out on the bank's credit insurance. Goldman also points to the collateral it held from AIG on the mortgage assets in making the case that the bank was fully protected.

That story is now coming apart at the seams. If it splits completely, it could have enormous repercussions for Goldman and key members of the Obama administration -- particularly Treasury chief Tim Geithner. As head of the Federal Reserve Bank of New York, he helped lead the negotiations with AIG's other financial counterparties. As we learned from the NYT yesterday, Geithner and other federal regulators went to extraordinary lengths to ensure that AIG would make Goldman whole on its CDSes, rather than accepting a "haircut" on the deal, as industry practice usually dictates. Among other things, the government barred AIG from pursuing any future legal claims against Goldman.

Financial Crisis panelist Byron Georgiou picked at a particularly nigglesome thread for Goldman. Claiming that it wasn't exposed to AIG, the bank maintains that it had purchased CDSes from other financial firms to guard against the insurance firm blowing up.

So who were these other firms, Georgiou asked? After all, at the time AIG was the biggest insurance firm in the world, with a market cap topping $2 trillion. If this financial titan was unable to honor its obligations to Goldman -- at least without massive government aid -- were other firms really able to fulfill the terms of their CDS contracts with the banking firm?

Viniar couldn't, or wouldn't, say, noting only that Goldman had bought the additional insurance from other large financial firms. He also appeared evasive in answering questions about Goldman's exposure to losses stemming from derivatives. The bank doesn't separate its profit and loss on derivatives from its business on cash or other securities products, he said. That makes it hard to tell how much money Goldman generates from swaps.

Georgiou, responding to Viniar's claim, seemed incredulous:

When you tell us that you don't know how much you make in your derivatives business, nobody here really believes it. And I'll tell you why -- it's crazy. It doesn't make any sense. Goldman Sachs is, if not the most sophisticated investment bank, certainly one of the most sophisticated investment banks, in the world. And nobody here believes that you don't know how much money you're making on various aspects of the business.

Other cracks are starting to appear in Goldman's alibi. Greg Gordon of McClatchy Newspapers cited an anonymous source at Goldman in reporting Tuesday that the bank used it own funds to bet against subprime mortgages in 2005 and 2006. That contradicts Goldman's repeated claims that it acted as a mere intermediary in serving clients when it bought billions of dollars of credit insurance from AIG. According to the story:

[T]he wagers were part of a package of deals that had a face value of $3 billion, and in a recent settlement, AIG agreed to pay Goldman between $1.5 billion and $2 billion. AIG's losses on those deals, for which Goldman is thought to have paid less than $10 million, were ultimately borne by taxpayers as part of the government's bailout of the insurer.

Think about that. Goldman paid something south of $10 million to insure $3 billion in potential mortgage-related losses, a stupendous mispricing of risk by AIG. When the securities underlying those assets went south, AIG lost a bundle. And, owing to the government's unusual dedication to covering Goldman's back, so did taxpayers.

Images from C-Span and the Financial Crisis Inquiry Commission

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• Why the Financial Crisis Inquiry Commission is Better than Valium
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