Bad Regulation: AIG and When Chickens Come Home to Roost

Just how out-of-date is our regulatory system? Given the current economic crisis, we are finally hearing calls for fixes to the government oversight of banks and other financial institutions. If we start with the deregulation of financial services companies that was accomplished in the Gramm-Leach-Bliley Act of 1999, we’re about a decade behind in terms of financial regulation. Why? Because the old structure was retained, with the Federal Reserve System and the Comptroller of the Currency regulating the commercial banks, the Securities and Exchange Commission overseeing the securities industry, and state insurance commissions responsible for the insurance industry.

Meanwhile, financial companies could enter any financial business in the search for profits and market share. That’s what got AIG (the American International Group) into trouble. It established an investment bank behind its rather dull but competently managed insurance businesses, which managed to eventually lose more than $18 billion (the reports for the most recent three quarters of operations). This AIG unit wrote credit-default swaps (CDS), a guarantee against default, with an exposure based on the notional (face or stated) value of nearly one-half trillion dollars! A CDS is a contract between two counterparties – that is, buyers and sellers – in which the buyer makes regular payments to the seller in exchange for the right to compensation if there is a default or “credit event” in respect of a third party (sometimes called a “reference entity”).

As poor credits including subprime securities began to fail, AIG hit the wall. The company couldn’t pledge enough collateral with its counterparties, prompting credit rating downgrades and more calls for margin. The New York State Insurance Commission actually did a fine job in regulating the insurance groups of AIG, and it appears unlikely that any loss will occur in those businesses. It is the investment bank – not subject to the insurance regulators – that was the culprit, and the cause of the requirement for an $85 billion credit facility bailout from the Federal Reserve.

This is the time for Americans to reconsider our approach to financial regulation, and indeed, to all business regulation. For the financial industry, we need the appropriate level of consolidated governmental oversight, probably by categories of risk. In my next blog, I will discuss a more thoughtful approach to regulation and suggest appropriate organizational ideas.

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Which Candidate Can Save Your Job?

Is U.S. Business Overregulated?

Senators Clinton, McCain and Obama seem to have three types of responses to the current business climate in their Presidential campaigns:

1.      throw money at the economy
2.      bash global business, or
3.      claim economic ignorance.

Here are some examples from early 2008 speeches and interviews:

#1. Clinton wants to renegotiate NAFTA and take other actions to protect U.S. jobs, including spending $2.5 billion a year to retrain workers for new jobs. Bashing global business may win some votes, but this really is populist claptrap and a terrible idea.  America is a part of the world, and ignoring global competition does not change the fact that we compete in the world. To fan the blames, she recently stated that “… we might be drifting into a Japanese-like situation,” meaning a prolonged recession.

#2. McCain has stated that “the issue of economics is not something I’ve understood as well as I should.” However, he is an economic conservative and a free trader, and opposes economic intervention in the credit and housing markets as a doomed attempt by the state to interfere in the market economy. McCain’s ignoring current problems is reminiscent of President Hoover’s refusal to allow the federal government to assist starving Americans after the 1929 stock market crash.

#3. Obama wants to spend $210 billion to create jobs in construction and environmental industries over the next 10 years. The money would come from ending the war in Iraq, cutting tax breaks for corporations, increasing taxes on high income earners and taxing carbon pollution. The problems with this proposal are that there is no automatic peace dividend, that Obama has never explained how we’d exit Iraq, that we now have the second highest corporate tax rate in the world, and that, as a country, we’re nearly $10 trillion in debt. Oh by the way, he denounces NAFTA.

What does the rest of the world see? Just look at the plunge of the U.S. dollar vs. every other important currency over the past eight years or so. So what should we do? In the U.S., we’ve underregulated the financial markets and overregulated the industrial markets. We need to create consolidated regulation for the financial services industry so that the newer participants do not fall through the cracks, and that financial firms that get into commercial banking are subject to the same standards as the banks (think Bear Stearns). We need to eliminate regulation that strangles U.S. business, like antitrust, the Sarbanes-Oxley Act (corporate governance), and archaic laws that stifle specific industries (such as airlines and communications).

Which candidate may get us there? We need restraint on spending, fewer restrictive economic laws, and an end to the bashing of global business. So far, none of the three candidates come close to meeting these requirements.

If, “It’s the Economy, Stupid!” Where’s the Plan?

