Bootleggers & Baptists: How Economic Forces and Moral Persuasion Interact to Shape Regulatory Politics (24 page)

Special Master for TARP Executive Compensation

A second response to the public outcry against AIG came when the Treasury Department appointed an overseer to determine optimal compensation packages for seven of the largest firms receiving TARP funds (Labaton 2009).
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Treasury later expanded this domain of responsibility to include all firms that received TARP monies (see Solomon and Lucchetti 2009).

The appointed overseer, Kenneth Feinberg, indicated that he viewed his role more as that of a broker. His efforts, while highly intrusive, were likely less constraining than what Congress would opt for. At a meeting with the AIG board of directors, according to one account:

Mr. Feinberg told the board that AIG would suffer if he signed off on exorbitant pay packages. “You’re looking to me to protect you,” Mr. Feinberg said. “If I just give you whatever you want . . . they’ll kill you up there,” he said, referring to Capitol Hill, where anger over AIG pay had persisted. (Goldman and Katz 2010)

In other words, Feinberg was pledging to take back less pork than his counterparts in Congress.

The primary outcome of Feinberg’s efforts was to replace bonus compensation in the form of cash with compensation in the form of stock options, reflecting the Obama administration’s emphasis on tying compensation to performance. Yet the creation of the office alone indicates how rapidly—and sharply—lawmakers can respond when a legislative deal breaks down. This is why maintaining a viable Baptist component in any major policy initiative is critical for the long-term success of not only political brokers but Bootleggers as well. When political arrangements go awry, unexpected and detrimental interference in market practices often follow.

Efforts to Tax the Recovering Firms

Finally, President Obama proposed a recoupment tax on January 15, 2010, to charge TARP recipients who had bounced back after the crisis. The tax was intended to recoup losses from outlays to companies that, struggling as they were to regain solvent positions, seemed unlikely to pay back all monies borrowed, such as AIG, Freddie Mac, Fannie Mae, Chrysler, and General Motors (Calmes 2010). President Obama’s proposed tax would be levied on large financial firms—regardless of their TARP participation—with more than $50 billion in assets and assessed at a flat rate of 0.15 percent of each firm’s liabilities. Projections suggest the tax would accrue $90 billion in revenue over the next 10 years. Later, Secretary Geithner proposed a weighted assessment of the tax that applied more heavily to riskier liabilities on a firm’s balance sheet as opposed to the flat tax approach. The ostensible purpose of this shift was to avoid discouraging these companies from purchasing Treasury securities (Vaughn 2010).

It is difficult to rationalize this proposal without appealing to political motivations. Like the tax on bonuses, the recoupment tax would reduce the pork appropriated by Bootleggers by taking it back. Though such a move might seem to follow from the recoupment clause in the Emergency Economic Stabilization Act described above, it was proposed several years before the five-year deadline indicated in the language of the bill and, indeed, before the budget report that was supposed to reveal the ultimate net loss of the TARP program.

Although ultimately the recoupment tax did not become law, along with the other two developments summarized above, it represented an unexpected shift in TARP policy, at least from the perspective of subsidized companies. Again, though the recoupment clause allows for reimbursement above the loans received by companies, such a tax would not likely have been proposed (at least this early) had the already shaky support for TARP not collapsed altogether.

Exodus from TARP, Interrupted Cash Flow, and the Aftermath

The immediate consequence of the AIG bonus controversy and subsequent political fallout shut down the call for more money from TARP. Not only did companies stop requesting the larger subsidies offered before this controversy, they also began to insist on paying TARP monies back to cut ties with federal overseers altogether. Bootleggers were now fleeing by the dozens.

The American Recovery and Reinvestment Act of 2009
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lays out the procedures for repayment of TARP monies:

Subject to consultation with the appropriate Federal banking agency (as that term is defined in section 3 of the Federal Deposit Insurance Act), if any, the Secretary shall permit a TARP recipient to repay any assistance previously provided under the TARP to such financial institution, without regard to whether the financial institution has replaced such funds from any other source or to any waiting period, and when such assistance is repaid, the Secretary shall liquidate warrants associated with such assistance at the current market price.

This provision indicates that the repayment of borrowed funds is not subject to scrutiny by the Treasury itself.

