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Wednesday, March 18, 2009

Obama Hamstrung

Today in testimony before Congress, AIG CEO Liddy was asked about the bonuses. AIG intends to spend over $160 million on retention bonuses to which they were "legally obligated," according to CEO Liddy.

There's a scandal brewing within the White House over the AIG bonuses, one involving Geithner's role in perhaps keeping Obama in the dark. HuffingtonPost at 10PM EST was headlining "Whodunnit solved" in reference to determining who weakened a bonus provision in TARP. Geithner was apparently fingered by Senator Dodd.

I'd been thinking Dodd. Mid-afternoon, HuffPo was questioning (the whodunnit) who in Congress had blocked a clause in the TARP funding that would have stopped AIG from paying the bonuses. At the time, I'd guessed that the Congresscritter has been responsible, one who'd received large campaign donations from companies receiving bailout funds or perhaps even AIG, like our President.

The damage of one Democrat ratting out another can hardly be good for the Democratic Party. In short the whole AIG bonus deal is an unfolding liability. Earlier today, President Obama, trying to damage control get ahead of today's Congressional testimony by Liddy, offered some comments about the egregious bonuses on the lawn of the White House. (See the video.) Obama's explains the origins of the financial crisis in concise, easy-to-understand language which I recommend.

At least Professor Obama scores some points for his professorial abilities, making a complex issue easier to understand. (For people who want more, lower down I have some more technical explanations for the crisis based on a summary of the collapse of the repo market, which is how the Federal Reserve raises cash.)

Obama has clarified what the government's role is to be, although Geithner may be trying to limit the impact of the mistakes the Fed made when he was a major player during the Bush years, CEO of the New York Fed.

As I've said in the past, I don't know how any solution can be engineered involving anyone who participated in the decision-making process that contributed to the crisis. They're damaged goods as far as I'm concerned.

The risks are high as Obama has invested a large amount of political capital in the bailout. Of course the more politicized government interventions have been, the more political risk associated with any extension of government credit grow.
As Congressman Gary Ackerman (D-NY) told AIG CEO Liddy during testimony, further help for AIG could be jeopardized by public reaction to the bonuses. The uproar over the AIG bonuses has unmasked inter-class tensions. The bonuses in particular show how little Wall Street cares about its public face, which could put into jeopardy any future bailouts, assuming the American people remain involved and incensed and politicians remain sensitive to these sentiments.

The scope of corporate influence--in this case from the financial sector--seems to limit Wall Street's accountability at the expense of the broader economy. Many of the people responsible for the mess still occupy lucrative positions on Wall Street, unlike millions of lower level jobs that have been unemployed.

The AIG bonuses reveal a huge gap between the compensation atmosphere on Wall Street and any accountability brought as a consequence of government intervention, i.e. for saving their ass. Essentially the management seems to be treating its top executives as if the house had never burned down. The crisis is showing itself to be a method, a la Naomi Klein's disaster capitalism, to funnel more public resources to private industries. Citigroup, the recipient of loan guarantees in excess of $200 billion, reported recently they'd made a profit. Is this a surprise to their management, who were whining Stuart Little-like as if the sky were falling as they begged for help in Washington.

The AIG spending on bonuses echoes the bonuses paid by Merrill Lynch (some $3.5 billion) to its top executives, after its merger with Bank of America. Now in defense of free-spending compensation on Wall Street, to retain the best talent requires large retention bonuses--less perhaps in bad times but amounts that stun the average person nonetheless. During the roaring days of deregulation, the way Wall Street does business was in the best interests of its shareholders--the rich and successful become even more so. As reality has set in, the losers in the post-crash are the taxpayers, assuming they've been granted ownership stakes in companies which have over-leveraged themselves and destroyed their share prices, perhaps never to recover. In typical disaster capitalism style, the public is left holding the expenses of running dying companies, wile those who profitted during the run-up are pampered by preferential treatment in Washington, and given lucrative bonuses to sustain their profligate lifestyles.

