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The Ultimate Risk of Government Influence Over the Private Sector

Recently, I have been incredibly disturbed by the seemingly capricious and disruptive government
meddling in the private sector. From AIG to Chrysler/GM to Bank of America, the Obama administration
and the Fed have consistently been willing to overlook or conveniently downplay the importance of the rule
of law and the sanctity of the contract in the name of saving the US from the current crisis. Over our
history, what has made the US different from other developing countries and emerging markets is the belief
that the US legal system (through due process) has the capacity to protect stakeholders from fraud, theft,
manipulation, corruption and disruptive government intervention. As a result of this trust in our system, the
dollar (at least to this point) has remained the world's reserve currency and US Treasuries have become the
universal safe haven for investors all over the world. Most importantly, foreign investors have been willing
to accept returns on capital that do not include a substantial extra risk premium due to political risk.

In his fantastic piece in The Atlantic (http://www.theatlantic.com/doc/200905/imf-advice), Simon Johnson

compares the current US political and financial system to those of an emerging market based on the
ascendance of a financial oligarchy that has taken control of the entire US system. In Johnson's mind, the
corruption and crony capitalism that have resulted from this "Quiet Coup" has made the US look more like
a banana republic than the world's most robust capitalist nation. Now, I want to take this analysis a step
further and discuss the lasting implications if Johnson is in fact correct. My thesis is that, at least in the
short run, as the powers that be appear to be willing to do anything to avert deflation, further stock and
bond market collapses, and runs on financial institutions. Accordingly, the US as a destination for capital, is
on the verge of deserving a legitimate risk premium in order for both foreign and domestic investors to be
compensated for the risks they are taking with their capital. I am going to use three separate egregious
incidents from the past year to illustrate my point and back up my thesis: the AIG bonus scandal, the
Fed/Treasury handling of the Bank of America-Merrill Lynch deal, and the recent arm twisting of
investment managers and banks in the Chrysler bankruptcy.

Let's start off with the recent outrage over the AIG retention bonuses. The scandal that erupted upon the
announcement of the intention of AIG to pay out retention bonus to current employees in the financial
products (FP) division is an example of dangerous populist outrage that is characteristic of a society and
legislative body searching for scapegoats. Despite the fact that most of the people who had written the
crippling Credit Default Swap (CDS) contracts at AIGFP were no longer even with the company, the
retention bonuses that were promised to the people who had been brought on or promised to stay in order to
unwind these toxic and unwieldy contracts caused a national uproar.

Look, no one likes the idea of paying any employee of AIG (a company that had to be bailed out by
taxpayers) a single dollar of bonus money. But the truth is that we need these people to help unwind these
CDS and from all indications they have recently been doing a fairly good job of reducing AIG's (and
taxpayer's) exposure to these ill-conceived derivatives. The LAST thing we want is for these people to be
incentivized not to care about the resolution of the CDS because it will only lead to more taxpayer losses.
There have already been numerous whispers on the Street that the huge trading gains racked up by some of
AIG's counterparties such as Goldman Sachs in Q1 2009 were the result of AIG traders selling at depressed
prices and allowing themselves to have their faces ripped off just to get out of these trades. If true, this has
obviously led to taxpayer losses that probably could have been avoided with the correct supervision. Do we
really want to encourage more of this behavior by taking away all of the financial incentive to protect our
investment? I sure don't think so.

In addition to the legitimate business reasons for honoring the AIG bonus contracts, I think the more
pressing issue has to do with the sanctity of the contract. The fact that the president, the Treasury and many
members of Congress were initially willing to ignore the presence of the signed contracts that provided for
these bonuses is a very dangerous precedent. If workers, investors, and managers start to worry that the US
government is ready, willing and able to skirt the rule of law to quench populist thirst, it will inevitably
make all stakeholders wary of investing in this country. I would also argue that this concern could stifle
innovation and prudent risk taking as people become skittish about being involved with any asset class
other than cash. At a time when the stock markets and the world economies need the capital currently
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sitting on the sidelines to move toward riskier asset classes (in order to get credit markets flowing
normally), the fear over potential government actions may only prolong the crisis and could serve to
undermine the credibility of the US as a safe destination for capital.

