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What is the legal status of the AIG takeover?

I've been wondering and maybe you have been too. Here is one opinion:

I imagine that the legal answer to that question depends on a nice distinction between practice and plain language. Under the plain language of the statute, interpreted imaginatively, the Fed can extend credit, upon the right showing, to any company or individual, and so why not insist on conditions on the loan? Heck, why couldn't EPA, in the name of fishable swimmable rivers (that's Clean Water Act language), ban all pesticides, including dishwasher detergent, or nationalize water users like the steel industry? Maybe it can! Which might be good news for environmental activists.

I thank David Zaring for the pointer to this very interesting analysis (there is a related version of this post up at www.marginalrevolution.com). Do you know more?

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The AIG Deal.

True, the Fed statute says that loans can be issued with conditions. As a commenter asks, what loan doesn't have conditions? See here also. But the Fed statute does not say that the Fed can purchase businesses, and it seems reasonable to interpret the statute to forbid the Fed to purchase businesses. So here's the question, is the AIG deal a purchase or a loan? I suspect the deal is a loan in form but a purchase in substance. Unfortunately, the details are not available, but the press accounts suggest that the Fed is receiving AIG equity (more precisely, the option to obtain equity) as collateral for the loan but that it's going to exercise the option more or less automatically. Here's an analogy. Suppose that I lend you $100 and we agree that all of the equity in your business will be collateral for the loan. The contract provides, however, that you must pay me interest of a gazillion dollars, due one second after closing, and that if you fail, that counts as a default, whereupon the collateral is mine. The parties use the loan form but substantively a sale occurs. A court would almost certainly interpret the transaction as a sale, not a loan, if tax or other legal consequences turned on the distinction. If the AIG loan is like this, then it's illegal. So: why aren't our rule-of-law friends yowling?

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Four Ways to Rationalize the AIG Deal --

1. It really is a loan, not a purchase. 2. It's a purchase but it's called a loan and words like "interest rate" are used, so therefore the Fed can do it under the terms of the statute. 3. Even if it's a purchase, the statute does not literally say that the Fed can't purchase things and therefore (presumably under Chevron), the Fed has the authority to purchase (see Marty's comment on my earlier post). 4. It's an emergency, and a Schmittian state of exception is in play. No one really cares whether the transaction is lawful or not, just do something! Cite something in the Constitution -- Article II, somewhere. I mean go to #3 and cite the canon of avoidance just to be sure! (Indeed, this post suggests that the executive branch is really pulling the strings.)

#2 is silly; #3 is a respectable type of legal argument, according to which every grant of authority to an agency for limited purposes turns into a grant of vast discretionary authority unless Congress very very busily lists all the things the agency can't do; #1 remains possible but unlikely; #4 is most plausibly the truth. We might call #3 the polite version of #4, but to find out for sure I agree we'd need a test case where the Fed actually broke a clear rule -- arrested AIG shareholders and put them in Guantanamo Bay or something like that. Maybe tomorrow.

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More on the (Absence of) Legal Authority for the AIG deal --

Whether or not the Fed has the authority to buy/lend to AIG, the story does not end there. In order to lend/buy, the Fed needs to come up with $85 billion, which is conveniently being supplied by the Treasury Department, which is in turn borrowing it from whoever will lend money to the U.S. government, to be paid back by us or our descendants, unless the AIG deal miraculously turns out to be profitable. On what statutory authority does Treasury Act? Unlike the Fed, the Treasury does not bother to explain where its authority comes from in its press release and I have found no other sources with this information. Does anyone know? A U.S. Code section would be a nice place to start.

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AIG, the War on Terror, and Executive Power.

Whether the Fed (and/or the Treasury) acted unlawfully depends on whether the transaction with AIG falls within the statute that authorizes the Fed to make loans to non-banks during emergencies. It is clear that the transaction mixes elements of debt and equity. The Fed probably will get the residual value of AIG—everything if its assets appreciate less than 8.5%, and 80% of the balance if they appreciate more than 8.5%. The Fed probably has almost complete control as well: it kicked out the old CEO and replaced it with a new CEO and although the Fed has not yet exercised its equity warrants, clearly this new CEO knows that the Fed can, whereupon its control will become de jure as well as de facto. Still, we don't know for sure, I suppose; in particular, I can't tell whether some condition must be met before the Fed can exercise its warrants or whether they are limited in some other way. But if, as some have argued, AIG was worth nothing at all, then it would be pretty crazy for the Fed to accept anything less than full ownership in the substantive sense, and we can reconcile ourselves to the fact that somehow the AIG shareholders were left with an ownership stake with the comforting thought that their shares have (almost) no value. (As long as AIG is on life support, there is a non-zero probability that its value will appreciate to the point that shareholders get some return.)

