Demanding Accountability at the Highest Levels

There are very few things upon which I agree with Congressional Democrats and even fewer with Speaker Nancy Pelosi (D-CA). In most instances they have a lot of complaints but few solutions. But this time, at least in concept, I think they are right on the money.

Speaker Pelosi and her Democrat colleagues have stated that as condition of approving federal government bailouts for the country’s financial institutions, the government should have the power to slash salaries, bonuses and severance packages of executives of institutions who accept the bailouts. Frankly, I don’t think the Democrats’ proposal goes far enough and, perhaps, in cannot because of the constitutional guarantees against “ex post facto” laws.

The problems in the financial markets, like the problems in the housing market, did not occur overnight. Many of the people, including advisers to both presidential campaigns, who were instrumental in developing the practices that inevitably led to the problems we are seeing today, have long since been rewarded with extraordinary bonuses and handsome severance packages. They got out before the “s**t hit the fan” and are now living high, wide and handsome on the misery they imposed on others. Justice requires that they too be relieved of their extraordinary bonuses and severance packages.

A quick review of how we arrived at this situation reveals the culpability of the government, the regulators and the corporate executives. More importantly, the underlying element of the problem is so painfully obvious it is hard to believe that intelligent, educated and experienced men and women could advance this notion — lending money to people who cannot afford to pay it back.

In the economic boom occasioned by the fiscal policies of President Ronald Reagan and continued through Clinton years and well into the second Bush administration, the growth in homeownership was explosive.

Most people were able to realize a portion of the American dream of owning their own home — most but not all. The ability to acquire a home continued to allude those just entering the job market and those stuck in the rut of minimum wage and/or seasonal jobs were simply unable to meet the income requirements for conventional financing for home purchases.

For the low income advocates and the minority race hustlers this fact became an open running sore — proof that the system did not work and that the country intended to keep success beyond the reach of their constituents. Their complaints began to resonate with those politicians who owed, in part, their election to those constituencies and they began to use the power of their offices to demand that a means be found to “include” their constituents in the dream of homeownership.

Federal regulators began to demand that a percentage of financial institutions’ portfolios include loans to lower income families. The term “red zoning” which originally applied to racial profiling was made to apply to economic strata.

The financial industry, never shy about finding a new way to make a buck — particularly when its government regulators are giving them the green light — noticed that the increased demand for homes was causing the average price of homes to accelerate beyond the normal rates of inflation thus creating “new equity” for homeowners. Both the financial institutions and the government regulators reasoned that even if a new buyer did not have the traditional ten to twenty percent equity to purchase a home initially, that they would “acquire” that equity within a short period of time because of the rapid escalation of the average price of homes. All of that might be true if you assume that the average price of housing would continue to escalate at a rate greater than inflation forever more. (This is the same type of baseless assumption that fueled the “dot.com” bubble and brought down the market less than a decade ago.)

But even with the new “no equity” loans, many still did not have the revenue stream to qualify for payment of the loans. The financial institutions, ever creative, derived, with the approval of government regulators, a new series of “sub-prime loans” which essentially matched the payment schedules to the available revenue stream of the borrower rather than determining whether there was sufficient revenue stream to amortize the loan over thirty years. In most instances this took the form of reduced payments for an introductory period followed by escalated payments somewhere down the road. In many instances, the borrower’s loan increased annually to account for the difference between his payment and the amount actually needed to amortize the loan. The banks and the government regulators reasoned that so long as the value of the house was increasing annually, the borrower’s equity was growing and was available to be “loaned against” to subsidize the low initial payments. Said more simply, for the initial period, the borrowers were required to borrow more to pay the interest on the amount they borrowed initially.

In both such instances, the whole rationale underlying the loans had nothing to do with the best interests of the borrowers, nothing to do with the long term interest of the financial institutions, and nothing to do with the shareholders in those institutions. In both such instances, introductory courses in finance, economics, and accounting would tell you that this was a license for a disaster. Both the financial institution executives and the regulators knew that the foundation for these loans were shaky at best and catastrophic at worst. But the financial institution executives were being rewarded handsomely and the regulators had the politicians off their backs.

These borrowers could not afford the loans on the day they borrowed, could not afford the loans for the initial period of reduced payments, and more than likely would not be able to afford the loans when payments escalated. But the executives and the regulators didn’t really care because they were both using Other Peoples Money.

Yes, that’s right, neither the executives, the regulators or the politicians urging them on, were at risk. And that is what needs to change. So if Congress is serious about this business then its members should include the following elements in their legislation:

1. Current bonus and severance packages for executives of institutions accepting the government bailout should be forfeited and salaries for officers should be adjusted downwards. The windfall from those forfeitures and reductions should be utilized to offset the cost of the bailouts.
2. The companies accepting a bailout should also commence actions against former executives who participated in the decisions responsible for these catastrophes and all proceeds recovered should be utilized to offset the cost of the bailouts.
3. Additional financial disclosure regulations should be put in place to alert investors of the dangers of policies and practices engaged in by corporate executives. Transparency is always the best means of control in a free market and such transparency did not exist in these instances. In this regard the disclosures should include a risk analysis of particular practices including the assumptions upon which practices was based and the likely outcome if the assumptions prove to be wrong. (In this instance if these financial institutions had disclosed that they were making loans to people who could not pay them back but assumed that the collateral would increase in value at a sufficient rate to cover any default, how many investors do you think would have placed their money with these firms?)
4. New criminal penalties with mandatory prison time should be created for executives engaging in conduct likely to mislead investors — in this instance for failing to make full disclosures regarding the practices, assumptions and risk analysis of the likely outcomes. The loss of money and the prestige of money for these executives is a painful but tolerable event. Jail time is not and it is the only thing they fear.
5. The politicians accepting campaign contributions from institutions or executives who are subsequently determined to have engaged in misconduct should be held personally, financially liable for repayment of all of those contributions to offset the cost of the bailouts.

In my lifetime, I have watched the greed of politicians and corporate executives fuel the savings and loan crises, the dot.com/telecommunications crash and now the housing/financial crises. And it is always the same, those who are the primary cause of the crises proceed, wealthy and unscathed, and those who can least afford it (investors and taxpayers) are left holding the bag. Something has to change.