Without any bonus pool, the over-pampered lot which makes up the Wall Street investment banking corps will simply go elsewhere or retire on the billions they made during the run-up whose end was inevitable, billions now sitting in overseas banking centers no doubt. Now, leaving the wreckage of their greed behind, they'll only work for ridiculous amounts of money, cashing in a second time on the fruits of their handiwork, whatever the cost to the public or long-term economy.

The role of our media in not covering Wall Street compensation has also strengthened outrage over the bonuses. The culture of greed is only a problem when transparency exposes the Wall Street culture, or when profits dry up as they have. Historically, the size of these bonuses go uncovered in the mass media.

I've written a great deal about how the increasingly corporate media become consolidated under Bush and lost any investigative edge while dumbing down content. The fruits of this media neglect is a shock wave of public outrage which could ignite politicians fury, or at least encourage meddling for political reasons, which is no way to engineer a private sector recovery, although allowing millions in bonuses is hardly constructive use of funds either.

Now Liddy has explained that AIG notified Geithner about the bonuses on March 14th, a day before their distribution. This struck me as odd, because AIG must have known the political controversy they would stir. And the presumption is that because Geithner knew the bonuses were coming, the White House knew late last week as well. Here is HuffPo:

"The White House for the first time on Tuesday night said Geithner learned of the impending bonus payments a week ago Tuesday; he told the White House about them last Thursday, and senior aides informed President Barack Obama later that day."

A small point but a crucial one if Obama now claims that the bonuses need to be stopped. Why wait until this week to stop them? It's as if the bailout has been conceived independently of the political ramifications of its implementation. Obama appears to be reacting to the news instead of working to prevent the bonuses behind the scenes. Apparently Obama can't exert that level of control over what AIG can do with the bailout money and it will take Congress to pass a law taxing the bonuses

The fruit doesn't fall far from the tree. Geithner is a product of the Wall Street environment he's now trying to save, perhaps by re-inflating the derivatives bubble and real estate markets by flowing cash in massive quantities to anyone, anywhere.

Above all, remember that the Fed is an extension of the New York banks. Geithner was the CEO of the New York Fed and actually oversaw the distributions in TARP while Bush was in charge. He's still intimately connected to the financiers whose misconduct precipitated the collapse and Bush-era people who failed their regulatory responsible or those in the Fed who fed it so much cheap money.

Behind the scenes, the largest partner and co-conspirator with the Wall Street banks is the Federal Reserve, especially the branch in New York once headed by Geithner. The Federal Reserve Banks are represented by the Fed, and two main banks--JP Morgan Chase and the Bank of New York essentially interoperate with the Fed to raise cash. What's good for the banks is basically good for the Fed. Now the Chairman of the Fed is a political appointee, but the entity is largely commercial, and aims to maximize profitability for bankers who compose its membership.

The Fed has poured in trillions in purchase agreements, debt windows, and other forms of guarantees and assurances to minimize pain for the bankers. Unfortunately their easy credit may be coming in an end, due to 1) the Chinese/Japanese dis-propensity to continue to fund US trade and budget deficits, and 2) the deconstruction of the Repurchase Agreement market through which the Fed typically raises cash.

On Wednesday, they announced they'd buy $300 billion in Treasuries, which sent inflation fears rising. The fear is that the Fed has added too much money--liquidity--and put at risk the dollar by making it too plentiful and therefore too cheap. The dollar set an all-time low versus the Euro.

Apparently the scope of losses is sufficiently great as to make all these additional funds more or less replaced the huge deficits created in the private credit markets--called also the shadow banking system--which came as the result of debt securitization, the bundling of debts as financial instruments known as derivatives.

I've said in the past that I don't know how any solution can be designed that doesn't make the banking constituency the ultimate beneficiary, even at the expense of sound money policy or the economy at large. If you use insiders to fix a problem, don't expect a solution that's constructed outside the corrupt influence of the system, one that benefits insiders at the expense of taxpayers.

