Congress, and financial regulators in America and other nations, have struggled endlessly with the problem of financial institutions too big to fail. Capital requirements have been increased, and regulation has been tightened (somewhat--much of the implementation of the Dodd Frank Act remains unfinished). But the problem remains.
There is a simple way to seriously reduce the possibility of another taxpayer-funded bailout. If a financial institution needs a government bailout, force the CEO, COO and CFO, and the members of the Board of Directors, to pay to the government the value of their entire compensation for the preceding five years. This would include salary, bonuses, stock options, restricted stock, fees, country club memberships, company cars, and all other perks and compensation. This payment would be required without regard to whether or not the executive officer or director was proven to have participated in any wrongdoing or neglect. It wouldn't be a penalty for misconduct. It would be an incentive to avoid sticking the government with the costs of mismanagement.
Any such proposal would, of course, provoke howls of outrage from financial institutions and their free-roaming packs of mouth-foaming running dog lobbyists. Such a measure would be unfair if the officer or director hadn't been shown to have engaged in misconduct, it would be argued. However, the SEC already has the legal authority to force a company's CEO and CFO to pay out all their compensation for the 12 months following the issuance of financial statements that are subsequently modified (in a form called a restatement)--see Section 304 of the Sarbanes-Oxley Act. The SEC isn't required to show that the CEO and CFO did bad things. They can be forced to make this payout simply because the original financial statements were wrong and needed to be restated. The courts have upheld this authority. There's nothing unfair about requiring senior executives to get important things right in the first instance.
Banks and other financial institutions might also object that they couldn't recruit the executive talent they need if this financial Sword of Damocles were to hang over their heads. But, when we consider the geniuses at some financial institutions in the recent past who steered their firms right over cliffs and into government safety nets, this argument loses its persuasiveness. Executive compensation arrangements at the too big to fail seem to incentivize risk-taking, even if it might entail unmanageable complexity. There needs to be a disincentive--and a strong one.
The government has been criticized for not penalizing the high and mighty for the financial crisis of 2008. Remember, however, that the statutes and regulations governing financial institutions are complex. Proof of violations can be difficult. A simple measure like a penalty of five year's compensation for a government bailout offers a way to nail the top dogs for signing a chit the taxpayers have to pay.
Showing posts with label Dodd-Frank. Show all posts
Showing posts with label Dodd-Frank. Show all posts
Sunday, September 15, 2013
Wednesday, March 2, 2011
The SEC's Inconvenient Case Against a Corporate Director
Yesterday, the SEC leveled charges of leaking inside information against Rajat Gupta, a former director of Goldman Sachs & Co. and Proctor & Gamble Co. He stands accused of passing inside information he obtained as a director of these two companies to Raj Rajaratnam, the founder of Galleon Group, an investment firm, who allegedly took advantage of that information to make millions in trading profits. Among other things, Gupta supposedly gave Rajaratnam advance notice of Berkshire Hathaway's 2008 $5 billion investment in Goldman. This investment was a crucial vote of confidence in GS, made at a time when the financial crisis cast doubt on the prospects of all major Wall Street firms. That this moment of salvation was allegedly corrupted by insider trading resulting from a Goldman director's leak only reinforces popular perceptions of Wall Street as a den of thieves.
Gupta has categorically denied the SEC's allegations, and pledged to fight the charges. Nevertheless, the case is rather inconvenient for Congressional Republicans hellbent on slashing the SEC's budget. Insider trading cases often involve high level corporate employees and executives. But they almost never reach the board of directors. Goldman was the premier investment bank in America during the financial crisis, and Proctor & Gamble is an iconic American business corporation. That these two companies would have a director allegedly leaking inside information to an investment firm illustrates why vigorous federal financial regulation is needed.
Insider trading isn't the focus of the Dodd-Frank bill. But uncovering alleged leaking by a director of elite American corporations casts a shadow over the complaints of the Chamber of Commerce and others that the Dodd-Frank legislation unfairly burdens honest and misunderstood businesses. If the allegations against Gupta prove true, they will remind us that private sector management and governance processes are not foolproof, and that federal oversight remains essential.