Nevertheless, Bootleggers hoping to exit the program found a recalcitrant lender waiting. Discussing the repayment of borrowed TARP funds on April 17, 2009, JP Morgan CEO James Dimon claimed: “We could pay it back tomorrow. We have the money” (Sidel 2009). Goldman Sachs Group Inc. likewise stated that its “duty” was to repay funds borrowed from the TARP (Wutkowski and Stempel 2009). However, these banks—now firmly solvent—were required to pass an exit program called the Supervisory Capital Assessment Program, designed as a sort of performance stress test.

The stress test measured each firm’s capital ratio under a baseline macroeconomic scenario and a more adverse macroeconomic scenario. In effect, this showed the before and after balance sheet effects of various hypothetical severe economic downturns. After passing the stress test, banks would be able to buy back the preferred shares held by the Treasury Department. They would not, however, be able to buy back equity share ownership warrants issued under TARP. This latter entanglement guaranteed that government will hold leverage over these companies for the foreseeable future.

In recognition of this obstinate entanglement, the American Bankers Association lobbied Congress to erase the warrants held by the Treasury Department. The organization called the payments generated by the warrants an “onerous exit fee” in addition to the already formidable stress test. Bank representatives even cited the unexpected evolution of TARP, in the form of additional executive compensation rules, as a reason why expunging the warrants would be justified. The bankers argued that “it’s fundamentally wrong and unfair for a contract to be changed that much” (Paletta and Solomon 2009).

By March 2011, $171 billion (83 percent) of the total $205 billion of the preferred stock, purchased from 707 firms, had been repaid (Congressional Budget Office 2011). Looking at exactly which firms were able to exit yields several important Bootlegger/Baptist insights. Wilson and Wu (2011) show how the first group of firms allowed to exit the TARP shared the following characteristics: (a) larger size, (b) high executive pay, (c) fewer problem assets, and (d) better earning performance pre-2009. The last two characteristics seem consistent with the reported objectives of the Supervisory Capital Assessment Program, that is, ensuring that banks that exit the TARP are sufficiently financially solvent to be able to withstand a significant negative macroeconomic shock. But the first two characteristics are curious, in that larger banks played the largest role in jeopardizing the systemic integrity of the financial system. Furthermore, the Obama administration singled out executive pay in particular as an important factor in these firms’ handling of risk, thus ostensibly exacerbating the financial crisis, despite the lack of evidence tying compensation packages to stock performance during the crisis. As Wilson and Wu (2011, 2) point out:

We cannot explain why banks often replaced cheap government capital with more expensive private capital. Thus, the decision by most banks to exit [various TARP programs] cannot be easily reconciled with standard investment analysis. It involved paying back capital with more expensive private capital.

Bootlegger/Baptist Theory and the Fate of TARP

This conundrum begins to unravel when we consider the arrangement in the broader context of Bootlegger/Baptist theory. Firms faced significant pork extraction as a result of the AIG bonus controversy. Without a Baptist counterpart to deflect public outcry, the beleaguered firms were left to fend off accusations by both lawmakers and the public of malpractice, corruption, and corporate excess.

When we think of which firms faced the greatest outcry, the first two characteristics of firms exiting the TARP offer important clues. As Wilson and Wu (2011, 3) note, “Larger banks are particularly exposed to this stigma because they have much larger reputations. The largest banks generate international, national, and local media attention.” Smaller banks only have to explain their TARP dealings to local media and customers who are generally pleased that their bank is still solvent. Wilson and Wu (2011, 3) go on to point out that “banks with higher paid CEOs will be more susceptible to social stigma as news stories, politicians, and blogs mention the CEO’s compensation package in reference to the federal bailout.”

The first two characteristics can be reconciled with early TARP exit when we consider the incentives of the Bootleggers left hanging in the wind. The AIG debacle forced lawmakers to constrain subsidies below the previously agreed-upon level. This would have the greatest impact on large firms with high executive compensation packages. Accordingly, firms that entered the TARP program after the AIG bonus controversy tended to be smaller. As Wilson and Wu (2011) also observe, smaller banks more easily fly under the public radar screen, and what media attention they do garner may not even be negative on net. Smaller banks were also less afflicted by the stigma clinging to big Wall Street banks, thereby allowing politicians to offer them pork barrel deals with less political baggage.

