AIG: Bankruptcy would have avoided the bonus debacle

The large bonuses at AIG have sparked yet another wave of revulsion amongst American taxpeayers.  And rightfully so.  This company has cost taxpayers $170 billion and counting and yet the bonuses of the same individuals complicit in the losses is still to be paid due to contractual obligation.  While Ben Bernanke, Larry Summers and others have expressed their contempt for this state of affairs, I suspect there will be consequences down the line.

Below is the crux of the problem as detailed in the New York Times:

The American International Group, which has received more than $170 billion in taxpayer bailout money from the Treasury and Federal Reserve, plans to pay about $165 million in bonuses by Sunday to executives in the same business unit that brought the company to the brink of collapse last year.

Word of the bonuses last week stirred such deep consternation inside the Obama administration that Treasury Secretary Timothy F. Geithner told the firm they were unacceptable and demanded they be renegotiated, a senior administration official said. But the bonuses will go forward because lawyers said the firm was contractually obligated to pay them.

Austan Goolsbee, staff director of the president’s Economic Recovery Advisory Board, on Sunday detailed Mr. Geithner’s reaction.

“He stepped in and berated them, got them to reduce the bonuses following every legal means he has to do this,” Mr. Goolsbee said on “Fox News Sunday.” “I don’t know why they would follow a policy that’s really not sensible, is obviously going to ignite the ire of millions of people, and we’ve done exactly what we can do to prevent this kind of thing from happening again.

The payments to A.I.G.’s financial products unit are in addition to $121 million in previously scheduled bonuses for the company’s senior executives and 6,400 employees across the sprawling corporation. Mr. Geithner last week pressured A.I.G. to cut the $9.6 million going to the top 50 executives in half and tie the rest to performance.

The payment of so much money at a company at the heart of the financial collapse that sent the broader economy into a tailspin almost certainly will fuel a popular backlash against the government’s efforts to prop up Wall Street. “There are a lot of terrible things that have happened in the last 18 months, but what’s happened at A.I.G. is the most outrageous,” said Lawrence H. Summers, President Obama’s chief economic adviser, during an appearance Sunday on ABC’s “This Week With George Stephanopoulos.” “What that company did, the way it was not regulated, the way no one was watching, what’s proved necessary — is outrageous.”

Yesterday, I had an e-mail exchange with a number of financial and economics professionals in which we discussed the AIG bailout and the specific issue of these large bonuses. One comment which I found particularly noteworthy came from Bill Black, a well-known economist from the University of Missouri-Kansas City. Bill is well versed in both the legal and financial sides of these affairs. Below is a short bio:

Bill Black is an Associate Professor of Economics and Law at the University of Missouri – Kansas City (UMKC). He was the Executive Director of the Institute for Fraud Prevention from 2005-2007. He has taught previously at the LBJ School of Public Affairs at the University of Texas at Austin and at Santa Clara University, where he was also the distinguished scholar in residence for insurance law and a visiting scholar at the Markkula Center for Applied Ethics.

He was also litigation director of the Federal Home Loan Bank Board, deputy director of the FSLIC, SVP and General Counsel of the Federal Home Loan Bank of San Francisco, and Senior Deputy Chief Counsel, Office of Thrift Supervision. He was deputy director of the National Commission on Financial Institution Reform, Recovery and Enforcement.

And this is what Bill had to say about the AIG situation (I have bolded the bits I find most significant):

This is the consequence of six things on the Treasury end of things:

  • (1) the failure to use Chapter 11 bankruptcy/pass-through receivership to deal with deeply insolvent financial institutions,
  • (2) the failure to expose, and to the extent possible, remedy through restatements the massive accounting fraud that AIG was/is engaged in that triggers the bonuses,
  • (3) the failure to bring criminal charges against the control frauds,
  • (4) the failure of Treasury as negotiators — they had all the leverage when they bailed out AIG and could have conditioned the aid on at least the VP tier and above giving up their bonuses,
  • (5) the weakness of Treasury’s current lawyers who, if press reports are accurate, couldn’t think of any way for the U.S. government to take effective action against what it reportedly views as a scandal, and
  • (6) (and I haven’t seen this discussed) why was Treasury blind-sided by this? It confirms that they did not conduct even the most obvious due diligence on AIG’s assets and contingent liabilities. Given what we know about the lack of due diligence by AIG on underlying assets, particularly nonprime paper, this confirms exactly how dangerous Treasury is to the the nation. It is also consistent with the concern that it faces such a critical staff shortage, particulary in the relevant skills (which the folks it hires from Wall Street lack). I doubt that they have five senior officials that have ever reviewed loan files for a living or conducted meaningful due diligence (which requires cracking the loan files).

