Lessons from AIG

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.

We Told You So

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.

Wall Street’s Best Investment II: 12 Deregulatory Steps to Financial Meltdown

What can $5 billion buy in Washington?

Quite a lot.

Over the 1998-2008 period, the financial sector spent more than $5 billion on U.S. federal campaign contributions and lobbying expenditures.

This extraordinary investment paid off fabulously. Congress and executive agencies rolled back long-standing regulatory restraints, refused to impose new regulations on rapidly evolving and mushrooming areas of finance, and shunned calls to enforce rules still in place.

“Sold Out: How Wall Street and Washington Betrayed America,” a report released by Essential Information and the Consumer Education Foundation (and which I co-authored), details a dozen crucial deregulatory moves over the last decade — each a direct response to heavy lobbying from Wall Street and the broader financial sector, as the report details. (The report is available here.) Combined, these deregulatory moves helped pave the way for the current financial meltdown.

Here are 12 deregulatory steps to financial meltdown:

1. The repeal of Glass-Steagall

The Financial Services Modernization Act of 1999 formally repealed the Glass-Steagall Act of 1933 and related rules, which prohibited banks from offering investment, commercial banking, and insurance services. In 1998, Citibank and Travelers Group merged on the expectation that Glass-Steagall would be repealed. Then they set out, successfully, to make it so. The subsequent result was the infusion of the investment bank speculative culture into the world of commercial banking. The 1999 repeal of Glass-Steagall helped create the conditions in which banks invested monies from checking and savings accounts into creative financial instruments such as mortgage-backed securities and credit default swaps, investment gambles that led many of the banks to ruin and rocked the financial markets in 2008.

2. Off-the-books accounting for banks

Holding assets off the balance sheet generally allows companies to avoid disclosing “toxic” or money-losing assets to investors in order to make the company appear more valuable than it is. Accounting rules — lobbied for by big banks — permitted the accounting fictions that continue to obscure banks’ actual condition.

3. CFTC blocked from regulating derivatives

Financial derivatives are unregulated. By all accounts this has been a disaster, as Warren Buffett’s warning that they represent “weapons of mass financial destruction” has proven prescient — they have amplified the financial crisis far beyond the unavoidable troubles connected to the popping of the housing bubble. During the Clinton administration, the Commodity Futures Trading Commission (CFTC) sought to exert regulatory control over financial derivatives, but the agency was quashed by opposition from Robert Rubin and Fed Chair Alan Greenspan.

4. Formal financial derivative deregulation: the Commodities Futures Modernization Act

The deregulation — or non-regulation — of financial derivatives was sealed in 2000, with the Commodities Futures Modernization Act. Its passage orchestrated by the industry-friendly Senator Phil Gramm, the Act prohibits the CFTC from regulating financial derivatives.

5. SEC removes capital limits on investment banks and the voluntary regulation regime

In 1975, the Securities and Exchange Commission (SEC) promulgated a rule requiring investment banks to maintain a debt to-net capital ratio of less than 15 to 1. In simpler terms, this limited the amount of borrowed money the investment banks could use. In 2004, however, the SEC succumbed to a push from the big investment banks — led by Goldman Sachs, and its then-chair, Henry Paulson — and authorized investment banks to develop net capital requirements based on their own risk assessment models. With this new freedom, investment banks pushed ratios to as high as 40 to 1. This super-leverage not only made the investment banks more vulnerable when the housing bubble popped, it enabled the banks to create a more tangled mess of derivative investments — so that their individual failures, or the potential of failure, became systemic crises.

6. Basel II weakening of capital reserve requirements for banks

Rules adopted by global bank regulators — known as Basel II, and heavily influenced by the banks themselves — would let commercial banks rely on their own internal risk-assessment models (exactly the same approach as the SEC took for investment banks). Luckily, technical challenges and intra-industry disputes about Basel II have delayed implementation — hopefully permanently — of the regulatory scheme.

