Public Policy Analysis & Opinion

Financial follies

The anger won't go away

By Kevin P. Hennosy

As committee work on President Obama’s health care reform initiative came to an end, officials turned their attention to restoration of financial sector regulation. On October 21, 2009, Neil Barofsky, the special inspector general of the Troubled Asset Relief Program (TARP), issued a quarterly report that took federal officials to task for their execution of the controversial financial bailout program.

The TARP program was approved by Congress in 2008, launched by the Bush administration, and executed by the Obama administration. Policymakers adopted the program as a means to stabilize financial institutions and inject liquidity into the economy in the face of a financial panic that followed nearly three decades of deregulation of the financial sector.

Barofsky stated in numerous interviews following the release of the report that he believes that the financial sectors must be re-regulated in order to rebuild confidence in the United States’ financial system.

In addition, the inspector general sees the weak response to fraud and failure on the part of officials as damaging to public trust in the government.

Furthermore, Barofsky argues that unless fundamental reforms are imposed upon the financial sector, the same forces that led to last year’s financial meltdown could bring about another one. And a new panic could be harder to stabilize than the one that hit in 2008. That’s because the financial sector has consolidated—sometimes through direct government actions—forcing mergers. Individual firms have grown fat on the influx of public funds, sometimes using them to support further capital market speculation.

The Barofsky report blasted the way the Obama administration implemented the TARP program, which includes various forms of public payments to private banks, securities firms, and automakers. In short, the inspector general insists that the Obama administration has not been tough enough with the entities that received public subsidies.

Reading the Barofsky report, a student of history is reminded of the Adolf Berle and Gardiner Means classic book, The Modern Corporation and Private Property. Berle and Means explained that the key aspect of modern corporate theory is the bond of ownership and control. The owners of a corporation not only hold the right to control business operations, but owners have a responsibility to control corporate operations.

Usually this theory means that corporate shareholders have the right and responsibility to control operations. In the case of mutual insurance companies, that right and responsibility rests with policyholders. In the odd and extreme cases of those failed financial institutions that through reckless management required massive infusions of public capital to remain going concerns, they are now owned by the people of the United States of America.

In short, Barofsky charges that Treasury officials did not act as responsible managers acting on behalf of ownership.

Barofsky held up for special scorn American International Group (AIG), the disgraced insurance holding company system, which has become a poster-child for bad behavior before and after its financial collapse.

Let’s first address an observation about AIG that is oft repeated but hard to comprehend: “The insurance companies at AIG are fine.” AIG was an insurance holding company system, and insurance regulators had responsibility to monitor the entire system. Furthermore, the insurance companies had a reputation for bending the rules: most recently with regard to finite reinsurance contracts, which should have brought increased state oversight of the company and did not. If federal officials had not committed $182 billion to that system, the insurance companies would not be in operation.

AIG was too big to fail because if its insurance companies had been sucked into the financial vortex by its exotic capital manipulations, failure would have overwhelmed the state-based insurance guaranty fund framework. Since that framework is eventually paid for through insurance company assessments that in turn are wholly or partially deductible from state premium taxes, such a failure would scuttle state budgets for many years to come.

The inspector general noted that the failed company was being propped up by $182 billion in public funds. The company was the first to attract public scorn for spending for executive travel and compensation. In the report and interviews after its release, Barofsky was brutally critical of lack of oversight provided to AIG and other failed institutions by the Treasury Department under both the Bush and Obama administrations in the first four months of the TARP program.

In the October 21, 2009, report, Barofsky discusses AIG’s deadly activities in Credit Default Swaps (CDS). These instruments amounted to insurance on loans with little or no scientific underwriting behind them. In addition, the seller of the CDS did not even have to own the underlying bond or debt instrument, so the entire transaction takes on the checkered-cloak of gambling. AIG took the lead in the sale of these noxious bundles of risk in plain paper bags marked “security.” The result of this twisted commerce heaped shame on American capital markets, American business and American government.

