Multinational Monitor Editors blog

What if the Obama administration treated the auto industry like Wall Street?

There’d be no talk of potential bankruptcy, no firing of executives, no demands to shed failing subsidiaries, no demands for honest accounting, no insistence that creditors share some of the companies’ pain. And we certainly wouldn’t hear about re-writing contracts, heretofore described as sacrosanct.

Instead, we’d be hearing about a scheme to get private sector players “now sitting on the sidelines” to invest in absorbing the auto industry’s excess capacity.

We’d see the Treasury Department announcing a Public-Private Investment Plan to tap hedge funds’ pools of capital and expertise to create demand for autos that GM and Chrysler could manufacture but are presently unable to sell at a satisfactory price. These excess cars would be called “legacy assets” (the euphemism for failing mortgage-related securities, more widely called “toxic”).

If the plan really paralleled Treasury Secretary’s Timothy Geithner’s proposal for dealing with Wall Street’s toxic assets, it would “incentivize” the hedge funds to buy up hundreds of thousands or millions of cars, and hold them for later sale, when the overall economy improves. The idea would be that the private investors may be willing to pay a price below the list price, but above the price at which GM and Chrysler could actually sell their excess cars right now — a price high enough to help GM and Chrysler.

What would be the incentive for the private investors to take this gamble? The government would offer to contribute $13 for every dollar contributed by the hedge funds. Thus, an investor could spend $1 billion to buy cars — bought well below sticker price — while paying only $71 million out of pocket.

With that kind of deal, it’s possible the private investors would pay enough to help GM and Chrysler. In doing so, they would be taking on enormous risk — they would be betting that they someday could sell the cars for more than $1 billion — but if they couldn’t … well, taxpayers would bear all of the losses except for the $71 million.

Does this sound crazy?

It is.

The Treasury plan for the banks’ toxic assets is impossibly complex, but its core feature is a massive, disguised taxpayer subsidy to Wall Street (Jeffrey Sachs of Columbia University roughly estimates the giveaway component as $276 billion, based on realistic assumptions about the risks embedded in buying the assets).

The Geithner plan for the banks contrasts starkly with the very tough and hard-headed approach taken by the Obama administration to the automakers.

The administration’s response to the automakers is deeply flawed. It should be faulted for continuing to demand still-more givebacks from unionized workers; for focusing too much on short-to-medium term results and not enough on investments in fuel efficiency and transformative technologies; and for threatening the use of bankruptcy, a move which would undermine efforts to direct the companies to major investments in R&D and sustainable technologies. These are very major problems.

But the overall approach is right in asserting: If the taxpayers are going to provide tens of billions in supports, then they have the right to make demands on the beneficiaries. They should demand the firing of CEOs who drove firms into insolvency. They should demand specific plans for transformation. They should demand creditors accept some of the cost of insolvency.

Why the tough love for Detroit and kid gloves for Wall Street? You can make up whatever story you like about the systemic importance of the financial sector as compared to auto manufacturing, but it is utterly uncompelling — especially as we move out of the phase of acute crisis and into chronic economic downturn.

There’s just no escaping that Wall Street has bought its gentle treatment through a long-term investment in Washington, the effect of which goes far beyond any specific policy. At the Treasury Department, they understand the point of view of Wall Street — there is a unity of culture between top officials at Treasury and Wall Street, not least because the decision makers at Treasury so often come from Wall Street. Treasury Department officials can’t imagine themselves in the shoes of auto executives, let alone auto workers.

The administration’s plan for the auto industry is deeply flawed, but at least it has the right attitude. Quick consideration of what it would like if the government treated Detroit like Wall Street shows how ridiculous the idea is.

What everyone should be asking is, What would it look like if the government treated Wall Street like Detroit? And, why isn’t that happening?

Watch out if you live in or visit Washington, D.C.

If you see a camera or microphone, be careful not to be trampled by a politician rushing to shout their “outrage” at AIG, and its brazen scheme to pay $165 million in bonuses to employees at the company unit responsible for driving the company to the edge of insolvency.

Maybe the politicians really are outraged. (They definitely know their constituents are.) But it would have helped if they had expressed some outrage — and opposition — during the decades-long period of deregulation that brought us the AIG collapse and the financial meltdown.

