CDS and systemic risk

As GoldmanSachs’ outstanding earnings and bonus plans ricochet through the news, one refrain is heard repeatedly:  Even though Goldman received more than $10 billion via the government’s bailout of AIG, Goldman did not need the money because it was “fully hedged”.

This is really a perfect illustration of how credit default swaps create systemic risk.  Goldman Sachs has effectively taken the position that it doesn’t matter whether or not AIG (or any other counterparty) is creditworthy — as long as it can find another counterparty who is willing to sell Goldman CDS protection against the event that AIG defaults.

In a world where financial institutions have perfect judgment, this system could not create systemic risk.  In a world, however, with management failures and inattentive or inexperienced traders it is highly likely that someone will be willing to sell too much default insurance on the AIGs of this world.

When a firm like Goldman Sachs — which is generally reputed to have the best risk management on Wall Street — is willing to extend tens of billions of dollars of credit to firms that are not creditworthy on the principle that it is protected by insurance, then the financial system has lost its strongest bulwark against systemic risk.  We need the Goldman Sachs of this world to use their judgment to reject large-scale trades with firms that are likely to default.

I think that most people would agree that there’s not much hope that the financial world can eradicate incompetent and short-sighted traders.  It is precisely for this reason that systemic risk is created when the few financial firms that are well managed act on the theory that it is possible for them to buy insurance against credit risk.

Does Goldman Sachs really believe that, if AIG had gone through bankruptcy court, its counterparties would have been in a position to compensate Goldman for its losses?

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