The blogosphere is buzzing over a report that the resignation of executives at AIGFP's French subsidiary could put AIG into default:
The executives at Paris-based Banque AIG, Mauro Gabriele and James Shephard, have resigned in recent days but have agreed to stay on for a transition, according to people familiar with the matter. In the wake of their resignations, AIG must replace them to the satisfaction of French banking regulators.
If they don't, French regulators may appoint their own designee to manage the bank -- an outcome that could trigger defaults under the bank's derivative contracts. The private contracts say that a regulator's appointment of a manager constitutes a change in control, according to a person familiar with the matter; the provision is often included in derivative contracts where parties want to preserve a way out if something about their counterparties changes.
Most have reacted to the notion that an executive's resignation could trigger a massive default, but this is what caught my eye:
Defaults, by no means inevitable, could not only hurt AIG but also could force European banks involved in the trades to raise billions in capital to cushion potential losses, according to AIG documents.
AIG is insolvent right now, but it still has outstanding contracts to insure $1.6 trillion of derivatives. Apparently European banks get to keep pretending that the AIG credit default swaps they're holding are actually worth their book value unless and until AIG defaults. At that point they'll have to quit pretending and raise more capital to fill the hole in their balance sheets. But they already have a big hole in their balance sheets. They're just pretending they don't.
If European banks are relying on AIG's credit default swaps to avoid insolvency, then they're under water right now. AIG's formal default would merely require them to admit it.
Matt Taibi (of all people) writing in Rolling Stone (of all places) has produced the best narrative explanation of the financial crisis I've seen. The real story, Taibi argues, isn't money, but power -- "the gradual takeover of the government by a small class of connected insiders, who used money to control elections, buy influence and systematically weaken financial regulations." Along the way Taibi clearly explains how amoral greedheads used collateralized debt obligations and credit default swaps to devastate the entire financial sector, and his piece would be well worth reading for that alone. Nevertheless, I emphasize his point about corporate power because neither the financial crisis nor the change in administration has broken the power of Wall Street.
The story begins in the last years of the Clinton administration:
For years, Washington had kept a watchful eye on the nation's banks. Ever since the Great Depression, commercial banks — those that kept money on deposit for individuals and businesses — had not been allowed to double as investment banks, which raise money by issuing and selling securities. The Glass-Steagall Act, passed during the Depression, also prevented banks of any kind from getting into the insurance business.
But in the late Nineties, a few years before [Joseph] Cassano took over AIGFP, all that changed. The Democrats, tired of getting slaughtered in the fundraising arena by Republicans, decided to throw off their old reliance on unions and interest groups and become more "business-friendly." Wall Street responded by flooding Washington with money, buying allies in both parties. In the 10-year period beginning in 1998, financial companies spent $1.7 billion on federal campaign contributions and another $3.4 billion on lobbyists. They quickly got what they paid for. In 1999, [former Texas Congressman Phil] Gramm co-sponsored a bill that repealed key aspects of the Glass-Steagall Act, smoothing the way for the creation of financial megafirms like Citigroup. The move did away with the built-in protections afforded by smaller banks. In the old days, a local banker knew the people whose loans were on his balance sheet: He wasn't going to give a million-dollar mortgage to a homeless meth addict, since he would have to keep that loan on his books. But a giant merged bank might write that loan and then sell it off to some fool in China, and who cared?
The very next year, Gramm compounded the problem by writing a sweeping new law called the Commodity Futures Modernization Act that made it impossible to regulate credit swaps as either gambling or securities. Commercial banks — which, thanks to Gramm, were now competing directly with investment banks for customers — were driven to buy credit swaps to loosen capital in search of higher yields. "By ruling that credit-default swaps were not gaming and not a security, the way was cleared for the growth of the market," said Eric Dinallo, head of the New York State Insurance Department.
The blanket exemption meant that Joe Cassano could now sell as many CDS contracts as he wanted, building up as huge a position as he wanted, without anyone in government saying a word.