It is indeed unfathomable that AIG went ahead with the bonus payments, and that the Treasury Department and Federal Reserve failed to act to stop the bonus payments before they were made.

What is vital now is that the public’s righteous anger is not expressed only as “no.” There are a lot of things to which We The People do need to say “no.” But we need a lot of “yes’s,” too. We need to demand that policymakers impose public controls over the financial sector. The financial sector restraint, shrinkage and displacement agenda is long and diverse, but there are a number of lessons that flow directly from the AIG debacle.

First, the government must exercise much more direct control over the firms it is bailing out (many of which, like AIG, are very likely to be subjected to government takeovers of one kind or another in the coming months). If the government exercised control commensurate with its ownership stake, it could simply refuse to permit outrages like the AIG bonus payments to occur. Beyond preventing outrages, there should be affirmative demands imposed on the beneficiaries of bailout funds. These should include, for commercial banks, the mandatory write down of principal on home mortgages where the outstanding loan amount now exceed the value of the home, and the end to usurious interest rates on credit cards.

Second, there must be far-reaching reform of compensation arrangements in the financial sector. Never again should anyone get away with saying this is a symbolic issue. The AIG bonus payments, and the manic response from the financial sector to modest executive pay restrictions added by Senator Chris Dodd to the financial bailout reauthorization legislation, demonstrate that the guys on Wall Street certainly don’t think it’s symbolic. Real reform must go beyond giving shareholders a say on pay to imposing public controls. There should be high tax rates on excessive compensation. Most importantly, there should be a prohibition on incentive pay that is linked to short-term performance. Bonuses based on annual performance give traders and others an incentive to take unreasonable risks — threatening the viability of their firms, and the overall financial system.

Third, the regulatory black holes in the financial system must be eradicated. One black hole concerns regulation of financial derivatives — the exotic instruments that threw AIG into virtual insolvency. During the Clinton administration, Fed Chair Alan Greenspan, Treasury Secretary Robert Rubin and Deputy Treasury Secretary (now director of the National Economic Council) Larry Summers crushed an effort by independent-minded regulators to adopt modest regulation of financial derivatives. In 2000, Congress prohibited such regulation by law. When regulations are finally adopted this year, as they almost certainly will be, they should prohibit certain kinds of financial derivatives altogether, and require that new ones prove their safety and social value before being placed on the market.

Fourth, we need a revitalized antitrust and competition policy to break up and shrink the size of the mega financial institutions (and, not so incidentally, we also need to shrink the size of the overall financial structure). These too-big-to-fail institutions are, as has been said, just too big. Or amended: they are too big and too interconnected. Their very existence poses unacceptable social costs, made worse by the fact they take greater risks knowing that they benefit from an implicit public insurance.

AIG itself has acknowledged the problem. In a company presentation apparently prepared to persuade the federal government to keep the bailout funds coming, AIG explained, “what happens to AIG has the potential to trigger a cascading set of further failures which cannot be stopped except by extraordinary means.”

AIG CEO Edward Liddy has drawn the proper conclusion: “Where safeguards are lacking” — and it should be added, it has proven far beyond the capacity of regulators to impose sufficient safeguards — “such companies need to be restructured or scaled back so they no longer come close to posing a systemic risk.”

Finally, renewed attention must be paid to corporate structure and prohibitions on whole categories of activity. Insurance companies should be prohibited from operating affiliates that function as de facto hedge funds. Commercial banks husbanding depositors’ assets should be prohibited from operating securities firms (as was law until 1999) or making securities firm-style speculative bets.

Will the outraged politicians demand these and other reforms? Will their outrage last once the media move on to the next story? That will depend almost entirely on whether an organized and focused public demands it.

Is it fair to complain about the actions of the financial deregulators?

Could anyone reasonably have foreseen the consequences of a decades-long regulatory holiday for the financial sector?

In a word, yes.

In preparing “Sold Out: How Wall Street and Washington Betrayed America,” a report that documents a dozen deregulatory steps to financial meltdown, it was remarkable to see that, at almost every step, public interest advocates and independent-minded regulators and Members of Congress cautioned about the hazards that lay ahead. Those ringing the alarm bells were proven wrong only in underestimating how severe would be the consequences of deregulation.

