Perhaps I’m just impatient. Perhaps Treasury needs to staff up first. But rather than trying to figure out “legal” ways to restrict salaries and bonuses for the folks in companies getting public bailout funds, I’d much rather see Congress work on re-regulating the system. Sure, it doesn’t fuel populist anger like taxing bonuses does, but it would be far more important in the long run.
Start with repealing Gramm-Leach-Bliley. That was the charming piece of legislation that removed the “wall” between various kinds of financial institutions. It allowed these entities to become to large to fail because they had tentacles into commercial banking, investment banking, hedge funds, and insurance. And it allowed legal space for companies to push the risk of loans far and wide while raking in the (temporary) profits. Thus the rise of credit default swaps, securitized mortgage loans, and all those instruments that are now so toxic.
President Obama is pushing to allow the government to seize not just banks but insurance companies (think AIG, or whatever they’re calling themselves these days), and investment banks (like Merrill Lynch, Lehman, Morgan Stanley and the others who’ve gone belly up in the melt-down).
I just caught a bit of Sec. Geithner’s testimony before Barney Franks’ committee, and he made a statement that bears repeating again and again. The topic was the monies AIG paid to its counterparties — the investment and foreign banks that had purchased the credit default swaps AIG was selling. The take away comment was that Treasury lacked the authority, even as the majority owner of AIG, to demand that the counterparties be made less than whole. The counterparties purchased CDSs as a hedge against mortgage backed securities — insurance in case these sliced-and-diced mortgages turned out to be worth far less than anticipated.
There is a direct line between Geithner’s statement, the need to repeal Gramm-Leach-Bliley, and the President’s proposal. Gramm-Leach-Bliley dismantled the regulatory wall that stood between commercial banks (the entities who traditionally have written mortgages), the investment banks (the entities who created the mortgage backed securities), and the insurance companies who created the credit default swaps. That wall had been erected as part of the regulatory framework created after the Great Depression to prevent another one.
A new or revised regulatory framework could mean that these hybrid companies would have to decide what they really want to be. They would have to create separate companies for each part rather than simply combining them into one uber-institution, now deemed to big to fail because failure would create systemic risk. There is danger in being too big to fail, and perhaps the best solution is to make sure that no business can get to that point.
As another part of the Depression Era regulatory framework, the FDIC was created to allow the government to seize a failing bank, pay depositors out of an insurance pool, and sell off the bank’s assets (its loans). A similar framework that would facilitate the orderly resolution of a failed investment bank or insurance company does not exist. That’s the direction the Obama Administration is heading — to create some sort of entity or entities that would serve the same function as the FDIC but for investment banks, hedge funds and insurance companies. FDIC has proven to be a successful model for making sure that depositors are protected and that assets can be sold off. Clearly part of the current difficulty lies in the question of how to unwind the legacy assets so they can be sold off and removed from the institutions’ balance sheets. In the process of a bank take-over, contracts with creditors and employees are subject to revision, thus preventing bonuses that serve to reward bad behavior.
AIG has rightfully been the target of a great deal of public anger in recent days. But it’s important to understand just how AIG got itself into its financial mess, because its story is a powerful argument for repealing Gramm-Leach-Bliley and establishing the kind of regulatory framework that will allow the financial system to return to long-term health. The LA Times has an article today that is worth reading. Unfortunately, its online edition doesn’t include some of the most interesting information — what went wrong. So, here it is:
In 2007, AIG was one of the world’s largest companies with $1 trillion in assets, $110 billion in reserves, 74 million customers, and 116,000 employees. Here are highlights of what happened.
- In 2001 it began selling credit default swaps — insurance protection against default on mostly mortgage-based securities.
- Those securities initially were given AAA ratings, which allowed AIG to expand this activity without putting up huge collateral or creating giant reserves.
- As homeowners began to default on mortgages in 2007, AIG began to incur heavy losses.
- Those losses led to reduction of AIG’s credit rating in September 2008, forcing it to post billions in collateral.
- With the credit crisis and the economy unraveling, AIG could not find financing or sell assets to cover its collateral.
Interestingly, but not surprisingly, the smaller community-based banks have generally fared well during the melt-down. They chose not to participate in sub-prime lending practices, did their own underwriting, and kept the loans in house. By assuming the risk themselves, rather than spreading it out among investors and then purchasing credit default swaps to hedge their bets, they were careful to lend only to credit-worthy borrowers. In hind sight, it’s fairly easy to see how the house of cards was built — and why it collapsed.
Instead of responding to and fueling popular anger, it’s time for Congress to lower the temperature, do their homework, and work with the Administration to determine the best way to prevent another feeding frenzy wherein greed and the promise of a quick buck reign supreme. Have we learned our lesson yet? That remains to be seen. Unfortunately, so long as the financial sector contributes so heavily to Congressional campaigns, we can expect that their influence in determining policy will remain strong. We — the voters and taxpayers — must remain vigilant.
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