After the Financial Crisis: Fixing the Market and Regulatory Failures

Every day we read the headlines, feel the tensions, observe the consequences of the recent failures of markets and government. Having a serious conversation about how to remedy these failures lies at the heart of current American politics. Among the questions that conversation should address are whether our response to the immediate crisis has been successful, and how might we restore an effective structure for corporate governance. The failures of corporate governance account for much of our economic troubles over the past 30 years. Getting out of the current mess will require addressing these underlying failures.

Regarding the question of whether government intervention related to the current crisis has been appropriate and effective, perhaps not surprisingly, my conclusion is that it has not. When our economic world appeared to collapse, there was absolutely no question that an enormous sum of money was going to be spent creating solvency and liquidity; money needed to be pushed into the system. On that premise, there was universal agreement. And when it was done — the number $24 trillion is thrown about when you aggregate the straight cash given out, the guarantees, the money we printed — everyone cheered.

But when the cheering was done, three difficult questions emerged. First, who will pay the bills? Second, which regulatory reforms do you impose at the moment when you have the leverage and, in all likelihood, the only opportunity to make a change before the status quo reasserts itself? Third, how do you address the desperate need for jobs in a troubled economy?

Who pays the bills for intervention?

On the first question — who pays? A lot of people say that’s obvious. We all do. But wait a minute: A lot of the executives of the companies left with enormous bonuses. There were opportunities for clawbacks, which would have required asserting claims to recover salary and bonuses paid over prior years, perhaps on a theory of unjust enrichment. In aggregate this wouldn’t have been a big sum compared to all that we put in. But in terms of the message sent and the appropriateness of the remedies, this should have been considered and still could be.

We also could have required more debt-equity swaps, where the debt holders of the companies still had claims on the companies. Forcing them to convert their debt to equity would have put them in a very different position: They would have been at risk and been held to a different standard. We could have driven the equity to zero in many of these companies that were insolvent because of their financial shenanigans, but we didn’t. Think about the consequences for those who held options in these companies, who held a huge sum of public money, as the stock now begins to come back. It might have been down to $2, but once it hits $30, $40, $50 again — because of the huge infusion of public money — they make out extremely well. Should they have been put in a position to benefit? We didn’t have the discussion about whether to drive equity to zero, wiping out those option values that remained in the hands of the folks who created the mess. It is fair to ask why.

Passing the cost of the bailout straight to the taxpayer was exemplified in the case of AIG. When AIG was being bailed out – the first investment was $85 billion — everybody said that we needed to pay off the credit default swaps (essentially insurance contracts against defaults on debt repayment). If the holders of the credit default swaps were not made whole, everything would go bad. That was rubbish. There was absolutely no reason for those counterparties to get a hundred cents on the dollar. But when Goldman showed up, and CEO Lloyd Blankfein said, “We want our $12.9 billion,” Goldman, as a counterparty, got $12.9 billion.

When Larry Summers, Director of President Obama’s National Economic Council, was asked why he supported the full payments to Goldman, his answer was that we are a nation of laws and there was a contract. That’s a silly answer. There was a contract, but taxpayers were not a party to it. We didn’t make a deal with AIG to make whole every counterparty to every contract. Our government — with our support — said, “Let’s do what needs to be done to resuscitate the economy and to make sure things don’t get worse.” Initially some of the low-level people at the Fed were asking the right question, trying to figure out what percentage to pay. They understood that this was the relevant question. But that question was taken off the table. The investment banks, the counterparties, got one hundred cents on the dollar and Goldman got a check for $12.9 billion, roughly the amount of their bonuses. Taxpayers funded their bonuses.

But it is even worse than that. Because then the Fed and the Treasury, who were being sanctimonious about this at the time, said, “We’re going to take stock in AIG.” Think about it. AIG was a worthless shell. Anybody would say: “I’m giving you, as a conduit, a check for $12.9 billion; you’re turning around and giving the check to Goldman? I want stock in Goldman. I don’t want stock in a worthless shell.” The Fed and the Treasury didn’t consider that possibility. I don’t know why, but it returns us to the question of who pays. The taxpayer picked up the whole bill. That was wrong.

