Wednesday, March 18, 2009

Misdirected Outrage: Public Should Bash the Feds for Giving AIG a "Blank Check"

The moralistic grandstanding from all sides of the political spectrum over AIG is nauseating to say the least. After hearing members of Congress propose some very questionable "legal" measures to recoup the $160 million in bonuses AIG paid some of its executives, I am convinced that AIG is the new Saddam Hussein. It is the leader of a financial "axis of evil." As with Iraq, the U.S. needs a smokescreen to mask its own bad decisions and complicity surrounding AIG and other financial institutions and to justify improper remedies for those mistakes. Get ready for a new round of "shock and awe."

Saddam Hussein, Iraq and the U.S.
Long before Bush I's Iraq War, the U.S. covertly (and perhaps illegally) supplied Hussein with weapons and intelligence data -- not because he was such a good guy, but because the government wanted to sponsor his eight-year bloody war against U.S. nemesis (and former regional buddy) Iran. Later, Hussein's own corruption and destabilizing behavior created an excuse for the U.S. to turn against its friend and to engage in imperialistic military action.

The "weapons of mass destruction" mantra became the rallying cry of the war machine. Absent from the political discourse, however, was any sustained conversation about the shady role the U.S. played in empowering Hussein, including tacitly supporting his prior use of banned chemical weapons. The construction of Hussein as an evil dictator with horrible weapons (presumably directed at the U.S.) allowed the government to conceal its own role in making him a supposedly dangerous individual.

Outrage Over Bonuses Masks Government's Role As AIG's Enabler
The Government Failed to Enact Reasonable Regulations to Protect the Investing Public. The U.S. propped up AIG long before the bailout. During the housing boom, AIG made billions of dollars insuring companies' investment risks with instruments known as "credit default swaps." The government, however, failed to regulate these instruments as "insurance," but instead treated them as securities.

Federal law requires insurance companies (and commercial banks) to maintain a certain level of "reserves" proportional to their outstanding risk portfolio. These reserve requirements protect the companies and the public by making sure that the companies can actually cover the risks they insure. These requirements, however, do not apply to investment instruments -- even if the investment instruments effectively operate as insurance and are issued by insurance companies.

AIG made enormous profits during the housing boom because mortgage-related financial instruments proved valuable as housing prices soared, home lending was robust and easy, and home values were skyrocketing. But AIG insured many extremely risky mortgage-backed securities that were formed by bundling subprime and other risky mortgage instruments. When the housing/lending party ended and homeowners started defaulting on their loans, AIG had to cover the losses of those companies with investments it insured.

AIG began losing billions of dollars, but it did not have the reserves to cover its outstanding risk portfolio. To save AIG -- and companies with investments it insured -- the government stepped in to salvage it. To date, AIG has received $170 billion in bailout assistance.

The Government Failed to Place Necessary Constraints on the Use of TARP Funds. During debates over the appropriateness of the bailout, many members of Congress stressed the need for accountability, transparency, and assistance to homeowners. But Congress passed legislation that gave the Treasury Department wide discretion to determine how companies used the money.

In January, some Democrats and Republicans in Congress threatened to block the release of the second $350 billion installment of TARP funds because they wanted more specifics concerning and restraints on the use of the funds. In response, President-Elect Obama marched to Capitol Hill and promised to veto such action. Congress released the funds after the President's veto threat -- an action that would have politically damaged the Democrats.

After his inauguration, President Obama came up with his own plan to create transparency in the use of TARP funds and to prevent wasteful practices among participants in the program. Most industry experts and news media, however, described Obama's regulations as being absolutely toothless. For example, it did not apply retroactively to companies that had already received TARP assistance.

Senator Dodd -- himself a recipient of millions of dollars in campaign donations from the financial sector -- proposed an amendment to the stimulus package that would have done much more than Obama's regulations to constrain the use of TARP funds. Specifically, Dodd's amendment would have severely restrained the ability of TARP recipients to pay executive bonuses, and it would have applied retroactively to companies like AIG that had already received TARP funds.

After the measure passed in the Senate, President Obama, Treasury Secretary Geithner and Economic Policy Advisor Larry Summers expressed disagreement with the provision, which exceeded the constraints in the regulation that Obama and Geithner had already created. At the time, The Hill published an in-depth report on the Obama administration's disagreement with Dodd's effort to constrain use of TARP funds.

Obama's Senior Advior David Axelrod stated that the administration would have a "dialogue" with Dodd in order to "come up with a good approach," an odd position to take given that the measure had already passed in the Senate. Perhaps Axelrod's statement was an indication of things to occur because the bill that emerged from the conference committee did not contain the retroactivity portion of Dodd's amendment and specifically stated that the bonus and salary restrictions did not apply to any employee contract that predated the passage of the statute.

Dodd denies agreeing to the change regarding retroactivity -- even though he voted for the stimulus package. Whether he did or not, it is clear that the Obama administration negotiated limitations on regulations that would have prevented payment of the very bonuses that Obama now finds so outrageous.

Public Will Be Duped Yet Again
The government, including some of its most outraged leaders, failed to regulate credit default swaps, and it resisted efforts to place stronger conditions upon the receipt and use of TARP funds. Now that AIG has become a political embarrassment for its enabler, the enabler is outraged. Regime change -- or at least "sanctions" -- will definitely follow.

Despite the trail of events that show governmental complicity in AIG's profitable-then-costly behavior, the government is skillfully exploiting populist opposition to corporate excess in order to mask its own actions that enabled AIG to transfer money from taxpayers to its executives and to avoid the consequences of its own financial recklessness.

