It has been both frustrating and painful watching the US Government’s response to the financial crisis unfold over the past year. That said, the events of the past two weeks have dropped our Government’s response to new depths. Mistakes compounding mistakes, while the PR machine is spinning to ensure that neither the US public nor its allies perceive things this way. First, the Treasury and the Federal Reserve applied inconsistent policies to distressed financial institutions, allowing some to live (AIG, Bear Stearns) while others were left to die (Lehman Brothers). Next, they stuffed certain terribly sick institutions with $200 billion of taxpayer dollars in the form of direct capital injections and capital guarantees (Bank of America, Citigroup, Merrill Lynch), little of which has flowed through to either new lending or the resolution and winding down of massive illiquid asset portfolios. And this doesn’t include AIG, which itself consumed $170 billion of taxpayer dollars, much of which went directly to AIG’s counterparties, a separate bailout unto itself. And certain of these institutions (Goldman Sachs, for one) were already recipients of TARP funds. Now, the Treasury proposes a plan, the PPIP, to engage the private sector in helping to liquify these illiquid asset portfolios, which only serves to highlight the divergent motives between the buyers (who wish to acquire cheap assets with Government-sponsored leverage) and the sellers (who are seeking to garner above-market prices for assets in order to clear their books without mark-downs). In short, PPIP lacks a catalyst to encourage the sellers to participate in the program. Finally, Thursday brought a relaxing of the FAS 157 mark-to-market standards promulgated by the Financial Accounting Standards Board (FASB), further reducing the likelihood banks will proactively address their toxic asset woes. Because if they can mark their books and they say they intend to hold these illiquid assets for the long haul then there really isn’t a problem, is there? All the public wants to hear about is executive pay, because this is what our leaders want us to think about. All form, no substance. Due to poor policy-making, a lack of leadership and fear, we are no closer to solving the financial system’s deep-seated problems today than we were back in September.
One would have thought that squandering and losing track of a few hundred billion dollars would have spurred the US Government, the Treasury and the Federal Reserve into action – constructive action – but this has hardly been the case. We’ve only seen more of the same. But our officials are certainly pleased with themselves in light of the recent stock market rally. This surely has to be validation that they are on the right track.They’ve placated the big banks, offered up fodder for already wealthy structured asset investors (BlackRock, PIMCO and the like), preserved their lobbyist cash flows by allowing the accounting rules to be changed for the banks’ benefit (needless to say, the American Bankers Association was pleased with the FASB’s change of heart) and staved off a market meltdown, right? Time will tell, but I am not optimistic. The embedded problems are the same: multi-trillion dollar asset problems; balance sheets laden with illiquid “hold to maturity” assets funded with much shorter duration liabilities; inadequate transparency into bank portfolios; poor tracking of US taxpayer dollars deployed in the bailout; special interests driving critical parts of economic policy; and the sense that the game isn’t being played fairly and for the benefit of the American people. It is a lack of trust that is central to our country’s problems, a breach that new runs deep within most of its citizens. If our Government can allow the rules of the game to be changed in mid-stream (as they were with Lehman Brothers, TARP, FAS 157 and company compensation), then how can the markets and its citizens judge when things are truly better? An absence of both trust and transparency are enormous barriers to emerging from this economic crisis.
When President Obama was elected, many felt change was afoot and that real diplomacy, tough decisions and transparent and rational decision-making was at hand. In the early days of his Administration, his style has arguably been more effective on issues of foreign diplomacy than on domestic policy. The financial crisis requires a strong hand, a strong stomach and avoidance of interference from entrenched and conflicted parties in both Government and the private sector. Unfortunately, too many of these people have garnered influence within the Administration, leaving us with an approach that is engineered to placate, pacify and perpetuate existing institutions. This is the wrong way forward.
Last year I had proposed the creation of an independent Stabilization Oversight Council (SOC), a group with the expertise and perspective to suggest the tough prescriptives while obtaining the support of the President and Congress. I believe now as I did then that the current policy team is not sufficient to make the difficult yet necessary decisions. When items as arcane yet as important as accounting rules become politicized, something needs to change. And it is incumbent upon our elected leaders to make these changes not for the good of their popularity, but for the good of their citizenry. And this doesn’t mean the lobbyists. It means their voting constituents.
