Larry Summers on ABC's This Week

As we have noted before, hedge funds, private equity firms, and their employees donated nearly twice as much to the Obama campaign as they did to the McCain campaign.  After the election, the new administration appointed some of its backers and friends on Wall Street to oversee TARP bailout money.  Few have given much scrutiny to this obvious conflict of interest until now.

On Friday the White House released the financial records of some of the administration’s top advisers.  As it turns out, President Obama’s chief economics adviser, Larry Summers, “earned” $5.2 million advising a New York hedge fund one day a week for the past two years.  Though the President desperately yelped to express his “outrage” at excessive AIG bonuses, he has remained conspicuously mum on the Mr. Summers’s lavish executive pay for such little work in an industry he now oversees.

Some have wondered why the administration has been so harsh on Detroit, threatening bankruptcy and executive firings, while only gently nudging Wall Street banks.  The fact that the administration has drawn so many warm suits and generous contributions from Wall Street suggests Mr. Obama holds his friends in finance to a milder standard.

When the Bush Administration let oil companies draft energy policy and let pharmaceutical lobbyists draft the Medicare drug benefit, Democrats cried foul, and rightly so.

Now Mr. Obama surrounds himself with smart bankers and economists who frequently spin around the revolving door between government and the finance sector, having made a fortune on risky bets and now seeing that the taxpayers are left to clean up the mess.

Public anger over the bonuses paid by AIG was well-deserved, but the resulting tax action by the House was unwise.

The House voted 328 to 93 on Thursday to confiscate via the tax code 90% of retention bonuses paid by recipients of TARP funds.  Though it is a moral hazard to reward bonuses for huge losses, the White House has even admitted that nothing in the TARP rules prohibits recipients from writing out such hefty retention checks in the first place.

Rep. Charles Rangel, the chairman of the House Ways and Means Committee, the committee that writes the tax code, was at first possessed by a rare fit of good judgment in cautioning his colleagues against using “the [tax] code as a political weapon.”  However, as public outrage mounted, Mr. Rangel himself sensed which way public opinion was going and introduced the confiscation measure.  (Mr. Rangel himself is beset by his own tax, rent-control, mortgage, and car scandals, but that’s “none of your goddam business.”)

This tax risks poisoning the TARP program altogether since banks will balk at terms that require them to abrogate existing contracts and that force them to lose necessary talent to competitors. It also sets an example that all future business decisions are subject to political, not economic, scrutiny.  Though it is fair that recipients of public money be held to public standards of accountability—as politicized as that may be—it is important that Congress and the Treasury view these banks as investments; when they lose, the public loses.

Even if both houses pass the measure and the President signs it (his press secretary says he’s open to the idea), it will face Constitutional challenges in the courts for several reasons:

It is a bill of attainder, which punishes people or a group of people without the benefit of a trial.  Since Members of Congress have already publicly expressed that the purpose of the bill is to punish a particular group of people, they may have unwittingly proven the case to a court that their intention was never to set a national tax policy, but rather to react against an act that benefited a short list of people.

Similarly, the bill denies due process.  The Fourteenth Amendment stipulates that the government may not “deprive any person of life, liberty, or property, without due process of law.”  However unwise the bonuses were, they were lawfully distributed, and an explicitly confiscatory tax against this group of recipients without any sort of trial deprives the recipients of any sort of due process.

Furthermore, the tax is an ex post facto law, confiscating income already lawfully distributed.  Though Congress certainly has the authority to tax and to tax income already distributed (i.e. existing wealth), the power to tax involves the power to destroy, and there is no doubt as to the inention of this onerous 90% tax rate.

The bonuses amount to a tiny fraction of a sliver of the TARP, but as we have argued before, even a small portion misspent is still irresponsible.  Nonetheless, some commentators on the Right have labeled this row “cosmic myopia” and a “bonfire of the trivialities.”

