"The New Deal wasn't written in a day," advised Tom Gallagher, senior managing director of the International Strategy and Investment Group, an institutional brokerage firm. "The policy response to burst bubbles takes years and years. First you put out the fire and then you build a fireproof house." And that requires trained, competent firefighters and fire inspectors -- lots of them.
The new legislation has created an Office of Financial Stability within the Treasury Department and charged it with implementing the Troubled Asset Relief Program. That effort will entail buying distressed mortgages and investing in failing financial institutions. It may require hiring more than 1,000 federal workers and at least that many more in the private sector, in part because this unprecedented task will demand skills and experience that current civil servants do not possess. Punishing those whose abuses triggered the financial meltdown and ensuring that the bailout process itself is not corrupted will also become high government priorities. And everyone will look to Congress for better oversight of the financial services sector.
Can Washington handle this challenge? For nearly three decades, deregulation has dominated policy debates in the executive branch, on Capitol Hill, and in much of the Washington think-tank community and the press. Federal financial-sector regulatory authority and expertise have been scattered across multiple agencies. Over the years, the civil servants responsible for such oversight have been demonized by Republicans, demoralized by their lack of political support from Democrats, and hamstrung by their shrinking numbers.
"Like all great national challenges," said Robert Dugger, a partner in a global investment company, "it will take some time to crank up the capability to deal with this." President Hoover created the Reconstruction Finance Corp. to cope with the Depression. But it wasn't until the Roosevelt administration that the agency hit its stride. Two decades ago, it took about a year for the Resolution Trust Corp. to get its hands around the savings and loan crisis.
"This is stuff that the government doesn't do great, but it's not impossible to do," said Adam Posen, deputy director of the Peterson Institute for International Economics. "Think of this as a public works project. It is no different from building the interstate highway system. You have to get the financial engineers, as opposed to the civil engineers, involved and set up specialized procurement processes."
Building a bridge to a more stable financial future is certainly a daunting task. But the die has been cast: The rescue is now the federal government's responsibility, and it is up to Washington to get it done.
An Unprecedented Challenge
The bailout's $700 billion price tag dwarfs any of the dozen U.S. government efforts to rescue troubled industries, companies, or public entities in the past four decades. Up to now, the 1989 S&L bailout was the most costly, ultimately requiring $218.7 billion in taxpayer money (in 2008 dollars). The 1980 rescue of Chrysler involved $4 billion. The 1975 federal aid deal for New York City cost $9.4 billion. In the end, taxpayers made money on the Chrysler deal, and New York City repaid its loan. The Bush administration hopes that the current bailout will turn a profit.
The newly created Office of Financial Stability has broad authority. This flexibility is intentional, to give Treasury the discretion needed to find creative solutions to a financial problem that everyone suspects will get worse before it gets better.
But Washington veterans question whether the framework designed to oversee the rescue will be up to the task. "This bill does not provide the institutional infrastructure to manage $700 billion in distressed assets," Dugger complained.
The Office of Financial Stability will be headed by an assistant Treasury secretary, a relatively low post in the bureaucratic pecking order. On Monday, Treasury named Neel Kashkari, 35, a former Goldman Sachs vice president in San Francisco and now the assistant Treasury secretary for international economics and development, to head the office until Jan. 20.
The Federal Emergency Management Agency, by comparison, is run by the equivalent of an undersecretary. Yet the potential damage of the financial hurricane dwarfs that of natural disasters such as Katrina. "There are no agencies with a budget of $700 billion run at the assistant secretary level," noted Paul Light, a New York University professor and the former director of the governmental studies program at the Brookings Institution.
Light argues that the Office of Financial Stability's chief will be buried under layers of political appointees, hardly a situation that encourages speed and accountability. Moreover, other federal financial regulators -- the Federal Reserve Board of Governors; the Federal Deposit Insurance Corp.; the Comptroller of the Currency; the director of the Office of Thrift Supervision; and the Housing and Urban Development secretary -- will constitute a Financial Stability Oversight Board charged by Congress to monitor the bailout.