Regulatory Reforms

On the second question, about regulatory reform, the government is doing even worse. (There may be some light at the end of this tunnel; on Capitol Hill there are some decent proposals that are being heard.) The biggest problems come from the terrible idea that some firms are “too big to fail.” Those who have analyzed the return of equity of major companies understand that when companies get that big they underperform because they cannot be managed. Too-big-to-fail is too big not to fail. But the major companies are now bolstered by what used to be an implicit, and is now an explicit, backstop of federal government/taxpayer guarantee on their debt. That guarantee — capital at virtually zero cost — does not improve company performance; it subsidizes continuing underperformance.

A global consensus has now emerged that too-big-to-fail is the biggest single threat to our bank system. Economist Henry Kaufman, a very conservative voice, had a lengthy op-ed in the Wall Street Journal that reaches this conclusion. Paul Volcker, Former Fed chairman and now chair of the President’s Economic Recovery Advisory Board, agrees. Former Fed chairman Alan Greenspan has said that too-big-to-fail is dangerous. Mervyn King — the Governor of the Bank of England — has said it. Unfortunately only two people seem not to get it: Larry Summers and Treasury Secretary Timothy Geithner. They say, “If it’s too big to fail, we’re going to backstop it.” That guarantee socializes risk and privatizes gain. You do that, and you’re going to get distorted investment patterns and the same willingness to tolerate risk that caused all the problems in the first place.

We’ve also participated in a regulatory charade. All the CEOs say, “It’s not our fault; the regulators didn’t get it right.” The regulators say, “We didn’t get it right because we didn’t have enough power.” So everyone runs to Capitol Hill to write new laws to give regulators more power. We didn’t need new laws. We needed regulators who would use the power they already had. The Federal Reserve is putting in place new rules that say banks can’t increase credit card fees without getting consent from consumers. Nice idea. Why didn’t they do it five years ago? All the dramatic steps the Fed has taken to resuscitate, to bail out, to restructure, to guarantee: They could have done it all before. So congress will pass a new law, there will be a big signing ceremony, and everyone will say it won’t happen again because now the Fed has the power. They already had the power. They didn’t want to use it, and passing a new law is not going to embolden them.

That’s what I refer to as the “Peter Principle on Steroids.” The Peter Principle says that people are promoted to the point of their incompetence. In the Peter Principle on Steroids, people are first promoted to the point of their incompetence, but their incompetence creates a crisis, and — here is the new twist — they use the crisis to get even more power. They get a promotion beyond the point of their incompetence because of the crisis that they created. In Washington, this is what we’re doing. The two entities at the heart of this crisis were the Fed and the Treasury Department. They failed. Completely, utterly failed. Now look at the reform proposals. The breakthrough idea is that the Fed is going to be our systemic risk regulator. Wow. That’s important. But I hate to break it to you: they already are. That’s their job. That’s what they were supposed to be doing for the last twenty years.

Another bold breakthrough: The Fed’s idea to conduct ‘stress tests’ on major banks. Great idea. But they are banking regulators. They had the power to do this. They just chose not to do it.

Think about what happened with subprime loans. Let me read you something written on the topic: “These loans are foisted on borrowers who have no realistic ability to repay them and who face the loss of their hard-won equity when all the inevitable defaults and foreclosures occur.” That’s from 2004, and I wrote it.

Now I am not a banking regulator. Still, we were trying to investigate subprime lending because back in 2004 we knew there was a problem. I don’t want anybody to misinterpret ‘foisted on’ as absolving the borrower of responsibility. Everybody bears responsibility, and, on both sides of this transaction, people are at fault. The point is that the consequences to the financial sector and to the economy were clear.

We understood in 2004. We tried to investigate. Our investigation was shut down by the Office of the controller of the currency (OCC). They went to court to block our inquiry. Their partners in the courtroom were all the banks that got TARP money. All the banks that got your tax dollars to fund the bonuses stopped the inquiry. The OCC’s legal argument was “We have the power to investigate, you don’t.” Did they investigate? No. They were too busy shutting down people who were trying to do what they should have been doing.

Regulators don’t need additional power, they just need to use their existing power appropriately. And this will not happen unless different people are in charge. We are going through a huge regulatory reshuffle because what went on was absolutely horrifying. But all the laws and regulatory reforms will not matter at all unless we put in charge people who actually believe in enforcement.

