AIG, Populist Rage, and the Future of Banks

When AIG top management approached their staff about foregoing bonuses, the response - as described at The Hill -- was "take a hike." Management, in turn, felt they had not choice but to pay the bonuses. Partly they were afraid of the costs of potential lawsuits for breaching contracts that had been written prior to the receipt of any bailout money, and partly -- most importantly -- they were afraid that without the bonuses they would be unable to retain the services of the "quants," the technical experts who had created the mess by devising Credit Default Swaps that got AIG into trouble in the first place. The feeling was that the quants who had created the mess are the only ones with the skills to undo it.

Okay, here I go saying the unthinkable: management has a point. If a nuclear reactor fails, it is probably not a good idea to fire all the nuclear engineers and bring in civil engineers to fix the problem. Which leads to a more general point that needs to be kept in mind. Everyone I talk to in the banking industry makes the same argument: government does not have the talent that one finds in the overcompensated private sector. Nothing complicated about this -- the smartest and most skilled operators follow the money, and the private sector pays better. Much better. Partly through bonuses.

Do we really want to try to change that situation? It is not feasible for government to pay the kinds of salaries that would be necessary to compete with the profit-making opportunities available at the commercial banks and hedge funds. (You feel outraged about taxpayer money going to these executives now? How would you feel if taxpayer money went to these guys at that rate all the time?) What about the opposite approach: using the power of government to prevent such high salaries being paid, especially by firms receiving bailout money? The problem, obviously, is talent drain, at a time when the firms receiving bailout money are exactly the firms where we most desperately need our best nuclear engineers on the job.

So what, we're stuck with this system of super-compensation for insane risk-taking backed by a promise of public funds in the case of failure? The infamous "privatize profit, socialize risk" approach? No, but in the short term we are stuck with the consequences of having adopted that system over the past decade. In other words, there are obviously some things we need to do to correct the system of incentives going forward, but until the reactor stops leaking radioactive steam into the atmosphere we have to keep the nuclear engineers on the job.

What are the steps for the future? We have to think structurally, not functionally. People react to incentives, smart ambitious people often seek to make as much money as they can, in a global financial system making money involves risk-taking, within limits risk-taking is a good thing that we want to encourage. Theoretically, the mechanism for rewarding and punishing risk-taking was supposed to be "the market," but there are publicly necessary functions that should be shielded form the operation of that system. As a recent NYTimes editorial put it, you don't want a utility and a casino in the same building, but that does not necessarily mean that you want to abolish casinos. So . . .

1. We do not want to nationalize the banking system. We really don't. No, not because of the idiotic analogy to Soviet communism - the USSR didn't have a nationalized banking system, it had a nationalized economy, which is not the same thing. But other countries have experimented with nationalized banking systems in capitalist economies (France, South Korea), with less-than-ideal results. There are other problems with a nationalized system, as well. Globally, it creates opportunities for arbitrage by international investors that can work to the significant disadvantage of the national bank. It is also the case - as unpopular as it may be to say at this moment - that government are not efficient allocators of resources. You do not want the political branches controlling the availability of investment capital, for starters. Privately controlled investment that makes money on its successes and loses money on its failures is still the best way we know to keep capital flowing. Which means that the risk of failure has to remain in place.

What we do want to do is identify those banking functions that are socially necessary - the utilities - and separate them from the risk-taking, purely profit-driven enterprises. Call it the Enron principle: we want to diminish the extent to which a system can be gamed in proportion to the extent that the consequences of gaming the system could be disastrous for our society. For the very same reasons that complete nationalization would be a very bad idea, partial nationalization might make some sense, so long as it is restricted to areas where we don't care so much about the inefficient allocation of resources - there are other goals besides efficiency - and do not need or want the services of the quants.

2. We do not really want the government - even at this moment - to be in the business of rewriting contracts. The behavior of the financial markets is all about confidence; the problem with the credit freeze, remember, is not that banks have no money to lend, it is that they have no confidence in seeing a return on those loans. The specter of the government using its power to undo transactions that people entered into in the hope of making money can only diminish global confidence in the system as a whole.

3. Where the consequences of failure are intolerable, the opportunities for profit need to be limited; that's the converse of the basic premise that smart risk-taking should be rewarded. Back in the Depression, the Glass-Steagall law tried to separate the utilities from the casinos by prohibiting bank holding companies from owning other financial institutions. That law was repealed in 1999 by a bill sponsored by Phill Gramm, the same economic genius who gave us the Commodities Futures Modernization Act of 2000 that deregulated the derivatives market. That Act included the notorious "Enron loophole" deregulating energy-related trades, specifically crafted by Enron lobbyists working for Gramm. The story is too good not to repeat: the bill was passed two days after the Supreme Court's decision in Bush v. Gore, was never debated in either the House or the Senate, and was signed into law as part of an omnibus spending package. In other words, an awful lot of good can be done just by undoing the spectacularly stupid and corrupt things we - our government representatives -- did recently. Laissez-faire capitalism did not work well in an industrial economy; it works even less well in a post-industrial finance-driven system of capitalism.