"By dint of their position in the hierarchy," Light observed, "they aren't going to spend time talking to an assistant secretary. They are going to talk to the secretary." He warns, "The more you push the office down into the bureaucracy, the more power rebounds to the Treasury secretary. I can see the assistant secretary being pushed around to favor investors that the Treasury secretary or the head of the Federal Reserve favor."
Light says that Congress should convert the Office of Financial Stability into an independent agency as soon as possible. "Treasury does not have the institutional memory to manage and oversee this kind of high-transaction operation," he said. Moreover, the S&L experience teaches that every government purchase of distressed assets and their eventual sale brings intense political pressure on the office from winners and losers. The Resolution Trust Corp.'s independent governance and operations helped to insulate it somewhat from such political meddling.
Help Wanted: Financial Managers
The federal workforce available to oversee this effort and the almost inevitable reregulation of the financial sector in the years ahead is a shadow of its former self. In 1992, the federal government had more than 20,000 financial regulatory employees, from accountants to bank examiners. In 2006, the last year for which there are comprehensive estimates, that regulatory oversight team had shrunk to fewer than 14,000, despite an exponential growth in the volume of financial assets being regulated.
Some of this workforce reduction is attributable to the declining number of banks in the United States after years of consolidation. But it also reflects the triumph of those who have long argued that the financial sector is far too large, too globalized, and too innovative to be efficiently or effectively regulated by Washington.
Just how many people will be needed to conduct the bailout is a disputed topic. Treasury officials have created the impression in some news interviews that a couple of dozen government employees can oversee the rescue, with most of the work subcontracted to Wall Street. Many experts with experience in these kinds of efforts say that Treasury woefully underestimates what will be required and that it would be unwise to scrimp on personnel. "You don't want to do this with too few troops," Posen said.
At the height of the S&L crisis, the RTC had about 10,000 people on the federal payroll. That huge workforce was needed because the government took over the management of houses, office buildings, and retail outlets financed by the thrifts. Someone had to make sure that the rent was collected and the lawns mowed until the properties could be sold. This time around, said Robert Litan, a vice president of the Kauffman Foundation and a former associate director of the Office of Management and Budget, "you will need fewer people and much smarter people."
To be sure, it will take only a handful of experts to design the process for acquiring distressed assets. But someone has to decide which assets to buy first and, in each case, what price the government is willing to pay. Many of the financial products involved are one-of-a-kind securities, each intentionally complex because its originator was often trying to hide its vulnerabilities. There can be no template for buying and selling these assets. Each will require unpacking -- a labor-intensive analytical and legal dissection.
Once the government owns these distressed securities, they can't just be stuffed in a lockbox for five or 10 years, to be sold when the market has recovered. Although Washington won't be managing buildings directly this time, someone has to be responsible for hedging against interest-rate changes on the mortgages and other economic developments that could hurt the value of the underlying assets.
The bailout legislation also directs the government to rewrite mortgages wherever possible to make them more affordable for the homeowners facing foreclosure. "You will need legal manpower to get down to that level of granularity," Posen said. And, Litan noted, "the post-crisis litigation is going to be incredible," requiring even more lawyers.
In addition, the rescue legislation permits Treasury to take over failing firms, rather than merely buying their distressed securities. Many observers think that such action will end up being a much larger part of the bailout than the Bush administration has suggested. Determining whether to buy assets, or a firm itself, will be time-consuming. "Once you invest in the company, you have to oversee that investment," Dugger noted. "That has not been done on this scale by the U.S. government since the Depression."
"And somebody is going to have to keep track of all these things," Light said. "Even if you charge [civil servants] only with housekeeping, there still has to be enough of them to handle it. One thousand people would be a reasonable total number, but it could run to 1,500. And that would just be the civil servants."
The FDIC could help; it is one of the few federal institutions to earn virtually unqualified praise during the crisis. Established in 1933, the FDIC insures deposits at commercial banks. Its examiners keep a close watch on a bank's bottom line and will take it over if necessary to avert a collapse. Under Chairman Sheila Bair, experts say, the FDIC has adroitly handled 13 bank failures this year, and it is carefully monitoring more than 100 other banks that could run into problems.
