“If you thought Lehman Brothers was a mistake, just stand by and see what nationalizing Citi or B.of A. would do,”

TO BE NOTED: From the NY Times:

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Stephanie Diani for The New York Times

Appearing on TV and bending the ear of the White House, Bill Gross of Pimco has emerged as one of the nation's most influential financiers.

"Treasury’s Got Bill Gross on Speed Dial

By DEVIN LEONARD

Newport Beach, Calif.

Every day, Bill Gross, the world’s most successful bond fund manager, withdraws into a conference room at lunchtime with his lieutenants to discuss his firm’s investments. The blinds are drawn to keep out the sunshine, and he forbids any fiddling with BlackBerrys or cellphones. He wants everyone disconnected from the outside world and focused on what matters most to him: mining riches for his clients at Pimco, the swiftly growing money management firm.

Mr. Gross, 65, has long been celebrated for his eccentricities. He learned some of his lucrative investing strategies by gambling in Las Vegas. Many of his most inspired ideas arrived while he was standing on his head doing yoga. He knows he has to be well dressed for client meetings or television — but instead of keeping his Hermès ties neatly knotted, he drapes them around his neck like scarves so he can labor with his collar open.

And with the collapse of Wall Street, Mr. Gross has emerged as one of the nation’s most influential financiers. His frequent appearances on CNBC draw buzz, as do his wickedly humorous monthly investing columns on the Pimco Web site. Treasury secretaries call him for advice. Warren E. Buffett, the Berkshire Hathaway chairman, and Alan Greenspan, the former Federal Reserve chairman, sing his praises.

“He’s a very individualistic person. He doesn’t come at analysis or investment judgment in the words, terminology or ambience that I have been used to over the decades,” Mr. Greenspan says. “That may be the secret of his success. There is no doubt there is an extraordinary intellect there.” Mr. Greenspan, it should be noted, now works for Pimco as a consultant.

Amid all of this, Mr. Gross and his firm are trying to shape the government’s response to the economic crisis. He is one of the most fervent supporters of the Obama administration’s plan to enlist private investors to help bail out the nation’s ailing banks and try to revive the economy.

That effort, known as the Public-Private Investment Program, or P.P.I.P., has gained little traction so far. But Mr. Gross has energetically defended its architect, Treasury Secretary Timothy F. Geithner, against critics like the New York University economics professor Nouriel Roubini and the New York Times columnist Paul Krugman — both of whom argue that the strategy is flawed and that it would be best for the government to temporarily nationalize so-called zombie banks to prevent a repeat of the Great Depression.

Such nationalization, Mr. Gross insists, would be an unmitigated disaster. “There are two grand plans,” he said this spring at a meeting of his firm’s investment committee. “One is the Krugman-Roubini plan. They think the banks have so much garbage they are beyond hope. The other side is the administration’s side. That’s the one we’re on. If the other side should ever gain credence, then we’ll have something to worry about.”

Mr. Gross is hardly a disinterested observer. Pimco, owned by the German insurer Allianz, is jockeying to be picked by Mr. Geithner to relieve the likes of Bank of America, Citigroup and other banks of an estimated $1 trillion in soured mortgage debt so they can start lending freely again. Mr. Gross calls the plan a “win-win-win” for the banks, taxpayers and Pimco investors.

The government is planning to announce soon which money managers will participate. A spokesman for the Treasury Department would not say whether Pimco would be one of them.

IN many ways, it is perfectly logical for the White House to turn to someone like Mr. Gross at such a time. Few investors understand the mortgage market better. As co-chief investment officer, he personally manages Pimco’s flagship, the Total Return fund, which has $158 billion in assets. As of the end of May, he had invested 61 percent of the fund’s money in mortgage bonds.

Mr. Gross has always been partial to mortgage bonds. And why not? He has done fabulously well with them. In an October 2005 letter to investors, he made one of the most prescient calls of the last decade, warning of the looming subprime mortgage crisis. Almost everybody ignored him. Today, they wish they hadn’t.

When the housing bubble burst and the financial markets fell apart, investors lost billions of dollars. Not Mr. Gross’s clients. Class A shares of the Total Return fund, for individual investors, were up 4.3 percent in 2008, or nine percentage points ahead of comparable bond funds, according to Morningstar; this year through Thursday, the shares were up 5.4 percent.

In the midst of an economic crisis, those numbers are impressive. So is the longer-term record: In the 10 years through Thursday, the fund had an annualized return of 6.42 percent, beating its benchmark by 0.54 percentage points, according to Morningstar.

That’s one of the reasons the government has courted him closely. Last fall, the Federal Reserve Bank of New York, run at the time by Mr. Geithner, hired Pimco — along with BlackRock, Goldman Sachs and Wellington Management — to buy up to $1.25 trillion in mortgage bonds in an effort to keep interest rates from skyrocketing.

Last December, when it was pressing Bank of America to complete its ill-fated acquisition of Merrill Lynch, the Federal Reserve also looked to Pimco for advice. According to recently released messages that Fed staff members sent one another that month, Pimco evaluated the two banks and concluded that Merrill wouldn’t survive without a capital infusion or additional government aid.

Today, Mr. Gross is eager to buy the same subprime loans he once refused to touch, as part of the Treasury’s distressed-asset initiative. After all, the thinking goes, if anybody can figure out how much all this debt is worth, it’s Pimco. But Pimco’s involvement in so many aspects of the bailout has made many other financiers and analysts uncomfortable. They say its proximity to the Treasury Department and the Fed may allow it to reap billions of easy dollars through federal contracts and preferential investment opportunities.

A frequent complaint is this: Why is the Federal Reserve paying Pimco to buy mortgage securities on its behalf, when the firm is already a huge buyer and seller of the same bonds? “That’s the equivalent of a no-bid contract in Iraq,” fumes Barry Ritholtz, who runs an equity research firm in New York and writes The Big Picture, a popular and well-regarded economics blog. “It’s a license to steal.”

No one, of course, has actually accused Pimco of theft. But there is a larger question: Whose interests is the firm looking out for in the bailout? Money managers, after all, have a legal obligation — a fiduciary responsibility — to put the interest of their investors before anyone else. Even Mr. Gross acknowledges that Pimco’s interests won’t always be aligned with those of the government.

Mr. Gross points out that he has never even met Mr. Geithner. For its part, the Treasury Department plays down Pimco’s influence. “We speak with a number of market participants and believe seeking out a diversity of perspectives is critical to our efforts,” says Andrew Williams, a spokesman for the department. He says the Treasury takes conflicts of interests “very seriously in all cases.”

Mr. Gross is well aware of the criticism that has been directed at Pimco. During an interview at its headquarters in Newport Beach, Calif., sitting at his horseshoe-shaped desk on its 4,200-square-foot trading floor overlooking the Pacific Ocean, he brings up the topic of perceived conflicts of interest himself.

He almost never personally buys and sells bonds. Pimco has dozens of traders who do this for him here. “There’s the mortgage desk over there,” he says, pointing to a group of well-scrubbed young people hunched over computers. “We’ve been buying some mortgages this morning. That’s our baby, so to speak. That’s our bag.”

He immediately adds that this mortgage trading operation is completely separate from the one on the floor below, where traders are working on behalf of the Fed. He says he can’t even visit that floor himself anymore without a company lawyer at his side. The last time he did was in December, when he wished the traders happy holidays.

“I said, ‘Merry Christmas,’ ” Mr. Gross recalls. “The lawyer said, ‘Mr. Gross says Merry Christmas.’ Right then and there, I knew that communications were basically severed. That’s the way the Fed wants it.”

He says he assumes that Pimco traders working on behalf of the government don’t talk to their peers trading for Pimco’s own accounts. Then again, he said he doesn’t know for sure what happens after hours.