The right approach has not changed that much over the months since the crisis moved into full swing. And as the issues have been addressed in bits and pieces over this time period, I will seek to offer a step-by-step prescriptive of how we can get our financial system on the path to recovery rather than merely deferring the day of reckoning:
- Impose strict mark-to-market standards on financial institutions’ balance sheets. If assets are classified as “held to maturity,” confirm that the financing is in place to carry these assets to term. Intention to hold to maturity is very different than the ability to do so, and the rules need to change to link these two principles. This exercise will quickly flush out the solvent from the insolvent, and create a regulatory capital surplus (deficit) for each and every bank, broker/dealer and insurance company.
- If firms are in a deficit position, and within a pre-defined distance from solvency, they can have a 60-day window within which to raise private capital to fill the deficit. If the required capital cannot be raised, then the firm is eligible for seizure by the Government. This also applies to firms in deficit positions that are not granted a 60-day capital-raising window. These firms are then taken over and reorganized in a pre-packaged bankruptcy, with obligors paid off with available capital. The courts will be closely involved in this process. Many will be out of luck. Common stockholders. Many if not all unsecured debtholders. Incumbent managements.
- After the window has expired, each firm’s bad/illiquid assets, now marked down to market values, are segregated from the healthy operations. These “bad” assets are held in a central repository administered by agents of the US Government on behalf of the US taxpayers. They will be warehoused and liquidated in a rational, non-fire sale manner over time. The healthy operations, including bank branches, core deposits, performing loans and liquid assets will be available for investment by private institutions, with the US Government potentially retaining a stake (with the intention of being sold as quickly as practicable). The “Good Banks” will be offered publicly almost immediately, with new managements, clean balance sheets, strong capital positions and a willingness and ability to lend. No longer will these banks have to hoard capital to cushion persistent losses from their troubled asset portfolios. Taxpayer capital will finally be put to good use; creating good banks that can make good loans to help good businesses emerge from the crisis.
- Rules governing financial disclosures will be modified to ensure full transparency, and financial accounting practices will be reviewed to ensure their consistency with new disclosure requirements. Further, off-balance sheet financial transactions will be sharply curtailed, simplifying both balance sheet presentation and footnote disclosure. Investors will no longer have to engage in time-consuming and costly forensic accounting reviews to get a true picture of a financial institutions’ health. It will all be there in the financial statements.
- Over-the-counter (OTC) derivatives transactions will be pushed to exchanges. This will enhance transparency, liquidity and collateral management in this opaque, multi-trillion dollar market. Transactions will no longer evidenced by customized firm-to-firm agreements whose terms are invisible to the marketplace, but by notional amounts of standardized contracts with collateral balances that are “trued up” at the end of every trading day. This will sharply reduce the risks of a replay of AIG, where a firm with a high public credit rating was allowed to accrue hundreds of billions of dollars in potential liabilities without having to post collateral until it was too late. The movement towards exchanges will both demystify and de-risk a huge part of the derivatives industry, one which has been maligned for complexity and the inappropriate behavior of certain of its participants. But the value of derivatives as a risk-management tool is unquestioned and its ability to serve as a vehicle for speculation is also important for enhancing market liquidity and price discovery. But only if the risks can be dynamically managed via collateral posting and disclosures are straight-forward easy to understand.
- Boards’ fiduciary obligations will be clarified and strengthened and anti-shareholder friendly provisions such as staggered Boards will be eliminated. The Government has started to get involved in discussions around corporate governance and executive pay. This is not the Government’s job; it is the job of company Boards as elected by its investors. Everyone has failed on this score. Boards allowed executive pay to spiral upward without reason, and shareholders neither objected strenuously enough nor had the easy ability to impact directors’ behaviors. Boards, plus their investor fiduciaries – the pension funds and endowments – all are resopnsible for the massive disconnect between executive performance and compensation. If Boards act as if they are in the pocket of the CEO, they should be replaced by vote. Right now Delaware state law is the big stumbling block to reform. Make it a Federal issue. This is where the Government should be spending its efforts; not on how executives should be compensated.
The Government’s approach to addressing the root cause issues of the financial crisis has thus far been inadequate. Market realities have slowly been forcing it towards the prescriptives I have described, yet at a glacial pace. We have no more time – or money – to waste. Issues of politics, perception and partisanship have to give way to pragmatism before it is too late. If only our legislators could shed the shackles of short-termism we as a country, and as a people, would be far better off.