What is more interesting is the strong parallel—which I hinted at before—between the current situation and the situation post-9/11. No one expects Congress to act in any meaningful sense. The executive has nearly unlimited discretion, relies on mostly secret information, and therefore its actions cannot be evaluated by outsiders. We can only trust that executive officials know what they are doing. People say, at least, we can trust Henry Paulson and Ben Bernanke. They seem competent and have the country's interests at heart. But that's what people used to say about Dick Cheney and Donald Rumsfeld. We really have no idea whether Paulson and Bernanke are making wise decisions, dumb decisions, or even politically motivated decisions—say, bailing out firms in which political allies have interests and not otherwise, or firms with lots of workers in politically important swing states. Sometime in the future, we may be able to evaluate their decisions, at which point our sole means of expressing our displeasure if those decisions were bad ones would be by voting against the person chiefly responsible for their appointments, George Bush—um, never mind.

Meanwhile, right now niceties of statutory construction must be ignored because the people who drafted the statutes did not anticipate the nature of this emergency though of course they knew that emergencies could happen. Back in 1932 (the most recent amendment was in 1991), Congress apparently believed that the Fed could respond to a financial crises solely by making loans so there was no need to give it the power to purchase businesses, a power that could be abused. Turns out this belief might have been wrong. Some loans may not be wise unless the lender can more or less control the borrower and can earn a portion of the upside, which just means that the Fed should have the power to purchase equity as well as debt. Going forward, all that Congress can do is provide even greater statutory discretion by expanding old authorities, so that next time round there will be no doubts about legality, and hope that the Fed does not abuse this discretion. There is, and can be, no serious debate about the best way to respond to the emergency in advance of it, and no time to have a debate during it. So Congress proves itself again an utterly helpless institution. It can whine today, hold oversight hearings tomorrow, and dutifully hand over more authority to the Fed on the next day. In the meantime, bad decisions by our government during this financial crisis, and future ones as well, will harm Americans and people around the world just as much as bad war-on-terror decisions do. Sorry, my libertarian friends; this is the world we live in. And there is no conceivable alternative.

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More on the Financial Meltdown and the Legal Response.

1. Why do people like me and Sandy Levinson keep talking about the Nazi philosopher Carl Schmitt? Schmitt was skeptical that a parliamentary democracy can handle crises: it can only role over and let the executive act. You can read Levinson here (marred only by the pervasive tone of indignation: what exactly does he (realistically) expect?), or for a scarily timely scholarly treatment of Schmitt and our administrative state, see this paper by Adrian Vermeule.

2. The legalists in American law schools rage at the Bush administration for claiming constitutional authority to wage the war on terrorism rather than going to Congress but are indifferent when the Bush administration cites, as authority to address the current financial crisis, a statute enacted by Congress seventy years ago and a judge-made doctrine that permits agencies to interpret ambiguous statutes expansively. Is it really so difficult to see that these two cases are the same from the perspective of the rule-of-law values that the rule of law is supposed to advance: public debate and authorization of policy by a representative body for the purpose of addressing events that it is actually aware of? I say that you have to approve of both or neither.

3. Speaking of which, see the bill the Bush administration is pushing on Congress, and this analysis by David Zaring. Note the "without limitation" language and the stripping of judicial review. Whatever you think of Bush administration lawyers, one cannot deny that they've learned some lessons from the Supreme Court's reaction to their war-on-terror policies.

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The Bailout:

Co-conspirator Eric Posner writes:

Meanwhile, right now niceties of statutory construction must be ignored because the people who drafted the statutes did not anticipate the nature of this emergency though of course they knew that emergencies could happen. Back in 1932 (the most recent amendment was in 1991), Congress apparently believed that the Fed could respond to a financial crises solely by making loans so there was no need to give it the power to purchase businesses, a power that could be abused. Turns out this belief might have been wrong. Some loans may not be wise unless the lender can more or less control the borrower and can earn a portion of the upside, which just means that the Fed should have the power to purchase equity as well as debt. Going forward, all that Congress can do is provide even greater statutory discretion by expanding old authorities, so that next time round there will be no doubts about legality, and hope that the Fed does not abuse this discretion. There is, and can be, no serious debate about the best way to respond to the emergency in advance of it, and no time to have a debate during it. So Congress proves itself again an utterly helpless institution. It can whine (http://online.wsj.com/article/SB122176444088253287.html?mod=googlenews_wsj) today, hold oversight hearings tomorrow, and dutifully hand over more authority to the Fed on the next day. In the meantime, bad decisions by our government during this financial crisis, and future ones as well, will harm Americans and people around the world just as much as bad war-on-terror decisions do. Sorry, my libertarian friends; this is the world we live in. And there is no conceivable alternative

