Will “False Claims” Lawsuit Against AIG, Goldman, Deutsche, BofA, SocGen on Fed Funding Lead to New Round of Embarrassing Revelations?

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Litigation may be slowly doing the job missed or only partially completed by various governmental investigations into the financial crisis. The Valukas report on the Lehman bankruptcy was revealing, and numerous foreclosure defense attorneys have opened cans of worms that the powers that be would rather pretend simply don’t exist.

The New York Times reports tonight that a case filed last year was unsealed last week. It plumbs a continuing sore point with the public, namely the generous terms of the AIG bailout, both to the company (which defied the government and insisted on remaining largely intact when the plan had been to sell its various units to repay the government funding) and to its credit default swap counterparties. The litigation has the potential to be revealing, particularly if it goes into discovery (various depositions are likely to become public in pre-trial jousting, um, motions). The Times gives an overview:

The lawsuit, filed by a pair of veteran political activists from the La Jolla area of San Diego, asserts that A.I.G. and two large banks engaged in a variety of fraudulent and speculative transactions, running up losses well into the billions of dollars. Then the three institutions persuaded the Federal Reserve Bank of New York to bail them out by giving A.I.G. two rescue loans, which were used to unwind hundreds of failed trades.

The loans were improper, the lawsuit says, because the Fed made them without getting a pledge of high-quality collateral from A.I.G., as required by law.

“To cover losses of those engaged in fraudulent financial transactions is an authority not yet given to the Fed board,” said the plaintiffs, Derek and Nancy Casady, in their complaint, filed in Federal District Court for the Southern District of California.

The lawsuit names A.I.G., Goldman Sachs and Deutsche Bank as defendants, but not the Fed.

The lawsuit itself names other defendants, including Merrill and its successor Bank of America, SocGen, and “Does 1 through 100.”

White shoe types will likely look down their noses at the filing. It makes rather eccentric use of graphics (for instance, including company logos) and includes charts, some of which are very helpful (tables with tabulations and timelines), while others are visual representations of arguments made in the text and hence would be deemed by style snobs to be redundant. It also is somewhat sensationalistic, even heated at points in tone (which does make for more lively reading) and does not unpack its arguments as much as appears to be typical in court filings.

Nevertheless, despite the rough style, there’s some intriguing reading, and the case does a clever job of juxtaposing e-mails and Congressional testimony by AIG executives with various disclosures of the AIG bailout process and the terms of the loan facilities.

To my non-expert eye, the case appears to hinge on the argument that begins on p. 43, that the Fed loans were in violation of the Fed’s authority under the widely-cited “unusual and exigent circumstances” clause. I had taken the reading of former central banker, now Citigroup economist Willem Buiter on this, that it gave the Fed the authority to lend against a dead dog if it chose to.

That appears to be inaccurate, and I wonder if the focus upon this section will embolden the Audit the Fed crowd to have another go at the central bank.

Specifically, the “unusual and exigent” language includes other restrictions, which I read as all being operative:

1. The central bank can lend against “notes, bills, and other drafts of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal reserve bank

2. The “notes, bills, and other drafts of exchange” must be discounted

3. The Federal reserve bank making the loan must obtain evidence that the non-bank party seeking the loan can’t get credit from other banks

4. “….five or more members of the Board of Governors must affirmatively vote to authorize the discount prior to the extension of credit.”

The case focuses on allegedly fraudulent representations made by AIG and the various major dealers in the course of obtaining the financing. But the part I find interesting is the Fed’s evident non-compliance with the requirements of this section, particularly the fact that the central bank lent 100% against the face value of the AIG CDOs, between taking out the CDS and then lending the bailout vehicle Maiden Lane III the funds to buy the CDOs. Interestingly, the SIGTARP investigation missed this issue. If this was at all considered, the argument may have been that the AIG equity in MLIII was tantamount to a discount, but the lawsuit argues that notion is bogus. Since AIG was broke, any money for the AIG equity came from the outside (in fairness, it’s a bit more complex, thanks to reserves set aside over the collateral dispute).

The suit argues that the initial loan was made under false premises, since the loan was secured by all assets of AIG, when the assets were already pledged (all the regulated subs have prior claims on them, both to creditors and policy-holders). The understanding, as depicted in various less-than-official accounts, like the Andrew Ross Sorkin Too Big Too Fail, is that the loans were secured by the equity of the subs. Fine in theory, but in practice, that isn’t what the loan document says, and as important (although not argued in the case) is the amount of the loan was based on what AIG needed to stay afloat, not on any effort to find a market value of the assets pledged and discount that.

In addition, the notion that it was acceptable to lend against stock appears to be based on the discount schedule that the Fed posts and revises from time to time as to the types of collateral that are accepted for lending and the various discount rates established for them. But note that schedule is for depositary institutions. The Fed acted as if it could simply lend against the same assets held by non-depositaries, but the language of the germane section does not appear to support that idea.

The various disclosures of how the Fed lent against pretty much anything the banks could round up, including defaulted securities, is troubling. Defenders of the central bank argue no harm was done since the securities have recovered from crisis lows (well save the ones that went to zero). The problem is that the logic is circular. In many cases, the value of the securities now depends on the fact that the Fed is willing to lend at super low interest rates. So the “market” values are fictive and dependent upon Fed intervention, which is coming at the expense of savers. The interdependence between the Fed’s rescue facilities and its continued interventions is given a free pass, but those of us who are not at the top of the food chain are continuing to pay the cost.

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  1. Moshi

    There was a complete review of this issue in a journal article by Alexander Mehra late last year, available on SSRN, abstract number 1821002. He also concluded the Fed exceeded their stautory authority.