With the initial stipulations of TARP so hurried, it's possible that AIG had to pay the bonuses, so I guess no one thought to include restrictions on them. Or maybe the concession to AIG and other TARP recipients was a well-planted sweetheart clause meant to help Geithner's friends.

So now the Treasury is thrusting ever more cash into the AIG ovens, where it goes out to financial institutions to whom AIG is obligated. Those companies in turn reduce the size of their derivatives, but at a very slow pace, leading possibly to a Japanese-style recession, where banks there were unable to clear bad loans off their balance sheets. Yes, it's great that AIG can pay its creditors, and that could prevent a collapse, but then again how many years can the government bail out AIG? How long before Congress has enough and reneges on AIG's obligations, opting instead for bankruptcy.

Ostensibly taxpayers own 80% of AIG--in itself a questionable number because no sane investor would pour so much into a company that can't possibly meet its obligations. I guessed we owned 80% when we put the first $60 billion in. After the second installment, I guess we now own 160% of what AIG is worth, which is according to the markets a lot less than we've out into the failing company. The government is either acting solely out of concern for the contagion effect or simply a really bad investor since letting AIG go bankrupt would likely save billions more that needs to be continually poured out in the years to come in order to pay its creditors, as well as manage whatever losses it produces (the company's losses in 2008 were the largest of any company ever.)

We saw billions in the AIG bailout go to foreign banks for precisely this reason. In order to calm fears of a system-wide collapse, the Treasury saw the need to fully capitalize AIG so it could handle any potential claims against it. Now as potential investors see that the system won't collapse, they are more likely to invest in the derivatives products which are at the center of post-Glass Steagall banking in the US and abroad.

What's done at one bank is duplicated in another--so much so that when Credit Default Swaps were the hottest game in town all the investment banks loaded up on them. The Your-On-Your-Own period which saw so many gains in wealth for the rich has evolved into a corporate nanny state.

The way previous borrowings were spent reflects a culture of corruption in D.C. that revolves around systemic problems based on lobbying influence and corporate over-representation. Like the environment surrounding AIG CEO Liddy, this overly cozy relationship dictates the options available to Obama, who's now part of the establishment. The new President can't offend the companies who've contributed so much to his campaign. AIG gave the President over $100,000 while he was a Senator.


Nowhere in recent memory has Washington's culture of corruption been made more evident than in the bailouts. The way funds have been spent so far by the recipients shows an elitist culture of self-entitlement prevailing on Wall Street.
The Federal government's mismanagement of bailout funds has contaminated the solution, turning it not into a savior for the broader economy but an ever-broadening morass, an Afghanistan of sorts, where more and more must be poured in, to save AIG, to save us all.

Our corrupt system obstructs any real recovery. Instead cash is thrown on the problem in the hopes it will go away. The more capital gets interjected, the less real accountability the recipients have. The more Washington gets involved with the bailout the more moral hazard emerges--namely the risk that executives feel they can get away with anything, or are too big and precious to the overall economy to be in any real danger.

The more politics dominate the recovery, the less impact it can have, as our nation's economy can't be directed out of Washington, even if the federal government is by far the nation's largest employer.

The amount of dollars needed to stave off a collapse cause by the concussion of the shadow banking collapse will continue to grow. Until the private credit money system is demolished, the dollar will be at the mercy of unscrupulous fraudsters who buy and sell debt-based securities, creating private credit out of thin air.

One day our government's capacity to borrow will eventually run dry. With a thousand stabs, the government albatross is bled, and feeds all the corruption and inefficiency that the invisible hand of the market should have cleansed. Yet the social safety net has hardly been repaired, the public's financial interests go underrepresented as evidenced in the bailout. Wouldn't it make more sense to just get out, and invest in something other than a bottomless pit?

A few years ago, the securitization of debt made great profits, now it's become a survival tool for anyone still standing in the banking industry, as the sheer amount of derivates owed is too great for any bank or even the government to reproduce through the traditional credit system, at least not without completely altering the ground rules.