Ideally, Congress and the Administration would tie future compensation packages to performance, but in the rush for due accountability, we cannot ditch the rule of law.

Photo: Susan Walsh, AP

The revelation of AIG’s extravagant bonuses is renewing calls for the Treasury to replace the leadership of bailed-out firms.  If these people brought their banks to such dire circumstances in the first place, so the thinking goes, they have proven their incompetence.  Fire them all, many say.

Though Monumentality hardly defends failed enterprises, one must wonder if the latest calls for executive firings would bring about the same calamity as de-Baathification did in Iraq.

When in 2003 the Coalition Provisional Authority, under L. Paul Bremmer, dismissed all senior officials of Saddam Hussein’s government, the result was a national Iraqi government devoid of leadership.  By categorically branding former officials as tainted, their replacements— a melange of political hacks, amateurs, and empty seats— ran the new Iraqi government FEMA-style.  We all know how that turned out.

Similarly, in the frenzy for well-deserved executive accountability at AIG and other firms, the Treasury should avoid repeating the mistakes of Baghdad.  Though executive boards and management (and the rank-and-file, too, to some extent) oversaw dodgy deals, they are ipso facto the people with the most knowledge of what deals need undoing.

Certainly it is possible for new-hires to gain the necessary institutional knowledge to lead these firm to a recovery, but it takes time.  Though the President is fond of solving all problems all at once, retribution and recovery are best served in separate courses.

The Treasury must not damage the viability of its (well, our) investments tomorrow for the sake of exacting a pound of flesh today.

Larry Summers on ABC's This Week

The hypocrimeter dinged loudly this morning when Larry Summers, the President’s top economic adviser, described the folly in rewriting bailout terms with A.I.G.  after the ink had already dried.  George Stephanopoulos brought up a breaking story that A.I.G., which had received a bailout loan from the Federal Reserve in late 2008, was issuing $1b in bonuses to some of the same employees who drove the company to the brink.  Since the terms of the Federal bailout did not preclude such compensatory profligacy, Summers said it would not be possible to force the company to withold the bonuses.  Summers told Geroge Stephanopolous on This Week,

Look, if you start changing the rules ex post [facto] on financial contracts— these kinds of contracts— you may get a feeling of satisfaction in the short-run, but the President said something very, very important, George, in his state of union speech: he railed and spoke very powerfully against what has happened, then he said but we can’t govern out of anger. And what’s being done here— no one wants to be doing these things, no one wants to see money going for this purpose with all the needs that our country has— but at the same time if we don’t, um, contain this situation, if we don’t respect laws on which people reasonably rely, the potential chaos, disruption, lack of credit, resulting unemployment will be that much greater.  Those are the agonizing judgments that our financial authorities have to make.

Summers is right.  Upholding contracts is a key part to upholding the rule of law and it reduces the risk of economic ventures.  When contracts are enforced properly, both parties have greater faith in the system and are thus more willing to invest in ventures whose risk would otherwise discourage investment.  If debtor banks learn that the terms of their bailout loans will blow with the political winds, banks will be less likely to take the necessary loans and stockholders in existing banks will lose faith and sell their shares.

The hypocrisy, however, lies in the Administration’s support of “cram-down” provisions that would allow bankruptcy judges to modify the loan terms (principal and interest rates) of mortgages for bankrupt homeowners.  If it is calamitous to rewrite financial contracts ex post facto, as Summers says, why does the Administration support rewriting the financial contracts between lenders and bankrupt borrowers?

A cram-down provision raises the uncertainty of mortgages, since a bankruptcy judge could rewrite the terms in a way unfavorable to a lender.  Lenders will likely respond to this added risk preemptively by adding a risk premium to interest rates.  Thus, to save some current insolvant borrowers, future borrowers must suffer.  But as we have written before, handing out political favors now at the expense of the future is easy. After all, the future can’t vote yet.  At least the Administration will, to quote Summers, “get a feeling of satisfaction in the short-run.”