But restoring sanity to the regulatory system may not be enough. People are right to be thinking about the need for structural changes. Toward that end, we may want to nationalize certain aspects of the banking system, or at least to regulate their operation to the point where they are effectively separated from the private financial markets. Such sectors would not attract the best of the "quants," but that's okay - the point is to create sectors that do not have the potential for nuclear meltdown even though hey will not produce nuclear power. It's the utility model again. So what functions that the banking system serves are analogies to clean water and electricity?

Start with private mortgages. It was a really dumb idea to turn Fannie Mae ove to private shareholders back in the 1968. That program was created in 1938 in response to a lack of liquidity in mortgage markets. The reason for change in 1968 was to get the costs of the programs off the government's balance sheets in order to help pay for a war -- something simultaneously classical and contemporary about that move, isn't there? Then in 1970 we created Freddie Mac to expand the secondary mortgage market. Both steps were essentially ways to raise revenue -- to pay for our wars -- by allowing utility-style function (enabling people to buy homes) to mix with casino-style functions (speculating on the future of those mortgages). Let's start by undoing those moves. It is worth remembering that the asset-backed securities on which AIG was writing insurance policies were not unregulated; at that stage of the transactions all the underlying valuation information was availablt. It's just that the form of the security (bundles of huge numbers of mortgages) and the system of trading created overwhelming incentives to ignore the underlying valuation information and rely on historical trends. So the ratings agencies and the bond underwriters and everyone else screwed up. That's what "risk" is all about, and it's why you don't want it in your living room.

On the other hand, you don't necessarily want the government to be in the business of supplying credit for real estate speculators like the folks buying up hundreds of properties in Detroit for a song. How about a public mortgage guarantee program that is limited to a single property that is used as a primary residence, and restricting the secondary mortgage-based investment market to other loans? How about offering rates that, while good, can still be undercut by private lenders willing to take on riskier loans, with assurances that in the event those riskier loans go bad those entities will not be "too big to fail"?

It is an equally bad idea to have private providers of student loans. That one should simply be nationalized outright. Which would not prevent any lender from offering a loan that could be used to pay for college, it's just that those loans would not come with any governmental support or guarantees. Conversely, a nationalized student loan program should define its mission as giving as many students as possible the opportunity to go to college; in terms of long-term returns, there is simply no better investment that the government can make.

What about commercial paper - the short-term credit that keeps our small businesses in operation? There is a good argument that the current crisis demonstrates the desirability of a permanent version of the instruments Geithner promoted at the New York Fed and now at Treasury, a backup system of government-provided short-term credit available in case the private system fails. Such a system has to be designed carefully to avoid creating structural incentives that make the government financing always the more attractive option; the idea is that publicly financed credit should be a last resort, not an entire competing system.

The credit card industry is a disgrace. One reason to avoid incentives for seeking rewards by taking on excessive risk is to avoid encouraging predatory behavior. A national usury law limiting interest rates on private credit agreements to 10% would mean that some people cannot get credit cards, but it would do a tremendous amount of good in reducing the chance of triggering yet another crisis that many forecasters see looming on the horizon. If you can't make a profit lending money at 10% interest, you're in the wrong line of work.

4. We have to use the power of government to reduce - not abolish, merely tame the excesses - of the risk-reward relationship in the private financial markets. We need to restore or invent limits on the level of leveraging. By ""we" I am talking about a global effort, not a local one. The only alternative would be some kind of weird financial protectionism that tried to limit the interactions of the American and global financial markets. Which would not work: any such system simply begs to be gamed. Some kind of an antitrust principle to limit the size of any single fund or coordination among funds might be a good idea, and the same goes for commercial banks and other financial institutions. Basic premise: in the private sector, no business should ever be allowed to become too big to fail, as a basic matter of preserving the risk-reward relationship.