Because all the players in the shadow banking system are interconnected, as long as there are AIGs out there teetering on the edge of collapse, buyers won't pay top price or worse, not even be able to calculate the value of a financial instrument, making them illiquid and of indeterminate value.

The swing away from real capitalism to a semi-socialist (as the word is defined in our mass media), bailout state signals the creation of a whole new level of big government, a political economy which dispenses federal funds--all borrowed to support its own reelection. Change is simply not possible.

The expanded budget has greater opportunities for those in the private sector who are tied to the federal spending machine. The private sector outcome is clear: executives who would have been fired are retained, a culture of corruption continues, and moral hazard inflates.

With corporations directing government policies, huge sums of government monies are claimed to be required in order to prevent a wider collapse. The FDIC, now headed by Forbes Magazine's second most powerful woman in the world, Sheila Bair, stepped in during the S&L crisis and is increasingly active in combatting a lack of confidence in the stability of the credit markets, which I consider a healthy disposition.

Confidence does play a huge role in reassuring investors and depositors, but just how good can it be for the banking industry to require such large-scale intervention. If the maangement of the banks is so bad as to lose trillions in stockholder equity, just how much confidence can they inspire?

Recently the FDIC jacked up the bank's deposit insurance limits to $250,000 per account holders in FDIC-insured banks. Again, not a gesture that indicates the FDIC has much confidence in the ability of banks to keep depositor money safe.
Libertarians have blamed the creation of FDIC insurance as encouraging banks to take on too much risk. If banks knew they needed to meet depositor redemptions without government aid, they'd be less likely to indulge in risky behaviors. Still, top banking executives appear a lot more concerned with bonuses and their own personal financial positions than those of their shareholders. It's unlikely that government guarantees alone would lead to mismanagement, but the confidence double-speak doesn't hold up, especially as bank stock languish at record lows.

Solution path

Obama talked about creating new federal government entity to solve the crisis, one that I see largely as the consequence of gutting regulations that would limit the growth of the shadow banking system and the Fed making too much credit available.

Creating a new governmental department is always sought as the ideal remedy for any problem. Bureaucracy always creates more bureaucracy and typically lower efficiency. Look no farther than Homeland Security for a new bureaucracy created after 9/11.

There was a precedent for a Resolution Trust-type arrangement. Still, the present bailout lacks additional safeguards and restrictions placed on the corporate recipients, perhaps like those issued in the S & L Debacle in the Eighties, a crisis which has some parallels with the current situation. The banks, or S&Ls, really had lost billions on risky speculation. The so-called Keating Five senators were associated with influence-peddling with Charles Keating, a figure at the center of the S&L crisis. Like banks with their powerful army of lobbyists in DC today, Keating had no qualms about reducing the regulations he saw as an impediment to (his) speculative profits.

The scale of the current bailout dwarfs that incurred by the Resolution Trust Company, a for-profit entity owned by taxpayers which sold off the real estate holdings of the bankrupt S&Ls. At least the RTC has land to sell. Land has a measurable value, unlike the trillions in derivatives held by the investment companies.

The instruments of financial mass destruction called Credit Default Swaps weren't as prevalent in Keating's day. Instead we have a credit crisis created by derivatives which banks lent to one another, carrying the CDSs as insurance. Now no one knows the value of derivatives because of the CDS which insure their failure may or may not have to be called. If the value of the underlying derivatives fall below a set point, the CDSs kick in, and insure the holder. But if a bank or entity like AIG falls, the CDSs, held by third parties, issued by AIG will become worthless. So there's a ripple effect.

Few buyers want to complex derivatives like CDOs (Credit Default Swaps) that aren't insured because of the concerns with the creditworthiness of the issuer of the financial product.

