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.