“I don’t drink beer with these guys; I have no idea what happens in the privacy of their own homes,” he says. He says that when he encounters traders working for the Fed outside the office, he doesn’t talk to them.

“I pass some of them on the way to the lunch shop,” he says. “I just sort of wave. I don’t know what to do.”

MR. GROSS is fond of saying he is the antithesis of a Wall Street “alpha male.” He is every bit the Southern Californian, with longish hair and a laid-back attitude. Most Wall Street executives won’t talk to a reporter without a public relations person hovering nearby. Even then, they can be disappointingly bland. No one would ever say such a thing about Mr. Gross. He approaches an interview is almost like a therapy session; it is a chance for him to make confessions.

“I’ll tell you an interesting story,” he says at one point. “I shouldn’t, but I will. It’s like I’m taking truth serum every time I do this.”

The tale is about “a very childish and immature” e-mail message that he sent Don Phillips, a managing director of Morningstar, the mutual fund research company, when Morningstar didn’t select him as its fixed-income fund manager of the year in 2008. It is an intriguing story. But it’s nowhere near as interesting as what he has to say about Pimco’s role in the bailout.

He sounds genuinely pained by the economic collapse. “There was always a big part of me that thought the Depression was just something from my old American Heritage history books,” he says. “I thought: ‘This stuff can’t happen really. I mean, this is just for the economic philosophers and the paranoid worriers.’ Then, in the last 6 to 12 months, you go, ‘God, this just might happen!’ ”

With the fate of the largest banks still uncertain, a heated debate continues about how to fix the problem. Mr. Geithner wants to enlist money managers like Pimco to buy distressed bank assets with financial backing from the government. That way, his supporters argue, they can offer such generous prices that banks can disgorge the assets without too painful a hit.

But proponents of bank nationalization say the Treasury’s plan won’t work because some banks can’t afford to take any losses on asset sales. This camp believes nationalization is the best path because it will let the government clean up banks’ balance sheets and restore their health.

Mr. Gross argues that this would completely destabilize the financial markets. “If you thought Lehman Brothers was a mistake, just stand by and see what nationalizing Citi or B.of A. would do,” he argued in one of his monthly letters to Pimco investors.

His mood brightens when he talks about how much money Pimco could reap by participating in the Geithner plan. No wonder: the terms are deliciously favorable for participants selected as fund managers. Money managers like Pimco would be expected to raise at least $500 million from their clients. The Treasury would match that with taxpayer dollars. Then Pimco and the Treasury would create a jointly owned fund of at least $1 billion that would buy distressed mortgage bonds.

Government largess doesn’t stop there. The fund will be eligible for low-interest financing from both the Treasury and the Fed that analysts at Credit Suisse First Boston estimate could be as high as four times the total equity in the fund. So if Pimco ponied up $500 million, the fund that it manages could borrow $4 billion.

Pimco would then negotiate with banks to buy their wobbly mortgage-backed securities. Mr. Gross says that some of these securities pay an interest rate as high as 14 percent and that even if default rates were 70 percent, Pimco and the government would still make a 5 percent return after covering their negligible borrowing costs. That means the government-Pimco partnership could make at least $250 million in a year on a $5 billion investment fund. Of that amount, Pimco would get $125 million — a 25 percent return on its original investment.

But here’s the part that makes Mr. Gross salivate. If things go badly, the government is responsible for repaying all that debt. “It’s just like in blackjack,” he says. “That puts the odds in your favor. If you don’t bet too much and if you stay at the table long enough, the odds are high that you are going to go home with some extra money in your pocket.”

Indeed, for all of Mr. Gross’s anguished talk about the crisis, there’s no escaping the fact that Pimco isn’t exactly suffering. In November, the Total Return fund became the world’s largest mutual fund with $128.4 billion in assets, according to Morningstar. Since then, its assets under management have climbed to $158 billion. The firm once had trouble luring prospective employees to Newport Beach. Now Pimco is being deluged with résumés.

Meanwhile, some of the most powerful people in the nation call Mr. Gross for advice. “Paulson will call, Geithner will call, and I’ll be like, ‘Yabba-dabba’ or ‘Blah-blah-blah,’ ” he says with a measure of self-deprecation — and an equal dose of pride. “I turn into a walking, talking idiot.”

Mr. Gross has been through crises before. He nearly died — and briefly lost part of his scalp — in 1966 when he crashed his car while making a doughnut run for his fraternity brothers at Duke University. He spent much of his senior year recovering in the hospital. He also became obsessed with blackjack after reading “Beat the Dealer: A Winning Strategy for the Game of Twenty-One,” by Edward O. Thorp, an M.I.T. mathematics professor (who is now a very successful hedge fund manager).

After he got his diploma, Mr. Gross hopped a freight train to Las Vegas with $200 sewed into his pant leg. He played blackjack for 16 hours a day. “After a while it gets pretty boring and pretty stinky,” he recalls. “People lose money. They don’t win it. You’re just watching the dealers.”

Even so, in four months, he turned $200 into $10,000 and used his winnings to pay for his studies toward an M.B.A. at the University of California, Los Angeles. He thought he could apply the lessons learned at the blackjack table to the stock market. After getting the degree, he called all the big Wall Street brokerage firms. Nobody called him back.

FINALLY, his mother showed him a classified ad for a junior credit analyst in the bond department at the Pacific Investment Management Company, a subsidiary of Pacific Mutual Life.

Although Mr. Gross had no interest in bonds, he took the job as a steppingstone to stock-picking. Back then, the bond market was a sleepy corner of the financial world. Mr. Gross’s job was to make sure that Pimco avoided buying bonds from companies that might go belly-up and burn their creditors.

By the mid-1970s, the market had become sexier as shrewd investors like Mr. Gross began trading bonds like stocks — and began earning outsize profits.

In short order, Mr. Gross also dived into the first mortgage-backed securities (which carried comfy government guarantees) and began studiously monitoring interest rates so he could place bets on his own macroeconomic predictions. This was highly unusual for a bond fund manager — and still is.

“There are a lot of big bond shops that frankly don’t feel confident doing this,” says Lawrence Jones, a Morningstar analyst. “It’s not part of their tool kit.”

Mr. Gross played well on television. In 1983, he became a regular on “Wall Street Week” on PBS; he loved the attention, and his ubiquity gave Pimco a big boost. Four years later, Pimco rolled out the Total Return fund. Over the next 10 years, its assets soared to $24 billion from $165 million. Much of this was because of shrewd investing. But TV did wonders, too. “It doesn’t do you any good to be good if nobody knows about you,” Mr. Gross says.

In 1999, he warned in his monthly investment column that the dot-com bubble would soon burst. The next year, it did. Despite the market downdraft, Mr. Gross’s fund ended 2000 up 12 percent, and that same year he and his partners sold Pimco to Allianz for $3.3 billion. Mr. Gross received $233 million for his stake, and Allianz also agreed to pay him $40 million in retention bonuses and seems to be giving him free rein.

Not that Mr. Gross was going anywhere.

FREE from distraction in a gym across the street from his offices, Mr. Gross happily rides a stationary bike, followed by a half-hour of yoga. Toward the end of his routine, he stands on his head for a few minutes in a position called the Feathered Peacock. He wobbles so much that you expect him to lose his balance and fall over, but he says some of his best ideas have come to him while he was upside down.

One of those insights came in 2005, when — while standing on his head — he began to worry about the real estate bubble.

He’d watched the prices of homes climb into the stratosphere in Southern California, and he says he felt as if he were witnessing something out of “Alice in Wonderland.” Was this happening all around the country?

Pimco dispatched 11 mortgage analysts to 20 cities to find out. They posed as prospective homebuyers and drove around with unsuspecting real estate agents and mortgage brokers who told them how easily they could get a home loan. “It was a little deceptive,” Mr. Gross says. “I didn’t feel good about that, but I didn’t know how else to get the real information.”

