The FreePasser Issues Still Remain!

However, despite the public claims of success, serious economic problems underlying the current global financial crisis still remain. These issues were largely avoided when it became evident that an agreement on them was not forthcoming. Our financial problems have developed as a result of globalization of the financial system, and any solution will require true global cooperation.

There is serious disagreement between governments regarding the use of fiscal stimulus. The United States and Great Britain favor it but much of Europe, particularly Germany, is against it. Unless the United States erects protectionist barriers, much of this stimulus which is funded by deficit spending may leak outside the country. Other countries will receive the benefits at the American taxpayer’s expense. And since there will be no increased stimulus by these countries, we will receive no corresponding benefit. In essence, these countries will become true FreePassers.

There are similar problems with bank bailouts, as we saw with American International Group (AIG). Several foreign banks with Credit Default Swaps with AIG were only able to be paid because of cash injections by the U.S. government.

The Threat of Protectionism Unless the FreePasser Issue Is Addressed

The entire world must be on the same page for any potential solution to alleviate the current crisis. Otherwise the more conservative countries, such as Germany, will continue to benefit from the actions of the more aggressive countries, such as the United States. This is an unfair and unstable situation. Protectionist sentiments can develop in the United States as a result with potentially disastrous consequences.

We saw this with the Smoot Hawley Tariff Act under the Hoover administration, which caused huge problems for the American economy. In addition, it was an indirect cause of the trade dispute between Japan and the United States that led to World War II.

Back to the Future

When it comes to Wall Street pay standards, it might be called “Back to the Future.” These pay arrangements sound extremely similar to the culture that prevailed at the investment bank before it went public:

• Compensation should be salary plus deferred compensation.
• For senior employees, most should be deferred compensation.
•  Performance evaluation should be over an extended period of time to avoid excessive risk-taking, at least three years.
•  Senior executives should be required to hold most of their stock until retirement.

It almost seems as if he was taking advice from my blog.

Feels the Anger

Mr. Blankfein understands the anger that is bubbling to the surface from the general public. He saw this when demonstrators from Operation Pink penetrated security to protest his appearance and government bailouts of the banks.

If this anger continues, he could very well find that the government is his permanent partner in the banking business.

Self-Regulation is the Best Alternative

I have often said that corporations should lead the charge for accountability and self-regulation. If not, they will lose control to a regulator who may be representing a very angry constituency.
 
Mr. Blankfein understands this quite clearly. Goldman Sachs was very profitable as a private partnership, and no one accused Goldman partners of being underpaid.

By leading the charge to create new regulations, he is addressing public concerns and creating an environment in which Goldman can prosper big time.

Now that Goldman is a bank subject to regulation, he has every incentive to make sure that the shadow banking system is subject to similar regulation. It levels the playing field and restricts potential competitors.

Let the Banks Pick up the Tab First!

However, there is one issue that Mr. Blankfein overlooked - Who pays for the cost of things like the AIG bailout? Goldman benefited from this tremendously because it was a counterparty for AIG’s Credit Default Swaps (CDS).

It seems only appropriate if there are costs that the government bears, that Goldman and other banks pick up the tab instead of the taxpayer. Sheila Baird has already started this process by raising FDIC fees.

The Example of the Resolution Trust Corporation (RTC)

Many use the Resolution Trust Corporation as an example and reference that, according to some estimates, the assets seized by the RTC were actually sold at a minimal profit. This may be true.

However, one must remember that the Savings & Loans that were the source of these assets first entered receivership. In addition, the banking system bore some of these costs in the form of higher FDIC insurance premiums.

A Short History of FHA Loans

The government has supported loans before. When I was in college, homeowners sought VA and FHA loans. VA loans were sponsored by the Veterans Administration as a way to compensate veterans for national service in the military. FHA loans were sponsored by the Federal Housing Administration and were designed for starter home buyers, but there were strict guidelines and the cost of the government insurance was paid by the homeowner. The guarantee was not free in either case.

What about Fannie Mae and Freddie Mac?