. . . In the biggest joke of all, Cassano's wheeling and dealing was regulated by the Office of Thrift Supervision, an agency that would prove to be defiantly uninterested in keeping watch over his operations. How a behemoth like AIG came to be regulated by the little-known and relatively small OTS is yet another triumph of the deregulatory instinct. Under another law passed in 1999, certain kinds of holding companies could choose the OTS as their regulator, provided they owned one or more thrifts (better known as savings-and-loans). Because the OTS was viewed as more compliant than the Fed or the Securities and Exchange Commission, companies rushed to reclassify themselves as thrifts. In 1999, AIG purchased a thrift in Delaware and managed to get approval for OTS regulation of its entire operation.
Making matters even more hilarious, AIGFP — a London-based subsidiary of an American insurance company — ought to have been regulated by one of Europe's more stringent regulators, like Britain's Financial Services Authority. But the OTS managed to convince the Europeans that it had the muscle to regulate these giant companies. By 2007, the EU had conferred legitimacy to OTS supervision of three mammoth firms — GE, AIG and Ameriprise.
. . . The situation worsened in 2004, in an extraordinary move toward deregulation that never even got to a vote. At the time, the European Union was threatening to more strictly regulate the foreign operations of America's big investment banks if the U.S. didn't strengthen its own oversight. So the top five investment banks got together on April 28th of that year and — with the helpful assistance of then-Goldman Sachs chief and future Treasury Secretary Hank Paulson — made a pitch to George Bush's SEC chief at the time, William Donaldson, himself a former investment banker. The banks generously volunteered to submit to new rules restricting them from engaging in excessively risky activity. In exchange, they asked to be released from any lending restrictions. The discussion about the new rules lasted just 55 minutes, and there was not a single representative of a major media outlet there to record the fateful decision.
Donaldson OK'd the proposal, and the new rules were enough to get the EU to drop its threat to regulate the five firms. The only catch was, neither Donaldson nor his successor, Christopher Cox, actually did any regulating of the banks. They named a commission of seven people to oversee the five companies, whose combined assets came to total more than $4 trillion. But in the last year and a half of Cox's tenure, the group had no director and did not complete a single inspection. Great deal for the banks, which originally complained about being regulated by both Europe and the SEC, and ended up being regulated by no one.
The rest, as they say, is history. The unregulated Wall Streeters promptly devolved into frenzied, irresponsible risk-taking with no effective oversight by anyone. Although they made out like bandits, they destroyed trillions of dollars of wealth and devastated the entire Western financial system.
It should be obvious that entities that are too big to fail are also too big to exist. Classical market theory assumes that individual market competitors are each too small to exercise any market power. As a result, each must do what the market demands or be slapped down by Adam Smith's "invisible hand". But when markets are dominated by a few huge players, the competitors gain sufficient economic and political power to make their own market. Through "regulatory capture" they can re-write the rules for their own benefit. Every indicator suggests that this is still going on, mostly in secret:
By early 2009, a whole series of new government operations had been invented to inject cash into the economy, most all of them completely secretive and with names you've never heard of. There is the Term Auction Facility, the Term Securities Lending Facility, the Primary Dealer Credit Facility, the Commercial Paper Funding Facility and a monster called the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (boasting the chat-room horror-show acronym ABCPMMMFLF). For good measure, there's also something called a Money Market Investor Funding Facility, plus three facilities called Maiden Lane I, II and III to aid bailout recipients like Bear Stearns and AIG.
While the rest of America, and most of Congress, have been bugging out about the $700 billion bailout program called TARP, all of these newly created organisms in the Federal Reserve zoo have quietly been pumping not billions but trillions of dollars into the hands of private companies (at least $3 trillion so far in loans, with as much as $5.7 trillion more in guarantees of private investments). Although this technically isn't taxpayer money, it still affects taxpayers directly, because the activities of the Fed impact the economy as a whole. And this new, secretive activity by the Fed completely eclipses the TARP program in terms of its influence on the economy.
While we're fussing about earmarks (or somewhat closer to the truth, obscene corporate bonuses paid by government-sponsored insolvents like AIGFP), the government is spending literally trillions of dollars without any more oversight than the insolvent Wall Street banks got:
When one considers the comparatively extensive system of congressional checks and balances that goes into the spending of every dollar in the budget via the normal appropriations process, what's happening in the Fed amounts to something truly revolutionary — a kind of shadow government with a budget many times the size of the normal federal outlay, administered dictatorially by one man, Fed chairman Ben Bernanke. "We spend hours and hours and hours arguing over $10 million amendments on the floor of the Senate, but there has been no discussion about who has been receiving this $3 trillion," says Sen. Bernie Sanders. "It is beyond comprehension."