7. No predatory lending enforcement

Even in a deregulated environment, the banking regulators retained authority to crack down on predatory lending abuses. Such enforcement activity would have protected homeowners, and lessened though not prevented the current financial crisis. But the regulators sat on their hands. The Federal Reserve took three formal actions against subprime lenders from 2002 to 2007. The Office of Comptroller of the Currency, which has authority over almost 1,800 banks, took three consumer-protection enforcement actions from 2004 to 2006.

8. Federal preemption of state enforcement against predatory lending

When the states sought to fill the vacuum created by federal non-enforcement of consumer protection laws against predatory lenders, the Feds — responding to commercial bank petitions — jumped to attention to stop them. The Office of the Comptroller of the Currency and the Office of Thrift Supervision each prohibited states from enforcing consumer protection rules against nationally chartered banks.

9. Blocking the courthouse doors: Assignee Liability Escape

Under the doctrine of “assignee liability,” anyone profiting from predatory lending practices should be held financially accountable, including Wall Street investors who bought bundles of mortgages (even if the investors had no role in abuses committed by mortgage originators). With some limited exceptions, however, assignee liability does not apply to mortgage loans, however. Representative Bob Ney — a great friend of financial interests, and who subsequently went to prison in connection with the Abramoff scandal — worked hard, and successfully, to ensure this effective immunity was maintained.

10. Fannie and Freddie enter subprime

At the peak of the housing boom, Fannie Mae and Freddie Mac were dominant purchasers in the subprime secondary market. The Government-Sponsored Enterprises were followers, not leaders, but they did end up taking on substantial subprime assets — at least $57 billion. The purchase of subprime assets was a break from prior practice, justified by theories of expanded access to homeownership for low-income families and rationalized by mathematical models allegedly able to identify and assess risk to newer levels of precision. In fact, the motivation was the for-profit nature of the institutions and their particular executive incentive schemes. Massive lobbying — including especially but not only of Democratic friends of the institutions — enabled them to divert from their traditional exclusive focus on prime loans.

Fannie and Freddie are not responsible for the financial crisis. They are responsible for their own demise, and the resultant massive taxpayer liability.

11. Merger mania

The effective abandonment of antitrust and related regulatory principles over the last two decades has enabled a remarkable concentration in the banking sector, even in advance of recent moves to combine firms as a means to preserve the functioning of the financial system. The megabanks achieved too-big-to-fail status. While this should have meant they be treated as public utilities requiring heightened regulation and risk control, other deregulatory maneuvers (including repeal of Glass-Steagall) enabled them to combine size, explicit and implicit federal guarantees, and reckless high-risk investments.

12. Credit rating agency failure

With Wall Street packaging mortgage loans into pools of securitized assets and then slicing them into tranches, the resultant financial instruments were attractive to many buyers because they promised high returns. But pension funds and other investors could only enter the game if the securities were highly rated.

The credit rating agencies enabled these investors to enter the game, by attaching high ratings to securities that actually were high risk — as subsequent events have revealed. The credit rating agencies have a bias to offering favorable ratings to new instruments because of their complex relationships with issuers, and their desire to maintain and obtain other business dealings with issuers.

This institutional failure and conflict of interest might and should have been forestalled by the SEC, but the Credit Rating Agencies Reform Act of 2006 gave the SEC insufficient oversight authority. In fact, the SEC must give an approval rating to credit ratings agencies if they are adhering to their own standards — even if the SEC knows those standards to be flawed.

From a financial regulatory standpoint, what should be done going forward? The first step is certainly to undo what Wall Street has wrought. More in future columns on an affirmative agenda to restrain the financial sector.

None of this will be easy, however. Wall Street may be disgraced, but it is not prostrate. Financial sector lobbyists continue to roam the halls of Congress, former Wall Street executives have high positions in the Obama administration, and financial sector propagandists continue to warn of the dangers of interfering with “financial innovation.”