Mr. Gross says he thought it was obvious what was driving this madness: subprime mortgages. He was certain that the real estate market would collapse and take the economy down with it, and he made those thoughts known in letters to his investors. Pimco steered clear of risky housing debt, which meant that, for a time, some of his competitors who stockpiled the briefly lucrative products outperformed him.

For a fiercely competitive man, it was an awkward time. “Bill takes it hard when the numbers aren’t what he thinks they should be,” his wife, Sue, confided by e-mail. “In 2006, he recommended a Pimco bond fund to the owner of a local doughnut shop, and when it didn’t do well for a while, he could hardly go in the shop for his favorite coconut cake doughnut.”

Fortunately for Mr. Gross, but not for the economy, this couldn’t last forever. The housing bubble finally burst in 2007, and the crisis followed. He was vindicated. Yet this was only part of the reason for his success. He also predicted in one of his monthly columns that the government would have to pump billions of dollars into the economy to avert a total collapse. At the same time, he and his Pimco team came up with an audacious plan: invest in bond sectors that Washington would be forced to support — like government-backed mortgages guaranteed by Fannie Mae and Freddie Mac.

Mr. Gross whimsically calls this strategy “shake hands with the government.” And he used his access to the news media to get the government’s attention. In a CNBC interview on Aug. 20, 2008, he argued that Americans were putting “their money in the mattress” because the government hadn’t rescued imperiled financial institutions like Fannie and Freddie.

On Sept. 7, Henry M. Paulson Jr., then the Treasury secretary, announced that the government was taking over Fannie and Freddie. The value of the Total Return fund rose by $1.7 billion in a single day.

Michele Davis, Mr. Paulson’s former spokeswoman, says Mr. Gross’s TV appearances had nothing to do with the decision: “There are $5.4 trillion of Fannie and Freddie securities around the world. Investors here and across the globe were worried and voicing the same concerns.”

But some of Pimco’s critics aren’t convinced. “The Treasury Department watches CNBC all day,” says Steven Eisman, a portfolio manager and banking expert at FrontPoint Partners, an investment firm. “I know that for a fact. He was putting pressure on them.”

Mr. Gross says nothing could have been further from his mind. He says he goes on TV with “a disbelief that people will believe or act on what I say,” adding that “people should think independently.”

At the same time, Pimco tried to influence the direction of the bailout itself. In the spring of 2008, Pimco’s chief executive, Mohamed A. el-Erian, a former policy expert at the International Monetary Fund, floated a plan in Washington for a public-private partnership similar to the P.P.I.P. plan that Mr. Geithner later unveiled. It didn’t get much traction.

But then Lehman Brothers collapsed on Sept. 15. Mr. Paulson asked Congress to pass the Troubled Asset Relief Plan, better known as TARP, which would enable the government to spend $700 billion to buy mortgage securities from teetering banks. The Treasury turned to Pimco and others for help.

“When we first asked for the TARP legislation in September, we were looking at purchasing assets,” says Ms. Davis, the former Treasury spokeswoman. “We definitely talked to Pimco and a lot of other asset managers. You had to find out how such a program might work and bounce ideas around to see how this thing would work.”

In the midst of the crisis, in October, Mr. Gross’s friend, Mr. Buffett, wrote to Mr. Paulson suggesting a plan similar to the one Mr. Erian had been pushing. However, Mr. Buffett says he came up with his idea independently.

“I called Bill Gross and Mohamed and said: ‘I’ve got this idea. If it goes forward, I hope you guys would manage it and would do it on a pro bono basis,’ ” Mr. Buffett recalled in an interview. “Within an hour, they said they were on board and they were willing to do whatever was called for.”

Mr. Gross publicly announced that his firm would do the job free. “I got call after call, e-mail after e-mail saying what Bill offered was right for the country and that he was a great American,” says a Pimco spokesman, Mark J. Porterfield. At first, it looked as if the Treasury might take Mr. Gross up on the offer. But his hopes were temporarily dashed when the Treasury simply gave TARP funds to the banks instead of purchasing bad assets.

And at the same time, people began to wonder about Mr. Gross’s motives. He made it clear that he was not afraid to put Pimco’s interests ahead of the government’s in the bailout. As part of its “shake hands with the government” strategy, Pimco had bet that the Bush administration would come to the rescue of the nation’s banks and other financial institutions. So it bought a variety of those bonds, including those of GMAC, the financial division of General Motors.

In November, as the economy continued to weaken, GMAC asked the Fed for permission to become a bank holding company so it could receive TARP financing. The central bank granted GMAC’s wish, with one caveat: GMAC had to swap 75 percent of its debt for equity, allowing GMAC to potentially buy back a big chunk of its bonds for just 60 cents on the dollar.

Mr. Gross balked at the arrangement because, as a GMAC bondholder, he would have been forced to take a big financial haircut. “We said: ‘It doesn’t look too good to us. We think we’ll just hold onto the existing bonds,’ ” he remembered. Much to the amazement of many people on Wall Street, the Federal Reserve, which declined to comment, still allowed GMAC to become a bank holding company and the government later guaranteed all of its debt, meaning that Mr. Gross’s GMAC bonds would be worth 100 cents on the dollar when they mature.

Mr. Gross is unapologetic about the outcome. “The government has a vested interest, and it’s not necessarily aligned with Pimco’s interest,” he says.

SIMON JOHNSON, a former chief economist for the International Monetary Fund and now a professor at the Sloan School of Management at M.I.T., says he isn’t surprised that Mr. Gross is such a virulent foe of nationalization. As Professor Johnson points out, Pimco is a major bondholder in some of the biggest banks. Nationalization would hurt his portfolio.

“It would reduce the present value of his holding,” says Professor Johnson, himself a proponent of nationalization. “Therefore, he is not going to look good as an investment manager.”

What of Mr. Gross’s predictions that nationalization would deepen the recession? Professor Johnson acknowledges that there are risks either way, but says he thinks that people should be skeptical when powerful financiers make doomsday predictions.

“I think we pay undue deference to people who are very rich and have been successful in the financial sector in this country,” he says. “We think they are the gurus who think they have unique expertise, and if Bill Gross tells us there will be a panic, it must be true. Well, no, I don’t believe it. These guys all say this kind of thing.”

The twist, of course, is that the Obama administration has embraced the same public-private partnership proposal that Pimco has been pushing along and that Mr. Paulson briefly considered last fall. Mr. Gross says that the Geithner plan is better because the government provides such generous debt financing.

Pimco is proud of its partnership with the government. Mr. Erian points out that the firm’s executives have been members of the Treasury Department’s Borrowing Advisory Committee (along with many other Wall Street executives) for years. Its current representative, the Pimco managing director Paul McCulley, says part of his job is to ingratiate himself with officials at the Treasury and the Federal Reserve so Pimco can better understand impending policy decisions. He boasts that he is on a “first-name basis” with both Mr. Geithner and the Fed chairman, Ben S. Bernanke.

“We have a whole lot bigger profile now than we did years ago, but the fact of the matter is we’ve been doing the same thing in the last year that we’ve been doing for the last 10 years,” Mr. McCulley says. “I’d like to think we’re having some influence in the public policy arena. And I say that first and foremost as a citizen.”

Citizen — but also investor. And some critics of the financial benefits that Pimco might snare if the P.P.I.P. gets rolling are quick to point out what Pimco stands to gain.

“The critics would argue that all the benefits go to Pimco,” says Representative Scott Garrett, Republican of New Jersey, who is a member of the House Financial Services Committee and a skeptic of the Geithner plan. “Well, maybe not all the benefits. But they get the best ones right out the door. And the taxpayers are on the hook.”

The Obama administration says it will soon select lead fund managers for P.P.I.P. It’s almost certain that Pimco will be among them. “If you are trying to encourage investment from the private sector, isn’t it only logical to involve the most successful asset management organizations in the private sector?” says Thomas C. Priore, chief of ICP Capital, a boutique fixed-income investment bank.

