Saturday, March 21, 2009

Citigroup Plans Big Bonuses Despite Rules Against Them

By Stephen Gandel

A Citibank branch in New York.
A Citibank branch in New York.

AIG isn't the only bailed-out financial firm paying big bucks to managers who helped steer their company to near collapse. Citigroup has pledged millions of dollars in bonuses to senior executives for the next few years, despite lawmakers efforts to eliminate such payments.

It's not clear whether the bonuses, which Citigroup says are for 2008 but won't start paying out until 2010, will be allowed. Under compensation rules passed by Congress in mid-February, cash bonuses are barred for top executives at bailed-out banks. (See pictures of the global financial crisis.)

But Citi finalized its bonus program shortly before the new rules were introduced. That might make the payments permissible, though they could be made almost worthless by new tax rules just passed by the House of Representatives and headed for consideration in the Senate. Even so, Citigroup's move in January to set in place bonus payments for years to come raises questions about whether it was trying to evade compensation rules it knew were coming.

"If an executive legitimately earns a bonus, then paying it out over a number of years makes a lot of sense,' says Paul Hodgson, a senior research associate at the Corporate Library, which examines issues of corporate governance. "But I find it hard to believe that any top executive at a bailed-out bank would have had the performance in 2008 to generate a multimillion-dollar bonus." (Read "Is Citibank Really Out of the Woods?")

Under Citi's proposed compensation plan, three of the company's top five executives would be paid a total of nearly $12.5 million in cash bonuses over the next five years. One of the executives, James Forese, is a co-head of Citi's Institutional Client Group, which lost $20 billion in 2008. Forese is rewarded $5 million under the plan. At least 15 other Citi executives are in line for multimillion-dollar payouts. Citi declined to say how much in total it has promised under the plan.

According to a proxy statement Citi filed with the Securities and Exchange Commission, the company finalized its bonus plan on Jan. 14. Twelve days later an amendment barring such payments was inserted by the House of Representatives into the $787 billion fiscal stimulus bill, which went into effect on Feb. 17.

A Citigroup spokesman denied that the company did anything wrong, noting the pay packages in question were set a month before the bonus ban became law. "Overall executive compensation [at Citigroup] substantially decreased from 2007 to 2008," the spokesman said. "CEO Vikram Pandit and CFO Gary Crittenden declined any bonus for last year as well. As always, we will comply with the new restrictions on compensation ... in addition to continued adherence to the substantial changes we already have made to our compensation structure.'

The revelations about Citi's bonus plan come at a time when anger over executive pay, particularly in the troubled financial sector, is boiling over. On Thursday, the House overwhelmingly passed a bill that would impose a 90% income tax on all compensation over $250,000 earned by employees at banks that have received more than $5 billion in bailout funds. The Senate is working on its own bill to raise taxes on highly compensated bankers. President Barack Obama indicated he would sign legislation that curtails bonuses.

"In the end, this is a symptom of a larger problem, a bubble-and-bust economy that valued reckless speculation over responsibility and hard work," Obama said in a statement released by the White House. "That is what we must ultimately repair to build a lasting and widespread prosperity."

Citi has also been criticized this week for an estimated $10 million renovation of its executive offices, and reports that the firm was considering boosting salaries for its top executives.

The bonuses for top executives at Citi are particularly surprising because the company is typically seen as the most in danger of failing among the nation's largest banks. Citi has received more government assistance than any other bank: $45 billion in cash infusions and over $300 billion in loan guarantees since late October. By comparison, none of Bank of America's top five executives will receive a cash bonus for 2008.

"There is no question [Citigroup] is violating the spirit of executive-compensation rules,' says Heather Slavkin, who studies executive-pay issues for the AFL-CIO. "Hopefully by the time Citi tries to pay these out we will have gotten over this idea about the sacredness of contracts, and these bonuses won't be allowed either.'

Citi has long deferred the payment of stock options that are granted at the end of the year. Cash bonuses, though, have always been paid at the time they were granted, typically in January for prior-year performance. But this year Citi decided to defer bonus payments for the first time. Instead of paying a lump sum in early 2009 for 2008 performance, payouts would be spread over four years, with the first payouts in January 2010.

For example, Forese, the Institutional Client Group executive, received a salary of $225,000 and was awarded a cash bonus of $5,265,000 for 2008. But he won't get any of his millions yet. Instead, he has a promise from Citi that he will get a check for $1.3 million in January 2010 and three checks for the same amount over the following three years.

On the surface, the plan looks like a good public relations move. At a time when people are angry about bonuses, Citi can say it isn't currently handing out bonuses to its top executives for work they did in 2008. What's more, the Citi bonuses include a provision that allows the bank to "claw back" the money if it is found that an executive made false statements to the company.

The problem is that Citi's payment plan is not consistent with executive-compensation rules put into place by the stimulus package. The American Recovery and Reinvestment Act signed by Obama on Feb. 17 says banks that have received money from the government's $700 billion Troubled Asset Relief Fund are barred from paying cash bonuses to their top executives. They can pay stock bonuses equal to as much as a third of an employee's salary, but the employee is not allowed to sell those shares until the government's money is paid back by their company.

The rub is that a provision was inserted into the stimulus package that says the rules do not apply to any bonuses contained in employment contracts signed before Feb. 11. (It is this provision that AIG has cited in defending its controversial bonuses to top executives.) Citi finalized its plan for paying 2008 bonuses in January. But it's unclear whether Citi's deferred-payout plan would be considered a valid employment contract under the rules set out in the stimulus package. The law leaves that up to Treasury Secretary Tim Geithner to decide.

Compensation experts say that as the government increases its efforts to curtail executive pay, companies will come up with more and more creative ways to keep their employees happy. "Citi may have bent the rules a bit,' says top compensation consultant Alan Johnson. "But if these firms don't come up with some way to pay their people, they are going to be out of business.'

Original here

A.I.G. Sues U.S. for Return of $306 Million in Tax Payments

Katie Orlinsky for The New York Times

Demonstrators marched in New York’s financial district Thursday to protest corporate excesses.


While the American International Group comes under fire from Congress over executive bonuses, it is quietly fighting the federal government for the return of $306 million in tax payments, some related to deals that were conducted through offshore tax havens.

A.I.G. sued the government last month in a bid to force it to return the payments, which stemmed in large part from its use of aggressive tax deals, some involving entities controlled by the company’s financial products unit in the Cayman Islands, Ireland, the Dutch Antilles and other offshore havens.

A.I.G. is effectively suing its majority owner, the government, which has an 80 percent stake and has poured nearly $200 billion into the insurer in a bid to avert its collapse and avoid troubling the global financial markets. The company is in effect asking for even more money, in the form of tax refunds. The suit also suggests that A.I.G. is spending taxpayer money to pursue its case, something it is legally entitled to do. Its initial claim was denied by the Internal Revenue Service last year.

The lawsuit, filed on Feb. 27 in Federal District Court in Manhattan, details, among other things, certain tax-related dealings of the financial products unit, the once high-flying division that has been singled out for its role in A.I.G.’s financial crisis last fall. Other deals involved A.I.G. offshore entities whose function centers on executive compensation and include C. V. Starr & Company, a closely held concern controlled by Maurice R. Greenberg, A.I.G.’s former chairman, and the Starr International Company, a privately held enterprise incorporated in Panama, and commonly known as SICO.

The lawsuit contends in part that the federal government owes A.I.G. nearly $62 million in foreign tax credits related to eight foreign entities, with names like Lumagrove, Laperouse and Foppingadreef, that were set up or controlled by financial products, often through a unit known as Pinestead Holdings.

United States tax law allows American companies to claim a credit for any taxes paid to a foreign government. But the I.R.S. denied A.I.G.’s refund claims in 2008, saying that it had improperly calculated the credits. The I.R.S. has identified so-called foreign tax-credit generators as an area of abuse that it is increasingly monitoring.