. . . And the Fed isn't the only arm of the bailout that has closed ranks. The Treasury, too, has maintained incredible secrecy surrounding its implementation even of the TARP program, which was mandated by Congress. To this date, no one knows exactly what criteria the Treasury Department used to determine which banks received bailout funds and which didn't — particularly the first $350 billion given out under Bush appointee Hank Paulson.
The situation with the first TARP payments grew so absurd that when the Congressional Oversight Panel, charged with monitoring the bailout money, sent a query to Paulson asking how he decided whom to give money to, Treasury responded — and this isn't a joke — by directing the panel to a copy of the TARP application form on its website. Elizabeth Warren, the chair of the Congressional Oversight Panel, was struck nearly speechless by the response.
"Do you believe that?" she says incredulously. "That's not what we had in mind."
Word is now leaking out that the Obama administration will address the financial crisis by giving huge subsidies to insolvent banks, hoping that asset prices will rise when the economy improves and that all will then be well. This news has been greeted with what can at best be characterized as mixed reviews. (For example, Paul Krugman is appalled, while Brad DeLong thinks it might work.) I have grave doubts that the Geithner plan will fix what ails the financial sector, but it absolutely will benefit the Wall Street titans, whom it will leave securely ensconced in their privileged positions of power. I think that is a terrible mistake. We would all be better off if the power of Wall Street were broken.
Acknowledging once again that they are no more than a "rounding error", the obscene AIG bonuses have generated a political firestorm because they crystallize our fear that we have no power over the Masters of the Universe who run Wall Street for their own benefit. That the game is rigged, and in their towering arrogance they don't even care if we know it. Hence the outrage.
The House of Representatives may be a "wretched hive of scum and villainy", but its swift passage of a tax clawing back the bonuses reflects a keen political judgment. It also reflects frustration with the administration's failure to get out in front on this issue. Barack Obama must quit deferring to his economic team, which appears not to comprehend the magnitude of either the economic crisis or the political crisis. Frank Pasquale captures the point nicely here:
As the bailout unfolds, phobia about "nationalization of the banks" results in a regime where no one appears to be in effective control of the situation. The "sanctity of contracts" becomes a catch-all shibboleth for rewarding even the most revolting greed.
. . . The outrage over the AIG bonuses is rooted in legitimate worry about a hapless, drifting state. The rage may eventually be quelled by sober economic analysis of the "real value" of executives and traders. But Americans now have a sick feeling that even after the repudiation of the most fatcat-friendly regime in our history, "Change We Can Believe In" has turned into continuity we can't stand.
. . . We live in "a world in which, according to 2006 statistics, one percent of the world’s adults own forty percent of all global assets[,] [t]he richest ten percent own eighty-five percent, while the poorest half own less than one percent." We should not be surprised when those in that glittering top percentile pull out all the stops to preserve and intensify those inequalities. But we are still inevitably disappointed by an administration that promised so much, and appears more at drift than mastering the financialization that has brought the nation to the brink of ruin. That's the kernel of truth and sorrow at the core of public outrage over AIG.
As noted below, the AIG bonuses are just a "rounding error", but the ensuing political firestorm could prevent the costly actions that will yet be necessary to stabilize the financial sector. AIG CEO Edward Liddy didn't help yesterday when he testified that multimillion-dollar bonuses were necessary to retain the people who made this mess, because they were the only ones capable of cleaning it up. Andrew Leonard captures this dynamic perfectly:
You have to love -- or hate -- the beauty of this showdown. The CEO of AIG tells Congress that giving out bonuses is necessary in order to prevent a financial cascade of destruction that could bring down the economy. And Congress tells the CEO of AIG that giving out the bonuses ensures that Congress will not authorize any more funds to mitigate exactly that disaster.
It will be an enormous challenge to channel popular outrage in a useful direction.
As Yves Smith puts it, the AIG bonuses amount to nothing more than a "rounding error", but their payment and the government's inability or unwillingness to do anything about it exemplify what's wrong with both Wall Street and our response to the financial crisis.