Gupta has categorically denied the SEC's allegations, and pledged to fight the charges. Nevertheless, the case is rather inconvenient for Congressional Republicans hellbent on slashing the SEC's budget. Insider trading cases often involve high level corporate employees and executives. But they almost never reach the board of directors. Goldman was the premier investment bank in America during the financial crisis, and Proctor & Gamble is an iconic American business corporation. That these two companies would have a director allegedly leaking inside information to an investment firm illustrates why vigorous federal financial regulation is needed.
Insider trading isn't the focus of the Dodd-Frank bill. But uncovering alleged leaking by a director of elite American corporations casts a shadow over the complaints of the Chamber of Commerce and others that the Dodd-Frank legislation unfairly burdens honest and misunderstood businesses. If the allegations against Gupta prove true, they will remind us that private sector management and governance processes are not foolproof, and that federal oversight remains essential.
Monday, February 21, 2011
Taxpayer Liability for Banks: the Missing Link in Balancing the Federal Budget
As if the federal budget balancing debate weren't complicated enough, a key issue is absent from the discussion. Virtually no attention is being paid to the potential budget-busting problem of taxpayer liability for the banking system. Although this is a contingent liability, it can wreak astounding havoc when the banking system hits the fan. Ireland illustrates the problem.
Like so many other nations, Ireland rode to seeming prosperity on a rising real estate market. Its banks were instrumental in financing this bubble. When Lehman Brothers collapsed in September 2008, Irish banks rapidly slipped off the precipice. Their stock prices fell and a liquidity crisis loomed. The Irish government moved posthaste to stem the panic, guaranteeing some $570 billion of bank liabilities (which should be compared to Ireland's GDP of approximately $170 billion). Eventually, the Irish government nationalized one major bank, Anglo Irish. While the Irish government's direct debt is about 65% of GDP (not much different from the U.S. government's direct debt), its guarantee of bank liabilities vastly increased its potential obligations. The resulting morass was so bad that Ireland needed an EU bailout earlier this year.
The U.S. government (and American taxpayers) are on the hook for the liabilities of the largest American banks. Not officially, but we all know they'll get a bailout if they need one. In addition, taxpayers are liable for the housing banks--Fannie Mae, Freddie Mac, the FHA and Ginnie Mae. The amounts of all these contingent liabilities are unclear but likely very large. Illiquid real estate assets held by banks (so-called Level 3 assets) may be overvalued by hundreds of billions. Vast numbers of defaulted mortgages remain in limbo as the foreclosure mess crawls toward a resolution that will probably entail more losses for banks. The continued decline of the real estate market means more mortgages going underwater, and probably more defaults.
In addition, the largest banks have trillions of dollars of derivatives exposure. Much of the derivatives exposure is hard to see right now. Current accounting standards allow banks sometimes to net derivatives assets against derivatives liabilities. Netting means we don't see them on balance sheets. Once international accounting standards replace U.S. generally accepted accounting principles (probably within a couple of years), a lot of current netting of derivatives holdings would likely have to be unwound. Balance sheets of the largest banks could balloon by more than $7 trillion, in the aggregate. America's GDP is around $14 trillion, while annual federal spending is around $3.5 trillion. Readers may painfully recall that during the 2007-08 financial crisis, derivatives assets had a scary way of losing value while derivatives liabilities remained unwavering. Taxpayers would be on the hook for the losses. Reining in the amounts of bank derivatives exposure may be necessary to reducing the potential bite on taxpayers.
So, we can see that balancing the budget doesn't just mean getting expenditures down and government revenues up. It also means limiting contingent liabilities. Ireland's government didn't flagrantly overspend. Profligate lending by too big to fail Irish banks made it fail. Fortunately, Ireland's not too big to be bailed out by the EU. But there's no brother big enough to bail out America. Truly balancing the U.S. government's budget requires limiting taxpayer exposure to the banking system.