Should the CDSs get called, the insurers will simply be unable to cover the size of the liabilities involved. If the government were to stop bailing out AIG, for example, all those trillions in derivatives they own would get called, and AIG not be able to cover their obligations, leading to a ripple effect in all the companies who own securities insured by AIG. Here is a post by Matthias Chang from marketoracle.co.uk:

"Dealer banks would not accept collateral because they rightly believed that if they had to seize the collateral should the counter-party fail, then there would be no market in which to sell it. This was due to the absence of buyers because of the deleveraging. This led to an absence of prices for these securities. If the value cannot be determined because there is no market – no liquidity or there is the concern that if the asset is seized by the lender, it will not be saleable at all, then the dealer will not engage in repo."

Chang explains the repo markets--Repurchase Market--in great detail, where "securities are exchanged for cash with an agreement to repurchase the securities at a future date." Chang lays down how the unraveling credit markets as the heavily leveraged players in the repo market either exited the market, or stayed in and lost big.

Anyone who wants to understand the origins of risk in our monetary system should look at Chang's description of the root causes. He breaks down the types of repurchase agreements and the problems with each financial instrument, or inadequacies in cash-raising methodologies used by the big banks, which contribute to the possibility of systematic failure.

Chang concludes the Federal Reserve is insolvent, because of the massive liquidity hole created by demands from failing institutions whose shadow banking activities precipitated the collapse. To keep the collapsing entities alive, the Fed has committed to pouring in billions, but their source of collateral is US Treasuries, but Chang ascertains that the Fed can't sell those assets through the Repo Markets any more.

The Fed does plan on issuing its own securities in order to re-inflate the bubble. As long as billions can flow into the banks, the loss of so many billions in shadow transactions, where private credit money was created without any asset backing it, making the value unascertainable.

By creating enough liquidity, the theory goes, the disappearance of so many billions can be overcome. Simply re-inflate the deflated holdings of the banks, which weren't real anyway, but rather repurchase agreements for which buyers now can't be found, except of course the Fed, operating on behalf of our government in trying to mend the damage from the shadow banking collapse.

All the Fed response does is delay the inevitable unwinding. The problem is not so much the loss of so many billions, in assets that weren't real anyway, but rather the systemic inadequacies of our monetary system. To grow--itself a biased term considering financial companies produce up to 40% of our GNP--we need more borrowing. And to finance the borrower, we need a lender. No amount of repurchase agreements can redefine the classic relationship between money and its demand. The more money is needed, the more expensive it gets. As risks of systemic problems like inflation rise, so too does the risk premium associated with holding dollars. Foreign lenders simply avoid buying dollars.

Many people have been surprised by the dollar's gains against most foreign currencies. As it turns out many foreign nations might be even more exposed to the impact of a collapsing private credit money system than we are. As such a big net importer, we've had to hand our money to foreign creditors and sovereign funds, which have seen fit to keep their dollar holding here in the US.

Every dollar spent on an imported product represents a increase in the exporter's dollar hoard. Likewise every dollar spent, or borrowed by our government, needs to come from somewhere. So at no time can we separate the dollar's value from how much it is in demand. Too many dollars out there will mean the dollar will be worth less. As the dollar loses value, all those dollars accumulated by foreigners will be sold, and converted into another currency rather than used to finance our debt by buying real estate, government, or corporate debt. When that happens the dollar will drop in value.

So far the Asian nations remain interested in holding dollars, which are still the world's reserve currency. As long as the Euro remains comparatively weak, the dollar might be safe. Still, dollars can't be created out of thin air without some real world consequence. Dollars can only be brought into existence through some transaction involving a lender--probably foreign--and a US borrower, whether the government itself, the Fed, or any private entity. We can ship dollars abroad but not without eventually reducing what they can buy, and requiring us to pay more interest to overseas lenders.

Oil exporters in the Mideast have been holding dollars abroad, without spending them, so at least the inflation effects are reduced. This does make us vulnerable to political risk, as per the Oil Shocks during the 70s, particularly considering we're dependent on foreign energy. The first shock came as a result of the 1973 Yom Kippur war where the Israelis dominated, os if Iran were attacked, the US could suffer a similar shock. (Worse in fact as we import now more of our petroleum needs from the Mideast than we did then.)

See Robert Reich's post at HuffPo.

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