Greetings from Jackson Hole, where I am attending the 7th Annual Rocky Mountain Economic Summit. Below is the latest research note from KBRA. Have received a number of interesting reactions from in and outside the Kremlin walls. You can read the comment with footnotes on www.kbra.com.
Dodd-Frank and the AIG Litigation: Implications for Investors
Kroll Bond Rating Agency
July 7, 2015
Kroll Bond Rating Agency (KBRA) believes that the recent court decisions regarding the bailout of American International Group (NYSE:AIG) hold significant implications for investors. Read together with the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act, the Court’s decision greatly narrows the discretion of the Fed in making emergency loans to troubled financial institutions. More, the AIG decision illustrates how excessive debt and related financial crises serve to erode the rights of investors by undermining prudential limits and the rule of law.
The 2010 Dodd-Frank Act limits the Fed's emergency lending to programs or facilities with broad-based eligibility and requires the approval of the U.S. Treasury Secretary before making such loans. The law also requires the Fed to wind down its emergency facilities in a "timely and orderly fashion" and prohibits the U.S. central bank from lending to insolvent institutions. The proposal defines an insolvent borrower as "any person or entity that is in bankruptcy, resolution under Title II of the Dodd-Frank Act, or any other Federal or State insolvency proceeding."
Prior to the July 2010 passage of the Dodd-Frank Act, the Fed was authorized under Section 13(3) of the Federal Reserve Act (FRA) to lend to "any individual, partnership, or corporation" provided certain conditions were met, including the presence of "unusual and exigent" circumstances and the approval of at least five members of the Board of Governors. In 2014, the Federal Reserve Board adopted changes to Regulation A that maintain those standards and others, while placing additional limits on the Fed's emergency lending authority as required by Dodd-Frank. Below we discuss how the changes made to the FRA and recent litigation impact how and when emergency loans can be extended by the U.S. central bank.
The AIG Litigation
Starr International Company, Inc. (Starr), a company controlled by insurance executive Hank Greenberg, commenced a lawsuit against the United States on November 21, 2011. The suit challenged the government’s financial rescue and takeover of AIG in September of 2008. Before the takeover, Starr was one of the largest shareholders of AIG. Starr alleged in its own right and on behalf of other AIG shareholders that the government’s actions in acquiring control of AIG in 2008 constituted a taking without just compensation and an illegal exaction, both in violation of the Fifth Amendment to the U.S. Constitution.
In a recent decision, the U.S. Court for Federal Claims ruled in favor of Starr and the other plaintiffs, confirming that the Treasury and Federal Reserve Board acted illegally in the rescue of AIG. The Court, however, awarded no damages. Of significance to investors, Judge Thomas C. Wheeler found that the Fed and Treasury (and their legal advisors) conspired to deprive investors of their rights. Treasury and the Fed, incredibly, then tried to argue in court that investors had somehow waived their legal privileges. The Court stated in its findings of fact:
“The record supports a conclusion that FRBNY, Treasury, and their outside counsel from Davis Polk & Wardwell carefully orchestrated the AIG takeover so that shareholders would be excluded from the process. These entities avoided at all cost the opportunity for any shareholder vote. Having intentionally kept the shareholders in the dark as much as possible, it rings hollow for Defendant to contend that the shareholders waived the right to sue by failing to object.”
The significance of the Court’s decision to investors in terms of the handling of future crises is manifold. Now that the U.S. government and the Fed’s Board of Governors have been rebuked by the judicial branch for the rescue of AIG, it appears unlikely that either the Fed or Treasury could orchestrate similar actions in the future. Even the most duplicitous of legal counsel tend to pay close attention to the utterances of federal judges when it comes to willful violations of law. Yet the fact remains that in rescuing AIG, our appointed officials chose to ignore the law (as well as the Fed’s long established rules on collateral) in the name of saving the world from catastrophe, real or imagined.
