AIG, Congress and Law of Unintended Consequences

By Robert E. Pritchard, Ph.D. | April 27, 2009

When corporations want to borrow large sums of money they usually rely on selling bonds. Introductory college finance courses always include a chapter covering interest rates and bonds. So, much of the information I provide below is well known even to those serving in Congress, many of whom are lawyers. That is why the whole issue surrounding American International Group’s (AIG) bonus payments is so remarkably tragic.

The key document necessary to sell bonds is the indenture. This legal document is designed to protect the bondholders and delineates the duties of the corporation. In addition to the standard provisions that require the borrower to maintain appropriate records, pay taxes, etc., restrictive covenants are frequently included.

Restrictive covenants are designed to protect the lender. For example, a restrictive covenant might limit the borrower’s cash dividend payments or even the payment of bonuses!

But, for the $750 billion in TARP funds, the horse got out of the barn before the door was closed; bonuses were not prohibited. Now Congress and, to a lesser extent, the President are demonizing AIG executives for giving bonuses. I am not arguing that AIG used good judgment when awarding the bonuses; I think it was wrong, arrogant and hurt the entire financial community. However, it is a usual practice in that business.

But where were all those screaming indignant members of Congress when TARP was passed? Why weren’t the appropriate restrictive covenants included in the TARP legislation? OK, it was last term’s Congress that passed the legislation. But a large majority of the faces are the same now as then.

So, instead of standing up and admitting that they were out to lunch, members of Congress jumped to enact penalty taxes to get the bad guys at AIG. They wanted to change the rules after the fact, and that is very scary. And, of course, they held hearings to get free airtime so they could condemn the bad guys from their self-righteous pulpits.

But there is more to this bad story: the unintended consequences.

First, at least two major recipients of TARP funds have now pledged to repay them quickly. So, instead of using the TARP funds to increase their liquidity and ease the credit crunch, they want out. They don’t want to have Congress as a partner and have someone looking over their shoulders waiting to make headlines.

Second, members of the private sector now know that Congress is ready to change the rules mid-play. Consequently, those in the private sector who are now being asked to participate in Treasury’s plan to deal with toxic assets will look long and hard before getting involved. By attacking AIG after the fact, Congress has reduced its credibility, thereby lengthening the recession.

Third, a number of key AIG executives have resigned. Will they get other jobs? Obviously, not at Lehman. But it is very likely they will be employed at other large brokerage firms, if not in the U.S., then abroad. Is the loss of talent bad for AIG or for the U.S.? Time will tell.

In this period of economic crisis, people want simple answers to complex questions. One of the pressing questions is “Who is responsible for this mess?” Finger pointing comes easily — the bad bankers are an easy target, and a very, very small number of bankers certainly contributed significantly to the mess. The larger question relates to the lack of regulations and the lack of enforcement of existing regulations that could have prevented this debacle.

Pritchard is the senior member of the Rohrer College of Business faculty at Rowan University, Glassboro, N.J. He completed both his undergraduate degree in physics and an M.B.A. at Drexel University, his M.A. in applied economics at the Wharton School of Business at the University of Pennsylvania and his doctorate in education administration at the University of Pennsylvania. Pritchard has authored/co-authored nine books in the fields of finance, small business management and marketing and has written more than 250 trade journal articles.

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