Stock-Blocking the Bailouts

The government’s bailout of insurance company AIG was illegal, according to a US judge’s decision last month. The decision is just a latest example of the consequences of delegating adjudication over complex regulatory questions to the legal profession.

A bit of background. The case was launched by AIG’s shareholders in the wake of the financial crisis that brought the company and global economy to its knees. Spearheaded by AIG’s former CEO and largest shareholder Maurice Greenberg and his company Starr International, the plaintiffs alleged that the government’s takeover of AIG’s management and absorption of 80 percent of the company’s shares constituted an illegal taking of shareholder property.

Media and pundits had denounced the claim as frivolous for much of the proceedings. However, Greenberg was represented by the best lawyers money can buy, led by David Boies, who has argued huge Supreme Court cases over the 2000 presidential election, and gay marriage. But some observers – including those familiar with the adventurous claims made in investment treaty arbitration – found it harder to so easily dismiss the claim.

Judge Thomas Wheeler’s decision essentially split the baby. First, he found that the AIG takeover was not a regulatory taking of property, but rather an illegal exaction. The liability implication for the government is essentially the same in either case, but the judge argued that – to be considered a taking – there must be a legally authorized government action in question, which Wheeler found the takeover was not. (More on that later.) Second, because AIG stock was essentially worthless at the time of takeover, the government – although it behaved illegally – did not owe any money to the shareholders. Predictably, both sides are appealing the split decision. Wheeler’s full decision is available here. I have a few takeaways. First, the chutzpah. Wheeler was willing to second guess decisions that policymakers had to make in the middle of the night September 15-16, 2008 over a few tense hours while the global economy rested in the balance – just hours after the collapse of Lehman Brothers. In contrast, Wheeler had nearly four years to think about the case, from shortly after the time it was brought in October 2011 to June 2015.

The extra time didn’t lead to a more nuanced decision. Wheeler concluded that the Federal Reserve Act authorized loans to troubled companies, but not takeovers. Specifically,

[The Federal Reserve Act] did not authorize the Federal Reserve Bank to acquire a borrower’s equity as consideration for the loan. Although the Bank may exercise “all powers specifically granted by the provisions of this chapter and such incidental powers as shall be necessary to carry on the business of banking within the limitations prescribed by this chapter,” 12 U.S.C. § 341, this language does not authorize the taking of equity. The Court will not read into this incidental powers clause a right that would be inconsistent with other limitations in the statute. Long ago, the Supreme Court held that a federal entity’s incidental powers cannot be greater than the powers otherwise delegated to it by Congress. See Fed. Res. Bank of Richmond v. Malloy, 264 U.S. 160, 167 (1924) (“[A]uthority to do a specific thing carries with it by implication the power to do whatever is necessary to effectuate the thing authorized – not to do another and separate thing, since that would be, not to carry the authority granted into effect, but to add an authority beyond the terms of the grant.”);

I’ll leave it to the lawyers to argue about whether this is a sound statutory interpretation.** From a policy standpoint, however, the federal government’s actions seem like reasonable responses to the situation on the ground – as it became clear what they were dealing with.

  • First, policymakers had a choice on September 16 about how targeted to make their bailout. The advantage to choosing AIG for this type of bailout was “bang for the bailout buck”. Once the housing market tanked and AIG’s insurance obligations came due, it became clear that AIG owed money to everybody – including all the major US and international banks. All the players were interconnected, but none more so than AIG. A targeted takeover of AIG would give the US leverage over a greater number of problems than simply going after the bank dominoes one by one. In particular, it was a way for US policymakers to bail out Europeans as well. (Given how slow Europeans have been to reform bank sector and deal with their own financial problems, it is hard to argue with Geithner’s call on the question to do for them what they would have been unwilling to do for themselves – reported on page 19 of the court case.) We can disagree with that decision in the light of day, but in the dark of night, it seems reasonable.
  • Second, once the government made the economic decision to target AIG, it has to decide how to politically manage the situation to make it tractable. They realized that one of the veto players was the existing management. So they decided to replace the management. They later realized that shareholders were possible veto players, so they took steps to sideline their voting rights. That shareholders might have brought down the company rather than agree to a necessary bailout seems entirely plausible: after all, that is essentially what this later Starr case was about. Subsequent events prove that the government was smart to take shareholders out of the picture.
  • Finally, they realized that Fed wouldn’t be able to directly hold the shares, so, by November 2008, they created special purpose vehicles to hold the assets. Instead of a reasonable effort to clean legal house after having made the economically correct decision, Wheeler interprets this as confession of a crime.

Unfortunately, it does not seem like the government chose to argue any of these broader points, instead falling back on facile invocations of basic law and economics notions like moral hazard. It would be a concession that the politics of the decision were a part of their thinking – something anathema to judges. But just how effective would a bailout have been without a consideration of the politics – especially at the firm level? Indeed, there was already political blowback for the US handing out money to banks without taking them over. The targeted takeover of AIG perhaps quelled that a bit, and allowed the government to do the least amount of interference with private management it could get away with and still save the economy.