The claim that AIG was contractually obligated to pay the bonuses underscores that the Masters of the Universe are concerned first and foremost with looking after themselves. They cut deals that gave them huge upsides if they turned short term profits and locked in lucrative bonuses even if they destroyed the entire Western banking system. They made out like bandits, and with the wreckage still falling down around us they're still taking more. With these perverse incentives it's no wonder the system collapsed.
The government's failure to restrict these bonuses when the initial bailout occurred and its failure to recognize that this would produce a political firestorm reveal a severe case of regulatory capture. Paulson, Bernanke, and now Geithner all seem to have internalized the view that these people really are the Masters of the Universe. How else to explain their willingness to transfer hundreds of billions of dollars with no strings attached or the contortions they've undergone to avoid nationalizing these insolvent entities? The bonuses are probably just the tip of an iceberg of sweetheart deals and self-dealing.
Although the government nominally owns 80 percent of AIG, it seems to have no control over what AIG does. This is insane. The government defers to the execs, the execs defer to the government, and no one is in charge. No private investor would imaginably make such an egregiously bad deal, and there's no reason why the government should either. As James Kwak puts it, "The seeming inability of the government to do anything but throw up its hands reflects the failed strategy of the bailouts so far: provide as much cash as needed, but do everything you can to minimize the impact on the companies being bailed out."
Meanwhile, the shifting rationales for these bonuses suggest that none has any merit. There's no basis to pay performance bonuses to people who just brought down the banking system, nor is there any reason to retain them. (In fact, 52 of those who received generous "retention bonuses" are no longer with AIG.) Kwak again:
The testaments to “the best and the brightest” - here, referring to the people of AIG Financial Products - reflect, I don’t know, either absolute, brazen obscenity, or a world-historical example of making the mistake of believing your own hype. The fact that people on Wall Street believe that they are the best among us is bad enough. The fact that people in Washington are willing to accept it is worse.
The latter point is the real problem, and it manifests most obviously in the person of Tim Geithner, who was present at the creation of this policy under the Bush administration and seems to be offering more of the same from his new post as Treasury Secretary. People understandably have trouble getting their minds around the complicated financial issues in play here, but everyone can understand that these bonuses are obscene -- or at least, everyone who hasn't been brainwashed by the Street can understand it. But Geithner seems not to understand it, and his tone deafness imperils everything Team Obama wants to accomplish. Yves Smith again:
On a separate topic, we have the lame defense of AIG by Timothy Geithner. I agree, as others have said, the bonus affair seems overdone, but on another level, it makes perfect sense. Intuitively, the public knows the execs and troops of the big financial firms were overpaid in recent years since the earnings were overstated, due to phony accounting and insufficient loss reserves. They can't get that money back, but the idea of even more going out the door, even amounts small relative to the bailouts, now that the companies are bust, is offensive.
But this truly intelligence-insulting bit from the Treasury secretary is this:
“We will impose on AIG a contractual commitment to pay the Treasury from the operations of the company the amount of retention rewards just paid,” Geithner wrote. “In addition, we will deduct from the $30 billion in assistance an amount equal to the amount of those payments.”
The money at this point is all coming from the government. That is what is so patently foolish. AIG is being treated as if it is a normal company with all the attendant rights thereto, when it from an economic standpoint is nationalized (Uncle Sam has paid multiples of its market cap even in better days); the fictive minority ownership is to avoid consolidating the debt onto the Federal books. But now we are letting accounting contrivances drive substance.
So the US government is haircutting a teeny weenie bit the loans extended to AIG. We said the bonuses were rounding error, and the loan reduction reflects that.
But the American public does not want a penalty imposed on AIG (even if this were a penalty, which it isn't). It wants one imposed ON THE EXECUTIVES. What about "no" does Tim Geithner not understand?
From a populist perspective, the greatest virtue of a nationalization/re-privatization approach would be that all of these assholes would lose their jobs, and not just their bonuses.
In the current political climate it will be impossible for Team Obama to do anything remotely like what will be necessary to fix this terrible problem. And if they don't get this fixed it will undermine everything else they're trying to do. This one loose thread could unravel everything.
I see that Rahm Emmanuel has now publicly said that Tim Geithner's job is not in jeopardy. I hope that means that Geithner's job is in fact in jeopardy. If this doesn't get sorted out within the next week, I think Geithner needs to make a very public exit from an administration that announces a very significant change in course.