Is U.S. Business Overregulated?There is no more critical issue facing America than its ability to compete in the global economy. The loss of manufacturing jobs to countries with five to twenty times lower labor costs may be the most important economic problem of our times. The U.S. has become a service economy that is heavily dependent on the goodwill of two classes of market participants:

• Foreign holders of dollars who keep buying our stocks, bonds, real estate, and other assets

U.S. consumers whose spending drives some 70 percent of our gross domestic product

 

So, what do our Presidential candidates suggest? What structural changes would their administrations propose? Unfortunately, one of the problems in following the candidates’ economics positions is that they don’t have any specific long-term plan. The composite position is some kind of short-term economic stimulus package totaling about $100 billion. While economists never agree on much of anything, there seems to be a consensus that a $100 billion stimulus applied to a $13 trillion economy will accomplish almost nothing. (It would take a $130 billion stimulus just to equal one percent of the size of the U.S. Gross Domestic Product [GDP]!)

 

We need some real discussion among the candidates about the long-term: changing laws, eliminating regulations, stimulating job growth, reducing corporate tax rates, etc. The closest to this probably has been Mitt Romney in Michigan who promised to revitalize the auto industry and restore jobs … although, to no one’s, surprise … the details are vague. (Hint to Mitt: Those auto jobs are now in Japan, South Korea and other countries, and they aren’t coming back.)

 

The U.S. has to change its vision of the 21st century economy. We have to consider repealing laws that seemed reasonable as long ago more than 100 years ago (for example the Sherman Act of 1890 concerning antitrust), and as recently as 6 years ago (the Sarbanes-Oxley Act of 2002 concerning corporate governance). America has never developed a comprehensive public policy toward global competition. In fact, the Department of Commerce, the agency charged with the promotion of international business, did not begin to emphasize sales to foreign markets until the 1970s, some 300 years after countries like Great Britain and Holland were actively developing world trade relationships.

<>If foreign holders of dollars and/or U.S. consumers ever falter in their support, the result could be a decade-long recession. This is no idle threat; by 2007, housing was in a slump with prices likely to be down for the years 2007 – 2009. And in recent years housing “wealth” was what sustained the consumer and supported all those trips to Wal-Mart <>and to Orlando or Las Vegas. Although there are no quick fixes, the argument of my new book Is U.S. Business Overregulated? (York House Press, 2008) is for a new look at our regulation of business to level the playing field against foreign competitors. We may well be our own worst enemy in limiting America’s ability to compete in the global economy!

The theme of this book is that there are “positive” regulations … and “negative” regulations, where government officials substitute their judgment for that of the market in situations when such substitution is inappropriate and may result in the suboptimal allocation of the factors of production….society cannot survive without laws to protect individuals and the environment against the corrupt or criminal actions of business.

 

Microsoft Ends 9-Year Fight

Is U.S. Business Overregulated?It was no great surprise that Microsoft recently agreed to end its 9-year fight against the European Union’s antitrust regulators; see The New York Times, Oct. 23, 2007, 1st business page. The company simply got tired of fighting a system that claims to support competition without consideration for the realities of the marketplace. Will freer competition and better customer service result? There may be little actually gained because of previous Microsoft agreements with other computer companies for cross-licensing and the sharing of technology.

 

The U.S. version of the case began in 1998 and ended with relatively minor penalties assessed against Microsoft in 2002. Our government had alleged that Microsoft illegally tied its Web browser to the Windows operating system despite the fact that injury to consumers was never proven. The Microsoft case illustrates the challenges facing 21st century courts attempting to reconcile innovation, the financial requirements of an industry heavily invested in research and development, and antitrust law that was enacted more than 115 years ago. At the time of the first law protecting competition – the Sherman Act of 1890 – America was evolving from agriculture to manufacturing, and there was limited foreign competition.

 

The concept of antitrust made sense when consumers had no choice in their sources of supply as small businessmen and farmers discovered in the late 19th century. That situation has clearly changed, and America is now scrambling to compete in global markets with international competitors from China, India and other fast growing economies who are not looking over their shoulders at antitrust regulators. Numerous legal cases have similar histories to Microsoft as the judicial process slowly wends its way through fact finding, analysis, discovery, motions, and trials. Markets move faster than antitrust, and a shrewd litigation team can drag out the process for a much longer time than the life or death of a competitor.

Whatever Happened to the “Giant Sucking Sound”?

Is U.S. Business Overregulated?The 2008 Presidential campaign has been underway for months (some say years), but economics and global trade are not getting the top headlines and sound bites. Although it takes some digging to discern the candidates’ positions, the Democrats have generally supported free trade and fiscal responsibility, although the campaign of John Edwards has somewhat strangely attacked free trade agreements while Hillary Clinton, Barack Obama and the leading Republican candidates seem to support them. On October 27, Mr. Edwards issued a very critical statement on the proposed bilateral free trade agreement with Peru (which is similar to the North American Free Trade Agreement or NAFTA); however, it was approved a week later by the House Ways and Means Committee.