And being selected by the government has other benefits, Mr. Priore adds. “If any endowment or public pension plan representative is looking for an asset management firm, he or she won’t get fired for hiring Pimco because, well, the government hired Pimco,” he says. “That certainly enhances your franchise value.”

P.P.I.P.’s fate remains uncertain. When the Treasury Department put 19 of the nation’s largest banks through a stress test, many passed the exam and their stocks prices rose. They have raised $50 billion in new capital. Now some of them are likely to hold on to their distressed mortgage securities in the hope that the housing market recovers — rather than face the pain of selling the assets at a loss now (a situation that may get dicey if housing doesn’t, in fact, recover).

The Treasury now says that Mr. Geithner expects P.P.I.P. to serve as “backstop” for banks that find themselves in a pinch.

There’s a darker scenario, possibly. If mortgage default rates do soar, some big banks may fail. Then the administration would have to seriously consider nationalization, which might devastate Mr. Gross’s holdings. He is, of course, well of aware of this possibility and says he’s watching Mr. Geithner as closely as he watched the blackjack dealers in Las Vegas.

“We just don’t want to flush it all down the drain,” he says. “You want to shake hands with the government. But maybe it shouldn’t be a super-firm handshake.”

AT a lunchtime meeting this past spring at Pimco, executives tell Mr. Gross that they’re worried about the fallout the firm will face if it receives a financial windfall as part of P.P.I.P.

“The risk is that you have a Congress with a populist bug,” Mr. McCulley says.

Dan Ivascyn, another of the firm’s managing directors, agrees. “I think there is a risk that we’re going to get criticized,” he says. “I think Pimco could get roughed up.”

“I think there is a much bigger chance of us getting roughed up personally,” says Scott Simon, head of Pimco’s mortgage-backed securities team.

Finally, Mr. Gross weighs in.

“So what are you saying?” he asks. “If we fail, we’ll get the shaft, and if we succeed, we’ll get the shaft?”

human instinct when rates are low and the yield curve is flat to reach for greater risk and enhanced yield and returns

TO BE NOTED: From the WSJ:


"Don't Monetize the Debt
The president of the Dallas Fed on inflation risk and central bank independence.

By MARY ANASTASIA O'GRADY

Dallas

From his perch high atop the palatial Dallas Federal Reserve Bank, overlooking what he calls "the most modern, efficient city in America," Richard Fisher says he is always on the lookout for rising prices. But that's not what's worrying the bank's president right now.

His bigger concern these days would seem to be what he calls "the perception of risk" that has been created by the Fed's purchases of Treasury bonds, mortgage-backed securities and Fannie Mae paper.

Mr. Fisher acknowledges that events in the financial markets last year required some unusual Fed action in the commercial lending market. But he says the longer-term debt, particularly the Treasurys, is making investors nervous. The looming challenge, he says, is to reassure markets that the Fed is not going to be "the handmaiden" to fiscal profligacy. "I think the trick here is to assist the functioning of the private markets without signaling in any way, shape or form that the Federal Reserve will be party to monetizing fiscal largess, deficits or the stimulus program."

Ismael Roldan

Richard Fisher.

The very fact that a Fed regional bank president has to raise this issue is not very comforting. It conjures up images of Argentina. And as Mr. Fisher explains, he's not the only one worrying about it. He has just returned from a trip to China, where "senior officials of the Chinese government grill[ed] me about whether or not we are going to monetize the actions of our legislature." He adds, "I must have been asked about that a hundred times in China."

A native of Los Angeles who grew up in Mexico, Mr. Fisher was educated at Harvard, Oxford and Stanford. He spent his earliest days in government at Jimmy Carter's Treasury. He says that taught him a life-long lesson about inflation. It was "inflation that destroyed that presidency," he says. He adds that he learned a lot from then Fed Chairman Paul Volcker, who had to "break [inflation's] back."

Mr. Fisher has led the Dallas Fed since 2005 and has developed a reputation as the Federal Open Market Committee's (FOMC) lead inflation worrywart. In September he told a New York audience that "rates held too low, for too long during the previous Fed regime were an accomplice to [the] reckless behavior" that brought about the economic troubles we are now living through. He also warned that the Treasury's $700 billion plan to buy toxic assets from financial institutions would be "one more straw on the back of the frightfully encumbered camel that is the federal government ledger."

In a speech at the Kennedy School of Government in February, he wrung his hands about "the very deep hole [our political leaders] have dug in incurring unfunded liabilities of retirement and health-care obligations" that "we at the Dallas Fed believe total over $99 trillion." In March, he is believed to have vociferously objected in closed-door FOMC meetings to the proposal to buy U.S. Treasury bonds. So with long-term Treasury yields moving up sharply despite Fed intentions to bring down mortgage rates, I've flown to Dallas to see what he's thinking now.

Regarding what caused the credit bubble, he repeats his assertion about the Fed's role: "It is human instinct when rates are low and the yield curve is flat to reach for greater risk and enhanced yield and returns." (Later, he adds that this is not to cast aspersions on former Fed Chairman Alan Greenspan and reminds me that these decisions are made by the FOMC.)

"The second thing is that the regulators didn't do their job, including the Federal Reserve." To this he adds what he calls unusual circumstances, including "the fruits and tailwinds of globalization, billions of people added to the labor supply, new factories and productivity coming from places it had never come from before." And finally, he says, there was the 'mathematization' of risk." Institutions were "building risk models" and relying heavily on "quant jocks" when "in the end there can be no substitute for good judgment."

What about another group of alleged culprits: the government-anointed rating agencies? Mr. Fisher doesn't mince words. "I served on corporate boards. The way rating agencies worked is that they were paid by the people they rated. I saw that from the inside." He says he also saw this "inherent conflict of interest" as a fund manager. "I never paid attention to the rating agencies. If you relied on them you got . . . you know," he says, sparing me the gory details. "You did your own analysis. What is clear is that rating agencies always change something after it is obvious to everyone else. That's why we never relied on them." That's a bit disconcerting since the Fed still uses these same agencies in managing its own portfolio.

I wonder whether the same bubble-producing Fed errors aren't being repeated now as Washington scrambles to avoid a sustained economic downturn.

He surprises me by siding with the deflation hawks. "I don't think that's the risk right now." Why? One factor influencing his view is the Dallas Fed's "trim mean calculation," which looks at price changes of more than 180 items and excludes the extremes. Dallas researchers have found that "the price increases are less and less. Ex-energy, ex-food, ex-tobacco you've got some mild deflation here and no inflation in the [broader] headline index."

Mr. Fisher says he also has a group of about 50 CEOs around the U.S. and the world that he calls on, all off the record, before almost every FOMC meeting. "I don't impart any information, I just listen carefully to what they are seeing through their own eyes. And that gives me a sense of what's happening on the ground, you might say on Main Street as opposed to Wall Street."

It's good to know that a guy so obsessed with price stability doesn't see inflation on the horizon. But inflation and bubble trouble almost always get going before they are recognized. Moreover, the Fed has to pay attention to the 1978 Full Employment and Balanced Growth Act -- a.k.a. Humphrey-Hawkins -- and employment is a lagging indicator of economic activity. This could create a Fed bias in favor of inflating. So I push him again.

"I want to make sure that your readers understand that I don't know a single person on the FOMC who is rooting for inflation or who is tolerant of inflation." The committee knows very well, he assures me, that "you cannot have sustainable employment growth without price stability. And by price stability I mean that we cannot tolerate deflation or the ravages of inflation."

Mr. Fisher defends the Fed's actions that were designed to "stabilize the financial system as it literally fell apart and prevent the economy from imploding." Yet he admits that there is unfinished work. Policy makers have to be "always mindful that whatever you put in, you are going to have to take out at some point. And also be mindful that there are these perceptions [about the possibility of monetizing the debt], which is why I have been sensitive about the issue of purchasing Treasurys."