The remainder of A.I.G.’s claim, for $244 million, concerns net operating loss carry-backs, capital loss carry-backs, a general refund claim and claims for refunds of other tax-related payments that A.I.G. says it made to the I.R.S. but are now owed back. The claim also covers $119 million in penalties and interest that A.I.G. says it is due back from the government.

In part, A.I.G. says it overpaid its federal income taxes after a 2004 accounting scandal that caused it to restate its financial records. A.I.G. says in part that it is entitled to a refund of $33 million that SICO paid in 1997 as compensation to employees, which it now says should be characterized as a deductible expense.

A.I.G.’s lawyers in the case, at Sutherland Asbill & Brennan, referred calls to the company. Asked about the lawsuit, Mark Herr, an A.I.G. spokesman, said Thursday that “A.I.G. is taking this action to ensure that it is not required to pay more than its fair share of taxes.”

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Can we bail out of the bailouts?

Women walk in front of the AIG building in Tokyo, Japan.

NEW YORK - What if the U.S. government got out of the bailout business?

The idea certainly seemed all right with throngs of Americans who were outraged by news that American International Group paid out millions of dollars in executive bonuses after it was rescued with taxpayer cash.

But would no bailout be even worse? Financial analysts and federal officials have warned that doing nothing to save AIG — or banks or the auto industry — would be a catastrophe, an economic domino effect of bank losses, stock market chaos and job cuts. No one — at least no one in the government — has the stomach for that.

Here's what might happen if companies deemed "too big to fail" were allowed to do just that.


For bailout backlash, it's hard to beat AIG. The government has made four separate loans and cash infusions to the crippled insurer, including $30 billion earlier this month. Total tab: $170 billion.

Public outrage reached new heights when word spread that AIG had paid executives $165 million in bonuses. President Barack Obama ordered his treasury secretary to grab back what he could, and one senator even suggested the recipients kill themselves.

So why not pull the plug? Because AIG has 74 million customers and operates in 130 countries, and letting it implode would positively unhinge financial markets around the world.

AIG built a murky, unregulated business issuing insurance for mortgage-backed securities and other debt held by banks. When the housing bubble popped and those securities went bad, AIG was left on the hook for billions of dollars in claims it couldn't pay.

Letting AIG die would make all of that insurance worthless. Banks around the world would be forced to take massive losses. Some could collapse, unnerving markets, driving up unemployment and maybe turning the recession into a depression.

The U.S. got a taste of that scenario in September, when bad debt forced investment bank Lehman Brothers into the biggest bankruptcy in U.S. history. Thousands of other firms were exposed to Lehman's complex financial contracts, and the resulting fear and uncertainty sent stocks plunging.

And that was just a small taste.

"AIG is about five times bigger than Lehman Brothers, and we learned that Lehman Brothers should not have gone bankrupt," said Mark T. Williams, professor of finance and economics at Boston University and a former Federal Reserve bank examiner.

It's not just AIG's life at stake. Over the weekend, the company named the trading partners who indirectly benefited from the taxpayer rescue. Those partners included Goldman Sachs ($12.9 billion) and Merrill Lynch ($6.8 billion).

So by bailing out AIG, the government is essentially bailing out those and other financial institutions whose fate depends on AIG's survival, said Sung Won Sohn, an economics professor at California State University, Channel Islands.

"If the money dries up, we'd see a lot more bad banks," Sohn said.

AIG itself has predicted nothing short of a financial apocalypse unless it stays on government life support.

In a bleak report to the Treasury Department late last month, AIG said its collapse could batter credit markets, bankrupt the U.S. insurance industry, depress the dollar, increase U.S. borrowing costs and shatter consumer and business confidence everywhere.

"The failure of AIG," the company warns in the report, "would cause turmoil in the U.S. economy and global markets, and have multiple and potentially catastrophic unforeseen consequences."

"What happens to AIG has the potential to trigger a cascading set of further failures which cannot be stopped except by extraordinary means," the report adds.

Not everyone buys the doomsday scenario. Some critics, including billionaire investor Jim Rogers, say keeping the company on the public dole is ruining the U.S. economy.

And Phil Kerpen, director of policy for Americans for Prosperity, an antitax lobbying group, said the government "should stop throwing good money after bad" and allow AIG to go into bankruptcy.

"There might be some contagion. There might not be. But we know for certain that the course we're on now isn't working," he said.

The government says letting AIG fail simply is not an option.

Federal Reserve Chairman Ben Bernanke, speaking to legislators earlier this month, warned that the damage to the world economy of an AIG failure would run into the "multiples of trillions."

That doesn't mean the government hasn't at least considered a world without AIG. On its Web site, the Treasury Department tracks what it calls "Systematically Significant Failing Institutions." There's a single company on the list: AIG.

So far, the government has invested $200 billion total in about 400 banks, and it says it stands ready to spend even more. Two titans of the industry, Citigroup and Bank of America, have received $45 billion apiece.

And the banks may actually be stabilizing. JPMorgan Chase, Citigroup and Bank of America all say they were profitable in January and February. Citigroup stock, which traded below $1, has bounced back to more than $3.

For now, the government has a 36 percent ownership stake in Citigroup. If the government pulled its cash and investors lost confidence and drove the bank into bankruptcy, financial markets would be devastated.

The Federal Deposit Insurance Corp. points out that no American has ever lost a penny in a failed bank. But the FDIC has also never handled a failure as big as a Citigroup or a Bank of America.

Bert Ely, an independent banking analyst in Alexandria, Va., said pulling the plug on the banks could have a destructive impact on markets similar to the convulsions unleashed by Lehman Brothers' collapse.

Letting Citigroup and Bank of America go down in the same way would be "like taking a house that had some damage and burning it down," Ely said. "It's economic arson."

The concern, not unlike with AIG, is that letting a big bank go under would leave its trading partners saddled with huge losses, shattering confidence and leading investors to pull out the money they have left in the market.

But others say keeping the bailout money flowing is only making things worse.

Bill Seidman, a former chairman of the FDIC who ran the government bailout during the savings and loan crisis, said he does not believe letting failing banks die would trigger a brutal domino effect.

He's calling for a temporary nationalization that would end bailouts for insolvent banks, clean up their balance sheets and sell them back into the private sector.

"I don't think we would bring down the system by doing that," he said.

The White House isn't taking that chance. Obama's 2010 budget proposal sets aside up to $750 billion more in bailout money if banks fall deeper into the abyss. That's on top of the $700 billion bank bailout launched by the Bush administration.

In the meantime, the administration is urging patience.

"It is surely tempting to say the hell with them all," White House economic adviser Lawrence Summers said in a speech last month. But he added, "You can't responsibly govern out of anger."


General Motors and Chrysler have received more than $17 billion in government loans and asked to borrow $21.6 billion more. Their financing arms have received $6.5 billion on top of that.

The auto industry contends the failure of either of the two would set off a chain reaction that could ultimately cost 3 million jobs and suck $400 billion out of the economy over three years.

That's because hundreds of companies that supply parts to the Big Three, not to mention dealerships, would also be hurt. In fact, the Center for Automotive Research in Ann Arbor, Mich., heavily funded by the auto industry, contends that just 239,000 lost jobs would come from the automakers themselves.

The industry contends that if just one of the Big Three failed, 1.5 million jobs would disappear in a year. Ilhan Geckil, senior economist for the Anderson Economic Group, which also studied the impact of losing an automaker, said Michigan's unemployment rate would probably rise from the current 11.6 percent to as high as 14 percent.

The good news: The job pain would be eased somewhat because both the surviving Detroit automakers and foreign automakers who have plants in the United States would start to pick up the slack.

And some doubt the job losses would be so dire to begin with.

Susan Helper, a professor of economics at Case Western Reserve University in Cleveland who has studied the auto industry, says the chain reaction would be smaller — although suppliers of parts for certain car models might be out of luck.