The Small Business Jobs Act

The recent Small Business Jobs Act further evidenced the shift in support toward smaller banks. On October 6, 2011, the
Wall Street Journal
published an item with the headline “Tale of Two Loan Programs” (Maltby and Loten 2011, C1). Complete with a triangular flow diagram, the story told how a federal program designed to jump-start community bank lending to small businesses became a way for the banks to pay off loans owed to the Treasury Department under TARP. It was pretty close to robbing Peter to pay Paul, but not quite.

Although Congress had authorized $30 billion when the Small Business Jobs Act of 2010 was passed, only $4 billion made it through the Treasury’s spigot to the banks. Of that, some $2 billion rolled right back in as payments on TARP loans. The nation’s unemployment rate stood at 9.6 percent when President Obama signed the law in September 2010. With midterm elections in the offing, Mr. Obama cheerfully declared: “It’s going to speed relief to small businesses across the country right away. We’ve got to keep moving forward. That’s why I fought so hard to pass this bill, and that’s why I’m going to continue to do everything in my power to help small businesses open up and hire and expand” (Obama 2010). The law had been endorsed by the U.S. Chamber of Commerce, the National Federation of Small Businesses, and the Small Business Administration (Mills 2010). Times were tough, and bringing jobs to struggling families sounded like the right thing to do—a Baptist theme emphasized in the president’s comments.

We seriously doubt that Mr. Obama—or any other politician—would ever have lobbied directly and openly for an infusion of taxpayer money to enable banks to refinance their TARP loans: it is impossible to imagine a law called The TARP Refinance Act making it through Congress in the fall of 2010. By then, the public was sick of bank bailouts. But a bill called the Small Business Jobs Act, which could be praised for bringing jobs to the unemployed, was just what the major players needed. And the results? The Baptist language was the key to the vault, just what the doctor ordered for the banks that wanted to escape TARP.

Although the law delivered some loan relief to struggling small businesses, the primary benefit was to small banks, the new Bootleggers in our story. As John Schmidt, chief operating officer of a Dubuque, Iowa, bank, put it, “It’s a bit of a shell game” (Maltby and Loten 2011, C2). Schmidt’s bank received $81.7 million from the fund and used all of it to pay off TARP debt.

Recall that banks receiving TARP funds gave the government special shares of stock that pay a 5 percent dividend. By contrast, funds received from the Small Business Jobs Act loan program carried a maximum interest rate of 5 percent, which could fall to 1 percent if the banks that received the funds increased their small business lending by 10 percent. As a story in the
Wall Street Journal
explained, “Of 332 banks that received cash through the lending fund, 137 used at least a portion—totaling $2.2 billion—to pay off their TARP obligations” (Maltby and Loten 2011, C1). We note that a 2013 report by Treasury special inspector general Christy Romero basically agreed with the earlier-described shift of funds from supporting small business lending to paying off TARP debt (Sparshott 2013).

One might wonder why a bank would use government-provided small business loan money to pay back government-provided TARP money, especially if the interest rate to be paid was 5 percent in each case. But this is easily reconciled once we factor in the numerous costs associated with TARP, such as closer surveillance and the possibility of heavier regulation of executive pay. In other words, whereas TARP dollars were both a benefit and a burden, small business loan dollars were a pure benefit—especially when used to pay off TARP loans. Once again, the case illustrates that where there is moral cover in the form of Baptist-inflected political activity, there is a Bootlegger waiting in the wings. The devil, as the old adage says, is in the details—especially in the world of Bootleggers and Baptists.

The Dodd-Frank Financial Reform Act

Although the TARP is still collecting previously disbursed funds, its viability as a pork barrel mechanism is over. The Dodd-Frank Wall Street Reform and Consumer Protection Act,
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signed into law on July 21, 2010, reduced TARP monies from $700 billion to $472 billion, permanently limiting the potential gains from the program. Furthermore, the act puts several restrictions on what can be purchased with remaining TARP disbursements and maintains Treasury’s authority over TARP-subsidized companies, despite their repayment of TARP monies.
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