The ERM Current™

U.S. Treasury Secretary Timothy Geithner will particpate in a hearing today conducted by the TARP Congressional Oversight Panel.  The focus of the discussion will most likely be the contents of a report issued by the Panel about the Treasury’s TARP Strategy.  In the report, the Panel explores various governmental interventions over the past century and identifies their sources of success.  Here are the four critical success factors: 

• Transparency.  Swift action to ensure the integrity of bank accounting, particularly with respect to the ability of regulators and investors to ascertain the value of bank assets and hence assess bank solvency.
• Assertiveness.  Willingness to take aggressive action to address failing financial institutions by 1) taking early aggressive action to improve capital ratios of banks that can be rescued, and 2) shutting down those banks that are irreparably insolvent. 
• Accountability.  Willingness to hold management accountable by replacing—and, in cases of criminal conduct, prosecuting—failed managers. 
• Clarity.  Transparency in the government response with forthright measurement and reporting of all forms of assistance being provided and clearly explained criteria for the use of public sector funds.  

The report falls short of offering an ultimate view on the best strategy to take in the current crisis.  However, it does indicate that there is dissent among the Panel members on efficacy of the Treasury’s current strategy. This dissent will most likely lead to a very interesting hearing.

Reports surfaced today that the U.S. Treasury is delaying the release of the stress test results until after the financial institutions have issued their first quarter earnings reports.  Here is what one report from the Boston Globe had to say.

The U.S. Treasury Department is asking banks not to mention the regulatory “stress tests” as part of their first-quarter earnings results, according to a source familiar with government discussions. Officials are still discussing how to release the results of the stress tests, and the decision will likely be made by the Treasury. The source said officials are aiming to release them in some form at the end of April after the first-quarter bank earnings season is over, and are trying to be sensitive to financial market reaction.

This is a very interesting development that could mean the results are not favorable.  The nature of the results remain to be seen, but one thing is certain – the U.S. Government is exerting a great amount of control over these financial institutions.  

The U.S. Treasury is having trouble staffing its team at the very height of the current economic maelstrom according to an article in the New York Times.  Last week, the nominee for the number two position at the Treasury withdrew herself from consideration while many positions remain unfilled.  The lack of qualified personnel is beginning to impede the progress of major initiatives such as the anticipated regulatory reform blueprint that was slated to be unveiled at the upcoming G-20 summit in London.  Here is what the Times reported yesterday.

Administration officials say they are postponing their plan to produce a detailed road map for overhauling the nation’s financial regulatory system by April, in time for the Group of 20 meeting in London. Though officials say they will still develop basic principles in time for the meeting, the plan will not include much detail.

Lack of detail creates a great deal of uncertainty.  Uncertainty is exactly what our fragile financial markets cannot support in times like these.  Let’s hope that Secretary Geithner can quickly staff his team to begin filling in the gaps in his plans.

The sudden about-face in the direction of the US Treasury’s Troubled Asset Relief Program (“TARP”) has brought on new fears of increasing systemic risk in the financial markets.  TARP was originally intended to lower systemic risk by ridding the markets of the toxic securities that currently plague the balance sheets of numerous financial institutions.  By leaving those securities on the balance sheets, many believe that a crisis in confidence will re-emerge.  Bloomberg.com noted the following comments yesterday from a credit strategist at BNP Paribas,

“Substantial risk still remains within the U.S. financial system,” said Rajeev Shah, a London-based credit strategist at BNP Paribas.  ”Uncertainty about existing troubled assets could lead to increasing systemic risk.”

Where do we go from here?  Who knows?  However, one thing is certain.  Changing plans in mid-stream is certainly no way to reduce uncertainty in the financial markets.

Yesterday, the Wall Street Journal discussed the impact of moral hazard on the behavior of both corporations and individuals.  With the ever increasing amounts of money being doled out to those who invested in risky derivative securities and their underlying assets, the impact of moral hazard cannot be ignored.  Wikipedia defines moral hazard in the following way.

Moral hazard is the prospect that a party insulated from risk may behave differently from the way it would behave if it were fully exposed to the risk. Moral hazard arises because an individual or institution does not bear the full consequences of its actions, and therefore has a tendency to act less carefully than it otherwise would, leaving another party to bear some responsibility for the consequences of those actions.

There is great debate about whether the current efforts by the US Government will lead to a greater risk of increasing moral hazard.  Some may compare today’s situation to the behavior of the good ol’ boys in the old TV show, “The Dukes of Hazzard”.  They never crashed their car or went to jail even though they drove recklessly in every episode.  Sound familiar?

Yesterday, the US Treasury released highlights of its proposed Executive Compensation Rules associated with the $700 billion Emergency Economic Stabilization Act (“EESA”).  Here is a summary of the key provisions.

Any financial institution participating in the Capital Purchase Program will be subject to more stringent executive compensation rules for the period during which Treasury holds equity issued under this program. The financial institution must meet certain standards, including: (1) ensuring that incentive compensation for senior executives does not encourage unnecessary and excessive risks that threaten the value of the financial institution; (2) required clawback of any bonus or incentive compensation paid to a senior executive based on statements of earnings, gains, or other criteria that are later proven to be materially inaccurate; (3) prohibition on the financial institution from making any golden parachute payment to a senior executive based on the Internal Revenue Code provision; and (4) agreement not to deduct for tax purposes executive compensation in excess of $500,000 for each senior executive. 

While this sounds good enough, there is a great deal of room for interpretation that may or may not help deal with the real problem at hand.  If you read my blog entry on September 24, you will have a better appreciation for the incentive programs leading to firms taking excessive risks.   The senior executives’ pay packages certainly added to the problem, but the great extent of the excessive risk taking is found throughout the institutions’ trading floors and mortgage origination ranks.  So, how will the Treasury ensure excessive risks are not taken by non-senior executives?  As with everything, the devil is certainly in the details.  I’m sure there will be more debate once the detailed rules are released. Stay tuned.