"I think the auto supply base is fairly intertwined," she said in an e-mail. "I think it's unlikely that every single supplier would be forced to stop production."

Copyright 2009 The Associated Press.

Original here

World economy 'to shrink in 2009'

IMF World growth forecast
By Steve Schifferes
Economics reporter, BBC News

The world economy is set to shrink by between 0.5% and 1.0% in 2009, the first global contraction in 60 years.

In its gloomiest forecast yet, the International Monetary Fund (IMF) says that developed countries will suffer a "deep recession".

The global economic body says "the prolonged financial crisis has battered global economic activity beyond what was previously anticipated".

Just two months ago, the IMF predicted world output would increase by 0.5%.

In the event of further delays in implementing comprehensive policies to stabilise financial conditions, the recession will be deeper and more prolonged

But in its report drawn up for the G20 group of finance ministers, the IMF now says that the whole world economy will shrink, and predicts that the advanced economies will suffer a decline in output of between 3% and 3.5% in 2009, and barely grow in 2010, with growth of between 0% and 0.5%.

The IMF says this will happen despite a big fiscal stimulus from many G20 countries designed to boost growth.

It says that the G20 as a whole is adding 1.8% of GDP ($780bn) to boost growth this year - but that the EU is lagging behind with only 1%.

And it warns that the UK is building up the biggest fiscal deficit amongst all the G20 countries, which will amount to 11% of GDP by 2010.

Financial crisis unresolved

The IMF warns that the economic conditions could still deteriorate further if the banking crisis was not tackled head on by governments around the world.

"In the event of further delays in implementing comprehensive policies to stabilise financial conditions, the recession will be deeper and more prolonged," the report says.

Bangladesh textile workers
The global slowdown has affected exporters such as Bangladesh

The IMF says its revised projections reflect "unrelenting financial turmoil, negative incoming data, sinking confidence, and the limited effect to date of policy responses with respect to the restoration of financial system health."

Japan is forecast to decline the most, by 5.8% this year, while the eurozone will contract by 3.2% and the US by 2.6%.

The most urgent problem in restoring the banking system to health is in the United States, where the Obama administration has yet to reveal details of its plan for private-public partnership to buy up to $1tn in toxic assets.

At the G20 finance ministers meeting at the weekend, restoring lending by tackling problems in the financial system was cited as the "key priority" - a message reinforced by G20 business leaders who met in London on Wednesday.

Warning on Eastern Europe

Meanwhile, the IMF was also warns of a serious risk that emerging economies will be unable to secure external finance, as banks and investors in rich countries withdraw their money.

"The risks are largest for emerging countries that rely on cross-border flows to finance current account deficits," it says.

And this makes central and eastern European countries likely to be the "most adversely affected" - with the Baltic states, Hungary, Romania and Bulgaria "suffering the greatest damage".

The IMF is already in negotiations about a rescue package for Romania.

East Asian countries, which rely heavily on manufacturing exports, have also been hard-hit by the decline of world trade, particularly in the IT sector.

In relative terms, the developing and emerging market countries as a whole, which are predicted to grow by just 1.5% to 2.5%, below the growth of population in many countries, have suffered the biggest downward revisions.

Fiscal stimulus

In addition to fixing the banking sector, many countries are now spending more public money to boost economic growth.

The IMF estimates that the G20 countries as a whole will spend an extra 1.8% of GDP ($780bn) in 2009 on fiscal stimulus, not far from its earlier recommendation that they spend at least 2% of GDP on boosting growth.

Taking into account the "automatic stabilisers", for example the increased spending on unemployment benefits that results from a slowdown, it says that in 2009 there will be a 2.4% boost to GDP from fiscal expansion.

It says the fiscal expansion could add around 2% to world growth in 2009 and create approximately 7 million new jobs (or 19 million if China and India are included).

But the IMF warns that there is much less spending planned for 2010, with extra government spending of only $580bn (1.2% of GDP) across the G20, and a total fiscal boost of only 0.4%.

This has caused much dissent among G20 members, with the US, whose huge fiscal stimulus plan runs well into 2010, urging other G20 countries to boost their spending further.

Original here

No Return to Normal

Associated Press

B arack Obama’s presidency began in hope and goodwill, but its test will be its success or failure on the economics. Did the president and his team correctly diagnose the problem? Did they act with sufficient imagination and force? And did they prevail against the political obstacles—and not only that, but also against the procedures and the habits of thought to which official Washington is addicted?

The president has an economic program. But there is, so far, no clear statement of the thinking behind that program, and there may not be one, until the first report of the new Council of Economic Advisers appears next year. We therefore resort to what we know about the economists: the chair of the National Economic Council, Lawrence Summers; the CEA chair, Christina Romer; the budget director, Peter Orszag; and their titular head, Treasury Secretary Timothy Geithner. This is plainly a capable, close-knit group, acting with energy and commitment. Deficiencies of their program cannot, therefore, be blamed on incompetence. Rather, if deficiencies exist, they probably result from their shared background and creed—in short, from the limitations of their ideas.

The deepest belief of the modern economist is that the economy is a self-stabilizing system. This means that, even if nothing is done, normal rates of employment and production will someday return. Practically all modern economists believe this, often without thinking much about it. (Federal Reserve Chairman Ben Bernanke said it reflexively in a major speech in London in January: "The global economy will recover." He did not say how he knew.) The difference between conservatives and liberals is over whether policy can usefully speed things up. Conservatives say no, liberals say yes, and on this point Obama’s economists lean left. Hence the priority they gave, in their first days, to the stimulus package.

But did they get the scale right? Was the plan big enough? Policies are based on models; in a slump, plans for spending depend on a forecast of how deep and long the slump would otherwise be. The program will only be correctly sized if the forecast is accurate. And the forecast depends on the underlying belief. If recovery is not built into the genes of the system, then the forecast will be too optimistic, and the stimulus based on it will be too small.

Consider the baseline economic forecast of the Congressional Budget Office, the nonpartisan agency lawmakers rely on to evaluate the economy and their budget plans. In its early-January forecast, the CBO measured and projected the difference between actual economic performance and "normal" economic performance—the so-called GDP gap. The forecast has two astonishing features. First, the CBO did not expect the present recession to be any worse than that of 1981–82, our deepest postwar recession. Second, the CBO expected a turnaround beginning late this year, with the economy returning to normal around 2015, even if Congress had taken no action at all.

With this projection in mind, the recovery bill pours a bit less than 2 percent of GDP into new spending per year, plus some tax cuts, for two years, into a GDP gap estimated to average 6 percent for three years. The stimulus does not need to fill the whole gap, because the CBO expects a "multiplier effect," as first-round spending on bridges and roads, for example, is followed by second-round spending by steelworkers and road crews. The CBO estimates that because of the multiplier effect, two dollars of new public spending produces about three dollars of new output. (For tax cuts the numbers are lower, since some of the cuts will be saved in the first round.) And with this help, the recession becomes fairly mild. After two years, growth would be solidly established and Congress’s work would be done. In this way, the duration as well as the scale of action was driven, behind the scenes, by the CBO’s baseline forecast.

Why did the CBO reach this conclusion? On depth, CBO’s model is based on the postwar experience, and such models cannot predict outcomes more serious than anything already seen. If we are facing a downturn worse than 1982, our computers won’t tell us; we will be surprised. And if the slump is destined to drag on, the computers won’t tell us that either. Baked into the CBO model we find a "natural rate of unemployment" of 4.8 percent; the model moves the economy back toward that value no matter what. In the real world, however, there is no reason to believe this will happen. Some alternative forecasts, freed of the mystical return to "normal," now project a GDP gap twice as large as the CBO model predicts, and with no near-term recovery at all.