Free trade has been kicked around in the Americas since debate began on NAFTA well before it came into operation on January 1, 1994. Some of you may remember 1992 Presidential third-party candidate Ross Perot’s prediction of a “giant sucking sound” of jobs leaving the U.S. for Mexico, where the labor cost has been significantly lower. Although Perot clearly touched a nerve (he received 18.9% of the popular vote but no electoral votes), his forecast of massive job losses were wrong. In fact, trade and employment has increased significantly among the three participating countries (the U.S., Mexico and Canada), although specific industries have lost jobs (e.g., textile, apparel). The debate about free trade in the Americas is now fairly quiet, and the Clinton and G.W. Bush Administrations have strongly urged the extension of NAFTA to other developed countries such as Chile, Brazil and perhaps, Argentina.

Because of Mexico’s unwillingness to extend NAFTA until progress is made on normalizing immigration, the U.S. has developed bilateral trade agreements with Western Hemisphere countries, including Chile, Colombia and Panama, as well as the Peruvian agreement noted above. (Note: the U.S. has also entered into such arrangements with Australia, Bahrain, Israel, Jordan, Malaysia, Morocco, Malaysia, Singapore and the UAE.) The jobs issue that became a centerpiece of the 1992 election seems to have vanished. As a nation, we are at full employment (typically 4.5% of American workers are unemployed in any reporting period but currently 4.7%), with nearly 5% annualized growth in workers’ output per hour and a five quarter record of positive growth in real wages (that is, inflation adjusted).

No candidate has made American competitiveness and global trade major campaign issues. Regardless, we need to hear about these concerns and what the next President will be doing to change the regulatory system that is strangling American business.

Churning is for Butter, not for Business Managers

An essential element in managing an organization is continuity: the idea that the same people will function in their jobs for an extended period of time so that their corporate responsibilities are conducted efficiently and effectively. Naturally, any business experiences some turnover, whether from new opportunities, departures or other events. However, this process should proceed with the minimum of disruption to the conduct of the company’s affairs. The regulatory environment has become so difficult for many managers that even 6-figure salaries are insufficient compensation to motivate them to stay in their current positions.

A recent survey by Liberum Research reports that the trend of recent years in finance continues to show high levels of management change. For example, more than 2,300 chief financial officer (CFO) positions turned over in 2006, with fastest rates of “churn” in businesses with $1 billion or more in revenues. The average time in position was 30 months, about one-half of the 5 year tenure in 2002. A major cause reported by Liberum is stress from such sources as regulation and global competition.

Stress has always been a component of any job, but current pressures far exceed past demands for profits and growth. The Sarbanes-Oxley Act of 2002 (Sarbox), passed in response to such fraud cases as Enron, WorldCom and Tyco International, establishes a large body of mandatory actions by public companies. Sarbox broke new ground by mandating that U.S. publicly-traded corporations regularly assess their processes to ensure transparency and protect shareholder value. The law was enacted to restore investor confidence by requiring actions concerning financial reporting, conflicts of interest, corporate ethics and accounting oversight. Heavy fines for senior managers and their corporations, and even imprisonment, are available remedies under Sarbox; the idea was to construct a strong enough incentive for business executives to be good citizens.

Sarbox makes new law in several important areas, some of which may create havoc for corporate managers, accountants and regulators. As one example, chief executive officers are now required to certify that a periodic financial report “fairly represents, in all material respects, the financial condition and results of operation of the issuer.” A knowingly false certification can result in a fine of up to $5 million and imprisonment of up to 20 years. Although Sarbox does not contain any clarification for this process, many public companies are requiring finance managers to “sub-certify” the sections of the financial reports for which they are responsible. One survey noted the following areas as the most common areas where financial professionals were being asked to sub-certify, leaving them with unresolved issues of liability:

· disclosures in management’s discussion and analysis or in footnotes

· specific account balances in banks

· compliance with company policies and procedures

· adequacy of internal controls in their department or business function

· compliance with company code of conduct

The answer to the fraudulent actions of a few very bad actors is not to pass expensive and overly punitive legislation. This solution contributes to the enormous cost of operating business and stresses managers to the point of their leaving their positions after only a short term of service. Sarbox should be repealed and other existing law used when fraud is detected. Incidentally, this was how the chief executives of Enron – Ken Lay and Jeffrey Skilling – were successfully prosecuted.

Response to John Carroll

Of course these are European decisions — but aren’t we free to criticize any restrictions on global free trade? Furthermore, there is absolutely no evidence that consumers have been adversely affected by the business policies of Microsoft. If anything, the company has been a great corporate citizen. I explain of of this in my forthcoming book.

J. Sagner