The bailout legislation gives the FDIC an unlimited credit line from Treasury to cover bank failures, and it directs Treasury to consider hiring the agency to manage some of the loans and securities that the department purchases. The FDIC, however, has its hands full and would need more people to expand its role. "The FDIC is far and away the most competent agency in D.C. at dealing with bank assets and exposures," a longtime banker who covers the industry writes on the Naked Capitalism blog. "If you have to have a stopgap, use the FDIC, and upscale it as quickly as you can."
Undoubtedly, people from other government regulatory agencies will be brought in to share the burden. But, said Steve Wallman, a former commissioner at the Securities and Exchange Commission, "you can't redeploy people without compromising other missions. Instead, you can have a few people tasked with overseeing it, and then you hire the folks from the outside who have the expertise, who do this for a living, who have the contacts, and who know whom to call."
Michael Bopp, chairman of the financial services crisis team at the Washington law firm of Gibson, Dunn & Crutcher, said, "The secretary has robust authority to hire people quickly to manage the assets, which is exactly what Treasury did with Bear Stearns; [it] hired an outside entity to manage the assets."
Treasury Secretary Henry Paulson Jr. has previously come under criticism for such outsourcing. But he moved quickly this week in that direction. On Oct. 6, Treasury solicited companies interested in managing bailout work. Bidders had to respond by 5 p.m. on Oct. 8, and the department said it would pick its lead firm by Oct. 10. Treasury wants a lead company with at least $500 billion in domestic assets. Industry sources say that half a dozen or more Wall Street firms may be brought on to buy troubled assets for the government, manage them -- probably for several years -- and eventually handle their sale. Press reports suggest that the firms interested in taking on the work included Pimco, Legg Mason, BlackRock, and MKP Capital Management.
Wall Street experts worry about the operational challenges involved in this effort. In the S&L crisis, the government took over properties without having to first determine their fair-market value, because the financial institutions that owned the assets were broke. Now Washington, or more accurately its agents in the private sector, will be buying distressed mortgages from troubled banks. The seller will try to maximize the price to benefit its shareholders. The government will want to minimize the price to safeguard taxpayers. How this will be done, through a reverse auction or some other means of determining value, remains to be seen. One thing is clear: It won't be easy.
How many people in how many firms will be involved in this outsourcing operation also isn't known. One indicator of the magnitude of such an operation: Pimco requires more than 1,000 people to manage its portfolio of $829.5 billion.
So, although it is impossible at this early date to know precisely how many people Treasury will need inside and outside the government to run the bailout, a couple of thousand seems a safe estimate.
The Civil Service Challenge
Beefing up the federal workforce side of this equation involves particular challenges in finding people with the necessary skills, paying them what they are worth, and policing their conduct. "There is not a lot of capacity lying around," Light lamented. "And that is a result of the lack of investment in the career workforce."
Allan Mendelowitz, a member of the board of directors of the Federal Housing Finance Board, said, "The area that needs to be strengthened the most is not the bank examiners. The real push has to be on the quantitative side, to strengthen the analysis."
Getting skilled personnel in a hurry won't be easy. The Office of Personnel Management recently announced that it hoped to shorten the hiring process for all federal workers to 80 days. The bailout legislation allows the Treasury secretary to waive some hiring rules to accelerate the effort. But bringing people up to speed is a separate issue. By some estimates, it takes five years to become a qualified bank examiner. Oversight of the bailout cannot wait that long, so the Office of Financial Stability will need to hire people from the private sector ready to take on huge responsibilities from day one.
With the shuttering of major financial institutions and the downsizing on Wall Street, many highly qualified people are looking for jobs, or soon will be. Some of those people may now work in London or Dubai, however. "As a taxpayer," a former senior Treasury official said, "I want to get the best people on the planet. But what if the best asset managers in the world are foreign nationals? That would be white-hot politically."
Federal pay constraints pose another obstacle. The maximum salary for an FDIC bank examiner was $160,910, according to a 2007 analysis by the Government Accountability Office. The highest pay for an SEC lawyer was $126,987. The pay cap for those in the senior executive service is $191,300. None of these salaries can compete with the remuneration available to the best and brightest on Wall Street.