Progress on that front is painfully slow. The Volcker Rule is constraining some of the riskier activity. But reform of the derivatives market is hard to spot, even on sunny days at high noon. Banks remain Brobdingnagian in size, and executive compensation may soon run wild again. Implementation of the Dodd-Frank provisions for improved financial regulation is hindered by lack of funding. Fannie, Freddie and the FHA guarantee almost all new mortgages. Proposals for limiting the burdens they place on taxpayers will be obstinately contested by the real estate industry. Although neither Republicans or Democrats want to face the tough issues in balancing the budget--entitlement programs like Medicare, Medicaid and Social Security--we will eventually have to reform those programs. But all the pain and controversy we will endure squabbling over entitlements will be for naught if there is another financial crisis. And another crisis hardly seems any less likely than the one we still haven't recovered from.
Like so many other nations, Ireland rode to seeming prosperity on a rising real estate market. Its banks were instrumental in financing this bubble. When Lehman Brothers collapsed in September 2008, Irish banks rapidly slipped off the precipice. Their stock prices fell and a liquidity crisis loomed. The Irish government moved posthaste to stem the panic, guaranteeing some $570 billion of bank liabilities (which should be compared to Ireland's GDP of approximately $170 billion). Eventually, the Irish government nationalized one major bank, Anglo Irish. While the Irish government's direct debt is about 65% of GDP (not much different from the U.S. government's direct debt), its guarantee of bank liabilities vastly increased its potential obligations. The resulting morass was so bad that Ireland needed an EU bailout earlier this year.
The U.S. government (and American taxpayers) are on the hook for the liabilities of the largest American banks. Not officially, but we all know they'll get a bailout if they need one. In addition, taxpayers are liable for the housing banks--Fannie Mae, Freddie Mac, the FHA and Ginnie Mae. The amounts of all these contingent liabilities are unclear but likely very large. Illiquid real estate assets held by banks (so-called Level 3 assets) may be overvalued by hundreds of billions. Vast numbers of defaulted mortgages remain in limbo as the foreclosure mess crawls toward a resolution that will probably entail more losses for banks. The continued decline of the real estate market means more mortgages going underwater, and probably more defaults.
In addition, the largest banks have trillions of dollars of derivatives exposure. Much of the derivatives exposure is hard to see right now. Current accounting standards allow banks sometimes to net derivatives assets against derivatives liabilities. Netting means we don't see them on balance sheets. Once international accounting standards replace U.S. generally accepted accounting principles (probably within a couple of years), a lot of current netting of derivatives holdings would likely have to be unwound. Balance sheets of the largest banks could balloon by more than $7 trillion, in the aggregate. America's GDP is around $14 trillion, while annual federal spending is around $3.5 trillion. Readers may painfully recall that during the 2007-08 financial crisis, derivatives assets had a scary way of losing value while derivatives liabilities remained unwavering. Taxpayers would be on the hook for the losses. Reining in the amounts of bank derivatives exposure may be necessary to reducing the potential bite on taxpayers.
So, we can see that balancing the budget doesn't just mean getting expenditures down and government revenues up. It also means limiting contingent liabilities. Ireland's government didn't flagrantly overspend. Profligate lending by too big to fail Irish banks made it fail. Fortunately, Ireland's not too big to be bailed out by the EU. But there's no brother big enough to bail out America. Truly balancing the U.S. government's budget requires limiting taxpayer exposure to the banking system.
Progress on that front is painfully slow. The Volcker Rule is constraining some of the riskier activity. But reform of the derivatives market is hard to spot, even on sunny days at high noon. Banks remain Brobdingnagian in size, and executive compensation may soon run wild again. Implementation of the Dodd-Frank provisions for improved financial regulation is hindered by lack of funding. Fannie, Freddie and the FHA guarantee almost all new mortgages. Proposals for limiting the burdens they place on taxpayers will be obstinately contested by the real estate industry. Although neither Republicans or Democrats want to face the tough issues in balancing the budget--entitlement programs like Medicare, Medicaid and Social Security--we will eventually have to reform those programs. But all the pain and controversy we will endure squabbling over entitlements will be for naught if there is another financial crisis. And another crisis hardly seems any less likely than the one we still haven't recovered from.
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