The clear picture that emerges from the complex details is that the Golden Rule ruled in the relationship between Goldman and AIG. And by the Golden Rule, I mean the one that states he who has the gold makes the rules. In this case, Goldman had the gold. The result was that when there was any ambiguity in the contracts between AIG and Goldman, Goldman got the benefit of the doubt. Now the SEC is investigating whether Goldman stepped over the line and used that clout to push AIG toward collapse.
In its 2007 and 2008 dispute with AIG, Goldman asserted that the mortgage-backed securities that AIG was insuring were worth less than AIG thought they were. And Goldman used that lower valuation to get more cash out of AIG while simultaneously using those lower valuations to boost the value of Goldman's bets on the collapse of the mortgage market.
In so doing, Goldman used the Golden Rule to its benefit. Goldman demanded and got $2 billion in payments from AIG. But AIG and Goldman did not agree on how much Goldman was owed. That conflict could have been resolved by following the letter of the contract between AIG and Goldman, but it was not. According to The New York Times, Goldman resisted letting third parties value the securities as its contracts with AIG required. And Goldman based some payment demands on lower-rated bonds that AIG's insurance did not even cover.
In this case, both Goldman and AIG thought that the other party was the greater fool. Goldman was paying credit default swap premiums to AIG to insure mortgage-backed bonds that AIG was confident about, meaning that it considered the premiums were pure profit. Meanwhile, Goldman was quite confident that AIG would end up on the losing end of the bet.
But Goldman could not have made these bets had AIG not provided the CDS coverage. And when Goldman's bets proved right and AIG's wrong, it was AIG that approached collapse while Goldman was in clover. The terms of the deals required AIG to pay more money to its counterparties as additional default triggers were snapped.
Those default triggers worked like this: If mortgage bonds were downgraded, if the bonds lost value, or if AIG's own credit rating was downgraded, AIG would pay Goldman more money. If all three of those things happened, Goldman would collect the most money from AIG. If none of them happened, Goldman would pay insurance premiums and AIG would pay no claims at all -- making the CDS business a pure profit machine.
In 2007, when Goldman held $2 billion in AIG's cash, AIG demanded all but $440 million back -- arguing that the mortgage bond valuations that Goldman used to justify keeping the $2 billion and demanding $4.6 billion more were way too low, according to The New York Times.
But thanks to Goldman's Golden Rule, it was able to force AIG to accept the lower valuations, which started a chain reaction that ultimately contributed to AIG's downgrade -- which meant still more gold for Goldman.
I will be pleasantly surprised if the SEC investigation yields a big payback from Goldman to AIG -- $12.9 billion seems like the right number to me.
Peter Cohan owns AIG shares, but has no financial interest in the other securities mentioned.