Fannie Mae and Freddie Mac were initially conceived as organizations designed to facilitate the origination of home mortgages. They would purchase the loans and then re-sell them. There was an implicit guarantee by the U.S. government on debt issued by these companies. However, this was considered to be almost like a working capital loan with minimal risk to the taxpayer. Sound familiar?

This changed as the Government Sponsored Entities (GSEs) held more mortgages and issued more debt. This implicit government guarantee became quite substantial. No one seemed concerned until the government guarantee became explicit and quite costly with the need for the government to assume the liabilities and inject capital.

Free Government Guarantees Create FreePassers!

Government guarantees may start out free, but they turn out to be quite costly. Why is this true? The FreePasser mentality! It is human nature to try to get what we can for free.

However, as Ihave mentioned, people assume more risk when the cost is borne by others. A free government guarantee changes behavior.

Recognize the True Cost of a Government Guarantee in Advance

For those who say that government guarantees in these bailouts have minimal if any cost, remember that we may be merely be postponing the bill into the future when it is substantially larger. It is much better to recognize what the true cost is in advance. Only then can we determine if it is worth the expense.

Nothing is free! The U.S. taxpayer eventually ends up paying the tab.

How do you handle such a situation? The current solution seems to be to enact a special tax to recover the bonuses. However, this presents a problem for several reasons:

• Such a tax may be unconstitutional as the law prohibits targeting specific people.
• The nature of the tax concerns the business community, which is rightly concerned that similar statutes (if this one is deemed legal) could be enacted to confiscate wealth on an arbitrary basis.
• This tax does very little to establish a workable framework to address similar FreePasser problems.

Thus, this may solve one problem but creates even more in the process. What can we do to resolve the situation?

Recognize the Insolvency First

I believe that the answer lies in existing bankruptcy law. When a company declares bankruptcy, there are opportunities to go back in the past to reclaim assets that have been unlawfully conveyed. This provision was created to prevent looting of the company.

Bankruptcy Provides a Framework

We are currently seeing this in the Madoff case, and in similar situations in the past. Investors as well as employees may be forced to return money that was paid to them previously. No one is arguing this concept, although they disagree about the legal ability to collect the funds.

Although the AIG bonus problem and similar situations are slightly different, this framework could be modified to deal with these issues. However, it does require us to deal with AIG’s underlying insolvency. Like a 12-Step program, we must first admit that the problem exists. Although the current bankruptcy framework may cause too much market disruption, we must admit that the government’s intervention represent a new form of receivership, not just a temporary liquidity injection.

Admit Insolvency Before Providing Cash

Recognizing this insolvency is the first step toward solving the problem. By doing so, we have a framework which gives us an established structure to deal with it on a more logical and valid legal basis.

The Sucker at the Poker Table

Have you ever heard the old story about not being able to figure out who the sucker is at the poker table because it turns out to be you?  In the case of AIG, I think that we now know who the sucker is at this poker table - the U.S. taxpayer. This is somewhat like putting up a reward for information leading to the recovery of money in a bank robbery, then paying the bounty to the bank robbers who then claim immunity from prosecution. The AIG bailout is no less absurd.

No Pitchforks and Torches-Yet!

Treasury Secretary Geithner and President Obama are looking for a way to rescind the bonuses. If they do not, the public anger building on both sides of the political divide will intensify. No one likes to be viewed as a sucker, especially the average American who is suffering the consequences of the gross mismanagement of these major financial institutions.

This righteous anger is building like a smoldering volcano ready to erupt. In the past, there was at least a question as to how responsible those receiving bonuses were for the disaster. In this case, the very people who bankrupted the company are receiving the rewards. These people are poster boys for my campaign against FreePassers.

Stealing It Fair and Square is Not an Option

If the public believes FreePassers can get away stealing taxpayer dollars, their distrust will spread to the government as well. Eventually, people will reach a boiling point and will tolerate no more. Allowing derivative traders to receive huge payouts while asking workers to reduce retirement benefits will be viewed as ridiculous.