Considerations of timing also influenced the choice of line items. The bill tilted toward "shovel-ready" projects like refurbishing schools and fixing roads, and away from projects requiring planning and long construction lead times, like urban mass transit. The push for speed also influenced the bill in another way. Drafting new legislative authority takes time. In an emergency, it was sensible for Chairman David Obey of the House Appropriations Committee to mine the legislative docket for ideas already commanding broad support (especially within the Democratic caucus). In this way he produced a bill that was a triumph of fast drafting, practical politics, and progressive principle—a good bill which the Republicans hated. But the scale of action possible by such means is unrelated, except by coincidence, to what the economy needs.

Three further considerations limited the plan. There was, to begin with, the desire for political consensus; President Obama chose to start his administration with a bill that might win bipartisan support and pass in Congress by wide margins. (He was, of course, spurned by the Republicans.) Second, the new team also sought consensus of another type. Christina Romer polled a bipartisan group of professional economists, and Larry Summers told Meet the Press that the final package reflected a "balance" of their views. This procedure guarantees a result near the middle of the professional mind-set. The method would be useful if the errors of economists were unsystematic. But they are not. Economists are a cautious group, and in any extreme situation the midpoint of professional opinion is bound to be wrong.

Third, the initial package was affected by the new team’s desire to get past this crisis and to return to the familiar problems of their past lives. For these protégés of Robert Rubin, veterans in several cases of Rubin’s Hamilton Project, a key preconception has always been the budget deficit and what they call the "entitlement problem." This is D.C.-speak for rolling back Social Security and Medicare, opening new markets for fund managers and private insurers, behind a wave of budget babble about "long-term deficits" and "unfunded liabilities." To this our new president is not immune. Even before the inauguration Obama was moved to commit to "entitlement reform," and on February 23 he convened what he called a "fiscal responsibility summit." The idea took hold that after two years or so of big spending, the return to normal would be under way, and the costs of fiscal relief and infrastructure improvement might be recouped, in part by taking a pound of flesh from the incomes and health care of the old.

The chance of a return to normal depends, in turn, on the banking strategy. To Obama’s economists a "normal" economy is led and guided by private banks. When domestic credit booms are under way, they tend to generate high employment and low inflation; this makes the public budget look good, and spares the president and Congress many hard decisions. For this reason the new team instinctively seeks to return the bankers to their normal position at the top of the economic hill. Secretary Geithner told CNBC, "We have a financial system that is run by private shareholders, managed by private institutions, and we’d like to do our best to preserve that system."

But, is this a realistic hope? Is it even a possibility? The normal mechanics of a credit cycle do involve interludes when asset values crash and credit relations collapse. In 1981, Paul Volcker’s campaign against inflation caused such a crash. But, though they came close, the big banks did not fail then. (I learned recently from William Isaac, Ronald Reagan’s chair of the FDIC, that the government had contingency plans to nationalize the large banks in 1982, had Mexico, Argentina, or Brazil defaulted outright on their debts.) When monetary policy relaxed and the delayed tax cuts of 1981 kicked in, there was both pent-up demand for credit and the capacity to supply it. The final result was that the economy recovered quickly. Again in 1994, after a long period of credit crunch, banks and households were strong enough, even without a stimulus, to support a vast renewal of lending which propelled the economy forward for six years.

The Bush-era disasters guarantee that these happy patterns will not be repeated. For the first time since the 1930s, millions of American households are financially ruined. Families that two years ago enjoyed wealth in stocks and in their homes now have neither. Their 401(k)s have fallen by half, their mortgages are a burden, and their homes are an albatross. For many the best strategy is to mail the keys to the bank. This practically assures that excess supply and collapsed prices in housing will continue for years. Apart from cash—protected by deposit insurance and now desperately being conserved—the American middle class finds today that its major source of wealth is the implicit value of Social Security and Medicare—illiquid and intangible but real and inalienable in a way that home and equity values are not. And so it will remain, as long as future benefits are not cut.

In addition, some of the biggest banks are bust, almost for certain. Having abandoned prudent risk management in a climate of regulatory negligence and complicity under Bush, these banks participated gleefully in a poisonous game of abusive mortgage originations followed by rounds of pass-the-bad-penny-to-the-greater-fool. But they could not pass them all. And when in August 2007 the music stopped, banks discovered that the markets for their toxic-mortgage-backed securities had collapsed, and found themselves insolvent. Only a dogged political refusal to admit this has since kept the banks from being taken into receivership by the Federal Deposit Insurance Corporation—something the FDIC has the power to do, and has done as recently as last year with IndyMac in California.

Geithner’s banking plan would prolong the state of denial. It involves government guarantees of the bad assets, keeping current management in place and attempting to attract new private capital. (Conversion of preferred shares to equity, which may happen with Citigroup, conveys no powers that the government, as regulator, does not already have.) The idea is that one can fix the banks from the top down, by reestablishing markets for their bad securities. If the idea seems familiar, it is: Henry Paulson also pressed for this, to the point of winning congressional approval. But then he abandoned the idea. Why? He learned it could not work.

Paulson faced two insuperable problems. One was quantity: there were too many bad assets. The project of buying them back could be likened to "filling the Pacific Ocean with basketballs," as one observer said to me at the time. (When I tried to find out where the original request for $700 billion in the Troubled Asset Relief Program came from, a senior Senate aide replied, "Well, it’s a number between five hundred billion and one trillion.")

The other problem was price. The only price at which the assets could be disposed of, protecting the taxpayer, was of course the market price. In the collapse of the market for mortgage-backed securities and their associated credit default swaps, this price was too low to save the banks. But any higher price would have amounted to a gift of public funds, justifiable only if there was a good chance that the assets might recover value when "normal" conditions return.

That chance can be assessed, of course, only by doing what any reasonable private investor would do: due diligence, meaning a close inspection of the loan tapes. On the face of it, such inspections will reveal a very high proportion of missing documentation, inflated appraisals, and other evidence of fraud. (In late 2007 the ratings agency Fitch conducted this exercise on a small sample of loan files, and found indications of misrepresentation or fraud present in practically every one.) The reasonable inference would be that many more of the loans will default. Geithner’s plan to guarantee these so-called assets, therefore, is almost sure to overstate their value; it is only a way of delaying the ultimate public recognition of loss, while keeping the perpetrators afloat.

Delay is not innocuous. When a bank’s insolvency is ignored, the incentives for normal prudent banking collapse. Management has nothing to lose. It may take big new risks, in volatile markets like commodities, in the hope of salvation before the regulators close in. Or it may loot the institution—nomenklatura privatization, as the Russians would say—through unjustified bonuses, dividends, and options. It will never fully disclose the extent of insolvency on its own.

The most likely scenario, should the Geithner plan go through, is a combination of looting, fraud, and a renewed speculation in volatile commodity markets such as oil. Ultimately the losses fall on the public anyway, since deposits are largely insured. There is no chance that the banks will simply resume normal long-term lending. To whom would they lend? For what? Against what collateral? And if banks are recapitalized without changing their management, why should we expect them to change the behavior that caused the insolvency in the first place?

The oddest thing about the Geithner program is its failure to act as though the financial crisis is a true crisis—an integrated, long-term economic threat—rather than merely a couple of related but temporary problems, one in banking and the other in jobs. In banking, the dominant metaphor is of plumbing: there is a blockage to be cleared. Take a plunger to the toxic assets, it is said, and credit conditions will return to normal. This, then, will make the recession essentially normal, validating the stimulus package. Solve these two problems, and the crisis will end. That’s the thinking.

But the plumbing metaphor is misleading. Credit is not a flow. It is not something that can be forced downstream by clearing a pipe. Credit is a contract. It requires a borrower as well as a lender, a customer as well as a bank. And the borrower must meet two conditions. One is creditworthiness, meaning a secure income and, usually, a house with equity in it. Asset prices therefore matter. With a chronic oversupply of houses, prices fall, collateral disappears, and even if borrowers are willing they can’t qualify for loans. The other requirement is a willingness to borrow, motivated by what Keynes called the "animal spirits" of entrepreneurial enthusiasm. In a slump, such optimism is scarce. Even if people have collateral, they want the security of cash. And it is precisely because they want cash that they will not deplete their reserves by plunking down a payment on a new car.