Addressing the Need for Jobs

The third question is about jobs, and here we are in deeper trouble than anyone wants to acknowledge. If you look at how many people are outside the employment structure, at what has happened to our manufacturing sector, at the few sectors that have added jobs — education and health care, which are hugely important, but do not form the long-term foundation of a competitive and self-sufficient economy — the trend lines spell disaster.

It did not have to be this way: All that money we spent could have been leveraged for job-creation. When we gave Goldman $12.9 billion and gave trillions to the banks, we didn’t say, “Do something useful, do something that will create jobs.” They went out and got involved in proprietary trading. If Goldman wants to make a fortune on proprietary trading, hats off to them. But they shouldn’t be doing that with tax dollars and our guarantees on their investments.

Let me give you two numbers: $12.9 billion and $8 billion. The first you’ve heard before. The second number is the amount in the stimulus package for investing in high-speed rail. Think about it. More than 50 percent more went to Goldman, even though there has been consensus for years that high-speed rail is critical: For energy, for efficiency. We’re not doing what needs to be done.

Or, consider the auto industry. We gave huge sums of money to resuscitate the shells of companies that probably won’t come back. Here’s another idea people had: why didn’t the government stand up and say, “We will buy 500,000 electric cars in 2013 from whoever gives us the best prototype, as long as 80 percent is produced domestically.” it doesn’t matter what the nameplate is — Kia, GM, Chrysler — but make them here. Set the number high enough so that the companies could generate a profit because of scale.

And here’s another idea: Eisenhower built the interstate highway system, but you can’t use an electric car there unless there are recharging stations. The government should build electric recharging stations wherever there are gas stations on the interstate highway system. There is an infrastructure project that creates jobs and transitions us away from gasoline-based cars and toward electric cars. We know we want to be leaders in that. We should be giving money to sectors that will invest in jobs and infrastructure in a big and fundamental way.

Corporate Governance and Fiduciary Duties

The success of everything I’ve discussed here depends on corporate governance. Corporations run the economy and they should. But if we don’t run our corporations properly, then we will not get ourselves out of this pit.

The chain of corporate governance includes a CEO, a board, and board committees. There are also three facilitators — lawyers, investment bankers, and accountants — who are hired to figure out how to implement the CEO’s plans. Then there are shareholders, who actually own the company.

I’m not going to spend time on the facilitators, but I’ll focus on where the problem is: Fiduciary duty. Fiduciary duty embodies all of corporate governance. If the decision-makers don’t understand this notion — to whom they owe it and how to act to enforce it — nothing will work.

Let’s start with an example: Corporate pay. Back in the mid-’80s the Business Roundtable — an organization of corporate America — did a study of the ratio of the average CEO’s compensation to the average worker’s. It was about 40:1. People said, “Okay, this is capitalism, and that’s how things are.” In Europe the ratio was closer to 20:1, but we believed we had a more dynamic economy, so things seemed fine. By the early 2000s, that ratio of 40:1 had exploded to 550:1. No one could seriously argue that CEOs became more than ten times more valuable to companies relative to average workers. Clearly the system had broken down. Anyone who digs into the issue of corporate compensation will see that what was going on was an outrageous betrayal of fiduciary duty.

Here’s another example. There’s something called spinning. When an investment bank does an IPO, and the IPO is hot — the stock is going to jump on that first day of sale — they give some of these hot stocks to the CEOs of their clients. Why? To keep them happy, so they stay as clients. As attorney general I said that should not be permitted; it violates the fiduciary duty of the CEO to the company. If the investment bank wants to give away something of value to keep a company as a client, it should give it to the shareholders, not the CEO. There’s an uglier term for spinning: Commercial bribery. In 2002 we negotiated a global deal and outlawed it. People got outraged. One extremely powerful regulator today, a Peter-Principle-on-Steroids survivor, asked me then, “Don’t CEOs have any rights anymore?”

These kinds of violation of fiduciary duty shape the whole system. As a result, the CEOs and compensation committees no longer focus, as they should, on company performance.

