A recent Marginal Revolution post has alerted me to Eric Posner’s January 2016 working paper, “What Legal Authority Does the Fed Need During a Financial Crisis?” Posner’s paper is remarkable, both for its assessment of the legality of the Fed’s emergency lending operations during the recent crisis, and for the policy recommendations Posner offers based on that assessment.
Posner’s account of the Fed’s actions reads like a long bill of indictment. The Fed’s Bear Stearns rescue, for starters, “was legally questionable.” The Fed couldn’t legally purchase Bear’s toxic assets, and it knew it. Instead it created a “Special Purpose Vehicle” (SPV), named it Maiden Lane, and lent Maiden Lane $28.82 billion so that it could buy Bear’s toxic assets. Voila! What would have been an illegal Fed purchase of toxic assets was transformed into a Fed loan “secured” by the very same assets.
But clever as the Fed’s gambit was, it wasn’t so clever as to render it entirely innocent of legal hanky-panky. “The problem,” Posner observes,
is that the transaction provided that the value of the Fed’s interest would be tightly connected to the value of the underlying assets. If the assets fell in value by as little as 4%, the Fed would lose money… By contrast, in a [properly] secured loan…the lender bears very little to no risk from the fluctuation of asset values. Functionally, the Maiden Lane transaction was a sale of assets, not a secured loan.
In rescuing AIG, the Fed resorted to the same “legally dubious” bag of tricks it employed in saving Bear, creating two more Maiden Lane vehicles, and again assuming considerable downside risk. The Fed also grabbed a 79.9 percent equity stake in AIG, which it placed in a trust established for the sole benefit of the U.S. Treasury. That transaction was later held by the Court of Federal Claims to have been been unauthorized by the Federal Reserve Act, and therefore illegal.
In fact, according to Posner, all of the Fed’s emergency lending programs, the TALF alone excepted, “raised legal problems.” In each case the Fed violated the spirit of 13(3), which requires that its loans be “secured to the satisfaction of the Federal Reserve bank.” Posner is especially good at explaining the speciousness of Fed lawyers’ claims that the Fed’s loans were indeed secured:
Imagine, for example that the Fed would like to make an unsecured loan to Joe Shmo, who has no assets. Following the legal division’s advice, the Fed could create an SPV called Shmo LC. Shmo LC would then lend money to Joe, and in return receive an unsecured note from him, that is, an IOU. Shmo LC would get its money from the Fed, which would make a section 13(3) loan to Shmo LC secured by Shmo’s note.
All of which would be just dandy, were it not for the inconvenient fact, pointed out by Posner, “that the Fed, Congress, and all other relevant actors have always understood section 13(3) to [require] ‘real’ security — in the sense of collateral that would render the loan riskless or close to that.”
Suppose, on the other hand, that the Fed’s lawyers were in fact correct. Suppose that it was perfectly legal for the Fed to have “secured” many of its 13(3) loans using assets of doubtful value. In that case, the Fed’s claim that it was unable legally to rescue Lehman Brothers was itself a sham, for a Fed that might have legally lent to Joe Shmo could certainly have lent legally to what was at the time the United States fourth-largest investment bank. Fed officials can’t have it both ways: either they lied about Lehman, or they broke the law left-and-right with the 13(3) loans they did make.
Posner himself believes that the Fed let Lehman fail for political and “operational” reasons rather than legal ones, and that the questionable legality of yet another Joe Shmo-type operation — and an especially blatant one at that — merely provided it with “a convenient excuse” for avoiding political backlash. I’m pretty sure he’s right. But although he recognizes the capricious nature of the Fed’s decision to let Lehman fail, neither that awareness nor his understanding that the Fed rode roughshod over existing laws causes Posner to see any need to limit the Fed’s last-resort lending powers.
Quite the contrary: so far as Posner is concerned, the fact that the Fed has been inclined to bend or break the law, or to invoke it only when it found doing so convenient, is reason, not for strengthening the rules governing the Fed’s last-resort lending, but for getting rid of them altogether! According to him, the problem isn’t that the Fed thumbed its nose at existing laws. It’s that “gaps in the government’s powers” made all that nose-thumbing necessary. What we need to do, Posner says, is fill those “gaps.”
For Posner, filling the power gaps means, first of all, consolidating within a single “Financial Crisis Response Authority” (FCRA), and preferably within the Fed itself, all of the crisis-response powers presently divided among it, the Treasury, and the FDIC. It also means granting to that authority the power to:
- buy assets, including equity.
- make unsecured loans to non-bank financial institutions.
- control non-bank financial institutions…in order to force them to pay off counterparties, lend money, and so on.
- wind up insolvent non-bank financial institutions….
- force non-bank financial institutions to raise capital.
- dictate terms of transactions, control the behavior of firms (for example, forcing them to lend), or acquire them where necessary.