The credit flow metaphor implies that people came flocking to the new-car showrooms last November and were turned away because there were no loans to be had. This is not true—what happened was that people stopped coming in. And they stopped coming in because, suddenly, they felt poor.

Strapped and afraid, people want to be in cash. This is what economists call the liquidity trap. And it gets worse: in these conditions, the normal estimates for multipliers—the bang for the buck—may be too high. Government spending on goods and services always increases total spending directly; a dollar of public spending is a dollar of GDP. But if the workers simply save their extra income, or use it to pay debt, that’s the end of the line: there is no further effect. For tax cuts (especially for the middle class and up), the new funds are mostly saved or used to pay down debt. Debt reduction may help lay a foundation for better times later on, but it doesn’t help now. With smaller multipliers, the public spending package would need to be even larger, in order to fill in all the holes in total demand. Thus financial crisis makes the real crisis worse, and the failure of the bank plan practically assures that the stimulus also will be too small.

I n short, if we are in a true collapse of finance, our models will not serve. It is then appropriate to reach back, past the postwar years, to the experience of the Great Depression. And this can only be done by qualitative and historical analysis. Our modern numerical models just don’t capture the key feature of that crisis—which is, precisely, the collapse of the financial system.

If the banking system is crippled, then to be effective the public sector must do much, much more. How much more? By how much can spending be raised in a real depression? And does this remedy work? Recent months have seen much debate over the economic effects of the New Deal, and much repetition of the commonplace that the effort was too small to end the Great Depression, something achieved, it is said, only by World War II. A new paper by the economist Marshall Auerback has usefully corrected this record. Auerback plainly illustrates by how much Roosevelt’s ambition exceeded anything yet seen in this crisis:

[Roosevelt’s] government hired about 60 per cent of the unemployed in public works and conservation projects that planted a billion trees, saved the whooping crane, modernized rural America, and built such diverse projects as the Cathedral of Learning in Pittsburgh, the Montana state capitol, much of the Chicago lakefront, New York’s Lincoln Tunnel and Triborough Bridge complex, the Tennessee Valley Authority and the aircraft carriers Enterprise and Yorktown. It also built or renovated 2,500 hospitals, 45,000 schools, 13,000 parks and playgrounds, 7,800 bridges, 700,000 miles of roads, and a thousand airfields. And it employed 50,000 teachers, rebuilt the country’s entire rural school system, and hired 3,000 writers, musicians, sculptors and painters, including Willem de Kooning and Jackson Pollock.

In other words, Roosevelt employed Americans on a vast scale, bringing the unemployment rates down to levels that were tolerable, even before the war—from 25 percent in 1933 to below 10 percent in 1936, if you count those employed by the government as employed, which they surely were. In 1937, Roosevelt tried to balance the budget, the economy relapsed again, and in 1938 the New Deal was relaunched. This again brought unemployment down to about 10 percent, still before the war.

The New Deal rebuilt America physically, providing a foundation (the TVA’s power plants, for example) from which the mobilization of World War II could be launched. But it also saved the country politically and morally, providing jobs, hope, and confidence that in the end democracy was worth preserving. There were many, in the 1930s, who did not think so.

What did not recover, under Roosevelt, was the private banking system. Borrowing and lending—mortgages and home construction—contributed far less to the growth of output in the 1930s and ’40s than they had in the 1920s or would come to do after the war. If they had savings at all, people stayed in Treasuries, and despite huge deficits interest rates for federal debt remained near zero. The liquidity trap wasn’t overcome until the war ended.

It was the war, and only the war, that restored (or, more accurately, created for the first time) the financial wealth of the American middle class. During the 1930s public spending was large, but the incomes earned were spent. And while that spending increased consumption, it did not jumpstart a cycle of investment and growth, because the idle factories left over from the 1920s were quite sufficient to meet the demand for new output. Only after 1940 did total demand outstrip the economy’s capacity to produce civilian private goods—in part because private incomes soared, in part because the government ordered the production of some products, like cars, to halt.

All that extra demand would normally have driven up prices. But the federal government prevented this with price controls. (Disclosure: this writer’s father, John Kenneth Galbraith, ran the controls during the first year of the war.) And so, with nowhere else for their extra dollars to go, the public bought and held government bonds. These provided claims to postwar purchasing power. After the war, the existence of those claims could, and did, establish creditworthiness for millions, making possible the revival of private banking, and on the broadly based, middle-class foundation that so distinguished the 1950s from the 1920s. But the relaunching of private finance took twenty years, and the war besides.

A brief reflection on this history and present circumstances drives a plain conclusion: the full restoration of private credit will take a long time. It will follow, not precede, the restoration of sound private household finances. There is no way the project of resurrecting the economy by stuffing the banks with cash will work. Effective policy can only work the other way around.

T hat being so, what must now be done? The first thing we need, in the wake of the recovery bill, is more recovery bills. The next efforts should be larger, reflecting the true scale of the emergency. There should be open-ended support for state and local governments, public utilities, transit authorities, public hospitals, schools, and universities for the duration, and generous support for public capital investment in the short and long term. To the extent possible, all the resources being released from the private residential and commercial construction industries should be absorbed into public building projects. There should be comprehensive foreclosure relief, through a moratorium followed by restructuring or by conversion-to-rental, except in cases of speculative investment and borrower fraud. The president’s foreclosure-prevention plan is a useful step to relieve mortgage burdens on at-risk households, but it will not stop the downward spiral of home prices and correct the chronic oversupply of housing that is the cause of that.

Second, we should offset the violent drop in the wealth of the elderly population as a whole. The squeeze on the elderly has been little noted so far, but it hits in three separate ways: through the fall in the stock market; through the collapse of home values; and through the drop in interest rates, which reduces interest income on accumulated cash. For an increasing number of the elderly, Social Security and Medicare wealth are all they have.

That means that the entitlement reformers have it backward: instead of cutting Social Security benefits, we should increase them, especially for those at the bottom of the benefit scale. Indeed, in this crisis, precisely because it is universal and efficient, Social Security is an economic recovery ace in the hole. Increasing benefits is a simple, direct, progressive, and highly efficient way to prevent poverty and sustain purchasing power for this vulnerable population. I would also argue for lowering the age of eligibility for Medicare to (say) fifty-five, to permit workers to retire earlier and to free firms from the burden of managing health plans for older workers.

This suggestion is meant, in part, to call attention to the madness of talk about Social Security and Medicare cuts. The prospect of future cuts in this modest but vital source of retirement security can only prompt worried prime-age workers to spend less and save more today. And that will make the present economic crisis deeper. In reality, there is no Social Security "financing problem" at all. There is a health care problem, but that can be dealt with only by deciding what health services to provide, and how to pay for them, for the whole population. It cannot be dealt with, responsibly or ethically, by cutting care for the old.

Third, we will soon need a jobs program to put the unemployed to work quickly. Infrastructure spending can help, but major building projects can take years to gear up, and they can, for the most part, provide jobs only for those who have the requisite skills. So the federal government should sponsor projects that employ people to do what they do best, including art, letters, drama, dance, music, scientific research, teaching, conservation, and the nonprofit sector, including community organizing—why not?

Finally, a payroll tax holiday would help restore the purchasing power of working families, as well as make it easier for employers to keep them on the payroll. This is a particularly potent suggestion, because it is large and immediate. And if growth resumes rapidly, it can also be scaled back. There is no error in doing too much that cannot easily be repaired, by doing a bit less.