Earthquake in Slow Motion

Eventually, this anger at FreePassers will find a way to express itself, and it won’t be pretty. Support for any future bailout plans may be very limited and could prevent necessary measures and reforms to deal with the financial crisis in the coming years. 

These bonuses need to be rescinded. Even if there are legal problems as a result, the alternative in terms of public unrest would be far worse.

It is amazing how people respond to incentives. My son often ignores my warnings or instructions but, when I threaten to take away his television privileges, his hearing improves immediately.

We All Are in the Same Boat

Many,  including the President, are saying that we are all in the same boat, and that the economy will crater if we do not assist our countrymen in need. There is truth to this but, if we take the analogy further, there have been severe penalties for individuals who endanger the operation of a ship. This included flogging and hanging in times past. No FreePassers in those days.

There Must Be Blood, But Only for Those Responsible 

There must be substantial penalties for those who are responsible for this mess. However, it sends the wrong message to send the bill to taxpayers, rich or poor, who were not in any way responsible. This is like kicking the dog out of frustration when you get home after a bad day at work. Eventually, Rover, like the taxpayer, is going to get very angry.

Require Insurance if Bailouts are Necessary

If we buy the argument that some institutions are too big to fail and have to be rescued to avoid a meltdown, we should accept it and require them to pay for that government insurance in advance. We already do this with the F.D.I.C. Why this can’t be extended to other financial activities as well? In fact, recent news has made it clear that the F.D.I.C may need to go back to the banks for additonal funding due to the extent of the current crisis. So, even in the midst of a true banking crisis, the responsibility to insure the depositor falls on the very institutions that have led us down this path.

The Model of Auto Insurance

Auto insurance is required in most states if you own a car. This ensures that there is money to pay the bill if someone causes an auto accident . If the person does not have insurance, then criminal penalties are levied against them. In addition, this discourages irresponsible behavior since. if you drive recklessly, you will see your insurance rates skyrocket. If goverment handles this in the right way, being a FreePasser can be very expensive.

Anger at Rewards for FreePassers

This appears to penalize those who “played by the rules” and reward FreePasser borrowers for irresponsible behavior, and most Americans are furious. According to a recent Rasmussen poll, 55% share this point of view. We also saw the controversy generated by CNBC’s Rick Santelli’s tirade on the subject on the floor of the Chicago Board of Trade.

The Plan Cannot Create an Obama Put

Although many may understand the need for the bailout, they are upset that good borrowers who may be suffering in this economy are also not receiving assistance. It can create a FreePasser mentality that makes people feel that they need not behave responsibly because of a future government bailout.

This sends the wrong message to future home purchasers who may borrow to buy a home. It can cushion the current foreclosure crisis but create a whole new generation of FreePassers with additional, even larger costs to the taxpayer in the future.

In the same way that I said earlier that the Fed (or Greenspan) Put encouraged irresponsible behavior by the finance industry, this plan cannot create an Obama Put for bad borrowers.

There Must Be Pain for Irresponsible Borrowers

The introduction of some type of penalty for those borrowers accepting government assistance might alleviate the anger associated with the situation and reduce the FreePasser danger associated with such actions.

Since the borrower’s economic situation could not withstand any additional cost today, this could take the form of a future fee or tax, and could be taken from the proceeds when the house is eventually sold in a similar way to which points are sometimes assessed when a mortgage is originally issued. It could also be structured as an additional tax upon future income for a period of years. 

If such penalties were added, the mortgage plan might no longer be seen as rewarding bad behavior of irresponsible borrowers but could still try to address the current foreclosure crisis.

Bringing up this question is sometimes criticized as being unpatriotic. Understand that I am not debating the need for these programs but, if we do not address how we are going to pay the bill, we are merely postponing our problems and not solving them. If it is decided that the answer is for the U.S. to issue more debt, we must realize that eventually the rest of the world may not want to buy any more. Addressing long-term consequences in the short-term helps avoid the FreePasser mentality that got into this mess in the first place.