Nonetheless, federal service does have appeal: patriotism and job security among them. The government should be able to find the people it needs, despite the salary constraints. "I used to compete very well hiring people," Mendelowitz said, referring to his tenure as a vice president of the Export-Import Bank and as the managing director of the GAO's international trade, finance and, economic competitiveness division. "If you have a high tolerance for idiosyncratic people, you can get very good ones."
But to attract the best, Light contends, "the agency needs the authority to create a pay system that rewards employees for measurable performance."
Subcontracting much of the bailout to the private sector will dramatically speed up the rescue and skirt many of these skill and pay constraints. The concern is that it may solve a short-term management problem by creating a long-term political one.
The private-sector firms that Treasury is likely to hire will need their own specialists. "They have to have quants," said Litan, referring to Ph.D. economists and mathematicians whose quantitative skills are high and who know how to use complex algorithms to develop financial derivatives. "Or they will get creamed. They will have to pay market rates for these guys, more than government salaries. I hope that congressional staff will understand that" when news stories start appearing about the "outrageous" earnings of those managing the rescue effort.
The Ethical Dilemma
Major ethical challenges also loom, both in staffing the Office of Financial Stability and in outsourcing the Troubled Asset Relief Program.
The wizards of Wall Street may be the only people with the skills needed to buy and eventually sell bundles of distressed mortgages. And it may take the engineers of today's complicated financial products to figure out how to regulate them.
The public, however, may balk at hiring the arsonists to put out the fire. The people intimately involved in some of the worst subprime mortgage and derivatives abuses must be off-limits to both Treasury and the Wall Street firms handling the bailout. The government will also have to carefully screen those who eventually buy distressed assets. The buyers can't be business associates or relatives of those doing the selling.
The next order of business, Wallman, the former SEC commissioner, said, is for "Paulson to call these people into his office, stare them in the face, and say, 'You say you want to do this to help the country and the world, and we believe you. You are working for the U.S. government now and not yourself or your friends. If you're willing to do that, stay. If not, go.' "
Yet, once specialists are hired, ethics conflicts are almost inevitable. Wall Street people are creatures of a different culture. The kinds of personal contacts and the casual trading of insider information that are commonplace in Lower Manhattan will be out of bounds along the Potomac. "Congress may want to prohibit all outside lobbying and gifts," Light offered, "while requiring full financial disclosure from every person in the organization as well as every analyst under contract."
Anticipating such problems, the bailout legislation, at the insistence of Congress, includes a robust framework for monitoring and enforcing ethical standards. Treasury has already issued guidelines to manage conflicts of interest in the program's administration. The department must publish details of purchases, sales, and other dispositions of troubled assets within two business days of their occurrence. There also is a requirement for an additional public accounting each time another $50 billion in assets have been purchased.
The comptroller general will exercise oversight, issuing reports at least every 60 days. Annual audits are required. Treasury must make monthly reports to Congress, and the department's actions will be subject to judicial review. An inspector general will be appointed to supervise Treasury's asset purchase program and a congressional oversight panel will be established.
Enforcement and Accountability
Accountability will be key to rebuilding public trust in the financial system and in Washington's ability to cope with such crises. Nothing may resonate as loudly with taxpayers as throwing a few wrongdoers in prison.
In 1990, in reviewing the S&L crisis, what was then the General Accounting Office reported that the RTC suspected that fraud or criminal activity on the part of directors, officers, or senior managers contributed to the failure of 40 percent of the thrifts it had investigated.
So it is little wonder today that many taxpayers suspect that fraud and corruption triggered or worsened much of the subprime mortgage mess and many of the economy's other financial problems. Moreover, in a late-September Pew Research Center poll, 72 percent of Americans said they were very concerned that "those who are responsible for causing the crisis will be let off the hook." Such public anger with the bailout will be appeased only by holding someone accountable.
This is not so much a legal problem as a political one. If only a few Wall Street small fry end up being punished because of the meltdown, the public may conclude that politicians are covering for their well-heeled campaign donors. Voters' faith in their elected officials would be further eroded, possibly making it even harder to obtain needed public support for any future government aid to the financial sector, with potentially catastrophic economic consequences.
