More on the AIG Case

I finally got around to reading U.S. Court of Claims Judge Thomas Wheeler’s opinion in the class action suit led by Maurice (Hank) Greenberg against the United States concerning the terms of the bailout of AIG. Nothing in it changes my opinion about Steven Pearlstein’s article in the Washington Post about this case, which I found to be incredibly biased for a news story.

I am no expert on the applicable law in this case, but Judge Wheeler’s opinion seems quite reasonable. In short, he held that the Federal Reserve exceeded its authority by demanding a controlling equity interest in AIG as condition for a loan that would keep AIG for filing for bankruptcy, but he found that AIG’s stockholders were not due any payment from the government for this action, since the alternative, bankruptcy, would have left them in a worst position economically. In a less noticed part of the opinion, the judge found that AIG’s reverse stock split in a ratio of twenty-to-one was done in order to keep AIG share price over $1.00 so as not to be delisted from the New York Stock Exchange. The judge found no evidence that it was done to avoid a stockholder vote on the government exchanging preferred stock for common stock. In other words, on this issue, the plaintiffs lost.

The judge’s descriptions of the events leading up to the AIG loan do not portray anyone in a very favorable light. In particular, one gets the impression that certain of the actors reveled in acting as the tough guys in the way they acted towards AIG. Left unexplained is why the terms of the AIG loan which involved the effective nationalization of AIG and a very high interest rate were so much tougher than what the government demanded of the banks. As I’ve indicated, the excuse that Pearlstein and Andrew Ross Sorkin proffer, i.e., the government did not regulate AIG, is questionable, since the Office of Thrift Supervision did have supervisory authority over AIG as a thrift holding company. Also the judge mentions, without much comment, that the Federal Reserve decided that AIG’s credit default swap counterparties would be paid the full amount they were owed, even though AIG was in financial distress but for the government backup. This seems to have been a way to help the banks.

As to the legal authority to take an equity interest in AIG, particularly telling is an email from a Davis Polk lawyer who was acting as the New York Fed’s outside counsel. In this email, the lawyer said that the government “is on thin ice and they know it. But who is going to challenge them on this ground?” Well, we know the answer to this question. How Mr. Greenburg feels about winning his case after paying a very expensive legal team led by David Boies but not receiving any payment in spite of this win is unclear, except that he is not satisfied. According to The Wall Street Journal, he plans to appeal Judge Wheeler’s decision on damages and an earlier decision to dismiss claims related to the “backdoor bailout” of banks by making them whole on the CDS contracts with AIG.

Also, of course, AIG is hardly blameless. The company took excessive risk by taking on the mortgage risk that the banks did not want to hold through credit default swaps. It is also true that the government actions led to AIG continuing in business.  Given the pressures of the time, the government officials were making the best decisions they could, and mistakes were inevitable. In retrospect, many think that the biggest mistake was letting Lehman Brothers fail. While Treasury and Federal Reserve officials claim that they did not have sufficient authority to save Lehman, this is not widely believed given their resourcefulness in other matters, including AIG.

Some Criticisms on the Reporting of the AIG Case in Today’s Washington Post and New York Times

I have not yet had time to read Judge Wheeler’s opinion in a Court of Claims case in which he decided that the Federal Reserve had exceeded its legal authority in obtaining an equity interest in AIG through a trust but did not award any payment to Starr International Company (effectively, as I understand it, Maurice Greenburg). Nevertheless, I am disappointed with two articles I read about this case this morning: one in the Washington Post and the other in the New York Times.

The Washington Post article is by Steven Pearlstein. While the article appears on the “Wonkblog” online, it is on page A3 of the print edition, i.e., it appears as a regular new article. Nevertheless, it is quite clear that Mr. Pearlstein is not writing as an objective reporter. It is obvious that he believes the judge’s decision is wrong. For example, he writes that the judge substituted “his judgement for that of the treasury secretary and the five-member Federal Reserve Board.” He also criticizes the judge for not noting “a key point. Although the government, as bank regulator, could control the behavior of the banks, without an ownership stake it would not have had control over an unregulated global insurance holding company to which it had just made the largest loan in recorded history.”

