Does the Goldman/AIG Mess Prove Volcker's Right?

Kudos to Gretchen Morgenson and Louise Story of the New York Times for their article in yesterday's paper casting light on one aspect of Goldman Sachs' role in the financial crisis.It's already widely believed that Goldman's aggressive collateral calls on AIG, which was insuring much of Goldman's mortgage-backed debt securities against default, helped bring the insurance giant down, depleting it of cash to meet its other obligations.

Yesterday's article provides some insight into Goldman's process of creating subprime mortgage-backed securities and buying protection against them from AIG, while expecting the housing market would tank and that AIG would have to pay enormous sums to Goldman (and also, while aggressively selling similar collateralized debt obligations to customers). Traders structured a number of deals called Abacas specifically to enable Goldman to benefit from the housing collapse. When AIG was bailed out, it had $5.5 billion worth of these Goldman deals on its books.

In August of 2008, after AIG had been pushed to pay $19.7 billion in collateral to trading partners in these deals, the insurance company tried to cancel the contracts that were draining it of cash. Goldman refused, and at the same time its equity research department published a negative report on AIG, saying it was in a "downward spiral which is more likely to ensue as more actual cash losses emanate" from the unit insuring subprime-backed securities. AIG shares fell 6% that day and the government bailed it out shortly thereafter, paying Goldman in full for all its contracts.

Reviewing this episode, one can see the validity of the points former Federal Reserve Chairman Paul Volcker has been making lately, that speculative trading activity should not be intermingled with the banking system nor eligible for government bailout money, and that more oversight should be applied to the capital markets and insurance industries. Although the Volcker Rule doesn't apply to Wall Street and insurance companies, had Volcker been a guiding force in Washington in 2008 and his principles executed, presumably Goldman would not have received its quickie bank charter and neither Goldman nor AIG would have received bailout money, they would have been allowed to fall in the death spiral they created for themselves, or simply suffer losses and recover, and none of this would have impacted the traditional banking industry. It's possible that the U.S. financial system and our economy would be better off today.