Widespread outrage about how the government bailout of AIG is playing out shows we need laws giving the Federal Reserve and U.S. Treasury clearer powers and duties when they provide money to large financial institutions that would otherwise go bankrupt.
Since the wheels started to come off the global financial system’s wagon in mid-August 2007, the Fed and Treasury have committed nearly $2 trillion to bail out financial firms. Less than half was appropriated by Congress.
This is unprecedented. However necessary these actions may have been, the current system fails basic tests of adequate legal authority, economic efficiency, fairness to ordinary citizens and even transparency.
Fortunately, some straightforward measures could alleviate these problems. The most important would be to give the Fed and Treasury the powers a federal judge would have in any Chapter 7 or 11 bankruptcy.
This would include the power to break contractual obligations like the one supposedly requiring payment of $165 million in bonuses to AIG derivatives traders and executives. It also would include the power to discharge debt obligations, giving the government clear authority to impose a “haircut” on derivative counterparties like Goldman Sachs, and the other domestic and foreign banks and states that, after the bailout, have gotten 100 percent of what AIG owed them.
Legal authority right now is tenuous. Congress passed the Federal Reserve Act in 1913 and in 1932 added section 13(3), authorizing the Fed to loan money to “any individual, partnership or corporation” in “unusual and exigent circumstances.”
Though I view the War Powers Act as an abdication of Congressional constitutional responsibilities, I believe it does serve as a model for legislation that would create clearer legal authority and responsibilities for future financial bailouts.
It could give the president the power to declare a financial emergency, subject to confirmation or override by Congress in some specified period like 60 days.
Only then would the Fed, in consultation with the Treasury, have the authority to implement the sorts of lending to nonbank financial institutions that it has done in the past year.
It could place limits on the amounts of money the Fed could lend and the degree of collateral interest it could demand as a condition. It could give the Fed broad powers to replace managers and boards of directors, rescind or even claw back bonuses and modify contracts.
The basic justification for such broad powers would be that if the government did not intervene in cases where a financial institution’s failure would harm the economy at large, the company would end up in bankruptcy courts anyway and be subject to similar sweeping intervention. The purpose of Fed and Treasury action is to protect the national economy and the general public, not the jobs, income or wealth of any private individual or company.
The Fed’s initial reading that it currently does not have legal authority to cancel bonus contracts may be right. It should have that authority. It may be prudent right now to completely pay off any of AIG’s derivative counterparties. But it also may be prudent to demonstrate that anyone entering into a financial contract like a credit default swap needs to bear counterpart risk and not rely on the government making them whole whenever they deal with a large institution like AIG. The Fed and Treasury should be able to make that choice.
Having clear laws and rules in place would prevent any future situation in which a Treasury secretary arrives on Capitol Hill with a three-page demand for $700 billion that includes total exemption from judicial or congressional review. It would give the Fed the authority to put the kibosh on payouts that rightly outrage millions of citizens.
© 2009 Edward Lotterman
Chanarambie Consulting, Inc.