He's probably right, sad to say -- Congress can no more give direction in crises like this one than it can direct troop movements during wartime. But one (small) point should be stressed here: the current bailout is being crafted not just by the Fed, but by the Treasury Department in conjunction with the Fed. It's not an insignificant point -- the Fed, after all, is almost completely shielded from political pressure, which is (usually) a good thing. But I, for one, would be a lot more nervous about the current bailout (and future bailouts) if I thought that the Fed was acting on its own; at least the occupants of the Treasury Dep't have some claim to having been chosen by the electorate, and are not entirely independent of voters' claims.

And I don't know about you all, but really, I sure wish that we had someone like Sarah Palin calling the shots here -- nothing like someone who knows absolutely nothing about the issues to steer us through a potentially planet-wide financial meltdown, eh?

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The Bailout Bill: What Should Congress Do?

There are two reasons to hate the Bailout bill. One is that it does the wrong thing; the other is that it gives the Treasury Department too much discretion. One internally consistent view is that nothing should be done. Another view, internally inconsistent but much more popular, is that the Treasury should be given even more power but that it should have less discretion. Not only should Paulson have the power to buy up mortgage-related assets; he should also have the power to make equity investments in distressed firms. Yet at the same time these critics—Paul Krugman is just one of many—say that the Bush administration is a bunch of clowns who can't be trusted. Paulson seems like a smart person but so did Rumsfeld and Cheney. How will he resist the temptation to pay too much for mortgage-related assets, so as to give a big windfall to millionaires? A good point. So then why give the Bush administration even more power than it is asking for?

Well, there is a way to square this circle. We give Treasury unlimited power but then we insist that it be subject to checks and balances. At this point, critics become vague. What are these checks and balances to be? We could imagine that whenever Paulson buys an asset or an equity interest, affected parties could challenge the purchase in court. Litigation would ensue, with the judge trying to determine whether Paulson paid too much. For equity investments, the inquiry would be even more complicated, with judges needing to determine whether an entire firm is a good investment rather than a more-or-less fungible asset. Judges are hopeless when it comes to making pricing decisions like these. Other types of review mechanisms could be imagined; perhaps they will be staffed with independent experts. But as oversight mechanisms are piled on, the flexibility needed to restore confidence will be lost. Perhaps there is an optimal tradeoff between flexibility and review but I have seen no serious discussion of this issue by proponents of alternative plans.

Meanwhile, the Democrats have good reason to worry. Under the current plan, if Paulson pays too little for an asset, he won't stop the business from going under. If he pays too much, he enriches its shareholders. He has every incentive to pay too much and generate a class of grateful investment bankers when taxpayers won't be able to tell in any event, in the process avoiding a financial crisis but generating large costs way down the line and considerable distributive unfairness in the short term. Democrats in Congress are responding not by making it impossible for Paulson to pay too little or too much --- as I have said, it simply has no way of doing that by statute because the pricing decision is a seat-of-the-pants judgment that can't be dictated in advance and can't be reviewed by courts after the fact. Instead, Democrats are preemptively playing the distributive game that they fear that Paulson will be tempted to play, and ensuring that their constituents will get a piece of the pie —- so far the idea of restrictions on foreclosure has been advanced, as has a "stimulus plan" which will presumably pay out cash to moderate- and low-income people whose votes Democrats want to lock up. In effect, the Democrats are willing to swallow the agency costs of the plan but ensuring that transfers to Republican constituents will be balanced by transfers to Democratic constituents.

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Does Congress think that Paulson asked for not enough power?

You might think so from reading the Dodd bill and the news accounts (including this very helpful discussion by Steven Davidoff):

1. Under the Paulson bill, Treasury will have the power to purchase mortgage-related assets. Under the Dodd bill, Treasury will have the power to purchase these assets and "any other financial instrument, as the secretary determines necessary to promote financial market stability." In Davidoff's words, the Dodd bill "could allow this program to expand to credit card debt, student loan debt, market purchases of equity and even the debt of the big automakers. Basically, the entire financial system."

2. Under the Paulson bill, Treasury would buy assets with cash. Under the Dodd bill, Treasury would be required to obtain equity warrants as well; Sorkin says that this provision will probably end up being discretionary. So Treasury will be able to obtain equity stakes whenever it believes that doing so makes sense (presumably, so as to obtain a portion of the upside if Treasury overpays for the securities), and will have to exercise whatever control its equity interest gives it, including possibly a say in the management of the firm (think of AIG).

