When the Bush administration submitted its three-page bailout proposal to Congress, taking equity positions in financial institutions was not included. Congress added it, hoping to recover some of the public's investment through the appreciation of shares companies would exchange with the Treasury Department for their illiquid assets.
Now this potent tool has become the centerpiece of the bailout effort, as well it should. We are dealing with a massive deleveraging, and more bang for the taxpayers' buck can be achieved on the constricted equity side of institutions' balance sheets than on the bloated asset side.
Having reluctantly embraced this tool, the administration regrettably has taken a half-hearted approach that limits the government, as the investor in these firms, to a totally passive role. This is consistent with the administration's guiding ideology, but our exit from this crisis would be hastened by a more activist approach in boardrooms and executive suites on behalf of "we the people" as investors.
We are reaping the harvest of a global failure of financial institution management. How odd that many of these managers blame an indulgent regulatory system for their own excesses. The seeds of this season were sown in instruments as massive as they were complex. The average CEO and the average director had no realistic understanding of the inherent risks of these instruments.
If taxpayers are to take an ownership interest in firms managed by these people, shouldn't the taxpayers' representatives take some oversight responsibility to avoid repeating the same mistakes? Britain, in the case of Royal Bank of Scotland, and the Dutch, in the case of ING, demanded board representation in exchange for their equity purchases. Shouldn't we?
I am a director of a federally chartered bank in the Boston area. This independent directorship was required by the comptroller of the currency when the bank was about to be acquired by a foreign firm. In these circumstances, I view my role as the eyes and ears of the comptroller and the taxpayers. Modestly, I believe that the managers would agree that my involvement, and that of another independent director, has been uniformly positive for the business and for the control environment in which it operates.
No one is suggesting that the Treasury or the Federal Reserve Board should take over managing these institutions entirely. We are trying to avoid the AIG scenario, but there is a recognizable middle ground between having the government act as the ersatz CEO and making it the passive enabler of bad corporate behavior.
It was only a few months ago that policymakers were concerned about the undue influence of "sovereign wealth funds," a $2 trillion collection of foreign capital that is investing in U.S. banks. Washington heavyweights worried (and still do) that the political agendas of these funds would override their own commercial interests and influence the behaviors of Citigroup, Merrill Lynch, etc.
Enter the International Working Group of Sovereign Wealth Funds, whose members includes the United States, China, and the United Arab Emirates. Two weeks ago the group released the Santiago Principles, a set of 24 standards designed to keep these funds on their best transparent behavior.
Guess what? The U.S. government — American taxpayers — are about to become the largest sovereign wealth fund of them all!
Missing from the Santiago Principles is any mention of how a sovereign fund exercises control over the institutions in which it invests. Fortunately, the Fed has given us some guidance in this area.
Eager to attract private-equity capital to the banking system, last month the Fed reversed a quarter-century policy. It voted to let private-equity firms have representatives on bank boards and advocate with managers on issues ranging from whether to sell the company to replacing the management team itself.
Although the Fed's new approach is not geared explicitly to offshore funds, there is every reason to apply it to our own homegrown sovereign fund. It follows that a fund created for the very purpose of restoring stability should be more active in overseeing managers than one whose primary goal is to maximize return on investment.
Make no mistake, putting a government representative in the corporate boardroom is a departure from over 80 years of democratic capitalism in the United States. Then again, so is the insertion of hundreds of billions of taxpayers' dollars into the balance sheets of these firms. And so is the government's backstopping the likes of Bear Stearns, Fannie Mae, Freddie Mac, Wachovia (almost), and American International Group.
America has a tradition to draw upon for insulating the government's involvement in finance from the vagaries of politics. Look to the Fed's structure and the use of bonding authorities at the state and municipal level. Activist shareholder oversight by the government can be done — and done wisely.
The credit crisis is all about confidence and trust. Clearly, we have lost confidence in the leaders of our financial institutions, and those leaders have lost confidence in one another. The stewardship of the federal government over the past several years has caused U.S. citizens to lose confidence in the government, as reflected in the low approval ratings of the current administration.
Having reached this nadir of confidence, few would envision the federal government playing the role of activist investor as anything other than a temporary measure. As one national politician says with reference to Iraq, "We should be as careful getting out as we were careless going in."
These cautionary words deserve to be kept in mind as we use the powerful tool that is equity capital.