A s these measures take effect, the government must take control of insolvent banks, however large, and get on with the business of reorganizing, re-regulating, decapitating, and recapitalizing them. Depositors should be insured fully to prevent runs, and private risk capital (common and preferred equity and subordinated debt) should take the first loss. Effective compensation limits should be enforced—it is a good thing that they will encourage those at the top to retire. As Senator Christopher Dodd of Connecticut correctly stated in the brouhaha following the discovery that Senate Democrats had put tough limits into the recovery bill, there are many competent replacements for those who leave.

Ultimately the big banks can be resold as smaller private institutions, run on a scale that permits prudent credit assessment and risk management by people close enough to their client communities to foster an effective revival, among other things, of household credit and of independent small business—another lost hallmark of the 1950s. No one should imagine that the swaggering, bank-driven world of high finance and credit bubbles should be made to reappear. Big banks should be run largely by men and women with the long-term perspective, outlook, and temperament of middle managers, and not by the transient, self-regarding plutocrats who run them now.

The chorus of deficit hawks and entitlement reformers are certain to regard this program with horror. What about the deficit? What about the debt? These questions are unavoidable, so let’s answer them. First, the deficit and the public debt of the U.S. government can, should, must, and will increase in this crisis. They will increase whether the government acts or not. The choice is between an active program, running up debt while creating jobs and rebuilding America, or a passive program, running up debt because revenues collapse, because the population has to be maintained on the dole, and because the Treasury wishes, for no constructive reason, to rescue the big bankers and make them whole.

Second, so long as the economy is placed on a path to recovery, even a massive increase in public debt poses no risk that the U.S. government will find itself in the sort of situation known to Argentines and Indonesians. Why not? Because the rest of the world recognizes that the United States performs certain indispensable functions, including acting as the lynchpin of collective security and a principal source of new science and technology. So long as we meet those responsibilities, the rest of the world is likely to want to hold our debts.

Third, in the debt deflation, liquidity trap, and global crisis we are in, there is no risk of even a massive program generating inflation or higher long-term interest rates. That much is obvious from current financial conditions: interest rates on long-maturity Treasury bonds are amazingly low. Those rates also tell you that the markets are not worried about financing Social Security or Medicare. They are more worried, as I am, that the larger economic outlook will remain very bleak for a long time.

Finally, there is the big problem: How to recapitalize the household sector? How to restore the security and prosperity they’ve lost? How to build the productive economy for the next generation? Is there anything today that we might do that can compare with the transformation of World War II? Almost surely, there is not: World War II doubled production in five years.

Today the largest problems we face are energy security and climate change—massive issues because energy underpins everything we do, and because climate change threatens the survival of civilization. And here, obviously, we need a comprehensive national effort. Such a thing, if done right, combining planning and markets, could add 5 or even 10 percent of GDP to net investment. That’s not the scale of wartime mobilization. But it probably could return the country to full employment and keep it there, for years.

Moreover, the work does resemble wartime mobilization in important financial respects. Weatherization, conservation, mass transit, renewable power, and the smart grid are public investments. As with the armaments in World War II, work on them would generate incomes not matched by the new production of consumer goods. If handled carefully—say, with a new program of deferred claims to future purchasing power like war bonds—the incomes earned by dealing with oil security and climate change have the potential to become a foundation of restored financial wealth for the middle class.

This cannot be made to happen over just three years, as we did in 1942–44. But we could manage it over, say, twenty years or a bit longer. What is required are careful, sustained planning, consistent policy, and the recognition now that there are no quick fixes, no easy return to "normal," no going back to a world run by bankers—and no alternative to taking the long view.

A paradox of the long view is that the time to embrace it is right now. We need to start down that path before disastrous policy errors, including fatal banker bailouts and cuts in Social Security and Medicare, are put into effect. It is therefore especially important that thought and learning move quickly. Does the Geithner team, forged and trained in normal times, have the range and the flexibility required? If not, everything finally will depend, as it did with Roosevelt, on the imagination and character of President Obama.

By James K. Galbraith

Original here

Why Do Check Cashing Services Exist?

by Dave

I caught a commercial a couple weeks ago where they were advertising that Wal-Mart will now cash checks for “only” three dollars apiece. The ad went on to say that, for an average person, that would be a savings of about two hundred dollars a year. In order to explain this concept to viewers, whom Wal-Mart obviously considers to be stupid at some sort of subhuman level, they stated that one could buy a small television set with the savings, a concept that seemed both idiotic and insulting to me. Nonetheless, I wondered how the average person would be saving that much money by paying for a service that anyone with a bank account in good standing could get free of charge.

Pennies on the dollar; a sound financial plan.

Since then, I have noticed commercials for several competing services on television, some of which appear to be businesses who do nothing but cash checks for people. This piqued my curiosity, so I began a very scientific campaign, via Google, to determine how much is costs to cash a check these days. Results were all over the map, ranging from a flat rate of three to ten dollars, to percentages from as little as one percent all the way up to forty percent. That’s right, forty percent.

I’m going to assume that people who use these services on a regular basis do so because they missed basic economics in high school. To help, I’ll offer them the following free personal finance tip: It generally isn’t a good idea to trade a dollar for sixty cents.

I’m not unfamiliar with the concept of cashing checks for a fee. I see many, many dive stores around metro Detroit, almost always in the poor and immigrant neighborhoods, that offer such services. Check cashing is almost always coupled with Lotto sales and cheap liquor, staples, it would seem, for the underprivledged. Generally these places will also allow people to pay bills, acting as some sort of usurious ghetto bank, which isn’t as cool as it might sound.

What surprises me is that a company as huge as Wal-Mart would be interested in hustling people the way tiny convenience stores do, not to mention taking the risk of cashing checks that will bounce, for three bucks apiece. I’m sure they have everything figured out, and stand to make a good profit at volume, but it still seems like a lot more trouble than it would be worth, the fact that those people would probably spend a healthy portion of that cash at Wal-Mart notwithstanding.

Now maybe I’m hanging out with the wrong people, but I don’t know a single person who needs to go to a store to cash a check. You know why? Because one hundred percent of the people I know have bank accounts. In fact, most of us don’t even need to go to the bank to cash a check, since our paychecks from work are automatically deposited on pay day. And what do we pay for all these services? Nothing. Not a goddamn cent.

It baffles me that anyone would choose to pay some jerk at a store to cash their paycheck instead of getting free checking account, especially since these days a lot of banks offer the service with free checks and no minimum balance. Hell, even if you didn’t want a checking account, you could still take the check to the bank from which it was drawn and get it cashed there. After considerable thought and effort, the only two reasons I could come up with for someone not getting a bank account were:

  1. They are an illegal alien and thus do not have the proper documentation required to start an account
  2. They have had accounts in the past the were closed do be being constantly overdrawn

Surely these two groups of people have to represent a tiny minority of check cashing customers, so who’s making up the difference? I’d honestly love to know, so if you have the answer, add a comment.

This has been Dave sayin’: “So you do have a plan! Yay Mr. White! Yay science!”

Original here

How AIG Became Too Big to Fail

By Bill Saporito

insurance bailout
AIG offices in New York City

Treasury Secretary Tim Geithner had every reason to think he had seen all of AIG's dirty laundry. The government owned 80% of the company, and Geithner had just orchestrated AIG's most recent handout — its fourth, if you are keeping score, for $30 billion on March 2 — to prevent the teetering insurance giant from going over the cliff and taking the rest of the global financial system with it. AIG had already cost the taxpayers some $170 billion, mostly to repair the damage done by one of its units, AIG Financial Products (AIG FP), which last year alone piled up $40 billion in losses related to its dealings in complex mortgage bond derivatives.