5. We do not want to abolish all "derivatives," a term that covers a multitude of different kinds of instruments ranging from currency futures to, well, credit default swaps. Derivatives were created to reduce risk - basically, they are various forms of side bets -- and they often work in just that way. When they fail, they can fail badly, but the solution is to ensure that the consequences of those failures do not endanger the "utility" side of the operations, not to prevent side-bets in our casinos. I recently wrote a post arguing that the sheer size of the derivative market and the relative opacity of at least some categories of those instruments makes them a danger - I called them the dragon in the living room. But the solution is not to kill the dragon, it is to get it out of the living room. Dragons, after all, keep the pterodactyl population in check. I should note that my previous post resulted in a fairly outraged e-mail from someone at the International Swaps and Derivatives Association, who argued that I was looking at the wrong numbers. I remain unconvinced - the role of CDS's and asset-backed securities in creating the current crisis cannot be denied - but he made some good points about other categories of derivatives. The real point is that if you want to talk about restructuring a nuclear reactor, you had better have some nuclear engineers in the room.

All of this may seem awfully obvious and old hat by now. In fact, I am pretty sure that what I am articulating here is close to the thinking of Geithner and others in the Obama administration. But lately the torches-and-pitchforks voices have begun to drown out serious discussion. Time to take a deep breath or two: populist rage is a rotten basis for policy-making.

Comments

[Veri]

When all rational means of resolving the situation are ignored by our leadership, then populist rage is the only means of correcting the problem. 'Nough said.

[KillTheMessenger]

Populist rage has never made anything better. It did bring some of the world's greatest empires down, though. You want to join them? Go for it!

[Veri]

This American Empire is touch and go. You and I both know that history is cyclical. Sometimes empires must fail. For better or worse. Notice how all the peasants (such as you and I) realize that something bad is happening. Except, we are outnumbered by those who say something and do nothing.

[research]

Populist rage has given us democracies around the world.

[winningticket]

I can see the pro-bonus shills like the blogger are pushing back with a vengeance. You say AIG needs those "talented" people to unwind the toxic mess? That's like keeping the arsonist becase he knows about how fires start.

[leftLibertarian]

What a load.

Most Americans were against the bailout but the House and Senate leadership pushed for it. Look at what has happened. Return all monies to the government. If the white-collar terrorists at AIG et al go under so be it.

This is rich:
"We want our money back and we want our money back now for the taxpayers," declared House Speaker Nancy Pelosi, D-Calif.

Yea Pelosi, you are a crook since you pushed for the bailout.

[arvay]

While it's true that "pitchforks" don't make good policy decisions, at least not reliably, the current opprobrium falling on the financial "industry" Is very good for the nation.

Far too many talented Americans have chosen careers in this field, abandoning science, art, manufacturing, and other more vital fields. Pounding the financial "industry's" rewards down to middling levels could help re-direct the talent flow to where it's really needed. We don't want government to control this, but there's nothing like mediocre wages and public scorn to turn people away.

Frankly, the kind of tightly regulated financial businesses we should have, rather than the partially parasitic, genius-driven frauds we got, won't need the best and brightest. It's an ideal business for the kind of risk-averse lovers of predictability that used to be the banker stereotype.

The transformation of our economy into a "service" economy has been a gigantic mistake. New industries -- companies that make things and then sell them -- need to be at the core of our economy. Not a flock of people selling metaphysical Ponzi products. The new energy industries and a refurbished auto industry are great places to start.

[SteveK9]

Well said. My sentiments exactly, from one of those idiots who chose to make Science a career.

[arvay]

Science, among other things, will provide us a way past many of humanity's problems -- hunger, expensive and polluting energy, new industries -- and serves as a reliable antidote to all the religious and social obscurantism that weighs us down.

[partyofone]

The NYT article quoting the A.I.G. executive who was nicknamed “Jackpot Jimmy” fuming at his Fairfield, Conn. address, about an "invastion of privacy. " So the reckless, greedy, bilking of the global economy costing milions of honest hardworking citizens their jobs, houses, lffe savings and futures, is something those people should just ignore, while the corproate profiteers continue to live in luxury and get paid millions in bonsues for their reckless actions?

Jackpot Jimmy may recieve his bonus, and may never be held accoutable under the law, but he is subject to judgment in the "Court of Public Opinion" and should get used to it. Privacy? He will have the best that money can buy. Good luck with that.

[watchTVgetSTUPID]

The next time Geithner announces he is spending more money on Wall Street
I AM GONNA PUKE

[LindaWarnke]

"The credit card industry is a disgrace. One reason to avoid incentives for seeking rewards by taking on excessive risk is to avoid encouraging predatory behavior. A national usury law limiting interest rates on private credit agreements to 10% would mean that some people cannot get credit cards, but it would do a tremendous amount of good in reducing the chance of triggering yet another crisis that many forecasters see looming on the horizon. If you can't make a profit lending money at 10% interest, you're in the wrong line of work."
You are so right! The credit card industry is a slow cancer on society. No matter what kind of "stimulus" you provide for the economy, if the consumer is being eaten away by debt, it's just going to be like a 'sugar rush'. Short term only.
And these companies ARE predatory! They aggressively seek out suckers, uh, customers.