Policymakers ignored the warnings. Good arguments could not compete with the combination of political influence and a reckless and fanatical zeal for deregulation. $5 billion — the amount the financial sector invested in the financial sector over the last decade — buys a lot of friends.

Example: Consumer groups warned of a growing predatory lending scourge at the beginning of this decade (and even in the 1990s), before the housing bubble inflated.

“While many regulators recognize the gravity of the predatory lending problem, the appropriate — and politically feasible — method of addressing the problem still appears elusive,” wrote the National Consumer Law Center and the Consumer Federation of America in January 2001 comments submitted to the FDIC.

What was needed, the consumer groups argued, was binding regulation. “All agencies should adopt a bold, comprehensive and specific series of regulations to change the mortgage marketplace,” the groups wrote, so that “predatory mortgage practices are either specifically prohibited, or are so costly to the mortgage lender that they are not economically feasible.”

Example: In 1999, Congress passed the Gramm-Leach-Bliley Act, which eliminated the Glass-Steagall and Bank Holding Company Acts’ longstanding ban on combining commercial banks and investment banks, or commercial banks and other financial service providers. This law paved the way for the creation of Citigroup, a merger of Citibank and Travelers Insurance, and helped infuse the speculative go-go culture of investment banks into commercial banks.

When Citibank and Travelers announced their merger in 1998 — a marriage that could only be consummated if Glass-Steagall and related rules were repealed — my colleague Russell Mokhiber and I wrote, “Expect to see lots of bad loans, bad investment decisions, teetering banks and tottering insurance companies — and a series of massive financial bailouts of new conglomerates judged ‘too big to fail.'” We didn’t envision exactly how the Citigroup and Wall Street debacle would play out, but we got the outline right. Our predictions echoed the warnings from consumer advocates.

Example: In 1998, the Commodity Futures Trading Commission (CFTC) suggested the need for regulation of financial derivatives. In a concept paper, the CFTC wrote that, “While OTC [over-the-counter] derivatives serve important economic functions, these products, like any complex financial instrument, can present significant risks if misused or misunderstood by market participants.” The agency suggested a series of modest potential regulations that might have restrained the proliferation of financial derivatives and required parties to set aside capital against the risk of loss (a policy that likely would have saved taxpayers tens of billions or more in the AIG bailout).

But the CFTC initiative was crushed by the then-Committee to Save the World (so designated by Time Magazine) — Treasury Secretary Robert Rubin, Deputy Secretary Larry Summers and Federal Reserve Chair Alan Greenspan. In 2000, Congress passed a statute prohibiting the CFTC from regulating financial derivatives.

Example: In 1995, Congress passed the Private Securities Litigation Reform Act, which made it harder for defrauded investors to sue for relief. Representative Ed Markey, D-Massachusetts, introduced an amendment that would have exempted financial derivatives from the terms of the Act. Representative Chris Cox, R-California, who would go on to head the Securities and Exchange Commission under President Bush, led the successful opposition to the amendment.

Markey anticipated many of the problems that would explode a decade later: “All of these products have now been sent out into the American marketplace, in many instances with the promise that they are quite safe for a municipality to purchase. … The objective of the Markey amendment out here is to ensure that investors are protected when they are misled into products of this nature, which by their very personality cannot possibly be understood by ordinary, unsophisticated investors. By that, I mean the town treasurers, the country treasurers, the ordinary individual that thinks that they are sophisticated, but they are not so sophisticated that they can understand an algorithm that stretches out for half a mile and was constructed only inside of the mind of this 26- or 28-year-old summa cum laude in mathematics from Cal Tech or from MIT who constructed it. No one else in the firm understands it. The lesson that we are learning is that the heads of these firms turn a blind eye, because the profits are so great from these products that, in fact, the CEOs of the companies do not even want to know how it happens until the crash.”

There was nothing inevitable, unavoidable or unforeseeable about the current crisis.

At every step, critics warned of the dangers of further deregulation. But with the financial sector showering campaign contributions on politicians from both parties, investing heavily in a legion of lobbyists, paying academics and think tanks to justify their preferred policy positions, and cultivating a pliant media — especially a cheerleading business media complex — the sounds of clinging cash registers drowned out the evidence-based warnings from public interest advocates and independent-minded government officials.