He returns to events on his recent trip to Asia, which besides China included stops in Japan, Hong Kong, Singapore and Korea. "I wasn't asked once about mortgage-backed securities. But I was asked at every single meeting about our purchase of Treasurys. That seemed to be the principal preoccupation of those that were invested with their surpluses mostly in the United States. That seems to be the issue people are most worried about."

As I listen I am reminded that it's not just the Asians who have expressed concern. In his Kennedy School speech, Mr. Fisher himself fretted about the U.S. fiscal picture. He acknowledges that he has raised the issue "ad nauseam" and doesn't apologize. "Throughout history," he says, "what the political class has done is they have turned to the central bank to print their way out of an unfunded liability. We can't let that happen. That's when you open the floodgates. So I hope and I pray that our political leaders will just have to take this bull by the horns at some point. You can't run away from it."

Voices like Mr. Fisher's can be a problem for the politicians, which may be why recently there have been rumblings in Washington about revoking the automatic FOMC membership that comes with being a regional bank president. Does Mr. Fisher have any thoughts about that?

This is nothing new, he points out, briefly reviewing the history of the political struggle over monetary policy in the U.S. "The reason why the banks were put in the mix by [President Woodrow] Wilson in 1913, the reason it was structured the way it was structured, was so that you could offset the political power of Washington and the money center in New York with the regional banks. They represented Main Street.

"Now we have this great populist fervor and the banks are arguing for Main Street, largely. I have heard these arguments before and studied the history. I am not losing a lot of sleep over it," he says with a defiant Texas twang that I had not previously detected. "I don't think that it'd be the best signal to send to the market right now that you want to totally politicize the process."

Speaking of which, Texas bankers don't have much good to say about the Troubled Asset Relief Program (TARP), according to Mr. Fisher. "Its been complicated by the politics because you have a special investigator, special prosecutor, and all I can tell you is that in my district here most of the people who wanted in on the TARP no longer want in on the TARP."

At heart, Mr. Fisher says he is an advocate for letting markets clear on their own. "You know that I am a big believer in Schumpeter's creative destruction," he says referring to the term coined by the late Austrian economist. "The destructive part is always painful, politically messy, it hurts like hell but you hopefully will allow the adjustments to be made so that the creative part can take place." Texas went through that process in the 1980s, he says, and came back stronger.

This is doubtless why, with Washington taking on a larger role in the American economy every day, the worries linger. On the wall behind his desk is a 1907 gouache painting by Antonio De Simone of the American steam sailing vessel Varuna plowing through stormy seas. Just like most everything else on the walls, bookshelves and table tops around his office -- and even the dollar-sign cuff links he wears to work -- it represents something.

He says that he has had this painting behind his desk for the past 30 years as a reminder of the importance of purpose and duty in rough seas. "The ship," he explains, "has to maintain its integrity." What is more, "no mathematical model can steer you through the kind of seas in that picture there. In the end someone has the wheel." He adds: "On monetary policy it's the Federal Reserve."

Ms. O'Grady writes the Journal's Americas column."

dozens of lawsuits from angry investors alleging that his companies used deceptive and misleading trade practices in representing the demand for and v

TO BE NOTED: From the NY Times:

Gary Bogdon for The New York Times

At Tesoro, a Ginn development, there is a $48 million clubhouse, along with 750 empty lots.

"It’s Tee Time. Where Is Everybody?

By GERALDINE FABRIKANT

Montverde, Fla.

OFF the turnpike here in central Florida, hidden behind stucco walls, sits a sprawling Tuscan-style clubhouse on a hill overlooking a string of lakes, a golf course and green fields.

This 1,900-acre property, called Bella Collina, was designed to hold 800 homes. Today, only 48 houses dot the landscape, and just three are occupied. The clubhouse, though open, is eerily quiet, and a promised swimming pool and equestrian center have yet to be built.

Bella Collina, the brainchild of Robert Edward Ginn III, looks like a ghost town. So does Tesoro, another resort opened by Mr. Ginn near Port St. Lucie, where just 150 houses sit on 900 lots. And the Conservatory in Palm Coast, also from Mr. Ginn, is even more barren: 335 out of 340 lots are empty.

As the real estate boom expanded in recent years, developers and home buyers believed that residential golf resorts were a sure-fire bet. Many buyers looked to buy properties that they could flip for a quick profit. Others were lured by stunning views, club services and security. While there is no reliable data on the growth in residential golf resorts, analysts say the market is well past its peak — particularly in the Sun Belt — and there is now an overabundance of developments.

“The aggressive building of new resort courses continued from the mid-1990s into the 2000s, contributing to an increasing glut of inventory that finally found no market,” said Joe Beditz, chief executive of the National Golf Foundation, a trade group that tracks data on the golf industry.

Mr. Ginn, 60, was able to cash in on the boom despite a spotty record that included some well-publicized failures on Hilton Head Island, S.C., in the 1980s. But when the real estate market began to tank in 2007, his empire came undone. “As property values plummeted, many investors had property worth less than their loans, and they were unprepared to pay their club and association fees,” says Toby Tobin, a Florida real estate agent.

Other golf resorts are also struggling. WCI Communities, which built resorts in Florida, Virginia and the Northeast, filed for bankruptcy in August. So did the Yellowstone Club in Big Sky, Mont., and three other resorts that, like some of Mr. Ginn’s, had loans arranged by Credit Suisse. Even the venerable Greenbrier Resort in West Virginia has sought bankruptcy protection.

For Mr. Ginn, a man who could sell 400 lots in a single day during the height of the real estate boom, it has been a huge comedown. While other developers may have built more golf resorts, few did so as grandly or as extravagantly. The tab for the 116,000- square-foot clubhouse at Tesoro reached $48 million.

“Most developers used consultants,” recalled Dean Adler, co-founder of Lubert-Adler Partners, a private equity firm in Philadelphia that invested in Mr. Ginn’s projects. “Bobby had a feel. He could be handed a topography map at a site and sketch out the entire resort.”

An amiable Southerner with a casual personal style, Mr. Ginn was a virtuoso at selling investors his vision of the luxe lifestyle.

“Bobby is very smooth and very likable,” said Hilton Wiener, a lawyer who bought an investment property at Tesoro. “He is a down-home guy who is not a pushy kind of salesperson.”

But when a new resort was in the works, Mr. Ginn knew how to generate a buying frenzy by holding lavish parties where potential buyers greatly outnumbered available lots, say agents and investors who attended the events.

“You would come to one of Ginn’s sales weekends and you would be drinking and thinking, ‘I hope I get chosen as one of the select few who gets to buy a lot,’ ” Mr. Wiener recalled. “The setting is very lush: hand-rolled cigars, fancy parties, vans with the Ginn name plastered on them.”

The high times ended when the market turned two years ago. Sales stalled, and Mr. Ginn had trouble paying off loans. Two of his properties, Tesoro and Quail West in Naples, Fla., filed for bankruptcy in December 2008 and were later sold for a fraction of what he had put into them. He sold Laurelmor, a resort in North Carolina, to another developer for $32 million. Mr. Ginn’s network of companies still owns the facilities at Bella Collina and the Conservatory.

Not all of Mr. Ginn’s 13 golf resorts are in such dire straits. But even at some of the most successful, like Reunion near Orlando, the Ginn Companies is considering programs to attract more buyers by offering fractional ownership at lower prices.

Mr. Ginn says his remaining properties will eventually pay off. “My belief is that when the depression ends, there will be a pent-up demand for happiness,” he said in an interview at his offices at the Hammock Beach Resort near Daytona Beach. “Sometime between 2035 or 2040, Florida will double in size.”