One could argue that the rescue of AIG really was about saving a number of large, politically powerful banks from financial loss, just as the alleged rescue for Greece has really been about bailing out EU banks and the politicians who stand behind them. But the fact of the AIG rescue and how different classes of investors were treated raises questions for the future. More important is the fact that exigent circumstances compelled U.S. officials to finance the AIG rescue using the balance sheet of the central bank. A federal court held that they did this without the authorization of Congress raises fundamental questions of public governance.
In the 1930s, the restructuring of troubled banks and companies were handled by specially empowered fiscal agencies like the Reconstruction Finance Corporation (RFC) and the Federal Deposit Insurance Corporation (FDIC). In contrast, the financial rescues of AIG and Citigroup (NYSE:C) were financed in haste and relied upon the balance sheet of the central bank as the financing mechanism. These bailouts by the Fed and Treasury evaded legal and Constitutional limits on government agencies incurring liabilities in the name of the public.
During the period following the 2008 market collapse, numerous U.S. banks were propped up using Fed discount window loans and even the deliberate placement of cash deposits by the U.S. Treasury, the latter being one of the least recognized methods of bailing out troubled banks. The Fed made the loans to AIG against dubious collateral, namely the equity of the insolvent insurer. These assets would likely not qualify as “good collateral” under the Federal Reserve Act, much less Walter Bagehot’s famous rule. As Professor J. Bradford DeLong notes, the properly-formulated Bagehot Rule is that in a financial crisis, the lender-of-last-resort:
- Lends freely,
- At a penalty rate,
- On collateral that is good in normal times, and
- Institutions that are still underwater get "resolved" immediately and completely.
In terms of public governance, the recent court ruling made clear that the appointed officials of the Fed and Treasury made decisions in lending to AIG that Congress did not authorize and thus interfered in the American political process.
Walker Todd, who served as legal counsel at the Fed of New York and collateral officer at the Reserve Bank’s discount window, provides an assessment of the Court of Claims decision in the AIG case:
“[A]t least the judge called out a lot of actors (one dare not say malefactors) in this drama, with particular attention to the lack of authority for the Fed to do what was done. And someone should have said the words ‘Reconstruction Finance Corporation’ in the judge's presence to address situations where (a) policymakers are desperate to do a financial rescue but (b) the Fed has no authority and should not be lending into those situations anyway. Rule no. 1: The Fed is not the RFC. RFC matters are fiscal policy matters, not monetary policy. Monetary policy is the Fed's business, not fiscal policy. Treasury/White House and Congress are the entities supposed to be accountable for fiscal policy. In any case, this opinion is a clear illustration that keeping Section 13(3) [of the Federal Reserve Act (FRA)] on the books is an open invitation to mischief going forward. Section 13(3) should be repealed.”
With the passage of the 2010 Dodd-Frank law, the ability of regulators to fashion such rescues has been greatly constrained, although as Todd notes there remains a mechanism for the Fed to make loans in “unusual and exigent circumstances” under Section 13(3) of the FRA. That said, KBRA believes that the combined effect of Dodd-Frank and the Court’s decision in the AIG case will lead to a narrowing of alternatives for the managers of troubled financial institutions.
Resolutions Post-Dodd Frank
In days gone by, the Fed and FDIC had discretion to make loans to troubled financial companies as a means of buying time in order to sell these institutions. In 1982, for example, former Federal Reserve Chairman Paul Volcker tried to convince then-FDIC Chairman William Isaac to bail out Penn Square Bank. Isaac famously responded that he would agree if the Fed bore half of the cost, but the Fed under Chairman Volcker balked.
A decade later in January 1991, the FDIC extended loans to Bank of New England (BNE) to facilitate the formation of bridge banks which were sold six months later. The resolution of the three BNE subsidiary banks is notable because the FDIC, considering the region’s financial conditions, decided to protect all depositors (except those affiliated with BNE Corp.), including those whose total deposits exceeded the $100,000 insurance limit. Of the approximately $19.1 billion on deposit in the three BNE subsidiary banks, more than $2 billion were in accounts larger than $100,000. Then-FDIC Chairman L. William Seidman stated, “It was clear to us that to protect the stability of the system, we should protect all depositors.”