On the AIG end we see the perverse incentives of keeping the senior level folks on that caused the crisis. They have every incentive not to be honest about the true extent of the losses. They know the place is dead (hopelessly insolvent) and have strong incentives to loot the corpse, e.g., through bonuses. They do not alert Treasury sufficiently in advance even to bonuses that they should know will be perceived as scandalous (though another problem with keeping these failed elites in power is that they are clueless about the reaction of normal people). They do not work to limit bonuses, e.g., by being honest about past accounting fraud. I believe when the facts come out that we will find that they did not make criminal referrals on the prior senior officials that led AIG’s accounting fraud (which would have given AIG and the Treasury a far stronger legal basis for refusing to pay bonuses that were “earned” via accounting control fraud.

I don’t oppose bonuses that are actually earned through long term performance. That is not the case with the AIG bonuses. We can offer well designed performance pay if we use bankruptcy or receiverships.

Bill’s argument is testament to the problems associated with nationalization as practised in the U.S. during this credit crisis. In effect, we are seeing private gain and socialized loss-writ large. To the degree that Citigroup or Bank of America or any other large institution is being nationalized, should we expect any different at those institutions?

I have been in favour of pre-privatization as a policy remedy in this crisis.  At a minimum, this episode should make clear that a pre-packaged or managed bankruptcy administered by the government would be superior to this ill-considered and attempted arms-length transaction at AIG.  My short-hand for this divide is “bankruptcy/pre-privatization vs. propping up zombie banks.” Propping up zombie banks while refusing to prosecute any illegal activities is likely to invite a negative populist response as I indicated in my recent post “Where are the perp walks?” In my view, the Obama Administration may well come to be viewed as an enabler of these events unless it can demonstrate a credible willingness to prosecute financial service criminal activity and end the ability of incumbent management to control likely insolvent institutions.

I will finish off my commentary with a snippet from a post by James Kwak on the Baseline Scenario, which gets right to the heart of this divide in policy options.

I think there are three main positions in this debate:

  • A1: The banking system is broken. Banks need to get rid of their toxic assets and they need more capital. The solution is for the government to buy their toxic assets at a high price (or insure those assets) and to give them lots of cheap capital.
  • A2: The banking system is broken. Banks need to get rid of their toxic assets and they need more capital. The solution is for the government to take them over, transfer off their toxic assets, recapitalize them, and (when possible) sell them back into the private sector.
  • B: The banking system is basically sound and will recover if we give it some time. In the meantime, the government should give the banks just enough money and intervene as little as possible to keep them afloat until asset prices recover.

The big divide is not between A1 (Rajan) and A2 (Simon and me). In both cases, you end up with a healthy banking system, at significant taxpayer expense. (A2 should be somewhat cheaper because it wipes out the shareholders, but I agree with Rajan that it is dramatically cheaper only  if the government is willing to restructure some of the liabilities.)

The big divide is between both of these and B, the position of the Bush and Obama administrations – both of which rejected aggressive measures in favor of just-in-time, just-big-enough bailouts. Now the government is conducting stress tests on an industry it has already said is adequately capitalized, and will follow that with a public-private asset-buying program that tries to split the difference between paying real market value and paying enough to keep the banks happy. I’ve quoted these exact words before, but here’s Krugman again: “The actual plan seems to be to keep the banks semi-alive by implicitly guaranteeing their liabilities and dribbling in money as necessary, all the while proclaiming that they’re adequately capitalized — and hope that things turn up.”

Now, let’s say you agree that something more needs to be done. Then you have to choose between A1 and A2. A2 is the one people typically call “nationalization.” But which is more consistent with a capitalist system: protecting the creditors who lent money to a failed bank, the shareholders who invested in a failed bank, and the managers who failed . . . or firing the managers, wiping out the shareholders, and maybe, if possible without triggering collateral damage, forcing some of the creditors to take some losses? Which one better approximates the incentives you want in a free market?

UPDATE: 637PM EDT – Bill Black has a post up on Huffington Post along with Tom Ferguson, Rob Johnson and Walker Todd that is a must-read about this issue. How to Stop AIG’s Bonuses. And Yves Smith also chronicled the email exchange with Bill Black and has her own take, “Wiliam Black Savages Treasury’s Conduct on AIG

Sources
A.I.G. Paying $165 Million in Bonuses After Federal Bailout – NY Times
Nationalization and Capitalism – James Kwak

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.