The AIG Bonuses, Part 10:
Compensation limits may apply to PPIP investors
21 Apr 2009 in Regulatory Economics, Regulatory Policy
In the seventh in our series of posts on the AIG bonuses and the incentive effects of efforts by the Obama Administration and Congress to forcibly recover them, we predicted that investors in the Treasury Department's "Legacy Loans Program" would be regulated by the same constraints on employee compensation and, ultimately, profits. We said that H.R. 1586, the House-passed bill to impose confiscatory taxes on bonus recipients, would have unintended consequences on the Treasury Department's Public-Private Investment Program (PPIP):
In short, the House's action, which President Obama did not contemporaneously discourage, creates the precedent that the government may choose not to honor the legal commitments it makes to investors who participate in the Treasury Department's new program. If investors earn "too much" in profit -- a term that would be defined subjectively after the fact -- they may be prevented from realizing these earnings. It is reasonable for prudent investors to discount the government's credibility.
The Obama Administration could have included strong language promising to protect these property rights in [the Treasury Department's Public-Private Investment Program], but it did not do so. Such a promise might prove to be unenforceable in fact, but the absence of a promise means there is nothing yet for investors to rely upon. This uncertainty may (or may not) be resolved when the Treasury Department issues implementing regulations. For now, the cleanup of underwater financial assets has entered a zone in which political risk -- uncertainty about the government's reliability -- may be as great or greater than financial risk.
A story in today's Washington Post says that this has come to pass.
Post staff writer Amit R. Paley reports:
Treasury Department lawyers have determined that firms participating in a $1 trillion program to relieve banks of toxic assets could be subject to limits on executive compensation, contradicting the Obama administration's previous public position, according to a report to be released today by a federal watchdog agency.
...
Speaking last month about the initiative to buy toxic assets, Treasury Secretary Timothy F. Geithner said, "The comp conditions will not apply to the asset managers and investors in the program."
But Treasury lawyers have told the special inspector general for the federal bailout that executives involved with that initiative and another $1 trillion consumer lending program "could be subject to the executive compensation restrictions," according to the report from Special Inspector General Neil M. Barofsky.
The Treasury's general counsel's office said in an April memo attached to the report that pay for employees of the Federal Reserve Bank of New York could also be limited because of their role in running the consumer lending program.
The 247-page report by the special inspector general criticizes the Treasury Department for failing to adequately oversee the bailout program, which now includes 12 programs that could involve nearly $3 trillion in public and private funds.
The report is on the website of the Special Inspector General for TARP ("SIGTARP") in pdf. The report briefly summarizes the Treasury Department's stated intentions regarding the extension of executive compensation limits on private investors in Treasury's public-private investment program (PPIP) (p. 110, footnotes omitted):
Executive Compensation
Treasury has not indicated to what extent the EESA executive compensation restrictions will apply to the participants in the legacy loan, legacy security, or
expanded TALF programs. According to Treasury, “the applicability of the executive compensation regulations, which have not yet been published, will be fact dependent. Until Fund Managers make proposals under the TALF program, it is not known whether they will seek to be co-owners of the PPIFs. If they do, they would not be passive investors and could be subject to the executive compensation restrictions."
Treasury believes that it has the statutory discretion not to impose these requirements on PPIP investors. However, Barofsky recommends that it do so (p. 138):
SIGTARP continues to recommend that Treasury require all TARP recipients to report on the actual use of TARP funds in the manner previously suggested. This recommendation is particularly important with respect to the potential expansion of the Capital Purchase Program (“CPP”) to include large insurance companies. The American people have a right to know how their tax dollars are being used, particularly as billions of dollars are going to institutions for which banking is certainly not part of the institution’s core business and may be little more than a way to gain access to the low-cost capital provided under TARP. Similarly, in light of the controversy surrounding AIG’s use of Government assistance, both through the paying of bonuses and in its dealings with counterparties, failure to impose this requirement with respect to the injection of yet another $30 billion into AIG would not only be a failure of oversight, but could call into further question the credibility of the Government’s efforts with respect to the assistance provided to AIG. This recommendation applies not only to capital investment and lending programs involving banks and other financial institutions, but also to programs in which TARP funds are used to purchase troubled assets, including details of each transaction in the Public-Private Investment Program (“PPIP”) as well as all transactions concerning the surrender of collateral (including the identity of the surrendering borrowers) in the Term Asset-Backed Securities Loan Facility (“TALF”) (emphasis added).
Later in the report, Barofsky addresses the PPIP explicitly, noting the potential for illegal conduct:
Many aspects of PPIP could make it inherently vulnerable to fraud, waste, and abuse. First, PPIP deals with assets that have recently been illiquid, making valuation difficult, therefore raising the danger that the Government will overpay for the assets. Second, many of the participants in these markets, such as hedge funds, are substantially unregulated and the internal oversight and compliance capability
at those institutions vary widely. Next, the interrelationships between the market participants can be extremely complex and difficult to anticipate: the same entity might buy and sell toxic assets for its own benefit and manage portfolios of toxic assets for others, all while holding or managing equity or debt securities of the banks and other institutions that have large positions in the same toxic assets.
Finally, the sheer size of the program — up to a trillion dollars for the PPIFs and up to another trillion dollars for the expansion of TALF — is so large and the leverage being provided to the private equity participants so benefi cial, that the taxpayer risk is many times that of the private parties, thereby potentially skewing the economic
incentives.
Illegal conduct almost certainly would be positively correlated with high profits, but that does not imply that high profits mean illegal conduct occurred. As Barofsky notes several times in the report, for example, private capital is very highly leveraged in the PPIP. Nonetheless, PPIP investors who earn high profits should not be surprised if their conduct is assumed to have been illegal.
Moreover, decisions concerning what profits are unreasonable will be made subjectively after the fact by political actors. Even if they escape criminal or civil prosecution, PPIP investors should expect profits to be confiscated if they are judged to be "too large."