Similarly, the Bush Administration manipulated the country's fear of terrorism and anger over the 9/11 attacks in order to justify waging a war against Hussein whom the U.S. had previously fed arms and other assistance so that Iraq could battle Iran, which had fallen into disfavor with the U.S.

Rather than scrutinizing the government's wrongful conduct, the public is once again falling for the rhetoric and smokescreen. Instead of focusing on AIG, voters should direct their attention to AIG's enabler: the U.S. government. The government essentially gave AIG a blank check. That action should anger the public more than AIG's subsequent use of the money.

Update: Glenn Greenwald is covering the Treasury Department's attempt to blame Dodd when actually the Obama administration demanded that Congress drop the retroactivity clause. Apparently, the New York Times is digging into the matter as well. The administration's "outrage" could potentially become an embarrassment itself.

9 comments:

Red In a Blue State said...

Amen! I couldn't agree more and have said the same exact thing for days, since this nonsense first started:
AIG Outrage: DON'T FALL FOR IT!!!!
http://redboyinabluestate.blogspot.com/2009/03/aig-outrage-dont-fall-for-it.html

Anonymous said...

I saw your post over at The Confluence. Thanks for bringing your post to my attention. I also gave it a Digg.

Roy Lofquist said...

During today's hearing an SEC regulator testified that the SEC studied the CDS's in 1994, had the power to stop them but chose not to.

What makes people think that regulators are smarter than the finance people?

Don't get me wrong. Regulations and regulators are absolutely necessary for the system. But they are only effective in enforcing standard, experience based rules. The current mess was caused by incorrect calculations of the risk factor for new types of instruments. It was a SWAG (scientific wild ass guess).

The proximate cause was a political decision to push the banks to lend to historically less qualified buyers. The banks, being sober institutions, were unwilling to carry this risk on their own books so a market was made to pass them along to the CFE's. The CFE's bundled them and peddled them other entities, increasing the leverage at each stage.

A Cosmic demonstration of the law of unintended consequences.

Roy Lofquist said...

Correction: 2004, not 1994.

Darren Lenard Hutchinson said...

Roy -

I think the cause was more than bad lending. It was reckless lending. And the borrowers were not "less qualfied." A lot of the people who are defaulting had "prime" credit, but they live in cities -- like DC or San Francisco -- where home prices soared so greatly that they were forced to buy homes with little or no down payments and with ARMs that start low but then increase. Unless you live in one of the most intense housing markets, it's hard to appreciate this side of the story.

Second, the bundling of the mortgages, as you stated, is another piece of the puzzle. Swaps are relevant here because they allowed lenders and investors in mortgage-backed securities to act as if they had "nothing" to lose -- they were "insured." But unlike ordinary insurance, the swaps did not require the "insurer" to hold adequate reserves. Once the defaults started, companies like AIG imploded. Had the law required AIG to hold reserves on the swaps, the company would have been forced to "internalize" the risk of the swaps long before the crisis happened.

Finally, your comment rests on a false dichotomy between "regulators" and "finance" peple. Industries greatly influence regulations that apply to them. Not only are the "regulators" drawn from industry, but the regulated industries are involved in the comment stage of legislation. With respect to reserve levels, an actuary could compute the safe amount of reserves related the insured risk. The problem in this situation: no reserves were required - the swaps were unregulated. Apparently, the "smart" finance people did not believe that they should impose the requirements upon themselves. Finance people may be smart, but intellect does not prevent stupid behavior.

Roy Lofquist said...

Dear Dr. Hutchinson,

No disagreement whatsoever. The whole situation is complex beyond comprehension.

By "less qualified" I meant those folks who fell outside the the normal parameters (scores if you will) of accepted banking practice. I did not mean to imply any judgment as to the correctness of these practices. All I meant to say is that the rules changed and people did not know how to properly deal with the new situation.

This has happened before, notably when the Congress repealed Regulation Q and radically changed depreciation schedules. This caused the "Savings and Loan" debacle.

Then, as now, we see massive CYA - like a fart in church. Who me? Jokes are made about five handed economists. How about fourteen fingered politicians?

Perhaps, someday, we'll figure out what really happened. Of course, we are still arguing about the Fall of Rome and the cause of Thirty Years War. And the Tulip Craze.

As for me, I am going to peruse the Dylan lexicon, become a Go master and switch to gin until the shouting is over.

Regards,
Roy

Darren Lenard Hutchinson said...

Roy, Have a gin for me! I cannot drink, because I have too much work to do. I understand your "less qualified" statement. I just want to supplement the common understanding that many of the people did have good credit, but they did not have enough "cash reserves" or a 20 percent downpayment to get a home. For some of these individuals, the lack of a downpayment was due precisely to the rapid appreciation in home values (in DC prices went up over 20 percent a year for about five or six years). I think we understate the magnitude of the problem if we only assume that subprime borrowers created the risk in the first place.

Enjoy your day and thanks for posting!

Roy Lofquist said...

Darren,

Again, total agreement. I do not believe that there was more than the normal level of greed, dishonesty, stupidity, cupidity, or body odor.

I supported expanded home ownership - thought it was the right thing to do. Turned out poorly. The best laid plans of mice and men aft gang agley.

Right now I can't stand the ugliness of the blame game. And a lot of it comes from people who should be fixing things rather than playing Grand Inquisitor.

Roy

Anonymous said...

Great research on the real source of the haemorrhaging of incompetence now forthcoming from the Obama administration. It seems as if this administration is but the other side of the Bush coin of incompetence and mismanagement! Keep up the objectivity and tell it like it, Hutchinson!

MSakel

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