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.