At the House Financial Services Subcommittee on Capital Markets hearing on AIG held Wednesday morning, a long line of Republican and Democratic congressional representatives expressed outrage at the bonuses given to employees of AIG's Financial Products subsidiary. Then the first panel of witnesses made their opening statements, and barely referenced the scandal.
The disconnect arose from the fact that the hearing had been scheduled before the bonus scandal broke. The assembled panel members, representatives from the Office of Thrift Supervision and the Government Accountability Office, an insurance regulator, and a representative from Standard & Poor's, were there to try to provide what insight they could into what had gone wrong at AIG.
The politicians were all too aware of this, because as soon as questioning began they stopped talking about bonuses, and started asking about credit default swaps and systemic risk regulators and the prospects for the American taxpayer recouping their investment in AIG.
Which is all to the point: The politics of the bonus payments are awful -- that's one of the few things that Republicans and Democrats have agreed on in the first two months of the Obama administration -- but they are not essential to the real problem at hand, which is dealing with the systemic risk posed by the failure of a company such as AIG.
On Tuesday, Felix Salmon set out a clear explanation of why the government felt it necessary to bail out AIG. In a nutshell: "it's basically the same reason why the government stepped in to prevent Bear Stearns from being forced into liquidation. It feared a cascade of counterparty failures which could kill the entire financial system."
The hoopla over the bonuses mainly serves to obscure the crucial points: 1) Our existing regulatory system had insufficient authority to oversee a company of the size and complexity of AIG, and 2) The financial product -- credit default swaps -- that financial institutions were using to ensure themselves against risk, was also unregulated. No one was watching the store.
The administration is now coming under political fire for not having exercised closer authority over AIG after starting to funnel billions of taxpayer money into the insurance company. And there appears to be pretty compelling evidence that the Obama administration's own efforts to limit restrictions on executive compensation leave it -- particularly Larry Summers and Tim Geithner -- vulnerable on the bonus issue.
At he Baseline Scenario James Kwak hopes that there is a silver lining to the AIG bonus scandal, that "it will force the administration's hand toward the decisive action that we need." In other words, the political firestorm will encourage Obama and his political hands -- Emanuel, Axelrod, etc. -- to bite the bullet and nationalize failing banks. But isn't it equally possible that the shouting and hollering about the bonuses will drown out the less flashy, less cable-news-friendly fare? How does a systemic risk regulator get set up? How should credit default swaps and even newer financial products get regulated? Where do we go from here?