The recent crisis shows, Posner insists, that “all these powers are necessary”:
Because of the fear of stigma, even liquidity-constrained financial institutions will be inclined to delay before borrowing from emergency credit facilities. The FCRA needs the authority to force those firms to borrow, and also to force healthy firms to borrow at the same time in order to prevent the market from picking off the weakest firm. Moreover, the crisis showed that when financial institutions accept emergency loans, they have strong incentives to hoard cash when the system as a whole benefits only if they lend into the market a portion of the money they borrow. For this reason, the FCRA needs the authority to order firms to enter financial transactions. Finally, the crisis showed that financial institutions that should be given emergency money may not be able to offer collateral for a loan, and it may be very difficult to value the collateral in any event. The FCRA needs the authority to make capital injections, unsecured loans, and partially secured loans; and to buy assets
Posner fails to recognize that the stigma problem to which he refers can be solved, without forcing anyone to borrow, by substituting an auction-style lending facility for the Fed’s discount window, as was in fact done during the crisis when the TAF was established; and his suggestion that financial firms’ hoarding of cash was something the Fed would have prevented had it had the power to do so, rather than something the Fed deliberately encouraged, doesn’t square with the facts. But these are secondary points. What’s most troublesome about Posner’s proposal is that it fills the “gaps” in the Fed’s power so generously as to do away with practically all limits upon the Fed’s ability to meddle with people’s property. His suggestion that a FCRA should be perfectly free to make unsecured loans and commandeer equity, for example, would allow it to lend to Joe Shmo on whatever terms it likes, and to nationalize private firms at will, with utter impunity.
Posner insists nonetheless that his proposed FCRA would not command unlimited power. Instead, its power would be checked by means of “a robust legal regime” that would “correct abuses after [a] crisis.” Specifically, firm shareholders would “be entitled to sue” the FCRA “and receive a remedy if they can show that the FCRA’s actions were unreasonable”:
The usual post-crisis analyses by independent government agencies with the power to compel testimony and discover documents from the FCRA will facility the litigation by collecting facts and making them publicly available.
With all due respect to Professor Posner, he seems here to be putting a great deal of weight on an awfully thin read, if not a broken one. If it was far from easy for Starr International to convince a court that the New York Fed acted illegally, and if Starr received no “remedy” even despite doing so, how much harder would it be for a plaintiff to establish that the actions of a much more powerful Fed (or FCRA), though perfectly legal, were nevertheless both harmful and “unreasonable”? And suppose such a plaintiff somehow managed to prevail. Might Professor Posner, or some like-minded legal scholar, not be inclined in that case to regret the discovery of still another “gap” in the Fed’s power, and to recommend, on the basis of the very same arguments Posner offers for filling already apparent gaps, further reforms aimed at ruling-out such lawsuits, to guard against the possibility, however remote, that the threat of them might discourage some desirable (if not obviously “reasonable”) anti-crisis measure?
Yet it would be unfair to accuse Posner of depending entirely on lawsuits to constrain his proposed FCRA. For it’s clear that Posner’s case for an FCRA wielding vast powers mainly rests, not on the naive belief that such an authority could be adequately constrained by the threat of successful litigation alone, but on the assumption that it will never (or hardly ever) abuse its powers in the first place.
What’s the basis for that bold assumption? Posner certainly can’t claim that it’s difficult to conceive of ways in which his proposed FCRA might behave badly. The rescuing of firms that might safely be allowed to fail, including ones that richly deserve to fail, is only one obvious example.
Instead, Posner’s postulate of an infallible Fed appears to take shape as a mutation of his much less heroic (if still doubtful) claim that the Fed did nothing wrong during the recent crisis. Early in his paper he explains that he plans “to assume that the mainstream view that the Fed acted properly during the financial crisis by lending widely is correct.” As a means for determining what reforms would have allowed the Fed to avoid errors of omission (but not ones of commission) during the recent crisis, the assumption makes perfect sense, even if it happens to be false. But Posner isn’t content to limit himself to such a counterfactual exercise: he wants to draw conclusions concerning “what reforms are necessary to supply [the Fed] with the proper legal authority” going forward. To do so he segues, perhaps unconsciously, from assuming, arguendo, that the Fed acted correctly this last time around, to assuming, implicitly, not only that it will act correctly in any future crisis, but that it will do so even if it wields much vaster powers than before.
Is it being uncharitable to suggest that, once we grant the assumption that the only errors that a government agency is ever likely to commit are errors of omission, we do not really need a legal scholar, or any other sort of expert, to tell us how to make that agency function ideally? The granting of unlimited power is in that case a no-brainer. To anyone who isn’t prepared to altogether set-aside the possibility of errors of commission, on the other hand, the sort of reforms Posner proposes must seem naive — and dangerous — in the extreme.
And that’s what troubles me most about Posner’s proposal. It’s not that his logic is bad. It’s seeing a legal scholar, and a very intelligent one, blithely cast aside the very idea of the rule of law, while championing its opposite: the arbitrary decisions of (practically) omnipotent bureaucrats.
Nor does Posner not realize what he’s doing. On the contrary: he’s aware of the complaint of other scholars that the Fed already demonstrates the dangers of substituting the rule of men for the rule of law, even citing a recent Cato Journal article by CMFA Adjunct Scholar Lawrence White to that effect. But having recognized White’s complaint, Posner dismisses it summarily, on the technical grounds that
the constitutional limitations on delegation of power to agencies — embodied in the nondelegation doctrine – are effectively nil. The requirement that the LLR use its powers to unfreeze the financial system would supply the intelligible principle required by the nondelegation doctrine under recent precedents.
But White isn’t arguing a point of U.S. Constitutional Law. He’s appealing to a fundamental legal principle that’s older than the U.S. Constitution, and one that transcends the laws of any particular nation. