Candidates for Scrutiny Under Barney Frank's Corporate 'Death Panel'

At Thursday's House Financial Services Committee hearing on systemic regulation, Chairman Barney Frank, Democrat of Massachusetts, argued that it is time to stop using taxpayer funds to save firms that pose a systemic risk to the U.S. economy. Frank knows exactly how he wants to put this practice to an end:

"There will be 'death panels' set up by Congress to put these institutions out of business," he said.
Frank has not yet provided details about how the "death panel" would make its decisions, nor can we even say if such a panel will in fact be created. But, a discussion draft the committee released on Tuesday proposed creating a Financial Services Oversight Council that will evaluate companies posing a risk to the U.S. economy.

The council would have nine voting members. Based on their current positions, the membership would include Treasury Secretary Timothy Geithner, Chairman of the Federal Reserve Board Benjamin Bernanke, Comptroller of the Currency John Dugan and six others. The panel also would have two non-voting members from the state banking and insurance regulatory bodies.

The council's broad responsibilities would include the authority "to advise the Congress on financial regulation and make recommendations that will enhance the integrity, efficiency, orderliness, competitiveness, and stability of the United States financial markets; and to monitor the financial services marketplace to identify potential threats to the stability of the United States financial system."

The discussion draft also says that the identity of the companies would remain secret. Despite that intent, it might not be difficult to determine which companies would fall under federal scrutiny.

For reasons explained below, the council might consider the following entities as candidates.

First, to identify potential threats to the stability of the financial system, the council should take a look at the most recent quarterly report from Dugan's Office of the Comptroller of the Currency (OCC). U.S. commercial banks now hold more than $200 trillion in derivatives, or nearly double the level at the end of 2005. Just five commercial banks account for 97 percent of that amount in notional derivatives and 88 percent of net credit exposure.

While the OCC data do not cover the entire derivatives market, when just five banks control such a large percentage of a market, we should be concerned. In order of their credit exposure to risk-based capital, these five are Goldman Sachs, J.P. Morgan Chase, Citibank, Bank of America and Wells Fargo Bank.

The potential systemic risk to the global economy these institutions create is obvious. They have more than $8 trillion combined assets, with J.P. Morgan Chase leading the pack with $2.2 trillion and Goldman Sachs bringing up the rear with its $880 billion. A failure of any of these banks would dwarf the impact of the Lehman Brothers failure, which had assets of $600 billion when it filed for bankruptcy.

Some might consider the insurance giant AIG to be a candidate for panel scrutiny, and based on media coverage of the company over the past year, this belief would seem justified. Yet, as most people might not realize, nearly all of AIG's troubles stemmed from a small band of traders located in AIG's London-based Financial Products unit, known as AIG-FP. It would be detrimental to punish AIG's generally successful insurance business (though some elements of the insurance business also invested in toxic mortgage-backed securities) for the misdeeds of its "London casino," as then-Sen. Paul Sarbanes termed the operation during hearings last October before the House Oversight Committee.

As is widely known, AIG-FP had a monumental exposure in the credit default swaps (CDS) market, with more than $500 billion in CDS outstanding at the end of 2007. Defaults in this market ultimately caused the near-collapse of what was then the world's largest insurance company. But keep in mind that most of the $180 billion AIG received from the federal government largely went to cover the mistakes made by about 400 of AIG's 160,000 employees.

As AIG's then-chairman, Edward G. Liddy, noted in his March testimony before the House Financial Services subcommittee, AIG's Financial Products unit had more than $1.6 trillion in notional derivative exposure with 1,500 major corporations. Liddy, who had become CEO of the company in September 2008, acknowledged that AIG was "too complex, too unwieldy and too opaque for its component businesses to be managed as one company."

AIG-FP perhaps epitomizes the greed that ruled in this sector. As AIG highlighted in its 2007 annual report, "the most significant component of . . . operating expenses [in the FP unit] is compensation." From 2003 through 2007, that unit paid $2.56 billion total compensation to its employees. AIG-FP's leader, Joseph Cassano, received more than $240 million during his eight years leading the unit. After AIG-FP reported losses of around $20 billion, Cassano left the company in March 2008 with a $34 million bonus, a $1 million-a-month consulting package and use of company housing.

There's one other fact about AIG that is important to recognize. The Office of Thrift Supervision (OTS) was responsible for regulating AIG-FP, but it failed to recognize the problems associated with the derivatives. Moreover, additional regulation in the United States would not have prevented the unit from entering into this business, as other regulators also fell down on the job. Although European regulators had granted the OTS the authority to supervise its European operations, the United Kingdom's Financial Services Authority could have regulated the London office of the Financial Products unit, but didn't. The U.K.'s Serious Fraud Office is now investigating potential irregularities in that office.

Given its reckless behavior, it is time to put AIG-FP out of its misery and to allow AIG to return to its roots as an insurance company that in 2008 insured the property of 94 percent of the Fortune 500 companies and 77 percent of the Financial Times 500 companies; it had more than 30 million policyholders in the U.S. and 74 million policyholders worldwide.

Next on the list are the financial units of General Motors and Chrysler. Putting these two entities under surveillance would meet the requirement that the council "facilitate information sharing and coordination . . . regarding financial services policy development." General Motor's financial arm, GMAC, which converted into a bank so that it would be eligible to receive federal bailout funds, is about to receive a third bailout from the U.S. government. This money would raise the government's stake in the company to about 35 percent and bring its total government funding to more than $12 billion. As with AIG, GMAC's biggest problem lies in its mortgage unit, which was responsible for $1.8 billion of GMAC's $3.9 billion losses in the second quarter this year.

Chrysler Financial received a $1.5 billion loan from the federal government that it repaid in July. Although Chrysler Financial has plans to exit the business in two years, its demise is not certain and, by examining its books, the panel could learn why the exit strategy has been considered. Chrysler Financial, which is owned by the private equity firm Cerberus Capital, is reportedly winding down its operations and transferring its business to GMAC. Cerberus Capital has stakes in both GMAC and Chrysler.

Finally, the creation of the council provides a perfect opportunity to dismantle Fannie Mae and Freddie Mac. Doing so would meet the first objective of the council, which is to make "recommendations that will enhance the integrity . . . of the United States financial markets." Investors believed that these government-sponsored entities had the implicit backing of the federal government. Although that was not the case, when the federal government placed Fannie and Freddie in conservatorship in September 2008, the implicit guarantee became explicit. Both entities were regulated by Office of Federal Housing Enterprise Oversight (OFHEO), but this regulation was not sufficient to prevent them from providing low-quality subprime mortgages.

Fannie and Freddie have lost a combined $165 billion since July 2007. The federal government has already given them $96 billion to help shore up their loans. Unfortunately, home foreclosures are still rising, meaning that the agencies are likely to continue to drain funds from taxpayers.

If the federal government is considering putting any agencies out of taxpayers' misery, as Barney Frank suggested, Fannie Mae and Freddie Mac should be on top of the list.