Pearlstein is wrong about the AIG’s regulatory status. AIG was a thrift holding company, then subject to the Office of Thrift Supervision (“OTS”) oversight and regulation. At the time of the financial crisis, this may have been overlooked because OTS was for the most part not taken that seriously as a regulator of thrift holding companies. Nevertheless, those managing the crisis may have been able to use OTS to control AIG’s behavior and other agencies could have lent staff to OTS with expertise. I do not know the limits of OTS’s holding company authority, but Pearlstein should have mentioned this possibility. . (In passing, I would note that some insurance companies bought small thrifts in order to be regulated by OTS as a thrift holding company. They did this in order to operate in the European Union without being subject to holding company regulation by an EU regulator. The EU accepted this, even though it was clear to many that OTS would not be doing much supervision.)

I am puzzled by Pearlstein’s exact status at the Washington Post. He was a regular columnist for the Post, but left a few years ago to become a professor at George Mason University, which is located in the Virginia suburbs of Washington, DC. While at George Mason (it is not clear whether he is still employed there, though he may be), he wrote occasional columns for the Post. Recently, I have seen news articles written by him, with a Washington Post email address after his name. If he is now writing news articles as a Post employee or contract worker, he and his editors should know the difference between writing an opinion column and a news article. I should not be able to read a straight news article about a court decision and know that the reporter disagrees with it.

Andrew Ross Sorkin in today’s New York Times has an article about the AIG decision where he ignores OTS, though what he writes is not inaccurate: “But the Fed did not have regulatory oversight of A.I.G., which is an insurance company, and therefore couldn’t maintain the same kind of control it did over the banks.” Sorkin also should have mentioned OTS.

I am not as critical of Sorkin as I am of Pearlstein, because the formatting of the article in the Times (jagged right margin) serves to indicate that this is an analytical piece reflecting the author’s views, not a straight news article. The line between what should go on the editorial pages of the Times and what analysis is appropriate for the news pages is very fuzzy. I have criticized Sorkin in the past for advocacy in an article he wrote about Antonio Weiss, which I thought should be better placed as an op-ed. I do not think, though, that he crossed any lines in today’s article, and attribute the OTS omission as an oversight.

Some Further Thoughts on Financial Regulation

As some of my previous posts have suggested, the ideal structure of financial institution and market regulation is maddeningly elusive. The U.S. structure was never well thought out and planned; it was created piecemeal in reaction to various historical financial developments, problems, and crises – most notably in the 1930s, 1970s, and more recently. Because of the way politics works and laws are enacted in the U.S., it is difficult to reform financial regulation absent a crisis, and even then reforms may fail to address some fundamental problems.

In the UK, by contrast, the government has been able to change the regulatory structure with less political difficulty given the nature of the political system (though, as the recent election there attests, the UK political system appears to be evolving in fundamental ways). For example, in 2000, the Labour Government headed by Tony Blair consolidated most financial regulation in the Financial Services Authority ("FSA"). In the aftermath of the financial crisis of 2008, the Conservative Government headed by David Cameron deemed the FSA to be a failure and in 2013 split the FSA into two entities, one for business conduct regulation and the other for prudential regulation and gave more authority to the Bank of England.

Sometimes, there is something to be gained by rearranging and consolidating or splitting (as the case may be) regulatory boxes. In the U.S., there is a good case to be made for merging the SEC and the CFTC and for having fewer bank regulators. The case for the former rests on the similarity of many of the market instruments the two agencies regulate; the case for the latter rests on forum shopping by banks. One could go further and pose the question whether insurance companies (life, casualty, and health) should be primarily regulated by the states given the important role these entities play in financial markets and also ask whether the regulation of pension funds is adequate.

One thing is clear. When Alan Greenspan was the Federal Reserve chairman, he liked to argue that multiple regulators would foster competition among regulators and that this would result in better regulation. Of course, that is an application of faith in the free market and competition in an area where it makes no sense. Greenspan’s not terribly well hidden agenda was that competition among regulators for entities to regulate would result in regulatory laxity, which he thought was desirable. Given the financial crisis of 2008, that is no longer a widely shared view.

