Sunday, August 2, 2009

Goldman and AIG: Two Strategies, Two Very Different Outcomes

Goldman Sachs (“Goldman”) continues to be a major player in the derivatives market. Unlike AIG, Goldman’s derivative strategy is much more conservative. AIG insured almost $430 billion in credit default swap (“CDS”) contracts; however, it took no offsetting positions against these contracts. As a result, AIG was able to make substantial profits from the premium payments it collected, since it did not pay any premiums to offset these contracts.

While AIG made substantial profits from this strategy, it proved to be one of the decisions that led to the current financial crisis. Conversely, Goldman’s derivative strategy has proven to be more efficient, especially under the current market conditions where competition in the derivatives market has “diminished and the spreads between buying and selling have widened.”
Goldman’s derivative strategy is very straight forward, for every CDS contract it insures, it attempts to secure an offsetting position in an amount equal to or greater than the CDS contract it protects. “A review of Goldman's 10-Q filing for the period ending March 31, 2009, shows that Goldman wrote credit derivative protection for others equal to $3.2 trillion or 12% of the $26 trillion notional value of these derivatives existing. Offsetting that $3.2 trillion position is $3.429 trillion in credit derivative protection in Goldman's name. This gives Goldman Sachs a cushion of $257 billion in notional CDS contracts as protection.” Through this strategy, Goldman makes a profit on the spread between the CDS contract it insures and the offsetting position it secures to cover the CDS contract. While the overall spread under this type of strategy is lower, it has proven to be highly efficient as well as profitable. In fact, “Forbes estimates that Goldman Sachs made about $1.8 billion in gross profits during the first quarter of 2009 from trading 12% of the total nominal amount of credit default swaps that exist. This profit would be the result of collecting only a 1.5 basis points spread on the $3.171 trillion CDS position. This estimate of $1.8 billion is before overhead, interest and taxes. Goldman reported total net profit of $1.8 billion for all of its activities during the first quarter.” Thus, a significant portion of Goldman’s profits from the period ending March 21, 2009 are from its derivative activities.

These two stories beg the question of whether AIG’s board and its officers should suffer sanctions given that AIG’s actions seem more reckless in light of Goldman’s derivative strategy. More specifically, how could AIG’s board and its officers legitimately believe, in good faith, that their strategy created a bottomless pit of money?


  1. professor clark: i agree that AIG's actions were unconscionable and i do believe that their reckless trading deserves sanction. that said, i am surprised to hear that the credit default swaps market continues in full force.

    is congress or the securities and exchange commission moving to regulate these swaps? do you think they should be regulated?

  2. The derivatives market should be regulated much like the government regulates the insurance industry. In fact, former President Clinton is of the same opinion. In an interview with ABC back in February of this year he suggested that he should have done more to regulate the derivatives market during his two terms; however, the general consensus at the time was for less regulation. More specifically, President Clinton stated that "Alan Greenspan and others thought we shouldn't regulate, didn't need to regulate derivatives, 'cause they would only be bought by very large, very wealthy, very sophisticated institutional buyers." While President Clinton thought that he should have done more, he averred that the majority of the derivatives that caused the market crisis were gathered up during the Bush administration.