Those Who Receive the Benefits Must Bear the Cost

If we are to cure the FreePasser problem afflicting our society, we must try to have the costs borne by those who receive the benefits from the programs. This cost may not necessarily be paid now but should be on their tab in the future. If we do not do this, we are simply creating another generation of FreePassers. We cannot simply pass on the cost to others who had nothing to do with creating the problems.

A Good Example: The Federal Deposit Insurance Corporation (FDIC)

The Federal Deposit Insurance Corporation, which is backed by the U.S. government, provides insurance for people who deposit their money in a bank. We have decided that this is beneficial from a societal point of view as it prevents the bank runs that were so common prior to its creation. This allows for our financial system to function more smoothly.

However, this insurance comes with a fee borne by the banks, and demands an additional layer of regulation. The system is not perfect, but it does attempt to pass on the costs of government assistance to those who make the mistakes.

The Fed (or Greenspan) Put

The idea behind The Fed Put, previously know as the Greenspan Put, was that the Fed could rescue us from a financial crisis by injecting liquidity into the economy. This was incredibly effective during the former Chairman’s tenure. However, there was no cost associated with this and, therefore, people increased the level of risk involved their financial transactions knowing that the Fed would be there to rescue them. One result of this FreePasser practice is our current financial crisis.

The Government May Cushion the Pain But Not Eliminate It

We can debate the desirability of government involvement in these situations. However, if we do decide that the government should be involved, as we did with the F.D.I.C., we must be sure that there are real costs and responsibilities to those asking for assistance.

If we do not do this, we are perpetuating the FreePasser mentality in a different form. Eventually, someone has to pick up the tab. The government can cushion the pain by spreading it over time but should be careful not to make the process too easy.

History has shown that there are limits to the degree of privatization that society will accept, so we need to address the urgency of introducing accountability into government. Fortunately, there are examples of such implementation, and the Police Department of New York City is an excellent demonstration of intolerance of the FreePasser mentality.

NYPD in the 1970’s and 1980’s: Bureaucracy in Action

Crime in New York during the 1970’s and 1980’s was rampant. People were discouraged and the malaise hanging over the city was accepted as a normal part of life. Subways were unsafe to travel at night and “muggings” were a part of every nightly newscast. We saw anger at this situation arising in period movies such as “Death Wish.”

When anyone tried to deal with the situation, their efforts disappeared into the huge city bureaucracy - classic FreePassers.

A New Approach to Crime: The Bratton Era

In 1994, Mayor Rudy Giuliani appointed William Bratton as Commissioner of the NYPD. With an iron hand, Bratton brought a new approach to the NYPD:

• The CompuStat system of tracking crimes was introduced and allowed police resources to be directed quickly to high crime areas.
• Better educated police officers were recruited.
• By decentralizing the bureaucracy, decisions were made at the precinct level, and local leaders were rewarded and penalized accordingly.
• Petty crimes which had previously been ignored now became a focus. The backlog of unserved warrants was cleared.

The Impossible Happens: A Dramatic Reduction in Crime in New York

These initiatives, among others, resulted in a dramatic reduction in crime in New York City during the 1990’s. This continued even after Commissioner Bratton left, and Michael Bloomberg became Mayor. The system proved to be able to outlast its developers.

Similar Results in Other Locations

Some people claim that this was a situation specific to New York. However, Commissioner Bratton subsequently became Police Chief of Los Angeles and effected decreases in crime using the same system of accountability. He also achieved similar results in other locations as a principal with Kroll Associates, a private security consulting firm.

The underlying principle in the Bratton strategy was accountability - results mattered and those in charge bore direct responsibility for their successes and failures.  Under-performing members of the command structure were replaced, resources were directed to where they were needed most, and the status quo was unacceptable. The “Civil Service” mentality that fostered doing the least in the short term to ensure a comfortable pension was scrapped in favor of a demand for performance.  The demise of the FreePasser in the NYPD offers hope to those of us who are urging similar changes in government institutions large and small.