3. Under the Paulson bill, Treasury has no power to determine executive compensation. Under the Dodd bill, the executive compensation provision, in Davidoff's words, "basically puts the Treasury Department in the business of setting compensation and disclosure policies for much of financial America."

4. Under the Paulson bill, Treasury has no power to adjust mortgages that go into foreclosure. Under the Dodd bill, Treasury is supposed to figure out some way to help homeowners whose property is subject to the securities it obtains, including reducing interest rates and principal.

5. Finally, with respect to the most important discretionary item of them all -- negotiating a price of the mortgage-related assets and most of the other terms of the deal -- the Paulson bill and the Dodd bill identically leave it up to Paulson and his successors.

The Dodd bill does do three things to confine the discretion of the Treasury Secretary. It provides for (1) limited judicial review (however, it is hard to imagine judges second-guessing pricing decisions); (b) more reporting to Congress; and (c) an oversight committee consisting of various notables that, however, has little power.

In sum, compared to the Paulson bill, the Dodd bill vastly extends the Treasury Secretary's powers, while putting in place very modest oversight mechanisms. Dodd, and apparently many of his colleagues, want Treasury to do more, not less.

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The Dodd Plan: A Contract Clause Problem?

Section 11 of the Dodd bill seeks to minimize foreclosures by allowing bankruptcy judges to approve Chapter 13 bankruptcy plans that adjust the terms of residential mortgages in the debtor's favor. Any Contract Clause experts willing to weigh in on this provision? There is no doubt that the section is lawful if applied prospectively, that is, to mortgages issued after the law goes into effect. But if it applies retroactively, as surely it is intended to, then creditors can assert a Contract Clause violation. The Supreme Court replaced the flat ban on this type of law with a balancing test during the Great Depression, under similar circumstances. Section 11 would pass the balancing test if interference with creditors' contractual rights is sufficiently limited and/or the government interest is sufficiently great. But, however bad things might be now, we are not in a Great Depression or even (yet) a Mild Recession, and we have very different personnel on the Supreme Court.

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The Bailout and Oversight.

Commentators have criticized the Paulson bill for claiming too much discretionary authority for the Bush administration, echoing a well-known complaint about Congress's authorization of the use of force against al Qaida. That authorization was a blank check, and this mistake will not be repeated, or so it is claimed, with the usual bromides about checks and balances.

It appears, though, that there are two criticisms rolled into one. One argument is that after 9/11 Congress did not deliberate enough before handing over power to the executive. The other argument is that Congress did not properly restrict the power of the executive in the course of issuing an authorization—by giving it limited powers or subjecting it to judicial or other types of review. Having learned from our mistakes after 9/11, we should insist both on democratic deliberation and enactment of meaningful oversight mechanisms.

These arguments are not so much wrong as question-begging. Congress has every incentive to deliberate; it will defend its institutional prerogatives and seek to ensure that the enacted law reflects its policy preferences. The problem is that, in the midst of a financial crisis, Congress does not have as much time as it ordinarily does. Most laws take months or years to pass. A complex optimal stopping problem arises: the longer Congress deliberates, the more that it will acquire information for making a good decision, but the greater the risk that the crisis will spin out of control. The stop-and-deliberate crowd (especially the economists among them!) need to acknowledge this problem. One suspects that their attitude merely reflects skepticism about the magnitude of the crisis or the ability of the government to solve it, not any real confidence that new information will emerge so that Congress can make better decisions. (That, or devotion to empty political forms.) How long should Congress take? A week? A month? A year? I can't see any reason to think that Congress will take any less time than it is reasonable for it to take given the urgency of action.

Meanwhile, the Dodd bill implements several oversight mechanisms -- or, more precisely, mechanisms that constrain the executive in some ways even as the bill hands over power to it in other ways. These mechanisms might be wise, but it must be acknowledged that they come at a price -- and their defenders have not shown that the price is worth paying.

1. Bankruptcy judges are given power to adjust mortgages. Democrats want to help homeowners. They give Treasury some discretionary authority to minimize foreclosures, but the sharing of power with bankruptcy judges is a crucial mechanism for limiting the power of the executive branch. Whether mortgage adjustment is good policy or not, the price of such a division of power is clear. The value of the mortgage-related securities you hold is in part a function of your prediction of how bankruptcy judges will trim the interest and principal in bankruptcy. The judicial system is highly decentralized and it will take years for common principles to develop. So it will be hard to predict how judges will act, and accordingly it will be hard to adjust the value of your assets. By contrast, if Treasury were given this power, it could issue some regulations and settle the issue. Remember that it is the valuation problem that is said to be the source of our current crisis in the first place.

