Posts filed under “Bailouts”
After seven years, the federal government has finally received its comeuppance. U.S. Judge Thomas C. Wheeler gave the Federal Reserve a severe tongue lashing, a tsk-tsking for the central bank’s financial-crisis overreach.
That ought to teach ‘em.
The actual result of the case is to confirm the status quo. In “emergencies,” restraint on government adds up to precisely nothing.
Consider the case at hand involving the bailout of the giant insurance company American International Group at the height of the 2008 panic.
Wheeler was confronted with an intriguing question of law: What are the limits of government intervention in the economy during times of crisis? It was a case with no good guys, only flawed actors, a suit I like to think of as Chutzpah v. Panic. You may know the case by its formal name, Starr International Co. v. U.S. (11-cv-00779). In more common parlance, it was also referred to as that crazy suit former AIG head Hank Greenberg filed against the feds.
On the one hand, in the cool light of hindsight, this was a clear case of government overreach. The Fed regulates the banking system, and has no jurisdiction over insurance companies. But during the financial crisis the Fed stepped in, covered AIG’s liabilities and claimed majority ownership.
As Wheeler wrote, “The Board of Governors and the Federal Reserve Banks . . . did not have the legal right to become the owner of A.I.G. There is no law permitting the Federal Reserve to take over a company and run its business in the commercial world as consideration for a loan.”
On the other hand, you have a company that was one of the worst and most reckless actors in the financial industry — and that was the least of the problems in this litigation. Before the government bailout, AIG was hurtling straight off a cliff toward bankruptcy, all by its own hand. Its shareholders were destined to get wiped out. As Wheeler noted: “The inescapable conclusion is that A.I.G. would have filed for bankruptcy. In that event, the value of the shareholders’ common stock would have been zero.” Hence, Greenberg’s demand for $40 billion in compensation was why his claim represented pure chutzpah. (For more on AIG, see this, this, this, this, this, this and of course this).
Complicating matters more, we know the AIG takeover was a debacle. The Special Inspector General of the government’s bailout program already told us the Federal Reserve Bank of New York screwed up the AIG rescue. The feds even wanted a national security exemption for AIG, to keep the whole mess secret. That was how much panic there was at the time.
In theory, the ruling may limit the Fed’s ability to deal with the next crisis. In practice, during a genuine panic, there are no rules. That is the most significant dicta of the case. The government overstepped its authority during what was considered to be an emergency. To prevent this, you can sue the government; seven years later, a pyrrhic victory is yours.
Consider how flexible the First Amendment becomes during times of war. Think of how much privacy rights shrunk after the terrorist attacks. How do we get the internment of 120,000 U.S. citizens of Japanese descent during World War II? How do we ignore our own treaties against torturing prisoners?
There is that word again: Panic.
The Fed certainly panicked as AIG (not to mention the entire financial system) teetered. The answer to the complaints was “Go ahead and sue us.” So Greenberg did. His victory was in name only.
What might this mean in the next financial crisis? Maybe a day of delay. Assume a plaintiff can find a friendly judge to issue a favorable ruling based on the Starr International case. It probably wouldn’t take the government more than a day to find an appellate court to overrule the judge on an emergency basis. Only after that takes place, can the plaintiffs begin their appeals. And as we just learned, that will take about seven years.
In an emergency, the government often ignores what courts say. The Constitution isn’t a suicide pact — that’s the phrase you will hear at such a time.
Best of luck. Maybe there’s a pyrrhic victory in your future.
Originally published as: Hank Greenberg’s Chutzpah vs. Fed’s Panic
This is an amazing decision; you should read the entire thing!
“The main issues in the case are: (1) whether the Federal Reserve Bank of New York possessed the legal authority to acquire a borrower’s equity when making a loan under Section 13(3) of the Federal Reserve Act, 12 U.S.C. § 343 (2006); and (2) whether there could legally be a taking without just compensation of AIG’s equity under the Fifth Amendment where AIG’s Board of Directors voted on September 16, 2008 to accept the Government’s proposed terms. If Starr prevails on either or both of these questions of liability, the Court must also determine what damages should be awarded to the plaintiff shareholders. Other subsidiary issues exist in varying degrees of importance, but the two issues stated above are the focus of the case . . .”
The weight of the evidence demonstrates that the Government treated AIG much more harshly than other institutions in need of financial assistance. In September 2008, AIG’s international insurance subsidiaries were thriving and profitable, but its Financial Products Division experienced a severe liquidity shortage due to the collapse of the housing market. Other major institutions, such as Morgan Stanley, Goldman Sachs, and Bank of America, encountered similar liquidity shortages.
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. The notorious credit default swap transactions were very low risk in a thriving housing market, but they quickly became very high risk when the bottom fell out of this market. Many entities engaged in these transactions, not just AIG. The Government’s justification for taking control of AIG’s ownership and running its business operations appears to have been entirely misplaced. The Government did not demand shareholder equity, high interest rates, or voting control of any entity except AIG. Indeed, with the exception of AIG, the Government has never demanded equity ownership from a borrower in the 75-year history of Section 13(3) of the Federal Reserve Act. Paulson, Tr. 1235-36; Bernanke, Tr. 1989-90 . . .
The Government’s unduly harsh treatment of AIG in comparison to other institutions seemingly was misguided and had no legitimate purpose, even considering concerns about “moral hazard.”4 The question is not whether this treatment was inequitable or unfair, but whether the Government’s actions created a legal right of recovery for AIG’s shareholders.
Turning to the issue of damages, there are a few relevant data points that should be noted. First, the Government profited from the shares of stock that it illegally took from AIG and then sold on the open market. One could assert that the revenue from these unauthorized transactions, approximately $22.7 billion, should be returned to the rightful owners, the AIG shareholders. Starr’s claim, however, is not based upon any disgorgement of illegally obtained revenue. Instead, Starr’s claim for shareholder loss is premised upon AIG’s stock price on September 24, 2008, which is the first stock trading day when the public learned all of the material terms of the FRBNY/AIG Credit Agreement. The September 24, 2008 closing price of $3.31 per share also is a conservative choice because it represents the lowest AIG stock price during the period September 22-24, 2008. Yet, this stock price irrefutably is influenced by the $85 billion cash infusion made possible by the Government’s credit facility. To award damages on this basis would be to force the Government to pay on a propped-up stock price that it helped create with an $85 billion loan. See United States v. Cors, 337 U.S. 325, 334 (1949) (“[V]alue which the government itself created” is a value it “in fairness should not be required to pay.”).
* * *
In the end, the Achilles’ heel of Starr’s case is that, if not for the Government’s intervention, AIG would have filed for bankruptcy. In a bankruptcy proceeding, AIG’s shareholders would most likely have lost 100 percent of their stock value . . .
Particularly in the case of a corporate conglomerate largely composed of insurance subsidiaries, the assets of such subsidiaries would have been seized by state or national governmental authorities to preserve value for insurance policyholders. Davis Polk’s lawyer, Mr. Huebner, testified that it would have been a “very hard landing” for AIG, like cascading champagne glasses where secured creditors are at the top with their glasses filled first, then spilling over to the glasses of other creditors, and finally to the glasses of equity shareholders where there would be nothing left. Huebner, Tr. 5926, 5930-31; see also Offit, Tr. 7370 (In a bankruptcy filing, the shareholders are “last in line” and in most cases their interests are “wiped out.”).
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