Due to the hour, and the fact that I want to work up the argument longer-form over a series of posts, I’ll give only an overview now as to why the popular handicapping on the AIG bailout trial, that the suit is ridiculous and not worthy of attention, is wrong.
While this case by any logic should be ridiculous, the Fed so egregiously overstepped its authority in the way it handled AIG (and for that matter, its other bailouts) that they handed Greenberg a decent legal argument. And to add to the government’s self-inflicted woes, all of its bailout cheerleading also plays straight into Greenberg’s hands.
Probably the biggest relief to the government so far is that the media has virtually ignored the trial. The only major news organization that has a reporter there daily is Bloomberg. Their reporter, Andrew Zajac, concurs with our view (and quoted us) that David Boies, the Greenberg attorney, has decent odds of winning the case. If Boies does prevail, you can expect an Administration-led firestorm of outrage, with the arguments previewed in a Steve Rattner op-ed in the New York Times.
But the grandstanding serves to obscure the legal argument, which when you get past the technicalities, has real significance politically. That is why the officialdom would rather distract the public by hammering on “That ungrateful deadbeat Greenberg. Who is he to want more money when by all rights he should have been wiped out?” If anyone bothered to look at what is really at stake here, it is that the Fed, with the help of the Paulson Treasury, greatly abused its powers. And that matters because as a practical matter, the Fed is unaccountable for its actions.
The guts of the AIG bailout trial revolves around the Federal Reserve’s “unusual and exigent circumstances” powers, known more formally as its Section 13 (3) lending authority. Under Section 13 (3), the central bank can lend to pretty much anyone against just about any collateral. And it can structure those loans with the full intent of wiping out shareholders, as the Fed did in its first post-Depression intervention, the implosion of Franklin National Bank in 1974, then the largest bank failure ever.
Section 13 (3) authority was created in the Depression, amid much controversy, since there was great reluctance to give the Fed, which was not accountable through democratic processes, the power to create winners and losers via who got emergency loans and on what terms. To prevent that outcome, the statute curbs the Fed’s discretion in rate-setting on Section 13 (3) loans. Thus while (somewhat in contradiction to the position that the Boies camp is taking in the AIG bailout trial) former New York Fed attorneys who had direct involvement in Fed discount window lending decisions say the central bank can lend at rates intended to be punitive, they have to be the highest of published rates, and they have to be applied consistently. Note that the lending agreement that AIG entered into on September 22 was at higher rates than the Fed had published, so on that basis alone it was impermissible under Section 13 (3).
It is conceivable that the Fed could have deemed AIG to be more distressed than, say, Morgan Stanley by some objective standard, and applied a less harsh rate to Morgan Stanley. However, the fact that both AIG and Morgan Stanley (and plenty of other firms) were dead without Fed emergency assistance, yet AIG was charged a rate well in excess of any published Fed rate, while the wobbly banks were given most favored nation treatment also flies in the face of Section 13 (3) requirements.
Another not trivial problem, which the New York Fed’s attorney Tom Baxter and the Board of Governors’ general counsel Scott Alvarez tried desperately to finesse in their trial testimony, is that buying or owning stock is verboten under 13 (3). The Fed can take warrants, and the term sheet that the Board of Governors approved did authorize the Fed taking warrants in connection with the tidied-up version of its lending facility (the central bank used a demand note to provide funds while it worked out the details, but to the considerable surprise of AIG’s board, they also increased the interest rate considerably when the central bank came back with terms for the longer-term facility).
The Fed’s attorneys have tried to pretend to the judge that the Board approved an equity interest and all equity is kinda-sorta the same (uh, no) and that the Board resolution gave the New York Fed latitude in dealing with AIG. While the latter may be arguably true, it is moot as far as the matter of taking anything more than warrants is concerned. A principal can’t convey rights to its agent that it does not possess. The Board of Governors did not have the right to take anything beyond warrants in connection with a Section 13 (3) loan and thus could not confer that authority to the New York Fed.
In fact, one has to look cynically at the extremely aggressive measures that the government took to get AIG to take the deal it was offered (such as allowing the board only two hours to decide) as well as the machinations to get control of the company without facing a shareholder vote. Given that the Fed and Treasury could easily have reduced AIG’s shareholders to penury without taking the equity, that clearly was not a driving factor. Nor does the lame “We were afraid of what AIG’s lawyer Rodgin Cohen might cook up” hold water. Cohen, America’s top bank regulatory lawyer, could not afford to cross the central bank. So the most obvious reason also seems to be the logical one: the authorities wanted control of AIG so they could launder bailout money through it, via its payouts on credit default swaps and on its other black hole, its securities lending portfolio. And that wasn’t the only method. Consider this post from March 2009: Guest Post: The Banks Were Profitable In January And February Thanks To… AIG. Note that the trades being unwound went well beyond the CDS related to Maiden Lane III, as in the toxic subprime-related CDOs:
I present the insider perspective of trader Lou (who wishes to remain anonymous) in its entirety:
“AIG-FP accumulated thousands of trades over the years, all essentially consisted of selling default protection. This was done via a number of structures with really only one criteria – rated at least AA- (if it fit these criteria all OK – as far as I could tell credit assessment was completely outsourced to the rating agencies).
Main products they took on were always levered credit risk, credit-linked notes (collateral and CDS both had to be at least AA-, no joint probability stuff) and AAA or super senior portfolio swaps. Portfolio swaps were either corporate synthetic CDO or asset backed, effectively sub-prime wraps (as per news stories regarding GS and DB).