The main problem with financial regulation is regulatory capture. While restructuring the agencies responsible for regulation may help, it does not solve this problem. When there are multiple regulators, there is a tendency for each agency to be an advocate for the entities it regulates and to fight any encroachment by other regulators. This can even extend to matters that are not strictly in the regulators’ jurisdiction. For example, some years ago there was a political fight over whether derivatives should be marked to market for accounting purposes, as the Financial Accounting Standards Board ("FASB") had proposed. (This simplifies FASB’s complex proposal but gets to what the dispute was about.) The bank regulators supported the banks in fighting the proposal, while the SEC supported it. The issues revolved around capital requirements and the stability of reported income. For broker-dealers regulated by the SEC this was not an issue, since SEC capital rules key off assets for which there is a market and are valued at market (or "fair value") prices. For banks, this had the potential to increase capital requirements if there were a decline in the value of certain of their derivatives holdings. Of course, the regulators could come up with a regulatory capital measurement that went contrary to FASB rules, but the regulators did not want to do that.

In the end, a version of the FASB rule was finalized. As for Treasury, the staff was divided. Those who worked on bank regulation argued against FASB; those who worked on securities regulation, which included me because of Treasury’s government securities market rule-making authority, sided with the SEC and FASB. Ultimately, Treasury political appointees sided with FASB. A provision was included that effectively stated that inflation-indexed bonds structured in the manner of Treasury’s inflation-indexed bonds did not have an embedded derivative that needed to be split out and marked to market. Whatever one thinks of the merits of that particular provision, it obviously was in Treasury’s interest for FASB to conclude this as the Treasury was trying to develop a market for the new security.

As for the SEC, the staff there seemed to be heavily influenced by the largest broker-dealers and held out Goldman Sachs as having excellent compliance programs. In some areas, Goldman no doubt has good compliance programs. But one wonders if the deference SEC staff paid to firms like Goldman led them to miss some of the practices that exacerbated the bursting of the housing bubble and the 2008 financial crisis.

Despite the foregoing, consolidating regulators does not necessarily solve the regulatory capture problem. It probably limits the types of entities that can do the capturing to the largest firms and exchanges, but these entities will find a way to both charm and pressure a regulator with broader responsibilities than the current one. After all, as the Carmen Segarra tapes suggest, the Federal Reserve Bank of New York ("FRBNY") will sometimes handle large and influential firms with a light touch (in this instance, Goldman Sachs), even though the FRBNY would seem to be powerful enough to be immune from influence and pressure.

There is no obvious answer on how to reform the regulatory system. Dodd-Frank made some improvements, but the ability to resist regulatory capture requires leadership and a change in the culture of the regulatory agencies. As regards leadership, it is not sufficient to have a gung-ho regulator who heads an agency for only a few years. The leadership must be sustained from administration to administration. Also, a gung-ho regulator may not always be for the best. It is not always the case that writing lots of regulations solves problems, especially if they are not well designed to solve identified problems. Moreover, regulators need to show good judgment, which was absent in the lead-up to the 2008 financial crisis. After all, the regulators had authority that they did not use, which might have at least lessened the severity of the crisis. Particularly egregious was Greenspan’s refusal to use the Fed’s authority to curtail what was happening with subprime mortgages.

Given the current state of our political system, it is hard to be optimistic about making significant improvements in regulation. Any administration which wants to improve regulatory oversight and appoints people to the agencies who share that view will get pushback from certain factions in Congress. The large financial entities know how to play the Washington game, including how to influence Congress and exploit rivalries and tensions among various government agencies. Currently, probably the best discipline on the financial sector is the memory of the 2008 crisis. However, as time passes, memories of that will fade and a new crop of ambitious people will be working at the firms with no personal memories of 2008 at all.

This does not mean that we should quit trying to improve financial regulation. While there will certainly be serious problems in financial markets – there always are – perhaps we can be able to mitigate them. The regulations we have and their application and enforcement are not worthless; they do a lot of good. They could, though, be better.