2. Judicial review of "any determination of the Secretary with regard to any particular troubled asset." Determinations will be set aside if "arbitrary and capricious, an abuse of discretion," etc. The risk here is that prospective sellers of bonds will fear that a court will subsequently set aside the sale because the price or other terms seem unfair. Maybe no court would do that, but maybe some would. Are they likely to do a good job? To decide cases consistently? The result is more uncertainty with respect to the value of assets that are not selling because their value is already uncertain.

3. Reporting to Congress and an oversight committee that includes two congressional appointees, one from the majority party and one from the minority party, plus the heads of the Fed (Bernanke!), the SEC (Cox!), and the FDIC. I like the bipartisan representation of the committee, but the committee has no power. But suppose that it does. Now we must worry that Treasury will make purchasing decisions to please particular members of Congress who care about particular businesses in particular districts -- creating more uncertainty in the market, unless market participants can guess who those people are.

The benefit that is purchased is that it will be harder for Treasury to use its powers to aid political friends, and perhaps some good-faith pricing errors will be caught or avoided. But if this benefit is really substantial, why stop here? Why not make judicial review more searching or set up an independent agency to purchase assets? Why not have a bipartisan committee to make purchasing decisions? No one has a theory about how power should be divided. Dividing power makes sense in the abstract, but in the concrete it just raises, in procedural form, all the questions of policy that have not yet been answered. It reduces the ability of government officials to abuse their power but also to resolve the crisis.

As I have noted before, the oversight mechanisms that have received serious attention are pretty trivial, which suggests that Congress and probably most experts, believe, rightly or wrongly, that the executive needs a free hand.

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Paulson v. Dodd: distributional considerations.

What is the difference between the two bills? Broadly, we can identify two dimensions: technocratic and distributional. On the technocratic side, Dodd supporters argue that the financial crisis will be resolved more cheaply if (for example) the government demands equity warrants or must submit to judicial review. Maybe, maybe not. The main difference, it seems to me, is distributional.

This difference is reflected both in political rhetoric (with the Democrats arguing that their bill favors the taxpayer) and the substance of the bills. If you think that the average over-indebted homeowner and the average taxpayer are less wealthy than those who operate and hold shares in big financial institutions, then the Dodd bill favors lower-income people relative to the Paulson bill, at least if its provisions work as intended. The homeowner relief provisions will transfer wealth from holders of bonds to homeowners who are likely to default (though not necessarily future buyers or sellers of homes). The constraints on executive compensation should transfer (a tiny amount of) wealth from rich people to taxpayers. The equity warrants are said to benefit taxpayers by giving them a share of the upside if there is one (I'm skeptical: remember that taxpayers will also have to pay more for the warrants). We can depict these distributional differences on the standard political scientist's diagram of one-dimensional policy space, as follows:

L____________D_____________P____________R

Where L is left, R is right, D is the Dodd plan, and P is the Paulson plan. However, as I have noted before, there is a twist, namely, the amount of discretion that each plan grants to the executive branch in the person of the Treasury Secretary. We can use brackets to show how discretion works, with "[ ]" for the Paulson plan, and "{ }" for the Dodd plan. One possibility is this:

L_____{_______D______}____[______P______]__R

The way I have written it, each plan gives the Treasury Secretary a great deal of discretion over distributional outcomes. Both plans give Treasury enormous discretion to set the price; and the pricing decision will determine whether wealthier people do better or poorer. But the Dodd plan, by offering protection for homeowners and taxpayers, shifts the range of outcomes to the left.

But there is another possibility:

L_____{_________D______[_______P______]}___R

The Dodd plan's leftward bias is almost entirely discretionary (or will be, apparently). Treasury has the option to limit executive compensation, demand equity warrants, and protect homeowners, but it is not really constrained to do so. So the Dodd plan extends the range of discretion, making more leftward outcomes possible but not necessary, in which case everything depends on who runs Treasury and hence, after Paulson, who wins the election.

It may be that the oversight mechanisms in the Dodd bill would confine Treasury's discretion more than I have suggested. Bankruptcy judges are given a lot of discretion, and if they, by inclination or office, tend to help poorer people, then the rightward squiggly bracket should be moved to the left. The same point can be made about judicial review. Perhaps judicial involvement moves outcomes toward the center, given the ideological diversity of judges.

P.S.: people on the left and right might oppose any kind of bailout because they believe that no crisis exists or that the government can only make it worse. I put this view to the side in this post.

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