In the meantime, he faces dozens of lawsuits from angry investors alleging that his companies used deceptive and misleading trade practices in representing the demand for and value of his properties. “We will vigorously defend against these false allegations,” Mr. Ginn said.

BOBBY GINN grew up in Hampton, S.C., where his father was a small homebuilder. “I dropped out of school when I was 19 to go into the business because I always had a passion for building,” he said.

When Mr. Ginn was in his 30s, he worked with the Butcher brothers, Jake and C. H. Jr., Tennessee bankers who went to prison for bank fraud. In 1986, the Federal Deposit Insurance Corporation sued Mr. Ginn, contending that he had participated in a scheme with the brothers to defraud banks under the pretense of developing a property in that state. Mr. Ginn said he settled with the F.D.I.C. in the early 1990s and paid $500,000, without admitting wrongdoing. An F.D.I.C spokesman said the agency did not have documents from that period detailed enough to confirm Mr. Ginn’s account.

In 1985, he bought several resort and residential developments on Hilton Head Island, including such landmarks as the golf course where the Heritage Classic was played. “I liked the resort business more than building condos and shopping centers,” Mr. Ginn said. “Selling fun is more enjoyable.”

But his Hilton Head project did not prove to be a good investment. Some critics argue that he took on too much debt. As his cash-flow problems grew, a local radio station carried bulletins announcing when Ginn employees could safely cash paychecks and bumper stickers began appearing that said: “Honk if Bobby Owes You.”

Mr. Ginn sold his Hilton Head assets in 1986 to pay off debts, and declared personal bankruptcy two years later.

He resuscitated his career by working for Rochester Community Savings Bank in New York as a consultant on its investment in Wild Dunes, a North Carolina resort.

He got a big break in 1997, when Lubert-Adler started investing in his projects. Over the next decade, the firm, whose investors include the endowments for Harvard and Princeton, pumped about $800 million into his properties. Their partnership was structured such that the private equity firm put up all the money and took 80 percent of the profits.

The timing of the relationship couldn’t have been better. “Their business really took off after Sept. 11, when people turned from financial investments to hard assets,” said Robert Gidel, a former president of the Ginn Companies.

Mr. Ginn’s development style was unusual: he didn’t build clubhouses or other services until a large number of lots were sold. “Typically, developers start with a hotel or amenities because skeptical buyers want to see things,” Mr. Gidel said. “But here the market was so strong, and people wanted to believe.”

Dan Gerner, who owned a home in Quail West, one of the few developed properties that Mr. Ginn bought, said Mr. Ginn’s lavish spending ornamented his operation with all the trappings of success. At Quail West, Mr. Gerner said, Mr. Ginn “spent $12 million remodeling the clubhouse, and when the members didn’t like it, he spent $4 million more changing it.”

Many buyers bought several properties and hoped to flip them for a profit.

Even Mr. Adler, the Lubert-Adler chief, was personally involved in at least one deal at Tesoro. According to property records, he bought a parcel in 2004 and quickly sold it for a $205,000 profit.

A partnership formed by Mr. Adler and Mr. Ginn, A & G, also bought and sold five properties at Bella Collina for a $2.5 million profit over a period of weeks.

Those transactions raised possible conflict-of-interest questions, experts in private equity say, because the partnership bought property in developments that were also assets held by private equity funds that Mr. Adler was helping to oversee. Steven N. Kaplan, a professor of finance at the University of Chicago, said that transactions such as this can be problematic because investors in a fund are deprived of profits that potentially accrue to insiders who buy assets for themselves.

Mr. Adler says that although he bought the single property at Tesoro in his own name, he had actually “made a loan to two individuals to purchase that property.” He said that they — not he — kept the profits from the transaction and that they repaid him with interest.

As for the five properties purchased by A & G, Mr. Adler said the situation was “rectified.”

“I transferred my investment back to Mr. Ginn and never participated or received a penny of profit,” he said. Mr. Ginn confirmed Mr. Adler’s account.

The A & G deals are cited in a class-action suit filed last week in federal district court in Florida, alleging a scheme to sell properties based on fraudulent appraisals. Although Mr. Adler and Mr. Ginn are cited in the case, their firms, and not they as individuals, are named as defendants. Mr. Adler said he was no longer a partner in A & G when the transactions took place and denied any wrongdoing. Mr. Ginn said he had not seen the suit but also denied allegations of wrongdoing.

In 2006, Mr. Ginn’s partnership with Lubert-Adler borrowed $675 million from Credit Suisse, out of which it took a distribution of $332 million. (Mr. Adler said that his firm put back roughly that amount after sales slowed.) The partnership used the balance of the Credit Suisse loan to finance four resorts.

But the next year, the real estate market began to enter a free fall, and by 2008 the partnership couldn’t make payments on the Credit Suisse loan. Tesoro and Quail West filed for bankruptcy, and Laurelmor was sold. “There were no buyers and no market,” Mr. Tobin said.

Mr. Ginn says he now faces about 30 lawsuits.

According to one filed in a Florida circuit court, buyers were required to turn over their power of attorney to Richard T. Davis, a partner in a law firm that represented several Ginn companies, in order to buy land in Tesoro. The suit alleges that Mr. Davis signed documents that never provided detailed disclosures about costs, as the government requires. Since Mr. Davis was the companies’ closing agent, the suit contends, he knew that the disclosures were incomplete.

“I assure you that we tried to disclose everything that was out there,” Mr. Ginn said. Mr. Davis’s lawyer said the allegations were without merit.

The Florida suit also alleges that Mr. Ginn worked to artificially inflate the prices of parcels in his development. In one case, according to the lawsuit, a buyer bought two properties for a total of $1.007 million, and Mr. Ginn’s title company recorded the respective sale prices as $1.007 million and $1. The company then used the larger price as a “comparable” figure in an appraisal for Roy Bridges, a British financial adviser who bought a property for $1.195 million, according to appraisal records. Mr. Bridges’s property is now in foreclosure.

Mr. Ginn contends that “the county recorded it incorrectly.”

According to a transcript of a video obtained by a law firm representing property owners in the suit, a Ginn salesman told a group of potential buyers at Bella Collina that “Lot 5 sold for $2.1 million this morning.” But property records showed that the parcel sold for just $416,900, according to the lawsuit.

Mr. Ginn said he was “shocked because the salesman deviated from company practices.”

MR. GINN’S partnership with Lubert-Adler still has three properties left to develop and owns some land at existing resorts. “At this point, we have invested more than we have distributed back to investors,” Mr. Adler said. “We got hit by the economic tsunami, and we did not anticipate how tough it would be.”

Mr. Ginn says he is “ready to sell properties in trophy locations” when the market turns around.

“If you can’t sell,” he said, “you die.”

Edward Liddy, who took over the insurer after it almost collapsed last year, told the board he plans to step down as soon as the directors replace him

TO BE NOTED: From Bloomberg:

"AIG’s Liddy to Step Down Once Board Finds Replacement (Update5)

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By Hugh Son, Erik Holm and Andrew Frye

May 21 (Bloomberg) -- American International Group Inc. Chairman and Chief Executive Officer Edward Liddy, who took over the insurer after it almost collapsed last year, told the board he plans to step down as soon as the directors replace him.

Liddy, 63, recommended the chairman and CEO roles be split, the insurer said today in a statement. AIG said separately that Harvard University Professor Martin Feldstein, James Orr and Morris Offit are stepping down from the board, making way for a new slate approved by trustees overseeing the government’s majority stake in the New York-based company.

Liddy’s replacement will be the fifth CEO since 2005 to run AIG, the world’s biggest insurer until losses on derivatives left it hours from bankruptcy in September. The new leader must find a way to sell assets, stem the exodus of customers and employees and repay the $182.5 billion U.S. bailout while enduring public scrutiny that made Liddy wonder aloud about potential damage to his reputation.