[KillTheMessenger]

A credit card can not be forced on you. Just say no. It's no different than with cigarettes, alcohol or drugs.

[PhilipTaylor]

So you deny the power and impact of MARKETING performed by the media, CNBC, Wall Street Banks, Credit Card Companies, Saks, Macy's, Mortgage Lenders, Madison Avenue Advertising Agencies, Magazines, Newspapers, Bush on TV repeatedly pushing home ownership in 2002, and hundreds of other marketing devices.

These are the TOOLS Wall Street Banks used to spur this Housing Hyper-Inflation, Credit Card Bubble to allow the creation of $700 Trillions in Toxic Paper (and $1.114 Quadrillion worldwide)!

The Consumer was a VICTIM of Wall Street GREED and Divisiveness!

[taikan]

Prof. Schweber and KTM rely on the assumption that putting AIG into bankruptcy (where executory contracts can be rejected) would have been the wrong move. The only "evidence" supporting that assumption is that the government has been shoveling massive amounts of money into AIG so isn't in bankruptcy, and the financial system hasn't yet melted down. However, that may only be a temporal connection, not a causative connection.

Prof. Schweber also assumes that only the people that created the credit default swaps can figure out how to extricate AIG and the financial system from the problem created by them. However, nothing will change two simple facts: (1) many, if not all, of the debts guaranteed by AIG were unworthy of being guaranteed, and (2) AIG doesn't have the money to make good on its guarantees. That a number of financial institutions (including national banks) made the poor decision to rely on AIG's guarantees without first checking to see whether AIG could perform on them doesn't change the situation. Those who made bad decisions should have to suffer the consequences. That's the essence of capitalism. The rest of us also will be damaged, particularly if the international financial system goes into collapse for a time. However, that may be the price we have to pay for not forcing government to maintain and enforce adequate regulatory authority to prevent companies such as AIG from issuing such risky insurance without having adequate reserves.

[KillTheMessenger]

If you read my previous posts (from when the crisis started), I was (and still am) all against bailouts. I am with the "let em fail" faction. But only because I can afford it and because I believe in learning by pain when learning by book has failed. But something tells me that most folks in the "let em fail" faction can't really afford to let em fail.

So that's an interesting dichotomy, there, isn't it? KTM cares nothing about rescuing the situation because deep in his heart he believes that people should pay for their mistakes, but at the same time he tries to convince you that you really don't want the kind of punishment that would follow if he got his wish.

Bwaaahhaah­ahahahahha­aa...

I love life. It's complicated. It's nuanced. It kicks like a mule. It's just plain wonderful! And most people don't get it...

[partyofone]

if the government must shovel money that gives it 80 percent ownership of AIG, and then is paying 100 percent of the risk insured by AIG to other reckless investors like Goldman Sachs, why is that not bankrupcy? Once again, taxpayers are being saddled with all of the losses but no respesentation in ENDING the greed, dishonesty and reckless gambling. All of the arguments about keeping these banks solvent serve the interests of those who have use investments to lose, except for the interests of the largest investors - the American taxpayer.

America is skating on the edge of chaos not because of the failure of banks but because average citizens are ready to take to the streets if their government does not act responsibly to protect their interests instead of protecting corporate execs and hedge funds.

[KillTheMessenger]

Bankruptcy is a legal term. Unless the preconditions for bankruptcy are met it's not a bankruptcy. It might look like one, smell like one, bark like one and the court will still say

"Too bad. If bankruptcy is what you really wanted, then bankruptcy is what you should have declared. Case closed."

[research]

All Leveraged Derivatives have to go.

The whole home loan default thing would have been just part of another recession,

had it not been for the unregulated, leveraged Swaps insurance and shorting.

The Swaps insurance has NO RESERVE. No money held to pay up because JPMorgan and Phil Gram wanted to get around Insurance regulations.

Swaps Debt overhang is 600+T$, compared to total world GDP of 60T$.

The stock market has gone from 90% stock trading, to 90% leveraged Swaps and Shorting.

The investment Bankers are addicted to leveraged gambling, specially now, that the government will bail out their losses, via insurance from AIG.

See my profile for links and proof.

Stop leveraged Swaps and Shorting, or all it lost.

[esaslaw]

It is not true that Glass-Steagall was passed without debate. The conference report was passed late in 1999, but a conference report cannot be amended. The debate was in the spring of 1999 and the bill, Gramm-Leach, passed the Senate after a strictly party line vote (with one exception, Fritz Hollings, a Democrat, voted for it.). (The 60 votes in the Senate meme had not yet commenced).

