Saturday, May 9, 2009

The Ultimate Risk of Goverment Influence Over the Private Sector (Part 1)

(Note: This is the first part of a three part piece on this subject. I hope to post the second and third parts sometime this week)

Recently, I have been incredibly disturbed by the seemingly capricious and disruptive government meddling in the private sector. From AIG to Chrysler/GM to Bank of America, the Obama administration and the Fed have consistently been willing to overlook or conveniently downplay the importance of the rule of law and the sanctity of the contract in the name of saving the US from the current crisis. Over our history, what has made the US different from other developing countries and emerging markets is the belief that the US legal system (through due process) has the capacity to protect stakeholders from fraud, theft, manipulation, corruption and disruptive government intervention. As a result of this trust in our system, the dollar (at least to this point) has remained the world's reserve currency and US Treasuries have become the universal safe haven for investors all over the world. Most importantly, foreign investors have been willing to accept returns on capital that do not include a substantial extra risk premium due to political risk.

In his fantastic piece in The Atlantic (, Simon Johnson compares the current US political and financial system to those of an emerging market based on the ascendance of a financial oligarchy that has taken control of the entire US system. In Johnson's mind, the corruption and crony capitalism that have resulted from this "Quiet Coup" has made the US look more like a banana republic than the world's most robust capitalist nation. Now, I want to take this analysis a step further and discuss the lasting implications if Johnson is in fact correct. My thesis is that, at least in the short run, as the powers that be appear to be willing to do anything to avert deflation, further stock and bond market collapses, and runs on financial institutions. Accordingly, the US as a destination for capital, is on the verge of deserving a legitimate risk premium in order for both foreign and domestic investors to be compensated for the risks they are taking with their capital. I am going to use three separate egregious incidents from the past year to illustrate my point and back up my thesis: the AIG bonus scandal, the Fed/Treasury handling of the Bank of America-Merrill Lynch deal, and the recent arm twisting of investment managers and banks in the Chrysler bankruptcy.

Let's start off with the recent outrage over the AIG retention bonuses. The scandal that erupted upon the announcement of the intention of AIG to pay out retention bonus to current employees in the financial products (FP) division is an example of dangerous populist outrage that is characteristic of a society and legislative body searching for scapegoats. Despite the fact that most of the people who had written the crippling Credit Default Swap (CDS) contracts at AIGFP were no longer even with the company, the retention bonuses that were promised to the people who had been brought on or promised to stay in order to unwind these toxic and unwieldy contracts caused a national uproar.

Look, no one likes the idea of paying any employee of AIG (a company that had to be bailed out by taxpayers) a single dollar of bonus money. But the truth is that we need these people to help unwind these CDS and from all indications they have recently been doing a fairly good job of reducing AIG's (and taxpayer's) exposure to these ill-conceived derivatives. The LAST thing we want is for these people to be incentivized not to care about the resolution of the CDS because it will only lead to more taxpayer losses. There have already been numerous whispers on the Street that the huge trading gains racked up by some of AIG's counterparties such as Goldman Sachs in Q1 2009 were the result of AIG traders selling at depressed prices and allowing themselves to have their faces ripped off just to get out of these trades. If true, this has obviously led to taxpayer losses that probably could have been avoided with the correct supervision. Do we really want to encourage more of this behavior by taking away all of the financial incentive to protect our investment? I sure don't think so.

In addition to the legitimate business reasons for honoring the AIG bonus contracts, I think the more pressing issue has to do with the sanctity of the contract. The fact that the president, the Treasury and many members of Congress were initially willing to ignore the presence of the signed contracts that provided for these bonuses is a very dangerous precedent. If workers, investors, and managers start to worry that the US government is ready, willing and able to skirt the rule of law to quench populist thirst, it will inevitably make all stakeholders wary of investing in this country. I would also argue that this concern could stifle innovation and prudent risk taking as people become skittish about being involved with any asset class other than cash. At a time when the stock markets and the world economies need the capital currently sitting on the sidelines to move toward riskier asset classes (in order to get credit markets flowing normally), the fear over potential government actions may only prolong the crisis and could serve to undermine the credibility of the US as a safe destination for capital.

(Stay tuned for part 2 on the BAC-Merrill deal and part 3 on the Chrysler bankruptcy and the inevitable conclusions based on these events)