“It really is a terrible job, I’m not sure who would really want it,” said Robert Haines, analyst at CreditSights Inc. “There is so much political baggage that whoever takes over the company is going to find it an extremely difficult and thankless job.”

AIG’s restructuring chief, Paula Reynolds, may be a candidate for the top spot, said Haines. Other possible successors include Ace Ltd. CEO Evan Greenberg, the son of former AIG leader Maurice “Hank” Greenberg, Haines said. Ace sidestepped the subprime investments that overwhelmed AIG.

Liddy said in an interview the insurer has “very strong internal candidates” for CEO and he called Reynolds an “exceptional individual.”

‘Several Years’

Liddy was appointed in September by the government to run AIG after the company agreed to turn over a majority stake in return for a federal rescue. He then helped persuade the U.S. to expand the bailout three times and devised a plan to sell assets and repay the Treasury. Liddy has been separating units, including two non-U.S. life insurers and the property-casualty business, to prepare the operations for public offerings and avoid what he said was the taint of the AIG name.

“It is likely to take several years,” to turn around the insurer, Liddy said in the statement. “AIG should have a leadership team committed to a similar time horizon and prepared to carry the plan to completion.”

Liddy had been the CEO of Allstate Corp., the largest publicly traded U.S. home and auto insurer. He was appointed to AIG by then-Treasury Secretary Henry Paulson, who was CEO of Goldman Sachs Group Inc. when Liddy served on the board of the New York-based securities firm.

Goldman Sachs

AIG paid Goldman Sachs $12.9 billion after receiving U.S. bailout funds. The payments helped settle transactions including credit-default swaps backed by AIG. Goldman Sachs was the biggest recipient of AIG payments after the bailout, and lawmakers including Representative Elijah Cummings have said Liddy’s ownership of Goldman Sachs shares raised the appearance of a conflict of interest.

After AIG was rescued, banks that had bought credit-default swaps from the insurer got $22.4 billion in collateral and $27.1 billion in payments to retire the contracts, the insurer said in March. Congress demanded to know how U.S. bailout money was being spent and pressured AIG to name its counterparties. Goldman Sachs, Deutsche Bank AG and Societe Generale SA were among the largest recipients. The swaps protected the banks against losses on fixed-income holdings.

Losing Confidence

The latest bailout package includes an investment of as much as $70 billion, a $60 billion credit line and $52.5 billion to buy assets owned or backed by the insurer. The terms gave AIG more time to pay back loans because Liddy was unable to sell units as fast as initially planned.

AIG has disclosed deals to sell assets, including a U.S. auto insurer, an equipment guarantor and a Japanese tower, for about $5.6 billion since the September rescue.

Liddy came under fire from lawmakers in March and some called on him to quit because of AIG’s plan to give $165 million in retention pay to employees of the Financial Products unit, whose credit-default swap derivatives helped push the firm to the brink of bankruptcy. The bonus plan was created before Liddy became CEO, and he persuaded some recipients to return part of the awards.

Congressional Criticism

The chief’s job paid only a dollar a year to Liddy, who came out of retirement to salvage the insurer. “My only stake is my reputation,” he wrote to Treasury Secretary Timothy Geithner in March.

Liddy “continued to lose the confidence of the U.S. Congress and of the American people,” Cummings said in an e- mailed statement. “It is critical that the new chairman and CEO of AIG be completely committed to transparency and accountability to ensure that the American people know what is happening with their money and when they will get it back.”

In today’s interview, Liddy called the AIG chief’s post “the most intellectually stimulating job” in the U.S. and said he expects to end his tenure with an “enhanced reputation.”

Geithner praised Liddy for his work.

“Mr. Liddy took one of the most challenging jobs in the American financial system,” Geithner said in a statement released today in Washington. “He shouldered this burden out of a strong sense of duty and patriotism.”

New Directors

The job of finding a successor will fall on the new board of directors. AIG today nominated a slate of 11 board candidates that includes a majority selected by its outside overseers. The proposed board includes five new candidates chosen by the trustees managing the federal stake, plus Liddy.

Directors Virginia Rometty, Michael Sutton and Edmund Tse had previously told AIG they wouldn’t stand for re-election at this year’s annual meeting, scheduled for June 30. Tse, described by AIG as the “architect” of the firm’s global life insurance operations, has been with AIG for about 48 years.

The new candidates are Harvey Golub, Laurette Koellner, Christopher Lynch, Arthur Martinez, Steve Miller and Douglas Steenland. The trustees told Congress May 13 that they’d selected five executives to join the board and AIG would pick one. The names of all the new candidates except Koellner were reported that day.

Liddy had shaken up management at the insurer, appointing a new chief financial officer, investment chief, restructuring head and leader of non-U.S. life insurance.

To contact the reporters on this story: Hugh Son in New York at hson1@bloomberg.net; Erik Holm in New York at eholm2@bloomberg.net; Andrew Frye in New York at afrye@bloomberg.net"

criticism of AIG serves only to diminish the value of our businesses around the world to the detriment of our shareholders, including taxpayers

TO BE NOTED:

May 12, 2009, 6:59 p.m. EST

AIG's Liddy: Insurer has cut its systemic impact to markets

Insurer has reduced, but not eliminated, its risk to global markets by selling assets

By Ronald D. Orol, MarketWatch

WASHINGTON (MarketWatch) -- American International Group Inc. Chief Executive Edward Liddy on Wednesday plans to defend the embattled insurer by describing steps it has taken to reduce its size and risk to the global financial system.

"The parent company will become smaller. The financial products unit will not exist. We have reduced, but not eliminated the systemic risk that AIG presents to the global financial system," Liddy said in testimony that he plans to deliver to a House Oversight and Government Reform Committee hearing on Wednesday focusing on the collapse and federal bailout of the mega-insurance company.

AIG (AIG 1.81, -0.09, -4.74%) has received over $180 billion in taxpayer-funded bailout dollars to keep it afloat, in part, because of concern by Treasury officials that the super-sized insurance corporation's collapse would have caused too much collateral damage to the financial markets. In exchange, the administration has received an 80% stake in the company.

AIG also has also come under criticism for paying out $163 billion in bonuses to traders of credit default swaps, considered central to the financial crisis.

Liddy, who took over as CEO of the company in September, argued that criticism the company received, in part, for granting the bonuses hurts the business and billions of taxpayer dollars invested in the company.

"Rampant, unwarranted criticism of AIG serves only to diminish the value of our businesses around the world to the detriment of our shareholders, including taxpayers, who own some 80% of AIG," Liddy said.

In testimony, Liddy said he expects AIG will complete its transfer of two key divisions, American Life Insurance Company, or Alico, and American International Assurance Co., or AIA, into a special purpose entity "in the near future." As part of a deal with bank regulators, AIG is moving the two units into this division in exchange for a substantial debt reduction.

AIG is also transferring its Global Property & Casualty Insurance unit into a special purpose entity to prepare for the potential sale of a minority stake in the business.

He pointed out that AIG has also reduced its exposure to "complex derivatives" from its peak of $2.7 trillion to $1.5 trillion. "We continue to explore multiple options to break apart these trading books so that we can reduce the remaining risks, sell off portions of the business..." Liddy said in the testimony.

Trustees seek new AIG directors

Liddy pointed out that the company works closely with trustees appointed by the New York Federal Reserve Bank. The three trustees are also expected to testify about their oversight of AIG at the hearing on Wednesday. According to a letter to Liddy on May 7, the Trustees are seeking to have a broad review of the insurer's compensation practices with a focus on "performance-based compensation philosophy," by the end of the year.

The three trustees are also planning to seek new AIG board members and will make a decision shortly, according to testimony prepared for delivery on Wednesday. "We are actively seeking new members of the board who could add important skills and perspectives," the Trustees said in testimony.