The semi-President (this is over a year before Bush v. Gore) threatend to veto it, but it was well known in DC that this was an empty threat, and was intended just to get a few sweeteners for the White House. Being an Eisenhower Republican masquerading as a Democrat, the semi-President (the other half of the presidency was lodged, improbably with the congressional leadership), signed the bill.

Think I have it wrong? Try this: http://query.nytimes.com/gst/fullpage.html?res=9C02EEDF1E3CF934A35756C0A96F958260&scp=1&sq=Glass+Steagall+AND+%22white+House%22&st=nyt

[partyofone]

Good information. Thanks for the post. Clinton and his Treasury Secretaries Rubin and Summers were parties to the de-regulation fiasco and cannot wipe their fingerprints off of it.

[RoloTomassi]

For the most part I agree with your assessment, but there were a few statements that I just have to comment on:

"But other countries have experimented with nationalized banking systems in capitalist economies (France, South Korea), with less-than-ideal results."

We have exactly what in regards to a "gold standard" to compare those results to? I'm working on 50 years on this rock, and I know that for the last 30 years we've been working towards this catastrophy; you cannot consider only the "high peformance" segments as the whole cloth of the US banking system--the failure now is the failure of the system for the duration of "Reaganomi­cs."

"Which means that the risk of failure has to remain in place."

What "risk of failure"? Please point it out to me, as it seems that the very cretins this article addresses are the same ones who were judged "too big to fail." I don't that they've had any real risk of failure, and that dubious status currently granted cannot be tolerated going forward.

"We do not really want the government - even at this moment - to be in the business of rewriting contracts.­"

As I and HuffPo bloggers have pointed out repeatedly, this is a double standard that favors only over-compensated CEOs and upper management; there is no such legal compunction when that notion is pointed at labor unions or any other employment situation that doesn't involve the corporate "powers that be."

[DiogenesOfAlaska]

If only I could agree more with what you say, I'd probably be happier or sleep better or both. Well, let's not exaggerate, actually I sleep pretty well at the moment, to tell you the truth. But it's not because of what you write.

The manner in which you employ the notions of 'talent drain', 'government' and 'risk-reward' metric shows that you much prefer to think about this crisis in the same old language. You're not ready to face the fact that these words must change their meaning - again - because they have all been hijacked.

Another one of those words is 'quant'. I'm afraid you're fighting yesterday's wars. Too much nostalgia for my taste.

The question is: what is the adequate design for a financial sector supporting the free enterprise system and the insurance and savings needs of the people of this planet. The fact of the matter is that the current financial infrastructure has failed grossly at this task. And because the task is immense and cannot be grasped by one person or one institution, the problem is we don't even know whether it can be done at all.

Certainly not by telling nostalgic fairy tales about talent and markets.

[dbaileyire]

If these people are as smart as you say then they knowingly put the entire economy of the united states and the world at risk and should be sent to prison for it . your analogy is a bad one. none of these people are as smart as any nuclear engineer. but they are smart and greedy enough to wreck the economy and let the government who by your estimation is staffed with dummies pick up the pieces.

[ILibertine]

Granted that populist rage is a poor premise, of itself. Unfortunately, without it, there doesn't seem to be any motivator toward change; moneyed interests are too entrenched. In the course of human events, seldom, if ever, has mere reasoned response corrected corrupt balances of power. Finding middle ground is difficult as one side endeavors to expand their wealth at the expense of those effectively trying to survive.

I disagree with the premise that only those who created financial schemes are able to "untangle". This is clearly indicator that such personalities aren't fit to have their hands upon the process. There are enough out of work to fill these gaps. Contracts weren't written in stone for auto workers, steel workers who lost pensions, et al. Insofar as rewriting contracts, for a few hundred billion of taxpayer-backed money, what in heaven's name is wrong with that!

We want to nationalize banks - to the extent they're shored up and split into smaller entities. Laissez-faire policy has created too-big-to-fail. Anti-trust actions are needed to reduce corporate size - financial, oil, pharmaceutical, food. Usury interest on credit cards is a result of too many big institutions and too little regulation.

Thanks for the "deep breath", a good thing; however, failure to be upset is, similarly, a dangerous course, for businesses have been accustomed to bilking the consumer at every opportunity. Thus rage is a fundamental part of waking up congress from their loooong nap, insofar as public interest is concerned.

[althusius]

While Wall Street was scheming for its own selfish ends, some intellectual elitist was rationalizing that private vice is really public virtue. Too bad the "invisible hand" of Adam Smith can't slap this author upside his head.