Fortunately, the furor over the AIG bonuses has at least temporarily died down as many of the people were
shamed into giving back their bonuses. For anyone interested in understanding the perspective of one of the
chastised individuals, I recommend (if you haven’t already) reading the Op-Ed piece in the NY Times by
Jake DeSantis entitled “Dear AIG, I quit.” http://www.nytimes.com/2009/03/25/opinion/25desantis.html)

Unfortunately, not long after the AIG bonus scandal an even more disturbing event came to light that I
believe completely overshadows it. In the AIG case, the president, Treasury, and Congress used the media
and the threat of legislation to cajole people into returning their bonuses. To my knowledge no reports have
surfaced regarding actual threats by the powers that be directed at individual employees of AIG, although
many members of AIGFP apparently feared for their safety as a result of the public’s distaste for the
bonuses. However, in the case of the BAC-Merrill Lynch deal, members of the Fed and Treasury allegedly
decided to use more extreme tactics in the name of protecting against further global financial meltdown.

According to testimony given by BAC CEO (and former Chairman) Ken Lewis in front of New York
Attorney General Cuomo, current Fed Chairman Bernanke and former Treasury Secretary Paulson applied
what I see as dubiously legal pressure on him to:

A. Not disclose the billions of dollars of losses at Merrill Lynch that had emerged after the merger
agreement had been signed
B. Not to attempt to invoke the material adverse change (MAC) clause in the agreement in order to get
out of the deal
C. Not inform the SEC regarding either of the two above items

Furthermore, according to Lewis, Bernanke and Paulson either implicitly or explicitly said that Lewis was
risking his position of Chairman/CEO and the entire Board’s position as directors if he pursued any
avenues to try to extricate BAC from the Merrill deal. In other words, Lewis indicated that he was led to
believe that if he did not complete the deal the government would used whatever power it had available,
possibly through its TARP investment, to remove Lewis and the entire BAC Board.

Now, let me take a step back and shed some light on what these allegations mean if they are indeed
accurate:

1. Using the Fed and Treasury as a conduit, the US government was willing to use its position as a
preferred shareholder of BAC to force the merger of two private companies who had agreed to
merge in a legitimate arm’s length transaction
2. The Fed and Treasury were willing to overlook the SEC rules that dictate that companies must
disclose material events to shareholders as indicated by Lewis’s claim that they specifically stated
they did not want a “disclosable event.”
3. One government agency and one “independent” body were willing to ignore the legally binding
rules of another government agency (the SEC) with no consultation, thus keeping the company’s
other shareholder completely in the dark
4. The government was willing to remove the Chairman/CEO and Board of a private company if the
company did not proceed with a good faith transaction that the government was not a direct party
to
5. In the name of protecting the global financial system from a shock they did not believe it could
handle, the Treasury and Fed were willing to blatantly overstep their mandates and legal authority

When you look at the above list, do these actions look like those of a banana republic or a developed nation
with well-established laws? I would argue that these actions are characteristic of authoritarian governments
whose countries prudent investors refuse to invest in without an appropriate premium for political risk.
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Now, we have to remember how fragile the US and world financial markets were in December 2008. While
things had calmed down slightly since the failure of Lehman Brothers earlier in the fall, it is possible that
the Merrill deal falling through could have sent the system into a very dangerous tailspin. However, my
concern is that the decision to force BAC to complete the deal was made by agents without the legal
authority to do so. I am not a lawyer but I do know that nothing in the Fed’s mandate says anything about
forcing mergers between private parties. Last I checked the Fed’s mandate revolves around fostering price
stability, full employment and economic growth.

In fact, the US does not currently have an entity whose duty it is to assess systemic risk and act
appropriately to protect against financial contagion. As a result the Fed and Treasury apparently decided to
assume that role, overstep their stated boundaries and act as the protector of last resort. To me, this is the
equivalent of a police officer arresting someone for something that he or she thought was wrong but is not
explicitly illegal. When authorities have (or believe they have) the right to make the rules up as they go, it
sets a very dangerous precedent. As a result of these seemingly capricious and not particularly well-
thought-out or legal actions (even taking into account the somewhat extraordinary circumstances), I believe
investors have further lost faith in the power of signed contracts and the idea that the laws of the US will be
consistently applied. I understand that this crisis has put the authorities in uncharted waters but I do not
believe that the current circumstances give the government the right to ignore the legal foundations that
have made the US the world’s business leader and the safest country in which to invest.

