The absence of effective regulatory oversight led to inappropriate compensation payments to companies like AIG.
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Recently, Andrew Cuomo, The New York Attorney General, announced that "Of the $165 Million pool, we calculate that employees have agreed to return approximately $50 million." This reflects about 20 percent of the $218 billion that Connecticut's Attorney General has said AIG paid in bonus compensation, but it's an impressive start.
President Obama, in an interview on 60 Minutes, indicated that cooler heads were prevailing. Although he took pains to take AIG and Wall St.'s actions to task, he also suggested that the proposed bill from Congress would use the tax code to penalize a specific subset of people and would be contrary to good public policy. "Well, I think that — as a general proposition, you don't want to be passing laws that are just targeting a handful of individuals. You want to pass laws that have some broad applicability. And as a general proposition, I think you certainly don't want to use the tax code to punish people." He later went on to say, "Main Street has to understand, unless we get these banks moving again, then we can't get this economy to recover. And we don't want to cut off our nose to spite our face." (See pictures of Barack Obama's family tree.)
But, for all the press coverage, the AIG compensation matter is a sideshow because the economy remains in a nosedive. The current financial difficulties makes retroactively changing agreements between the government and private companies a risk as the Administration tries to enlist private enterprise to help consumer lending by reinvigorating the securitization market.
Judging by current unemployment figures and mortgage delinquency rates the economy is getting worse as each month passes. According to TransUnion, a leading consumer credit reporting agency, mortgage loan delinquency, traditionally seen as a precursor to foreclosures, increased for the eighth quarter in a row. This statistic is up approximately 53% from the same period last year. Likely contributing to that rise, unemployment rose in February from 7.6 to 8.1%. And a new Reuters poll of economists forecasts that unemployment will top 10% as early as next year.
Worse still is the availability of credit in the economy in general. According to the New York Times, "By one estimate, as much as $1.9 trillion of lending capacity — the rough equivalent of half of all the money borrowed by businesses and consumers in 2007, before the recession struck — has been sucked out of the system." Based on these figures the government's programs have yet to reach the American public.
Banks & Toxic Assets
Before 1970, banks were content to make loans to consumers and business which remained on their books, collecting interest until the principal on the loan was satisfied. This approach made for a relatively illiquid market for the buying and selling of loans. Accordingly, this system insured that lenders were unable to sell their loan portfolios easily. Market illiquidity exposed the lender to the risk that individual loans would default or that rising interest rates would force the lender's interest cost higher than its income on the individual loan.
Asset backed securities ("ABS") gave banks the opportunity to bundle loans into a pool that could then be sold to other banks. The bank purchasing the loans would then hold them as an investment or resell them in the secondary market. This market improved the ability of banks to lend by transferring the risk of the loan default to a third party while providing financing to the bank to make new loans. In time, the public grew accustomed to the increased availability of credit. (See pictures of the printing of money.)
The purpose of Emergency Economic Stabilization Act, known as the bailout plan, was to restore stability and liquidity to the U.S. financial system. The TARP, one of the Act's driving initiatives, was intended to be a mechanism for financial institutions to offload toxic assets, in general, heavily leveraged ABS securitized by banks and held on their books. An ABS is considered a toxic asset when the value of the ABS is less than the original investment. The toxic asset has a negative impact on the bank's balance sheet which, when multiplied, reduces the banks ability to lend.
As an example, many Mortgage Backed Securities ("MBS"), a species of ABS, became toxic following the collapse of the housing market. Like all ABS, MBS derive their value from underlying loans, in this case, mortgages. A large group of mortgages provides the payment stream to the holders of ABS in the form of individual interest and principal payments made by a borrower to the bank.
As a result of declining home prices, if a borrower defaults on their mortgage, market prices for the home would be less than the balance on the mortgage. However, since MBS derive their value from a pool of loans — typically thousands of individual mortgages — the default of some portion of the mortgages would not mean the security had no value, only a reduced value. Unfortunately, banks, in an effort to increase their investment returns, exacerbated the problem by using enormous leverage to purchase and securitize mortgage loans. Thus, even if MBS's value declined because of defaults, because of the use of leverage, the security could still be toxic to the bank.
Finally, the seemingly unprecedented drop in prices together with increased default rates made it nearly impossible to assign value to MBS. As a consequence, MBS that had some intrinsic value were illiquid, and banks were forced to keep the toxic assets on their balance sheets.