AIG Bailout Trial Judge Rebukes Fed for Overstepping Its Powers but Awards No Damages

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.


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  1. AQ

    Thanks, Yves, I saw the headline yesterday and knew you’d have a good breakdown of the information soon. Much appreciated.

    1. Kim Kaufman

      Yes, same here. And I instinctively thought it would be about precedent. Wonder how much it cost Greenberg in legal fees. But that’s what rich guys can afford to do – spite lawsuits. Good thing he was at least right.

    2. Nathanael

      Really good ruling — totally accurate. Now we’ll see whether the politicized appeals courts decide to overturn it.

  2. ptup

    No whoop, but made some lawyers richer. Won’t really change a thing, except the next time, if the lawyers on the sinking ship act fast and get to a judge first, the powers that be will just do some quick judge shopping to counter in that time of panic. Hindsight is so 20-20.

  3. JohnnyGL

    Very interesting outcome. Thanks for the write-up, Yves!

    It’s always fun when the public interest is served for all the wrong reasons :)

  4. jsn

    I continue to be amazed by the BS the Times reports on these issues: all framing and clipping to fit the approved narrative.

    Thanks for taking the time to highlight the salient realities others are trying to overwrite!

  5. steelhead23

    OK, so there’s no rationale for awarding Starr monetary damages, but what’s to keep the Fed from doing this again? Such deterrence is the purpose of “punitive” awards. What is needed here is some kind of punishment or the Fed is sure to do this again – next time. And I’m pretty sure there will be a next time.

  6. Sarah from TX

    Thanks for the BS-free version of this story, including a post of Judge Wheeler’s full opinion!

    1. ptup

      Because Greenberg wanted Ghietner, Bernanke and Paulson on the stand under oath. That’s about it.

      1. todde

        I meant for future lawsuits.

        I don’t see why a shareholder would try to stop the Fed from doing this again.

        1. jsn

          Fed acts (illegally), saved suitor who’s peeved about terms files injunction, whole clustefuck is drawn into some judges chambers who has to halve the baby in real time or extricate it from the crisis behind court protection… maybe?

          1. todde

            All I get out of it is: Be careful when saving a wealthy person’s ass, they may sue you for more.

    2. Yves Smith Post author

      It’s not a save if you get nothing or close to nothing. For instance, both Fannie and Freddie were put into conservatorship. Freddie was in bad shape, Fannie not so much. The Fannie CEO and board were shocked at the conservatorship “proposal” from Paulson and said, “No way, we are a viable company.” Paulson said (and this is in the record, in Andrew Ross Sorkin’s Too Big to Fail), basically, “I don’t care. I’m worried about contagion risk. If I put Freddie under, the market thinks you are just the same. And I have the ability to do this to you whether you cooperate or not.”

      Now Fannie and Freddie are under different regs, but you could make the argument that this was also an illegal exactment, that this was overreaching as far as the authority of the then OFHEO was concerned. The board capitulated because they didn’t think they could win this fight. With this ruling, the board might have have been able to say they’d seek an injunction, or unhappy shareholders could have sought one.

  7. tegnost

    Just as in greece, pay off the banks as secretly as possible. I recall the articles yves wrote early on and am not surprised her take turned out to be prescient

  8. Michael Hudson

    It seems to me that the REAL question is whether bankruptcy would have enabled AIG to AVOID paying Goldman its demands. In bankruptcy, payments would have been held up. Fine.
    But then, waiting for time, AIG would have recovered.
    Would stockholders really have been wiped out by not paying CDS? Could AIG have insulated itself from the London office that had the losses? The domestic business was solvent.
    CAN AIG defend this claim?

    1. Steve

      Remember that AIG did not exist in a vacuum. If AIG were allowed to go bankrupt, how many of the purchasers of AIG CDS would take hits down the credit chain. My memory of the total amount of notional CDS sold by AIG is that it was a staggering sum indeed. This is why Geithner and Bernanke used AIG as the backdoor bailout. I’m not saying they did the right thing! I’m saying that I don’t believe AIG could have paid off all the claims on insurance they sold on the cheap.

    2. grayslady

      These are relevant points. More importantly, as I read the Findings of Fact, the AIG board never had accurate information from the government, so it was impossible to make a fair evaluation of bankruptcy versus a 13 (3) loan. The Findings of Fact make it clear that up until the very moment when the government walked in and said “We’re taking over your company,” everyone on the board thought that only warrants would be issued as part of the bailout, not the preferred stock that the government settled on. Would the board have agreed to an ostensible 13 (3) loan if they knew that, in fact, the government planned a takeover rather than a loan with warrants?

      As to whether AIG could have convinced a court to approve a reorganization plan, on the plus side, Price Waterhouse certified on August 8 that AIG had no liquidity issues worth mentioning in the financial statement footnotes. On the negative side, even though AIG stopped writing the CDS in 2005, they were stupid enough to allow asset swaps for existing deals. In other words, when the crooks who were originating these mortgage scams began to sense that the music was going to stop, and they all faced being the party left without a chair, they began to swap out the really atrocious packages written between 2005 and 2007 with the earlier packages, which, while still bad, were nothing compared with the bottom-of-the-barrel transactions that came along towards the end. Still, it’s possible the nature of the swaps might have been overlooked by bankruptcy analysts, or else the monetary differences would have been too difficult to calculate in a short period of time, and the court would have allowed AIG to reorganize.