Then Geithner's staff made the discovery that would infuriate nearly everyone in Washington. On March 10, the Secretary learned, 10 days after his staff first got wind of it, that AIG had paid out $165 million in retention bonuses to executives at the unit that compelled the U.S. to bail out the company in the first place. It took Geithner until 7:40 the next night to place what must have been a tense phone call to AIG's newish CEO, Ed Liddy. The bonuses were not tenable; they had to be canceled, he demanded. Liddy, a dollar-a-year man who took over the company after the bonuses had been promised, replied that AIG's lawyers had decided that the contracts could not be broken without even bigger costs to taxpayers. Geithner sent Treasury's lawyers searching for a way out, but they couldn't find one. (See 25 people to blame for the financial crisis.)

On the balance sheet of debacles caused by this economic crisis — the $700 billion Troubled Asset Relief Program (TARP), the stock-market swoon, the credit crunch and the ongoing global recession — $165 million is small change. But the revelations of the AIG bonuses, like nothing else, seemed to finally tip the mounting public furor over corporate malpractice into a full-scale rebellion. Yet Geithner, embarrassed for discovering the bonuses so late, plans to dock AIG that much out of the next $30 billion in bailout funding when it is delivered — which amounts to a mere 0.1% of the total AIG has received. Assorted Senators, from New York Democrat Chuck Schumer to Montana Democrat Max Baucus and Iowa Republican Chuck Grassley, have proposed a number of tax and legal schemes to snatch back the bonus bucks from AIG FP executives — 73 of whom got payouts of $1 million or more, according to New York State attorney general Andrew Cuomo. (Read "Treasury Learned of AIG Bonuses Earlier Than Claimed.")

With all the political theater and populist grandstanding, though, the bigger issue has been obscured. And that is, Just what is AIG doing with the $170 billion? Does the company's strategy, which is to wind down its exposure to toxic assets and sell some of its profitable insurance divisions to help pay off the government debt, stand a good chance of succeeding? And if it does, will the world avert financial Armageddon?

Those questions have taken on greater urgency, since it turns out that AIG has become the banking industry's ATM, essentially passing along $52 billion of TARP money to an array of U.S. and foreign financial institutions — from Goldman Sachs to Switzerland's UBS. Those firms were counterparties to the credit-default swaps (CDSs) that AIG FP sold at least through 2005, and the companies were collecting on the insurance-like derivatives. AIG paid out an additional $43.7 billion to many of the same banks, which were also customers of the securities-lending operation run out of AIG's insurance division. In this case, AIG managed to take a business specifically designed to be low risk, low return and amp it into another dicey venture — with taxpayers on the hook.

The outrage will pass, and when it does, we're going to have to focus on whether keeping AIG afloat is preventing a sharp recession from becoming a prolonged one. The reason AIG has cost taxpayers $170 billion — and the reason the Obama Administration seemed willing, at least at first, to hold its nose and accede to bonuses for the company's managers — is that it's too big to fail. It's an often heard phrase, but what does it really mean? (See the top 10 financial collapses of 2008.)

The idea is that in a global economy so tightly linked that problems in the U.S. real estate market can help bring down Icelandic banks and Asian manufacturers, AIG sits at some of the critical switch points. Its failure, so the fear goes, would set off chains of others, rattling around the globe in short order. Although some critics say the fear is overblown and the world economy could absorb the blow, no one seems particularly keen on testing that approach.

How We Got Here
AIG seems an unlikely candidate for the company that could bankrupt the planet. Founded 90 years ago in Shanghai, AIG moved its headquarters to New York City as the world headed toward war in 1939. After Maurice R. (Hank) Greenberg took over in 1967, AIG consolidated its global empire. By the time Greenberg was forced out in an accounting scandal 38 years later, AIG had become one of the world's biggest public companies, with sales of $113 billion in 2006 and 116,000 employees in 130 countries, from France to China.

AIG says it has written more than 81 million life-insurance policies, with a face value of $1.9 trillion. It covers roughly 180,000 small businesses and other corporate entities, which employ approximately 106 million people. That makes AIG America's largest life and health insurer; second largest in property and casualty. Through its aircraft-leasing subsidiary, AIG owns more than 950 airline jets. Just for good measure, AIG is a huge provider of insurance to U.S. municipalities, pension funds and other public and private bodies through guaranteed investment contracts and other products that protect participants in 401(k) plans. "We have no choice but to stabilize [it] or else risk enormous impact, not just in the financial system but on the whole U.S. economy," said Fed Chairman Ben Bernanke.

The risk is not in any one business but in the connections among them and in the industries in which they compete. As AIG has pointed out in its own analysis, "The extent and interconnectedness of AIG's business is far-reaching and encompasses customers across the globe ranging from governmental agencies, corporations and consumers to counterparties. A failure of AIG could create a chain reaction of enormous proportion." Among other effects, it could lead to mass redemptions of insurance policies, which would theoretically destabilize the industry; the withdrawal of $12 billion to $15 billion in U.S. consumer lending in a credit-short universe; and even damage airframe maker Boeing and jet-engine maker GE, since AIG's aircraft-leasing unit buys more jets than anyone else.

While AIG's holdings are diverse, nearly all its losses centered on AIG FP, which until March 2008 was led by its high-rolling president, Joseph Cassano, a tough-talking Brooklyn, N.Y., native who in the past eight years banked $280 million in cash compensation, or exactly $115 million more than the bonuses at the center of the current controversy. Cassano, who helped found the AIG FP unit in 1987, built his money machine not on anything fraudulent but on what's been described as regulatory arbitrage. As Bernanke explained recently, "AIG exploited a huge gap in the regulatory system. There was no oversight of the Financial Products division. This was a hedge fund, basically, that was attached to a large and stable insurance company."

That hedge-fund-like unit built up a portfolio of $2.7 trillion in derivatives. AIG FP eagerly offered to insure billions of dollars in derivative portfolios, building up potential liabilities many times its capacity to pay out if the portfolios defaulted. Few financial experts ever imagined the scope of the impending defaults. Neither did regulators. AIG's uncollateralized insurance combine was regulated by Washington's Office of Thrift Supervision, whose task is to watch over savings-and-loan companies, not global insurers. And it wasn't watching.

AIG, like other institutions, was making a mint dealing in derivatives tied to the U.S. real estate market. The boom was financed in part by collateralized debt obligations (CDOs), securities based on subprime mortgages that have come to define toxic asset. Companies that held CDOs could offset their risk by buying CDSs from AIG FP. Or they could simply speculate with the instrument. It all worked fine until overbuilding by housing firms and overleveraging by consumers caused the bubble to burst. Which in turn caused the value of CDOs to plunge. Which caused holders of CDSs on such securities to demand payment from AIG.

Although a CDS is, in its simplest form, an insurance policy, AIG was selling something far more exotic. Say you buy a house and insure it. The insurer doesn't offer the same policy on your house to everyone else in the neighborhood; if it did and your house went up in flames, the insurer could get wiped out. In its CDS contracts, though, AIG wrote multiple insurance policies covering the same underlying package of increasingly toxic assets. In essence, it was underwriting systemic risk. This is the opposite of what insurance companies are supposed to do: diversify risk across the universe of policyholders. "One thing about the insurance model: it relies on diversification as its means to exist," says a top exec at an AIG competitor. "If an insurance company plays in a field where they underwrite systemic risk, that's a totally different experience." Is it ever. Insurance companies can handle catastrophic risk but not systemic risk. That's why you can buy hurricane insurance from private companies but not terrorism insurance. Only a government can take on that risk. At its most basic, AIG took on colossal risks that it could not afford.

With its high credit rating, AIG FP wasn't required to stockpile reserves, or collateral, as traditional insurers must to cover potential losses. As the CDOs that AIG insured began to crater, the counterparties began asking for more collateral to back their policies, which was written into the contracts. Cassano said in August 2007 that he couldn't imagine a situation in which AIG would "lose one dollar in any of these transactions." He was right. AIG didn't lose a dollar; it lost billions of them.