Fixing Corporate Governance:  Boards and Shareholders

These are vexing problems, and much has been said and written about how to resuscitate corporate governance. Boards and shareholders are the only real long-run answers. Boards have to become more active, and that means they will have to be chosen in a fundamentally different way. CEOs, frankly, need to have their wings clipped because the internecine relationship between CEOs and boards has led us down a dangerous path.

Every now and then, the SEC begins to approach the problem and proposes that shareholders choose the board members. The proposal is met with indignation: Shareholders, we are told, will speak like a narrow special-interest group. Well, yes, they are the owners. The opposition to the notion that shareholders actually be given power is crazy.

But the participation of shareholders is genuinely difficult. The problem starts with the remarkable liquidity in the stock market. Owners of shares can trade out and sell their positions easily. Isn’t that a good thing? Of course. But it also means that shareholders do not stay in for the long, hard slog of reforming companies in which they have a momentary ownership interest. Liquidity thus undermines the urgency of and the argument for participation.

Albert O. Hirschman’s 1970 book, Exit, Voice, and Loyalty, brilliantly captures this dynamic — how decision-makers consider the various options they face when they see a product, whether toothpaste, a political party, or a share in a company, and need to decide whether to use their voice to improve it or to exit and find something better. Hirschman presciently observed the implications of easy exit options for “perpetuating bad management”: Because of the “ready availability of alternative investment opportunities in the stock market . . . any resort to voice rather than to exit is unthinkable for any but the most committed stockholder.” Somehow we have to overcome this problem. Perhaps shareholders should be given additional voting power if they own a stock longer. That solution has its own troubles. But we need to find a way to give shareholders the power and incentive to get involved.

Exit options are not the only hurdle to shareholder power. Consider who the largest shareholders are: Mutual funds and pension funds (and university endowments, which are kind of the same thing). Why is that a problem? Let’s take the case of mutual funds.

When I was attorney general, I participated in a panel on mutual funds at Harvard Law School. At that time an issue with mutual funds was whether they would disclose their proxy voting, whereby they exercise their customers’ voice on the boards of the companies they invest in. One of the participants was the general counsel for an enormous mutual fund company. She was asked if she would disclose how her company votes its proxies. And she said no, that it would be too expensive. That was a ridiculous answer. The reason mutual fund companies don’t want tell their shareholders their proxies is that they almost always vote with the management of the companies in which they hold shares. Why? Because mutual fund companies make money by increasing the size of the assets they manage, and the size of those assets is directly related to whether they are chosen by companies to be the recipient of 401(k) business. If they vote against management, they won’t be put on the 401(k) option list. As a result, mutual fund companies help entrench management.

Because pension funds have never been activist either, we have denied ourselves the dynamism that we could get from the largest participants in the marketplace. CEOs and entrenched boards retain the power. We went down this path without taking a hard look.

To begin to repair corporate governance, it is important to understand what happened. I hope the Financial Crisis Inquiry Commission, which is supposedly the equivalent of the post-1929-crash Pecora commission, will investigate information flows along two lines. The first is about information flows up to the boards at the major banks that failed. What were they told about the creditworthiness of their positions? One possibility is that they weren’t told anything, which tells us a great deal about their level of involvement. Or maybe they were told they were in a creditworthy position and need not worry. Or, they were told they were in jeopardy, but they didn’t do anything. Knowing the answer would give us a better understanding of the failures of corporate management. The second line focuses on the Fed and the Treasury. What did the New York Fed, the most important regulator of banks, and the Treasury know about the debt and leverage situation of these failing banks, and what did they believe?

Conclusion:  Seven Points

To sum up, I want to leave you with seven points:

• “Too big to fail” is too big not to fail.
• We’re suffering from the Peter Principle on Steroids, and it will get us into deeper trouble.
• Taxpayers have been getting the short end of the stick in everything we’ve been doing. The Treasury Department is not negotiating for us.
• Risk is real, and no complex scheme of financial instruments can make it go away.
• We have de-leveraged the wrong way, by socializing risks and privatizing benefits. The government has accepted all the debt obligations of the private sector, and taxpayers now owe this money.
• The only way to reform corporate governance is to get the owners — the shareholders — of companies involved and actually paying attention.
• All of this is very tough: Being able to diagnose a problem is a whole lot easier than mustering the will to fix it.