The more extreme response of the Treasury and the Fed to the BAC-Merrill situation as compared to the
AIG bonus scandal reflects an escalation when it comes to the tactics these entities appear poised to engage
in to get the outcomes they feel are proper. (By the way, if you thought to yourself as you were reading that
I should make a distinction between the Fed and other government entities because the Fed is
“independent,” I am intentionally lumping the two in together. Right now the Fed looks about as
independent as an unemployed teenager living at home with his or her parents is financially independent.)
The original reason I decided to engage this topic was that I felt the recent escalation required a warning
that the government had embarked on a very slippery slope, based both on a legal and practical basis. When
I originally developed the concept for this piece I planned only to use the BAC and AIG examples to
illustrate my point about the actions of the government could undermine investors’ long term trust in the
US a place to invest capital. Luckily for me (but unfortunately for hedge funds and investors worldwide)
before I could gather my thoughts Chrysler went into Chapter 11 and the fight to see who would have the
pole position for both asset recovery and eventual control began.

The Chrysler bankruptcy and the inevitable GM filing have been two of the more obvious slow-moving
train wrecks in this crisis. With demand for cars and trucks way down and legacy liabilities haunting the
balance sheets of these companies it was hard to imagine that either company could survive without going
through some form of restructuring. What I think none of us, especially Chrysler’s senior creditors, could
have anticipated was what the Obama administration and the president himself would be willing to do to
get the favored outcome. Specifically, the authorities have apparently moved from the use of the media to
shame employees to threatening to fire CEOs to using what look like outright scare tactics to get their way.
In the next few paragraphs I will discuss what looks to be the final outcome of the government’s battle with
Chrysler’s senior creditors and attempt to capture how severe the long term implications of the methods the
government employed could be.

First, I think we should let some people who are likely much smarter than I am weigh in on this issue:

The Economist, May 7th:

Bankruptcies involve dividing a shrunken pie. But not all claims are equal: some lenders provide
cheaper funds to firms in return for a more secure claim over the assets should things go wrong.
They rank above other stakeholders, including shareholders and employees. This principle is now
being trashed… In effect Chrysler and the government have overridden the legal pecking order to
put workers’ health-care benefits above more senior creditors’ claims, and then successfully
argued in court that the alternative would be so much worse for creditors that it cannot be
seriously considered.
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Wall Street Journal, May 11th:

At noon the next day, April 30, Mr. Obama said Chrysler would file for bankruptcy. He blamed
"speculators" who had turned down the $2 billion offer for their $6.9 billion of debt. A lawyer for
holdout firms, Tom Lauria, accused the White House of threatening to destroy the reputation of
Perella Weinberg. The White House denied exerting pressure on it.

"The overarching sense of political pressure," Mr. Lauria said, "remained out there till the end."

Wall Street Journal Op-Ed, May 8th:

The sources, who represent creditors to Chrysler, say they were taken aback by the hardball tactics
that the Obama administration employed to cajole them into acquiescing to plans to restructure
Chrysler. One person described the administration as the most shocking "end justifies the means"
group they have ever encountered. Another characterized Obama was "the most dangerous smooth
talker on the planet- and I knew Kissinger." Both were voters for Obama in the last election.

One participant in negotiations said that the administration's tactic was to present what one
described as a "madman theory of the presidency" in which the President is someone to be feared
because he was willing to do anything to get his way. The person said this threat was taken very
seriously by his firm.

New York Times, April 30th

The dissident creditors said they had a fiduciary responsibility to seek the best possible returns for
their own investors — which, the group said, include teachers’ unions, pension funds and
endowments.

“The government has risked overturning the rule of law and practices that have governed our
world-leading bankruptcy code for decades,” the group said in a statement Thursday. The creditors
suggested banks that had received bailout money were being strong-armed by the administration, a
view some of the bankers privately said they shared.

Say what? This is America, right? Did I suddenly move to the USSR without knowing it? With the banks in
tow and the dissident hedge funds and asset managers disbanded by a combination of being shamed in the
media for protecting their investors and some apparently strongly worded threats, the government got its
way. In the end, this is how it looks like it will shake out. The senior creditors who are owed $7B will get
$2B and no equity in the restructured company, the equivalent of $.28 on the dollar. The UAW, whose
position is lower in the capital structure, will receive $.43 on the dollar for its $11B+ in claims. In terms of
ownership, the UAW would own 55% of the company, Fiat would initially own 20% with the right to
increase that stake to 35% and the Treasury would eventually hold only 10%.