In a rare interview, former CEO Greenberg, who is suing AIG and being sued by the company over financial-management issues, tells TIME that once the company lost its top credit rating, AIG FP should have stopped writing swaps and hedged, or reinsured, its existing ones. But Cassano's unit doubled down after the spring of 2005, writing more and more subprime-linked swaps as the ratings plunged, which made the possible need for collateral enormous in the event its debt was downgraded. The downgrades occurred in 2008. "Of course they were going to run out of money," says Greenberg. He adds that as the liquidity crunch hit in 2008, AIG FP should have renegotiated terms with the banks to ease their demands on collateral. "You can renegotiate almost anything, anytime."

Last September, with global stock markets collapsing and credit markets frozen, Geithner, then head of the New York Fed, and Bernanke believed AIG was too close to collapse to do anything other than stop the bleeding. Failure by AIG to pay might have threatened its counterparties — for instance, Citigroup and, in turn, Citi's counterparties. A bond or a derivative is, after all, a promise to pay someone, and if there is no confidence in its fulfillment, the financial system ceases to function. It is not a fear that has gone away simply because AIG has been stabilized.

Bailing Out the Bailed Out
Keeping the financial system fluid might explain why so many banks got paid in full, which strikes some as a scandal way bigger than the bonus payouts. Many experts wondered why AIG paid 100 cents on the dollar. Among the biggest beneficiaries of the AIG pass-through, at $12.9 billion, was Goldman Sachs, the investment-banking house that has been the single largest supplier of financial talent to the government. Critics have been quick to note — and not favorably — the almost uncanny influence of former Goldman executives. Initial phases of the rescue were orchestrated by ex–Goldman chairman Hank Paulson, who was recruited as Treasury Secretary in part by former White House chief of staff and Goldman senior exec Josh Bolten. Goldman's current boss, Lloyd Blankfein, was invited to participate in meetings with the Fed. AIG's Liddy is a former Goldman director and an ex-CEO of Allstate. Another alum, Mark Patterson, once a Goldman lobbyist, serves as chief of staff at the Treasury, while Neel Kashkari, who runs TARP, was a Goldman vice president.

Goldman has repeatedly declared that its exposure to AIG was "immaterial" and fully hedged. But some rivals point to the fact that Goldman had uncharacteristically piled into contracts with a single counterparty. "I am shocked that Goldman had this much exposure [with AIG]," says an analyst at a competing bank. "This was a major failing, but they got bailed."

Goldman got bailed twice: first on its CDS exposure and a second time, to the tune of $4.8 billion, for another AIG fiasco, losses on its securities-lending business.

Securities-lending is supposed to be a sort of Christmas club of high finance. Companies like insurers, which own tons of equities and Treasury bonds that they are holding long term, lend them out short term, often overnight, to borrowers who need the shares to fulfill other commitments. For instance, if hedge funds want to sell shares short, they borrow them, putting up cash collateral that includes a small spread to the lender. Typically, the owner of the shares takes that collateral and invests it in something with low risk and of short duration, like commercial paper. The lender is exposed to some risk, but it usually isn't catastrophic. However, AIG took the collateral and invested in longer-term, higher-risk mortgage- and asset-backed securities. "Crap," as a portfolio lending expert describes them. When those securities crashed in value, so did AIG.

Between the CDS and securities-lending fiascoes, AIG still has lots of work to do. Gerry Pasciucco, the new head of AIG FP, is working to whittle down AIG's trading book by $1.1 trillion. Which raises the question, Does he really need those $165 million bonus babies to finish the job? AIG says yes, because they know the trades and the system, but not everyone agrees. "This is an engineering problem," says Rick Bookstaber, a risk expert and the author of A Demon of Our Own Design, which predicted the predicament we're in. "Right now there are probably a million guys out there who can do it."

The Great Clawback
How was AIG able to live so dangerously for so long? In part because for years Washington looked the other way. The company befriended politicians with campaign cash — $9.3 million divided evenly between Democrats and Republicans from 1990 to 2008, the Center for Responsive Politics reported. And it spent more than $70 million to lobby them over the past decade, escaping the kind of regulation that might have prevented the current crisis.

The fact that AIG was in Washington long before the current Administration hasn't spared the Obama team from criticism over the recent bonus payouts. The main target for the opprobrium is Geithner. He still enjoys the confidence of U.S. allies abroad and understands the deeply complicated world of global finance far better than the lawmakers who may soon write new legislation to regulate it. But he has not been a strong public face for a government that needs to project confidence. He has been slow to staff his department, hampering the Administration's ability to react to the crisis — and possibly helping explain Treasury's leaden-footed reaction to the AIG bonuses, which were first reported in January. A former Treasury official blames Geithner for a "strategic hesitation that has really affected the confidence index, not just in the financial marketplace but in the political marketplace." A veteran Washington Democrat was more direct: "He's not a wartime consigliere."

Geithner's backers note that he took over an office that was drowning in crises and has had to address failing banks; impossible-to-price toxic securities; a continuing auto-bailout program; woes at Citigroup, AIG and other financial houses; a housing crisis; and an upcoming G-20 summit all at the same time. Even his detractors admit that the to-do list is the deepest any Treasury boss has faced in 80 years.

Which helps explain why, at least for now, Geithner benefits from a rare bipartisan agreement. Republicans have largely been reluctant to scare away a Treasury chief who has roots in the Bush era and understands their benefactors' core businesses; Democrats are even more reluctant to publicly criticize the President's choice at a moment of economic peril. "I have complete confidence in Tim Geithner and my entire economic team," Barack Obama said. "He is making all the right moves in terms of playing a bad hand." Still, a longtime Treasury observer says, "his margin for error has been reduced."

Geithner's failure to reckon quickly with the existence of large retention bonuses for AIG employees in the Financial Products division is perplexing. On Jan. 27, Bloomberg News reported that AIG has offered "about $450 million in retention pay" to the AIG FP staff, a program that AIG confirmed. Representative Elijah Cummings, a Maryland Democrat, knew about the bonuses two weeks earlier, on Jan. 15, when he met with Liddy, and the Congressman never kept his displeasure secret. Nor was he alone in raising alarms. In January, Richard Shelby, the ranking Republican on the Senate Banking Committee, called the bonuses a "waste of taxpayer money."

But Geithner, who was overseeing the AIG rescue effort with the Federal Reserve, says he had no idea until March 10 that more bonuses were in the pipeline for AIG FP. The President found out two days later, igniting an internal firestorm of White House indignation as officials scrambled to stem the public-relations damage. And now both the White House and Congress are determined to limit the pay packets of executives of any company that is getting TARP money or other government assistance.

There are proposals in Congress to reverse some of the bonuses through legislation, and Liddy called on executives to spit back half their bonus. Some have done so. The program for 2009 has already been pared. That my placate, for now, Main Street constituents who want to get back at those overpaid Wall Street types.

But, considering the risks still infecting the system, the clawback is pointless. Geithner and Bernanke have way more important things on their plate. Did we mention the economy, with unemployment headed toward 10%? And the upcoming G-20 meeting that has the U.S. and Europe at odds over what to do first — regulate the global economy or stimulate it? Nor will the albatross of AIG be removed from the government's neck anytime soon. Liddy said his goal is to restructure AIG's core businesses into "clearly separate, independent" companies that are "worthy of investor confidence." AIG has "made meaningful progress," but the company is still at the mercy of the economy. In the businesses it wants to keep, like commercial insurance, competitors sense an opportunity to grab market share. For the assets it wants to sell, there are few buyers. What remains is still a huge, vulnerable company.

Lastly, the Obama Administration will need perhaps $750 billion in new funding merely to stabilize U.S. banks, which it hopes will be enough to ease the credit markets, stimulate lending and get the economy moving again. There's no telling what kind of political wrangling will happen over that, but one thing seems certain: if you are an executive of a bank that gets federal money, it wouldn't be a smart idea to count on a bonus.

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