The damage done by AIG and other Wall Street operators deserves swift and complete justice, and the inspector general clearly does not see that justice being delivered.

A week before the release of the Quarterly Report, Barofsky decried the fact that the Treasury Department had not yet put a stop to AIG’s bonus-driven compensation program. On October 13, Barofsky charged that Treasury officials were wrong to defer control over compensation at AIG to the New York Federal Reserve Bank.

The AIG Financial Products unit that trafficked heavily in credit default swaps persisted in using a bonus-driven compensation system that seemed designed to attract Barofsky’s ire. The company offered $475 million in retention bonuses.

On Main Street, the concept of a retention bonus is not easily understood. People who work a shift on a shop floor, or own a small business, do not have experience with being paid a bonus to entice them to stay in their jobs. Call these people unsophisticated, but they receive a paycheck or take a draw in compensation for work.

The AIG Financial Products compensation plan would have been viewed by most Americans as fantasy-like before the financial crash of ’08, but afterwards the very mention of retention bonuses at AIG was received like “fightin’ words.”

On October 22, 2009, Kenneth Feinberg, the Treasury Department special master for TARP, “lowered the boom” on the top executives of AIG and six other failed institutions. AIG received a 22-page letter from the special master that spelled out new conservative rules for executive compensation.

Secretary of the Treasury Timothy Geithner, who has taken much of the heat for the kid-glove treatment applied to TARP recipients, issued the following statement:

“Ken Feinberg has done a commendable job of applying the strong compensation standards of the Congressional legislation to the companies that received exceptional assistance from the government. We gave him the difficult task of cutting excessive pay, striking a balance between compensation and risk taking, and keeping strong management teams in place to help the companies recover—all in the public interest.

“We all share an interest in seeing these companies return taxpayer dollars as soon as possible, and Ken today has helped bring that day a little bit closer.”

Secretary Geithner’s praise for the special master tends to gloss over his own hesitancy to take corrective measures or enforcement actions against Wall Street financiers, which undermines public confidence in the federal government’s willingness to regulate in the public interest.

Before becoming treasury secretary, Geithner served as the head of the New York Federal Reserve Bank. In that position, Geithner built close, personal relationships with many of the bankers and financiers who played active roles in bringing about the financial crash. Geithner’s defenders argue that these relationships made him the perfect person to restore regulation to the financial sector. His critics believe that Geithner is too close and deferential to Wall Street leaders to regulate their activity.

October 22, 2009, also saw the House Financial Services Committee pass enabling legislation to create the Consumer Financial Protection Agency. The agency’s mission will be to promote a fair and transparent marketplace for financial products and to safeguard the American public from abusive industry tactics. The bill also extends federal supervision to a host of financial businesses, such as payday lenders and mortgage originators, which have long escaped oversight.

Congressman Barney Frank, who chairs the House Financial Services Committee, introduced the bill and rejected calls to give consumer protection activities to the Federal Reserve. Congressman Frank argued that a new agency was necessary because existing institutions have failed to protect consumers against abusive practices. In particular, Frank pointed to the Federal Reserve, which failed to use authority it has held since 1994 to oversee mortgage lending.

Some commentators and lobbyists for financial institutions had begun to express hope that Congress might have waited too long to enact sweeping new rules to govern their clients’ business. This belief was based on the expectation that people would forget how mad they were at Wall Street when capital markets crashed in 2008; therefore, there would be no political reward to Congress for passing new laws. Yet when word of the massive bonuses being paid to executives at failed institutions that operate on the public dole hit the headlines, people got mad all over again. The political benefit of reform grew once more.

One can expect more headlines to come. In mid-January 2010, Neil Barofsky is scheduled to issue another report on the TARP program. He has already promised that his next report will go into greater detail about the AIG bonus program.

While AIG, augmented with public money, announced a modest profit in the second quarter of 2009, the company has missed dividend payments in each of the last three quarters.

In his current report, the inspector general reminds readers that if the company misses a fourth straight dividend payment on November 1, 2009, the government could use its shareholder rights to force the selection of a new board of directors.