Fiat? Where did Fiat come from? Has anyone seen Fiat on the list of creditors? Nope. In exchange for
providing the company’s technological expertise Fiat could own up to 35% of Chrysler while the senior
creditors do not own any equity whatsoever. What happened to our nationalism? We are giving away 35%
of an iconic US company to an Italian company at the expense of banks and asset managers who operate in
the US? Apparently nationalism is only important when we want to keep Chinese steel out of the US. Let
us also not forget that the UAW is a huge contributor to the campaigns of many democrats so of course it is
no surprise that it would be able to leapfrog the much chastised financial companies that supposedly had
higher ranking claims.

Essentially, the government was able to force the banks to give up their spot in the capital structure by
using their TARP investments as leverage and used a combination of threats (allegedly) and the media to
coerce the asset managers and hedge funds to do the same. I would argue that this precedent could
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eventually make it much more costly for certain companies to borrow money because investors will want to
get paid for the risk that the traditional understanding of the capital structure no longer applies. If I were
offered the chance to buy senior debt of a company that the government also had an investment in I would
sure be concerned enough about the government’s potential actions to demand a much higher rate than
normal.

After what we learned from the testimony of BAC’s Ken Lewis and the way Congress was willing to
special create legislation to tax a certain number of AIG employees, would it surprise anyone if the
allegations listed in the excerpts from the above primary news sources were true? I sure wouldn’t as it
appears that the current crisis has created situation in which the ends justify the means and just about
anything will be done in the name of protecting from a further meltdown. In the process the authorities
have turned capital structure hierarchy on its head, tarnished the sanctity of signed contracts, and have
ignored the laws of this country. This is all in addition to ignoring the rights of investors and private
companies who will eventually be critical in helping the US emerge from this downturn.

Accordingly, it is important to assess the implications of the recent actions of the government. I am a US
citizen and investor and I have very little faith that the government would protect my contract and property
rights in the current environment if those rights were not aligned with what the government had decided
was “best” for the country. I see the capital markets fluctuating based on the whims of the government and
that is why I am sitting on the sidelines in cash. In order to invest I would either need to see a situation in
which the government was no longer propping up or intervening in multiple sectors of our economy or
would like to be compensated for the extra risk I believe I am taking. If I were a foreign investor I would
have the same fears. From an outsider’s perspective the US government’s actions look no more consistent
or rational than those of the autocratic governments that get so much negative publicity and are vilified by
the leaders of this country. Therefore, I would have to choose between investing elsewhere or only
investing in US assets that provided a return that was commensurate with the existing political risk.

Finally, I will conclude this long diatribe by sharing some thoughts from Nobel Prize winner Paul Krugman
in a recent piece in the New York Times:

But what worries me most about the way policy is going isn’t any of these things. It’s my sense
that the prospects for fundamental financial reform are fading.

Does anyone remember the case of H. Rodgin Cohen, a prominent New York lawyer whom The
Times has described as a “Wall Street éminence grise”? He briefly made the news in March when
he reportedly withdrew his name after being considered a top pick for deputy Treasury secretary.

Well, earlier this week, Mr. Cohen told an audience that the future of Wall Street won’t be very
different from its recent past, declaring, “I am far from convinced there was something inherently
wrong with the system.” Hey, that little thing about causing the worst global slump since the Great
Depression? Never mind.

Those are frightening words.

This is what worries me most about what has happened as well. We have created this system in which the
largest financial companies have a tremendous say in what happens in Washington and have set the
precedent that the government can and will do anything it pleases without fear of substantial media and
popular scrutiny or political backlash. Right when it appears that we need to embark on a road that includes
serious reforms of our financial and government institutions, the stock market has gone back up, the banks
have passed their stress tests, the populist furor seems to have died down, and some of the powers that be
seem intent on rebuilding what was the status quo prior to the crash. I think this is very dangerous because
we need to do something to solve the conflicts of interest between Washington and Wall Street. We also
need to make sure the regulators that are watching over the markets and the economy have the power and
will to enforce the rules. And we need to examine what role the government should take in the middle of
crisis so that we can (in the future) avoid a situation in which the rights of companies and individuals are
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overlooked to the extent that both domestic and foreign investors are afraid to put their capital to work in
the US.