Sam Jones has a great piece this morning on regulatory arbitrage under Basel II -- which turns out to have been one of the big business lines of the doomed AIG Financial Products.
Banks have to have a certain amount of capital to backstop their risky assets. The riskier the asset, the more capital they need. So banks would go to AIG Financial Products to de-risk their assets, thereby reducing the amount of capital they needed and increasing the total amount of leverage they could take.
AIG was quite open about this: it described the credit default swaps it sold to these banks as being "for the purpose of providing them with regulatory capital relief rather than risk mitigation".
The rescue of AIG, then, saved billions of dollars for any bank which had a lot of exposure to AIG counterparty risk.
The question, of course, is whether Goldman hedged its AIG counterparty risk. Goldman says it did:
When the insurer's flameout became public, David A. Viniar, Goldman's chief financial officer, assured analysts on Sept. 16 that his firm's exposure was "immaterial," a view that the company reiterated in an interview...
Lucas van Praag, a Goldman spokesman, declined to detail how badly hurt his firm might have been had A.I.G. collapsed two weeks ago. He disputed the calculation that Goldman had $20 billion worth of risk tied to A.I.G., saying the figure failed to account for collateral and hedges that Goldman deployed to reduce its risk.
My gut feeling is that we can trust Viniar on this one. He says that Goldman had hedged its AIG exposure, and I don't think he's the type of person to come out with a bald-faced lie.
On the other hand, how does one hedge $20 billion of AIG counterparty risk? Do you just buy credit default swaps on AIG from someone else? Is there some other way?