The Fed appointed Jill Considine, a member of the Council on Foreign Relations and the Economics Club of New York, Chester Feldberg, former chairman of Barclays Americas, and Douglas Foshee, owner of El Paso Corp., a natural gas pipeline system, to oversee the insurer.

The New York Fed said it set up the trust agreement to avoid conflicts with the New York Fed's supervisory and monetary policy functions."

It’s troublesome that the government would take this interest and not control

TO BE NOTED: From Bloomberg:

"AIG Trustees Should Answer to Taxpayers, Not Fed, Towns Says

By Mark Pittman, James Sterngold and Hugh Son

May 12 (Bloomberg) -- A House panel plans to ask trustees assigned to safeguard the U.S. government’s $182.5 billion investment in American International Group Inc. whether their supervision by the Federal Reserve Bank of New York serves taxpayers’ interests.

The trustees -- Jill Considine, Chester Feldberg and Douglas Foshee -- were appointed in January by the New York Fed, a private institution owned by member banks, which has the power to overturn some of their decisions and to remove them. Edolphus Towns, a New York Democrat who chairs the House Committee on Oversight and Reform that will hold hearings tomorrow, said he’s concerned that the interests of AIG’s customers and trading partners may outweigh those of taxpayers.

“As a $182.5 billion recipient of taxpayer dollars, AIG should no longer be able to operate in the dark,” said Towns in an e-mail. “The American people, who now own a major portion of this company, deserve clarification on core issues of the AIG bailout -- who exactly is in charge at AIG and who is protecting the taxpayer’s multibillion-dollar investment?”

AIG is the biggest recipient of government rescue funds. Whether it can repay the money may depend on actions by the trustees, some of which must be approved by the New York Fed. The New York-based insurer has received four bailouts valued at $182.5 billion since agreeing in September to turn over about an 80 percent stake in the company to the government.

AIG Counterparties

Peter Bakstansky, a spokesman for the trustees and a former spokesman for the New York Fed, said the three are “prepared to talk about” what they have been doing since their appointment when they testify. He said the trustees speak weekly with AIG management by telephone and meet monthly in person. He declined to give further details.

Deborah Kilroe, a spokeswoman for the New York Fed, declined to comment.

The insurer’s counterparties include firms connected to the New York Fed, such as Goldman Sachs Group Inc., which has received more than $8 billion of AIG’s bailout funds to settle credit-default swaps it had with the firm. Towns’s committee plans to ask the trustees and AIG Chief Executive Officer Edward Liddy, who is also scheduled to testify, why the company didn’t try to negotiate for payments of less than the full amount.

New York Fed President William Dudley worked until 2007 as Goldman Sachs’s chief economist. Stephen Friedman, who resigned as New York Fed chairman May 7, was once CEO of Goldman Sachs and supervised the search for Dudley.

Friedman resigned from his New York Fed post after the Wall Street Journal reported that he bought 37,300 shares of Goldman Sachs last year while seeking a waiver of Fed policy that would have precluded him from sitting on the Goldman Sachs board and being New York Fed chairman at the same time. The shares have since gained $3 million in value.

‘Widening Morass’

“These programs are drawing the Federal Reserve into a widening political morass and compromising Fed independence,” said William Poole, former president of the St. Louis Fed. The Fed lending programs “ought to have legislative authorization and ought to be run out of the Treasury or some other agency of the federal government.”

Goldman Sachs CEO Lloyd Blankfein rejected calls to remove Friedman. “He is a credit to our board,” Blankfein said last week at the firm’s annual meeting in New York. Friedman said he bought the shares “because I thought Goldman Sachs stock, under tangible net worth, was at a very attractive price.”

The New York Fed is one of 12 regional Federal Reserve banks and the one charged with monitoring capital markets. It is also managing $1.7 trillion of emergency lending programs. While the Fed’s Washington-based Board of Governors is a federal agency subject to the Freedom of Information Act and other government rules, the New York Fed and other regional banks maintain they are separate institutions, owned by their member banks, and not subject to federal restrictions.

‘Right to Disclosure’

JPMorgan Chase & Co. CEO Jamie Dimon and Richard Carrion, chairman and CEO of Banco Popular de Puerto Rico, are also on the New York Fed board, along with General Electric Co. CEO Jeffrey Immelt.

“Fed resources are public resources, and taxpayers have a right to disclosure,” Poole said.

The congressional hearing will be the first public appearance for the trustees, who are under pressure from lawmakers to show they are helping to turn around the insurer. Towns said he will ask Liddy and the trustees “what they are planning to do with the company and how this plan, whether it is to liquidate or rehabilitate the company, will ensure that American taxpayers are repaid.”

Representative Darrell Issa of California, the ranking Republican on the oversight committee, said he wanted greater accountability from the trustees.

$100,000 a Year

“There is a significant and troubling lack of transparency and accountability in Treasury’s delegation of authority to an ‘independent’ trust that manages the government’s and taxpayers’ interest in AIG,” Issa said in an e-mailed statement. “The American people have a right to know how these trusts are going to be designed, how they will operate and how the trustees can be held accountable.”

The trustees were hired by the New York Fed, which pays each of them $100,000 a year, under a contract completed on Jan. 16 in the final days of the Bush administration. They wield the government’s 77.9 percent stake in AIG through a trust and control votes on asset sales, mergers and the selection of board members and top executives, according to a company filing.

The contract says the trust was created “to avoid any possible conflict” with the Fed’s supervisory and monetary- policy functions. Dudley, the New York Fed president, said in a Jan. 16 statement that the trustees “have a legally binding obligation to exercise all of their rights as majority owner of AIG in the best interests of the U.S. taxpayers.”

Approval of Fed

While the contract says the New York Fed “wishes the trustees to have absolute control over the trust stock” and that developing a divestiture plan for selling AIG shares is a key goal, it states that the trustees cannot sell the shares without the approval of the New York Fed after consultation with the Treasury Department.

Under the contract terms, the New York Fed will control any litigation. If a trustee is indicted or found “to have demonstrated untrustworthiness or to be derelict in the performance of his or her duties,” the New York Fed has the right to remove the trustee.

The agreement doesn’t define untrustworthiness or dereliction of duty.

Considine, 64, is a former chairman of the Depository Trust & Clearing Corp. and served a six-year term on the New York Fed’s board, where she was chairman of the audit and operational risk committee. She was the New York State superintendent of banks from 1985 to 1991 and is lead director of Ambac Financial Group Inc., the New York-based bond insurer whose shares have dropped 98 percent from a 2007 peak.

Feldberg, 69, a former chairman of Barclays Americas, was an executive vice president in charge of the New York Fed’s Bank Supervision Group for nine years through 2000.

Foshee, 49, was chief operating officer at oilfield- services provider Halliburton Co. before joining El Paso Corp. in 2003 as president and CEO.

‘Soft Power’

“The people appointed are long-time Fed players,” said Mark Roe, a professor at Harvard Law School in Cambridge, Massachusetts, who has written a book on corporate governance. “They’re likely to take signals from the Fed anyway, even if not obligated to.”

Steven Davidoff, a law professor at the University of Connecticut in Storrs, Connecticut, said the problem with the trust agreement is that it creates the appearance that the New York Fed is not in control of the AIG shares while allowing the Fed to maintain “soft power” over the company.

“The great value of this agreement is that it allows the government to say it doesn’t control AIG, while keeping its back-door influence over the company,” said Davidoff, who delivered a paper on the AIG rescue at a legal conference in Philadelphia last week. “This gives the government a sort of plausible deniability in this situation.”

“It’s troublesome that the government would take this interest and not control,” because it clouds the question of accountability, Davidoff said.

To contact the reporters on this story: Mark Pittman in New York at mpittman@bloomberg.net or; James Sterngold in Los Angeles at jsterngold2@bloomberg.net; Hugh Son in New York at hson1@bloomberg.net."