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April 5, 2009
The New Golden Rule of Bailout World
The new Golden Rule governing bailout initiatives planned by the Obama administration is based on the premise that those handing out the gold can break their own rules.
A Washington Post article, dated April 4, entitled “U.S. aims to help firms sidestep bailout rules” is found here. It begins with,
“The Obama administration is engineering its new bailout initiatives in a way that it believes will allow firms benefiting from the programs to avoid restrictions imposed by Congress, including limits on lavish executive pay, according to government officials.The WaPo reporters think they’ve stumbled on a journalistic scoop:
“This strategy has so far attracted little scrutiny on Capitol Hill, and even some senior congressional aides dealing with the financial crisis said they were unaware of the administration's efforts. Just two weeks ago, Congress erupted in outrage over bonuses being paid at American International Group, with some lawmakers faulting the administration for failing to do more to safeguard taxpayers' interests.”The reporters cite the use of a “special-purpose vehicle” (SPV) and imply a nefarious intent on the part of the government by dropping the “E” word:
“In one [bailout initiative] program, designed to restart small-business lending, President Obama's officials are planning to set up a middleman called a special-purpose vehicle — a term made notorious during the Enron scandal — or another type of entity to evade the congressional mandates, sources familiar with the matter said.”So are SPVs evil? Not necessarily, according to a report issued by Knowledge@Wharton, “the online research and analysis journal of the Wharton School of the University of Pennsylvania,” entitled “Enron Aside, Special Purpose Vehicles (SPVs) Are Legal, Innovative and Widely Used.”
“But while much of Enron's SPV use was illegal, most SPVs are proper and they can serve a variety of functions. Many are separate business-financing operations whose transactions do not appear on the parent company's books. They can be used to create easily traded asset-backed securities that allow their "sponsor" companies to convert cash flows expected over many years into immediate lump-sum payments, says Gary B. Gorton, professor of banking and finance atWharton.” (p. 1)
“The Enron case left many people with a bad impression of special purpose vehicles, since that company used them to improperly hide its financial problems from shareholders and regulators. But when used properly, SPVs can benefit the broad economy as well as the sponsoring companies. SPVs allow lenders and other businesses to shift risks to investors willing to shoulder it, Gorton says. ‘If you spread risks, you don't have risks concentrated in the banking system," heOn their face, SPVs are not mean gargoyles. The question is: What’s their intended use by the government? Back to the WaPo article.
“Yet as the Treasury has readied other programs, it has increasingly turned to creating the special entities. Legal experts said the Treasury's plan to bypass the restrictions may be unlawful.So, the issue is not about SPVs as a financial tool, but whether they’re being used in new bailout initiatives to circumvent Congressional efforts to limit the use of taxpayer monies for what some deem to be excess senior executive salaries and bonuses. (The Enron reference was a WaPo red herring.)
David Zaring, quoted above, writing in his role as Associate Professor, University of Pennsylvania, The Wharton School of Business, co-authored a January 29, 2009 (73 pages) study entitled “Big Deal: The Government’s Response to the Financial Crisis.” In the first paragraph of the “Analysis And Conclusion” section the study states that,
“Government responses to crises have their own pattern as well. The problem often begins with the scramble of governments to keep up with fast-paced and deleterious market events, leading to an initial, ad hoc phase in government action, where emergencies are responded to with emergency-style rules, and emergency-style process. The next phase is usually a legislative one – beginning with outraged congressional hearings and then new legislative authority. At about this time, implementation of the criminal investigations hit their stride, leading to the ex post punishment – often quite severe punishment – of a few symbols of the crisis – high ranking CEOs, and some unfortunate exemplars of excess.” (p. 63)
This was written weeks before the AIG executive homes bus tour sponsored by A.C.O.R.N, before the CEO of GM joined the unemployment lines, and before President Obama made his now famous “pitchfork” statement to the bank presidents visiting the White House.
The first few sentences of the study’s abstract read as follows:
“How should we understand the federal government’s response to the financial crisis? The government’s team, largely staffed by investment bankers, pushed the limits of its statutory authority to authorize an ad hoc series of deals designed to mitigate that crisis. It then decided to seek comprehensive legislation that, as it turned out, paved the way for more deals. The result has not been particularly coherent, but it has married transactional practice to administrative law. In fact, we think that regulation by deal provides an organizing principle, albeit a loose one, to the government's response to the financial crisis.”
The WaPo article is most about the Law of Unintended Consequences.
The federal government was clearly caught flat-footed by the financial crisis last fall. Consequently, as the scope of the ordeal unfolded, it was forced to play catch-up. It operated out of purely reactive mode, wheeling and dealing on the fly, making it up as they went along. As the Wharton study cited above concludes:
“In short we view the government’s turn to the EESA [Emergency Economic Stabilization Act of 2008] as a signal that it felt bound by legal restraints, and ultimately could not push past them until it acted to adopt a more comprehensive, confidence building program designed to alleviate the lost confidence, fear and information asymmetry in the markets. It was at this point that the principle of moral hazard was abandoned for more practical approaches.
Here the key to interpreting the WaPo article:
While the use of SPVs may make perfectly good financial sense, it gives the appearance of conflicting with the politically-generated emotions surrounding executive bonuses that, while not forbidden in earlier bailout agreements, became retroactively toxic when the Obama administration chose to make AIG bonus recipients targets of class warfare. (What was the administration’s motive? Divert attention away from worsening economic problems by personalizing and demonizing an enemy?)
The rules shifted as flexibility in compensation became necessary for a round of bailouts that requires the involvement of private financial enterprises that, while receiving federal funds, will also be required to engage their own monies borrowed from the Fed.
Consequently, the Obama administration now may face an uprising of pitchforks of their own making.
The Law of Unintended Consequences.