The long-anticipated verdict in the AIG bailout trial came yesterday, and the Fed is not happy. The central bank lost the case, with Judge Thomas Wheeler ruling that the Fed had engaged in an illegal exaction. In layperson speak means it made a demand, usually for money or property, that was outside what was permitted under the law. However, Judge Wheeler concluded that he could not award damages, since Starr International, the investment vehicle that held Hank Greenberg’s AIG stock, had not suffered any economic harm, since the alternative was bankruptcy, in which case Starr’s AIG shares would have been worth nothing.
We’ve embedded the ruling at the end of the post. It’s well written and crisis junkies might enjoy its findings of fact, in which Wheeler gives a reap of the drivers of the crisis and a very detailed account of the government takeover of AIG. Here was our recap of the basic issue:
The Starr International v. the United States of America suit is, at its core, about whether an insolvent borrower still has the right to the protection of law. It’s thus a high-end, big-ticket replay of the same form of arguments that homeowners fighting foreclosure often tried in court to obtain a mortgage modification: we don’t dispute that we aren’t able to meet our obligations, but the party foreclosing on us needs to go through the proper steps to take possession of our house. In the mortgage borrower’s case, that meant establishing standing, as in proving that they really were the proper party to initiate the foreclosure. In the case of Starr, the AIG executive enrichment vehicle controlled by former CEO Hank Greenberg, the argument is that even though AIG was insolvent, the bailout, which included through a series of maneuvers getting control of 79.9% of AIG stock, was impermissible.
We weren’t surprised by the ruling; in fact we were early to say Greenberg his attorney David Boies were likely to prevail (note we made our call when conventional wisdom was that the suit was groundless). since based on our reading of the opening arguments some of the trial testimony, well thought it was very likely that Greenberg and . The government seemed almost to be dialing in its argument, which amounted to, “There was a big crisis! Well intentioned hardworking public servants labored mightily to save the system! And Greenberg would have been toast anyhow, so what does he have to complain about?”
The big reason this case is important is that it sets limits on the Fed’s authority under Section 13 (3) lending powers. The Fed has seldom made 13 (3) loans, and in the past has made them on its own recognizance. An overview from an older post:
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…
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).
It was not hard to make the argument that the government had abused its authority in forcing AIG to surrender equity as a condition of a “must have” loan. Boies also presented evidence that Morgan Stanley was even more of a goner at the time of its rescue (for instance, its liquidity black hole was even bigger relative to the size of its balance sheet). And the judge also took issue with the government’s efforts to depict AIG as more destructive than other financial firms:
Thus, while the Government publicly singled out AIG as the poster child for causing the September 2008 economic crisis (Paulson, Tr. 1254-55), the evidence supports a conclusion that AIG actually was less responsible for the crisis than other major institutions.
It was clear during the trial phase that the government was fighting discovery to a degree that the judge thought was defying the authority of the court. That sort of thing does not sit at all well with jurists. Yet even though Wheeler made clear that he really wanted to throw the book at the government, he was limited by precedent in his ability to award damages. From his ruling:
As the Court noted during closing arguments, a troubling feature of this outcome is that the Government is able to avoid any damages notwithstanding its plain violations of the Federal Reserve Act. Closing Arg., Tr. 69-70. Any time the Government saves a private enterprise from bankruptcy through an emergency loan, as here, it can essentially impose whatever terms it wishes without fear of reprisal. Simply put, the Government often may ignore the conditions and restrictions of Section 13(3) knowing that it will never be ordered to pay damages. With some reluctance, the Court must leave that question for another day. The end point for this case is that, however harshly or improperly the Government acted in nationalizing AIG, it saved AIG from bankruptcy. Therefore, application of the economic loss doctrine results in damages to the shareholders of zero.
However, it’s a mistake to think that the Fed gets off scot free with this ruling. If the central bank were again to try to go beyond the scope of its 13 (3) powers, an aggrieved shareholder could go to court and use Walker’s ruling to get an injunction. As the New York Times pointed out:
“Greenberg proved he was correct, that the government didn’t have the authority to do what it did,” said Carl Tobias, a law professor at the University of Richmond. “I think it’s wrong to say it was a hollow victory because it didn’t come with money attached. It could have huge implications for public policy going forward.”
Wheeler’s findings of facts also supported the widely-held view that AIG served as a vehicle for laundering bailout money to credit default swaps counterparties like Goldman, Merrill, and Soc Gen. And that point was not lost on the press. From the Financial Times:
It will also fuel the charge that officials including Hank Paulson, then Treasury secretary, and Mr Geithner, then president of the Federal Reserve Bank of New York, only rescued AIG as a “backdoor bailout” for the banks. The banks were the ultimate recipients of the bulk of the money, paid as collateral on insurance for souring mortgage bonds.
Thus the government is almost certain to appeal the verdict, and Starr is expected to as well on the issue of damages. The Fed issued a short, huffy press release (hat tip Deontos):
The Federal Reserve strongly believes that its actions in the AIG rescue during the height of the financial crisis in 2008 were legal, proper and effective. The court’s decision today in Starr International Company, Inc. v. the United States recognizes that AIG’s shareholders are not entitled to compensation for that decision, and that the Federal Reserve’s extension of credit to AIG prevented losses to millions of policyholders, small businesses, and American workers who would have been harmed by AIG’s collapse during the financial crisis. The terms of the credit were appropriately tough to protect taxpayers from the risks the rescue loan presented when it was made.
Notice that the “appropriately tough” obscures the issue that only AIG was subjected to punitive rates (which the Fed has the right to demand) but the other banks that got 13 (3) loans got much more favorable terms.
An unlikely, unpopular figure like Greenberg has done an important public service by putting far more information about a critically important episode in the crisis in the public domain, and by having the judiciary, at least for now, put some curbs on the Fed. But this wrangle over money, the Fed’s powers, and who gets to influence perceptions of history will continue.