Judges have an easier time with dealing with discrimination stories than administrative planning stories. One of Wheeler’s key considerations – to which he dedicated relatively little ink – was that AIG’s treatment was much harsher than that meted out to others:

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 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.”

But, as I argue, that was because AIG was the fulcrum – the easiest means by which to influence the broader course of events. It actually doesn’t matter whether AIG was or was not responsible, from an emergency effectiveness standpoint. Moral hazard theory is an endemic problem, not one specific to the choice of delivery mechanism.

Wheeler also displays a revisionist libertarianism in his conception of consent.

While it is true that AIG’s Board of Directors voted to accept the Government’s proposed terms on September 16, 2008 to avoid bankruptcy, the board’s decision resulted from a complete mismatch of negotiating leverage in which the Government could and did force AIG to accept whatever punitive terms were proposed. No matter how rationally AIG’s Board addressed its alternatives that night, and notwithstanding that AIG had a team of outstanding professional advisers, the fact remains that AIG was at the Government’s mercy.

Either consent means consent, or it means something else. Few judges would interpret labor or consumer law in such a way that individuals’ relative weakness vis a vis corporations weakens legal definitions of their consent. But many are all too willing to assert an asymmetry between state and corporate power, and to weaken corporate consent in the face of this asserted asymmetric power.

Moreover, letting Wheeler make the call over the AIG bailout wasn’t even particularly beneficial from a corporate standpoint. Sure, Greenberg gets his “moral victory”, but wouldn’t shareholders prefer some cash? As Wheeler notes, “Common sense suggests that the Government should return to AIG’s shareholders the $22.7 billion in revenue it received from selling the AIG common stock it illegally exacted from the shareholders for virtually nothing.” But, he claims to be bound by case law that blocks him from coming to this economically reasonable conclusion. As there is no real precedent for Greenberg’s lawsuit, the claim of binding case law rings a bit hollow. If Wheeler was going to break new ground by judicially creating a huge disincentive for emergency bailouts, why not go all the way and make it economically meaningful for market participants? (This elevation of legalism above economic substance is ironic, given Wheeler’s accusation that the federal government did the same by creating the Maiden Lane holding vehicles in November 2008.)

In short, judicial libertarianism cuts against both states and markets. In the merits phase, Judge Wheeler found government liability for its actions relative to a hypothetical static market-friendly scenario (takeover relative to loans or doing nothing). At the damages phase, Wheeler found no damages relative to a static market outcome (no stock value on September 18), rather than a longer term valuation. As Karl Polanyi taught us long ago, states and markets help constitute one another dynamically. In real life social processes, these judicial benchmarks are misguided.

This case shows the clash of decision-making models between branches of government. Each model carries its own costs and benefits. When the legislature works well, it democratically channels the wishes of the majority. When it works poorly, it is captured by a minority interest. When the executive branch works well, it is capable of impressive industrial policy planning – scientifically aggregating information and interests in a rational policy framework. When it works poorly, it is a tyrant. Compared with these downsides, the judiciary seems relatively rosy. On the upside, it delivers justice. On the downside, it is trapped in its own legalism – thinking of formally correct or equitable outcomes between two parties, rather than the society at large. But, because the risk seems so benign, we seem less able to check it playing an outsize role. The conundrum was hinted at in Andrew Ross Sorkin’s column on the decision:

Dennis Kelleher, president and chief executive of Better Markets, an advocacy group for financial reform, called Judge Wheeler’s ruling perplexing. “The court bizarrely expressed repeated sympathy for A.I.G. while failing to properly weigh the economic wreckage suffered by the American people,” Mr. Kelleher said in an email.

If I am correct, the lack of systemic weighing is exactly what we would expect by kicking cases like this to the judiciary.

 ** The argument does seem weak here. Wheeler finds that the open-ended provisions in the Federal Reserve Act should be interpreted restrictively when it comes to the question of government ownership of corporations. This conclusion seems to be driven primarily by the fact that the government hasn’t done much takeover before. Of course, the very exceptional nature of emergencies undercuts the persuasiveness of this claim – at least from a policy standpoint. Moreover, he cites the Government Corporation Control Act of 1945 as precedent. This Act – which it isn’t clear applies to the Fed, an independent agency – was brought about to resolve a very specific problem: the wartime creation of agencies that had struck around past the war. If government control over AIG had persisted long past the crisis, this may have been worth considering.

Moreover, Wheeler cited the case of Suwannee S.S. Co. v. United States, a 1960 case that specifically envisions more discretion for executives in the field of foreign affairs. As I note above, the AIG takeover was very much about effectuating a foreign economic policy, calling into question whether Suwannee – far from constraining executive power – is not an invitation to make ample use of executive discretion.

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