"There has to be some very aggressive enforcement activity," said Kenneth Donohue, HUD's inspector general, who was the assistant director of the RTC's office of investigations. "You have to be very proactive."
The FBI has about two dozen corporate fraud investigations under way in the financial services sector and about 1,400 other investigations into smaller companies and individuals suspected of mortgage fraud. Much of this is being done by local task forces, but some in Congress have pushed for a major effort on the national level. To counter the public's cynicism, the next administration may have to create a high-level enforcement arm headed by a respected, scrupulously independent prosecutor with unlimited resources.
Moreover, the Office of Financial Stability will have to be vigilant in policing its own activities. With $700 billion in taxpayers' money on the table, Dugger, the investment firm partner, said, "this poses every potential problem that Iraq has: corruption, conflicts of interest, theft, and waste of government resources. It's Blackwater, Halliburton, and KBR, but right here at home."
History suggests that some fraud may be inevitable. In the S&L bailout, the RTC faced allegations of favoritism in the hiring of outside counsel, document shredding to conceal criminal evidence, and the use of front men to mask the identity of those buying real estate from the government.
"Protecting against fraud will be a huge part of the operation," said William Seidman, a former chairman of both the FDIC and the RTC. "You will be sitting there with a large bundle of money to give out, and it is unbelievable how many bad people are attracted by that."
Wallman's advice to Treasury is to be explicit in warning its private-sector hires about the penalties they will face for mismanaging taxpayers' money: "Here's how we are dealing out the cash and how we would like you to [handle the buying and selling of distressed mortgages]. And, by the way, we will send in an inspection team from Treasury, GAO, [and] FDIC, and ensure that we do the necessary things in auditing to make sure that you did the right thing. If there is any fraud, any corruption, we will deal with it. And you understand that it will be criminal. Therefore, please don't do it; we know where to find you."
At the same time, oversight must not become second-guessing, Wallman warned. "You don't want somebody two years from now saying, 'You bought it for 10 cents on the dollar for the government, and the economy is now better and we believe it was only worth 4 cents on the dollar when you bought it.' And then you have to stand up and say, 'We were trying to save the global economy, and that is what you told us to do,' " he observed. "People involved in buying and selling these securities for the government will need a strict indemnification so that, except for mischievous conduct, they have no liability."
Given the politically poisonous atmosphere that is likely to continue to surround this massive expenditure of taxpayers' money, such protection may prove easier to promise than to deliver.
The Political Transition
All of this effort to set up an organization in the midst of a financial calamity could not come at a worse time in Washington, where the impending transition to the next administration, with its inevitable bureaucratic reshuffling, threatens to further complicate the bailout.
Dozens of political appointees in the financial regulatory agencies will lose their jobs in January and are understandably distracted. "They have only a few more paychecks before they are working somewhere else," one banking lobbyist noted. "Who among them is not spending time updating their résumés?"
In the next few weeks, Treasury Secretary Paulson will be reaching out to those he wants to staff the Office of Financial Stability. The first question that prospective hires are likely to ask him is whether their appointments are for the duration of the Bush administration, or longer.
With the pressing need to rapidly buy up distressed assets, continuity of action between administrations is of paramount importance. "Maybe Paulson will want to reach out to both campaign teams and privately vet people" in advance, Litan suggested. "You would not want to bring on a guy no one could live with."
But there may be limits to what the next administration will commit to. Barack Obama and John McCain each knows full well that as president, he will ultimately be held accountable for the success or failure of the bailout. The new president may not want to be saddled with structural and programmatic decisions that he had no role in crafting. He is also likely to want his own people in key roles.
Whatever happens in the transition, Congress can help by putting all appointees to the Office of Financial Stability on the same fast-track confirmation process accorded to senior national security nominees.
The bureaucratic challenge facing Washington as it gears up to manage the bailout is, in the financial world, comparable to the complexity and difficulty it faced in creating the Homeland Security Department after the attacks of September 11, 2001. In its own way, the bailout is no less important. Washington fumbled the formation of Homeland Security. It cannot afford to get it wrong again.