False Profits?

Suddenly, everything is coming up rosy for Goldman Sachs. After converting to a "bank holding company" last year and receiving $10 billion dollars in TARP assistance from the federal government, Goldman, formerly known as the nation's largest "investment bank," has shocked observers by posting a "profit." The company also sponsored a stock offering in order to raise funds to repay its debt to the government and to free itself from TARP.

Bye Bye December
Financial market analysts have approached Goldman's purported profits with skepticism. First, Goldman's earnings report excludes the entire month of December 2008. Floyd Norris, financial reporter for the New York Times, explains that Goldman converted to "calendar year," rather than quarterly reporting after it elected to become a bank holding company. Consequently:

Goldman’s 2008 fiscal year ended Nov. 30. This year the company is switching to a calendar year. The leaves December as an orphan month, one that will be largely ignored. In Goldman’s earnings statement, and in most of the news reports, the quarter ended March 31 is compared to the quarter last year that ended in February.

The orphan month featured — surprise — lots of write-offs. The pretax loss was $1.3 billion, and the after-tax loss was $780 million.

In response to Norris' arguments, Goldman says that banking law requires the change in its reporting schedule. This change, however, does not undo the reality that under the old schedule, Goldman may not have earned a profit. According to Norris, Goldman has declined to disclose whether it would have earned a profit under its traditional reporting schedule.

The Goldman-AIG Connection
Another area of skepticism concerns the controversial $12.9 billion payment Goldman received from AIG -- the troubled insurance company that has received over $100 billion in TARP assistance. AIG "insured" Goldman's investments in risky mortgage-related assets. Even though the market has effectively deemed these assets "toxic" (i.e., worthless), Goldman recovered much more than the market value of its investment after AIG used TARP assistance to cover Goldman's risk.

Had AIG entered into bankruptcy like other banks and, presumably, as the automobile industry will soon do, it is unclear whether (and probably unlikely that) Goldman would have received far more than market value for the unsecured insurance policies. Accordingly, the bailout of AIG represented a major financial gain for Goldman.

After stating that the public's interest in Goldman's relationship with AIG has "mystified" him, Goldman CFO David Viniar dismissed speculation that Goldman's receipt of controversial payments from AIG allowed the company to realize a quarterly profit. Viniar said that most of the transfers from AIG occurred last year, and that the transfers from January to March 2009 "rounded to zero."

Viniar also stated that December 2008 transfers from AIG were "insignificant," but he does not provide any numbers. As Norris argues, however, Goldman has doctored its reporting by excluding December from its quarterly numbers altogether. Norris also questions whether Goldman's December losses would have been even larger absent the AIG transfers.

Goldman's "Fuzzy Math" Excludes $28 Billion In Government-Secured Loans
Goldman has only announced a plan to pay back $10 billion in federal loans that it received by participating in TARP. Goldman, however, borrowed an additional $28 billion on the open market, but the government acted as a guarantor on those loans. According to Norris, Goldman has no concrete plans to repay those loans, but the federal guarantee undoubtedly conferred value to Goldman.

Goldman's Competitors Are No Longer Around
The Bush administration decided to save AIG, which has undoubtedly benefited Goldman. Bush officials, however, refused to bail out Lehman Brothers -- which was Goldman's biggest competitor. Many of Goldman's other competitors (e.g., Morgan Stanley) were folded into other companies in distress sales.

Goldman's recent "profits" likely result in part from the elimination of other leading financial institutions as serious sources of competition. Because many former and current Goldman staff participated in the government's decision to bail out AIG and allow Lehman Bros. to collapse, AIG's survival and payment of billions of dollars to AIG has provoked a substantial amount of scrutiny and controversy.

Is the "Market" Skeptical Too?
How has the market reacted to Goldman's "good" news? Today, just one day after Goldman announced its profits and generated 1/2 of the money needed to repay its debt to the government, the company's stock fell 12 percent.

Tangled Webs: Goldman Sachs, AIG and the Feds

Goldman Sachs Chief Financial Officer David Viniar held a conference call with journalists yesterday in an effort to calm a growing storm over the company's relationship with AIG. Goldman, like other investment banks, invested in and marketed "mortgage-backed securities," which AIG "insured" with "credit-default swaps."

The implosion in mortgage-related financial instruments, however, caused AIG to suffer enormous losses. The company ultimately required a massive governmental bailout because it lacked the resources to cover other companies' investment risk.

Goldman, AIG and TARP
After refusing to do so for many months, AIG recently released the names of companies it paid using TARP assistance. According to the disclosure, AIG has paid Goldman $12.9 billion.

Seeking to mute speculation that the federal government bailed out AIG in order to funnel billions of dollars in TARP assistance to Goldman, Viniar insists that even if AIG had entered into bankruptcy, Goldman would not have suffered financially. Viniar says that Goldman hedged its market exposure through agreements with third parties and had already received $7.5 billion in collateral from AIG prior to the company's insolvency.

But Viniar's comments raise other concerns. First, even though Goldman hedged its risks using third parties and had received collateral from AIG, it is possible that it would have received less money in a bankruptcy proceeding. Second, the close relationship between financial regulators and Goldman will undoubtedly create a wall of suspicion around the company, regardless of whether it benefited from the bailout. This suspicion will only grow deeper if it turns out that the government's decision to keep AIG alive helped Goldman, just as its decision to let Lehman Bros. implode necessarily helped Goldman because it removed one of the company's chief competitors from the market.