Credit linked notes are done through single-name CDS desks and a cash desk (for the note collateral) and the portfolio swaps are done through the correlation desk. These trades were done is almost every jurisdiction – wherever AIG had an office they had IB salespeople covering them.
Correlation desks just back their risk out via the single names desks – the correlation desk manages the delta/gamma according to their correlation model. So correlation desks carry model risk but very little market risk.
I was mostly involved in the corporate synthetic CDO side.
During Jan/Feb AIG would call up and just ask for complete unwind prices from the credit desk in the relevant jurisdiction. These were not single deal unwinds as are typically more price transparent – these were whole portfolio unwinds. The size of these unwinds were enormous, the quotes I have heard were “we have never done as big or as profitable trades – ever“.
As these trades are unwound, the correlation desk needs to unwind the single name risk through the single name desks – effectively the AIG-FP unwinds caused massive single name protection buying. This caused single name credit to massively underperform equities – run a chart from say last September to current of say S&P 500 and Itraxx – credit has underperformed massively. This is largely due to AIG-FP unwinds.
I can only guess/extrapolate what sort of PnL this put into the major global banks (both correlation and single names desks) during this period. Allowing for significant reserve release and trade PnL, I think for the big correlation players this could have easily been US$1-2bn per bank in this period.”
For those to whom this is merely a lot of mumbo-jumbo, let me explain in layman’s terms:
AIG, knowing it would need to ask for much more capital from the Treasury imminently, decided to throw in the towel, and gifted major bank counter-parties with trades which were egregiously profitable to the banks, and even more egregiously money losing to the U.S. taxpayers, who had to dump more and more cash into AIG, without having the U.S. Treasury Secretary Tim Geithner disclose the real extent of this, for lack of a better word, fraudulent scam…
What this all means is that the statements by major banks, i.e. JPM, Citi, and BofA, regarding abnormal profitability in January and February were true, however these profits were 1) one-time in nature due to wholesale unwinds of AIG portfolios, 2) entirely at the expense of AIG, and thus taxpayers, 3) executed with Tim Geithner’s (and thus the administration’s) full knowledge and intent, 4) were basically a transfer of money from taxpayers to banks (in yet another form) using AIG as an intermediary.
For banks to proclaim their profitability in January and February is about as close to criminal hypocrisy as is possible. And again, the taxpayers fund this “one time profit”, which causes a market rally, thus allowing the banks to promptly turn around and start selling more expensive equity (soon coming to a prospectus near you), also funded by taxpayers’ money flows into the market.
In case this is still all a bit arcane, the critical part is that these “portfolio unwinds” involved corporate credit default swaps, not credit default swaps related in any way to subprime risk. These were NEVER mentioned as a trouble spot at AIG, yet they were wound down (a step of questionable necessity to begin with) in a way that provided big and unnecessary losses to AIG (increasing the total size of its bailout) and corresponding profits to its Wall Street counterparties. While this tidbit is not part of the AIG trial, it serves to confirm the idea that the government wanted to get control AIG to launder bailout money through it.
Now of course, the judge could deliver a Solomonic solution and declare Greenberg to be a winner but award him minimal damages. At this point in the trial, we only have the Greenberg valuation arguments. However, a not-trivial issue for the government is that to justify lending to AIG, they worked up rough internal valuations and those show excess value, meaning that they deemed AIG to have positive net worth. And they’ve since brayed that all the bailouts made money for the government. So their own machinations and PR do pose a bit of a hurdle they need to overcome. We’ll work through the valuation experts’ testimony in due course.
What is the political argument that the government must be pleased as punch has gone missing? Boies has not touched the fact that Section 13 (3) loans are only meant to be for short-term liquidity needs. Even them extending beyond a few days is (or was) considered questionable; the Fed finessing its Franklin National loans to extend five months back in 1974 was seen as a dubious stretch of its authority. Recall that when the Fed was called in to lend to Bear Stearns, it originally was going to lend only for 28 days, then cut it back to what amounted to overnight, for reasons that were never explained. Fed watcher assume that the reason was that Bear was insolvent, and Section 13 (3) loans are not meant to go to insolvent institutions.
In other words, even if the Fed has stuck to the term sheet that the Board of Governors authorized, and extended a two-year loan with warrants, in the opinion of the former NY Fed lawyer I spoke to, that amounts to an impermissible capital injection. That action should have been undertaken only as budgetary allocation, subject to the approval and oversight of Congress. In the Depression, the Commerce Department would have sought authorization; during the crisis and now, Treasury runs that drill. And in the Depression, there was a vehicle for making bailouts, called the Reconstruction Finance Corporation. Its head, Jesse Jones, was widely described as the second most powerful person in Washington, which troublingly is the status that the Fed has held for decades.
In other words, unless Greenberg wins his suit and the judge’s decision focuses firmly and articulately enough on the issue of the Fed abusing its powers so as to stir pundits and media to focus on this issue, this trial is going to serve as a lost political opportunity. The Fed’s conduct during the crisis, and its efforts to step into a quasi-fiscal role with QE, is a wild expansion of its scope of authority. Yet despite hand-wringing since the Nixon Administration about the rise of an imperial presidency, we’ve seen far less concern about mission creep at the Fed and a similar encroachment upon Congressional authority. Let’s hope we get lucky and that if Greenberg prevails, it leads to calls for Audit the Fed 2.0.