      1. backwardsevolution

        “On the negative side, even though AIG stopped writing the CDS in 2005, they were stupid enough to allow asset swaps for existing deals. In other words, when the crooks who were originating these mortgage scams began to sense that the music was going to stop, and they all faced being the party left without a chair, they began to swap out the really atrocious packages written between 2005 and 2007 with the earlier packages, which, while still bad, were nothing compared with the bottom-of-the-barrel transactions that came along towards the end.”

        Now, who do you suppose allowed this at AIG’s Financial Products Division (AIGFP)? Joseph Cassano? There is something very mysterious about that guy. He does all this damage, and yet walks away unscathed, with an absolute fortune, no less. He refuses to speak to the media (his prerogative), but I just wonder what went on there.

        I read a great article re AIGFP a few years ago, how people tried to stop Cassano, but I can’t find it now. This one is not bad.

  9. Steve

    The interesting aspect of this to me is that Boies won a case that most experts? Said was a waste of time and not winnable. He really did his homework and put on a good case. Hope he wins on appeal because he clearly has produced an excellent record. Paulson and Geitner were forced to admit to certain facts and basically lie or forgot about others. Good win no matter what happens.

  10. MikeNY

    Apparently Mr Greenberg’s cronyism was not so practiced and polished as to merit ‘preferred’ treatment.

  11. ian

    I don’t see the logic in the idea that this will constrain the Fed in the future. Suppose there is another company facing bankruptcy like AIG – are they really going to file an injunction against the Fed if an AIG-like deal is the only one they can get?

    1. Steve F.

      This is very good for systematically important businesses that have continuity planning. Easy to foresee a best rates clause in the playbook when approached with a FED bailout such that rates will be adjusted based on other deals given by FED. Hard for FED to argue you need to be punished “more”. That visibility and potential injunction will bring FED to the table.

  12. Chauncey Gardiner

    Haven’t read the entire decision, but if it’s allowed to stand, I wonder if this ruling isn’t also another shot across the bow in effectively saying “Buh Bye!” to the Fed’s independence and sovereign immunity? If so, that could open Pandora’s box, since almost by definition there are economic winners and losers in the wake of nearly all the Fed’s monetary actions and policy decisions, not just its loans to terminally distressed SIFIs and the terms of those loans.

    For example, why should individual Fed officials be allowed, through over six years of Zero interest rate monetary policy, to select economic winners and losers between the largest banks and wealthiest segment of society versus savers, or those who buy stocks vs. those who short stocks, or those who take particular derivatives positions or buy long-term U.S. Treasury bonds versus those who don’t or who take the opposite side of those trades?

    Not defending the Fed or its specific actions and policy decisions, some of which I personally disagree with. Just sayin’.

    1. backwardsevolution

      Chauncey Gardiner – good post. That’s what I was wondering too. The Fed HAS set up winners and losers. One of my favorite daydreams is where the losers initiate a class-action lawsuit against the Fed in order to recoup the losses they have incurred as a result of the Fed’s actions, basically steering and engineering a field day (make that field “years”) for the winners. Do you think this could be done in light of all of the Fed’s manipulation?

  13. John Merryman

    As most any child and the occasional politician learns at some point, lies are more trouble than they are worth.
    As they say, the coverup is worse than the crime.
    In the long run this is just one little ray of sunshine through all the shinola, but eventually the whole house of cards will crumble, as those with the most to lose, can’t sustain a facade that will naturally shrivel, as the rot it tries to cover keeps seeping out.

  14. Sluggeaux

    The good thing here is that David Boies has exposed for the historical record that Hank Paulson got himself appointed Secretary of the Treasury in order to bail out Goldman’s via the AIG CDS scam and that he and Geithner, via Bernanke’s Fed, were running roughshod over the Rule of Law in order to crush their competitors and to loot the public fisc.

    They will be judged harshly by future historians on this record. For this I am grateful.

  15. z80

    In retrospect, this ruling truly marks the end of my real estate career. When the market crashed, I made it a personal goal to get to the bottom of things so that I could grow and learn from my mistakes Seven years later, I have finally found closure to problems I simply couldn’t understand or identify at the time they manifested themselves. Surprisingly, I still can’t find an alternate path I could have taken to change the fate of my career absent fraud or dishonesty. Every year, I learn a little bit more about human nature and the inner workings of our social ecosystem.

    It’s becoming more apparent to me that our social accomplishments are less prominent than I previously assumed and are probably regressing at this point. I still can’t believe that the public majority thinks we wouldn’t be in this mess if people didn’t take on more than they could afford.

    On another note, there is no reason for the Federal Reserve to exist other than to enslave the little folks and siphon wealth from the general public to the upper classes. My personal opinion is that the federal reserve is a critical element in a Coup D’Etat instigated by the banking system. The argument that the Federal Government needs to borrow money from the FED or banks to support infrastructure is a lie. There is no reason that the Federal Government should pay any interest on debt because they have the power to print money to pay off the debt; It’s just a handout to all of the debt holders and free money for the banking system. The Federal Government has the power to print money and cancel all debts if necessary. Heck, they could grant the entire country a tax holiday and just print more money as stimulus but that would give the serfs the wrong idea. For a fun mental exercise and to highlight the ridiculousness of the modern financial system so many have confidence in, check out this Wikipedia article about the trillion dollar coin:

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