Bankruptcy versus Bailout
AIG avoided bankruptcy because of the federal bailout. If AIG had entered into bankruptcy, it is unclear whether Goldman would have recovered the same amount of money. For example, the government financed AIG's purchase of $5.6 billion in securities related to its agreements with Goldman. At the time of the purchase, however, the market value of the securities was 1/2 less than the contract price. Had AIG been in bankruptcy, it is highly unlikely that a judge would have allowed AIG to pay Goldman a price that greatly exceeded market value.

Also, a bankruptcy judge could invalidate (as a "voidable preference") the transfer of collateral or money from AIG to Goldman if the transfer took place within 90 days of the filing of the bankruptcy petition. Bankruptcy law disfavors payments to creditors on the eve of bankruptcy because they tend to benefit more powerful creditors and frustrate the underlying policies of bankruptcy law, which include the distribution of the debtor's assets to all creditors in proportion to the debt owed them. Early payments to an individual creditor could drain the debtor's resources and make them unavailable for a proportional distribution. It is unclear whether Goldman could have recovered from third-parties the same amount of money it obtained from AIG, but it is definitely debatable whether it could have extracted the same amount from AIG had the company entered into bankruptcy.

Tangled Web
Viniar's conference call will likely lead to greater scrutiny of Goldman's relationship to AIG because many influential politicians and banking industry executives have connections to Goldman and to the Treasury Department -- the federal agency that administers TARP.

Henry Paulson, Secretary of Treasury during the Bush administration, is a former Chairman of Goldman Sachs. Paulson was responsible for administering TARP, and he had a large role in structuring the legislation.

Robert Rubin, Secretary of Treasury during the Clinton administration, was a Co-Chairman of Goldman (along with Stephen Friedman -- see below) before he earned a Cabinet post. Although Rubin does not have a formal position in the Obama administration, he has served as an informal economic advisor to the President. Also, current Secretary of Treasury Tim Geithner worked as an assistant to Rubin (and later to Lawrence Summers -- former Secretary of Treasury and current head of Obama's National Economic Council) when he headed the agency. Paulson was also a partner at Goldman when Rubin was Co-Chairman.

Mark Patterson, Geithner's Chief of Staff, is a former lobbyist for Goldman. Obama waived his anti-lobbying rules in order to secure the job for Patterson.

Tim Geithner, current Secretary of Treasury, served as the President of the Federal Reserve Bank of New York until his current position. In that capacity, he helped to structure the federal bailout of AIG. Geithner, unlike many of the other individuals listed in this article, never worked at Goldman, but he worked for Rubin during the Clinton administration and for Summers, who replaced Rubin. Summers heads Obama's National Economic Council.

Stephen Friedman, the current Chairman of the Federal Reserve Bank of New York, was the Co-Chairman of Goldman with Rubin, and he has held several other executive positions at the company. In his current position, Friedman presumably will have a significant role in the ongoing federal bailout of AIG. Friedman also sits on the board of directors of Goldman.

Update: After discussing this issue with a friend of mine, I have an additional comment. Assume that the AIG bailout was a wise policy decision that coincidentally benefited Goldman. This still does not explain the differential treatment of Lehman Bros.

Although I mention the disparate treatment of Lehman Bros. in the original essay, I primarily discuss why bailing out AIG helps Goldman. But allowing Lehman Bros. to collapse helped Goldman tremendously, because it eliminated one of its main competitors. The deeper story may lurk behind this issue.

FactCheck.Org Confirms What Neither Party Will Admit: Bipartisan Blame for Wall Street Woes

When venerable Wall Street institutions like Lehman Brothers started imploding, liberal blogs and newspapers were quick to blame Republicans. Republicans on the other, said that Democrats caused the crisis. Turns out both are wrong. The nonpartisan website FactCheck.Org has concluded, as I did in a previous post on the financial crisis, that neither party can claim innocence with respect to the financial crisis (nor can the public, for that matter).

Democrats typically point vaguely to "deregulation" as causing the banking crisis. When pressed for specifics, they most commonly blame the Gramm-Leach-Bliley Act of 1999, which allowed traditional banks, insurance companies, and investment banks to consolidate. Republicans often accuse Democrats of resisting tighter regulation of Fannie Mae and Freddie Mac. Neither explanation really works.

Let's start with the Democrats narrative. FactCheck nails it by locating the cause of the crisis in the housing and securities markets. Very low interest rates, the risky mortgage, greed among homebuyers who overextended themselves in order to reap the benefits of soaring home appreciation, and the securitization of bad debt caused most of this mess. The Gramm-Leach-Bliley Act did not effectuate this, and even if it did, many Democrats supported the legislation (including Bill Clinton and Robert Rubin).

With respect to the Republican argument, tighter regulation of Fannie Mae and Freddie Mac might have prevented their troubles, but that certainly cannot explain the poor state of US and world markets. They are just one piece of a very large puzzle. Also some of the proposals that Republicans made on this issue came very late in the game, perhaps too late to prevent the crisis .

Because we are in an election year, public officials cannot resist the temptation to distort this important issue with partisanship rhetoric. But that does not change the fact that blame is everywhere.

Update: The RSS feed for FactCheck.Org now appears in the media section on the left side of the blog. FactCheck is truly a vital resource.