Now, however, these lending powers have been significantly qualified. While the FDIC retains its discretion in paying out bank depositors consistent with achieving a least cost resolution, neither the Fed nor the FDIC would be able to extend open bank assistance as was done in the past. This means, in our view, that in the event that a financial institution becomes unstable, the situation is far more likely to end up in either a traditional bankruptcy or FDIC receivership under the Dodd-Frank Act.
KBRA sees several possible avenues for the resolution of a troubled financial institution. In the event that the operating units of the troubled entity are book solvent, a financial institution can in theory file for a voluntary restructuring under Chapter 11 of the U.S. bankruptcy code – but market factors and investor concerns would probably lead to a liquidity crisis that would make that choice impractical. From the perspective of creditors, a voluntary bankruptcy reorganization is preferable since the management keeps control over the assets of the institution and has an opportunity to reorganize short of a liquidation.
A more likely scenario, KBRA believes, is that the troubled financial institutions would likely be subject to a receivership under the FDIC as provided under Dodd-Frank. In this scenario, the FDIC would have complete control over the restructuring process and could replace management, separate the assets and liabilities from the troubled institution, and would be empowered to pursue claims against third parties who contributed to the failure. By now, all market participants should understand that any financial institution that is large enough to be considered “systemically significant” should be subject to an FDIC receivership to forestall the problems made obvious in the cases of Lehman Brothers, Bear Stearns, and AIG.
The Court’s decision with respect to damages sought by Starr et al was the correct conclusion, KBRA notes, because AIG was insolvent and thus the shareholders had no basis for a claim. The AIG rescue and the Court of Claims ruling, however, illustrates why the government cannot lawfully just take an equitably insolvent entity's stock without providing due process to investors. “The government needs to appoint an equity receiver such as the FDIC to first assure there is nothing left for shareholders before ignoring them,” notes attorney Fred Feldkamp.
The Treasury continues to claim that its actions and those of the Fed with respect to AIG were both lawful and justified, but the AIG case seems to confirm that ad hoc financial rescues of failing financial institutions are contrary to current law and public policy. But so long as regulators and central bankers are given discretion with respect to using the public credit to satisfy private investor claims, it will be impossible to say that “too big to fail” is truly eliminated. What does seem clear, however, is that the options available to public officials for exercising discretion have become greatly limited in the wake of the Dodd-Frank law and the Court’s finding with respect to the AIG rescue.
In the case of AIG and other financial rescues following the 2008 financial crisis, U.S. officials arguably went beyond their legal authority, this under the rubric of saving the world, and ignored the rights of investors in the process. Events of default such as the restructuring of General Motors (NYSE:GM) and Chrysler Corporation also saw investor rights ignored or actively attacked by officials of the U.S. Treasury. The fact of financial distress and market constraint gave regulators and their political sponsors free license to ignore the contractual rights of investors in favor of some ill-defined public policy objective.
It can be argued that the rescue of AIG delivered enormous benefits to markets and investors, preventing the failure of yet another large financial firm in that terrible year of 2008. But KBRA notes that public governance and the rule of law are important attributes of a sovereign rating. The refusal of regulators to address the risky behavior that led to the AIG failure and the subsequent ad hoc rescue should not serve as a source of comfort to investors. Quite the contrary, KBRA believes that the rescue of AIG and other institutions illustrate the need to call for greater focus on how investors are treated in insolvency situations.
 See Christopher Whalen, “Inflated: How Money & Debt Build the American Dream,” John Wiley & Sons (2010) Pgs 313-314
 See “Managing the Crisis: The FDIC and RTC Experience,” Chapter 8, Federal Deposit Insurance Corporation