      1. jpe

        Per the article, “discounting” is a technical term meaning “collateralized lending.” If that’s the case, the argument advanced by the qui tam plaintiffs that no % discount was applied fails.

        1. jpe

          BTW, the complaint is pretty professional. I haven’t read it closely enough to assess the merits, but I was expecting a POS and was pleasantly surprised.

  2. Jim A.

    “But of course this collection of bottle caps and pocket lint is worth $5 million. See that’s what it’s trading at.”
    “The only reason that it’s trading at $5 million is that you are willing to accept it at collateral for a $5 million loan.”

    If we learn nothing else from the RE bust it’s that lending based on collateral value without regard to ability to make the payments has a way of blowing up real bad.

  3. doug

    So, which is this? The Fed jumping in at the speculative Minsky stage (interest can be paid; but not principal)? Or, the Ponzi stage (neither can be paid)?

  4. liberal

    While I wouldn’t be surprised if the Fed exceeded their mandate; and would like to see the Fed taken down a few notches (at least!); and would be happy if this lawsuit proceeded apace; and am not a lawyer…I’m predicting that the courts will claim that the plaintiffs have no standing. (sigh)

  5. pezhead9000

    “The interdependence between the Fed’s rescue facilities and its continued interventions is given a free pass, but those of us who are not at the top of the food chain are continuing to pay the cost.” — yes, us monkeys (and our children) at the lower end of the food chain will suffer.

    Interestingly, my senator had this to say about auditing the FED (2009):

    “As the Federal Reserve Sunshine Act is currently written, I am opposed to the legislation. Under common usage of the term audit — an examination of accounts and records — there is already a 100 percent audit of the Federal Reserve.”

    “Ultimately, it would be taxpayers who would bear the brunt of any losses resulting from policies caused by untimely disclosure of sensitive information”

    1. pjwrites

      “sensitive information”
      Is that where they’re calling proof of fraud these days? Just curious, because the laws have become so nonsensical, that actually may be what it’s called now.

      1. pezhead9000

        Yes. This is also the Colonel Nathan R. Jessep “You can’t handle the truth!” response. #AFewGoodMen

  6. Jeffrey Bagpants

    “Embarrassment” Oh heavens, say it ain’t so momma! In the tragic realm of inconveniences to have the parasite class face public humiliation. Oh my, oh my!!! Handwringing!! Panic!!!

    Let’s pile all of their shit on the curb, send in the SEALs and use helicopter deployed cargo netting in Manhattan to round up the Bonnanno family within each listed corporate entity. Because of the sensitivity of the operation – all corporate media will be firmly blacked out – approved bloggers, random hacks will post, forward and distribute. Don’t get me started on Sh-twitter Inc.

  7. Brick

    Going by past examples we can expect a new statute to appear saying something like the following.

    1. The central bank can lend against anthing it likes.
    2. Notes, bills, and other drafts of exchange dont have to be discounted
    3. The Federal reserve bank making the loan does not need evidence that the non-bank party seeking the loan can’t get credit from other banks
    4. Any member of the Board of Governors or passer by must affirmatively vote to authorize the discount prior to the extension of credit.

    The law does not really work against those that can change the law at a whim. In my opinion it will either be thrown out or the rules changed.

  8. pjwrites

    I’m no economist, but if I understand this article, then what I am taking away from it is that our government and the Federal Reserve are both part of some criminal organization (and I use the term “organization lightly) that believes they are above the law.
    Typical behavior for them that can though, ain’t it?

    1. adam

      This is a qui tam suit on behalf of the federal govt under the False Claims Act. Under the statute, under certain circumstances a private plaintiff may be able to sue on behalf of the govt, but can’t sue the govt itself (so the Fed can’t be a defendant).

  9. Susan Truxes

    I don’t understand why the Casadys did not name the Fed as a defendant? Please splain me that one. Is it to protect their standing? We the people obviously can go after fraud by the big institutions. So the Casadys are OK there. I feel so sorry for Bernanke. I truly think he is doing his level best to save us all. But in order to do it he has to condone fraud. And that alone in the end will bring us all down. I also don’t understand why anyone would want to invest in the skeletal remains of the CDOs (Maiden Lane III) after all the CDSa were satisfied – What does this leave to invest in?? Were the CDSs specific to a mortgage; a tranche; a big fat CDO? What? Bottom line with me is that we as a country have been so ripped off by this we are all rapidly becoming berzerk. Where did all the money go that we are being asked to pay as taxpayers? It wasn’t something that was rescinded. The money went away.

  10. Mindrayge

    Yves, one more thing about the AIG situation. On the day before the first Fed bailout (loans) the Governor of New York along with the NY Insurance Commission granted an emergency action for AIG to borrow $20 billion of reserves held by the insurance subsidiaries. This I suspect would have effectively bound up any equity the insurance subs were carrying.

  11. doom

    Doesn’t the False Claims Act get you qui tam awards? Considering the scale of the fraud, white shoe firms, or at least highly competent shysters, ought to be falling all over themselves to buff up that suit.

    1. Yves Smith Post author

      Exactly, I don’t know why this sort of suit hasn’t been filed sooner.

  12. beowulf

    This suit was actually filed February 2010 (and amended in October) but False Claims suits are always filed under seal to give the federales an opportunity to pick up the ball and run with it (the whistleblower would still get a percentage of what Uncle Sam recovers).

    Its only after DOJ declines to take over is the original lawsuit unsealed. And standing is clearly not an issue, even AIG (backhandingly) concedes that–
    “AIG said in a statement that the Casadys only had standing to sue because the Department of Justice declined to intervene in the action or pursue its own lawsuit”.

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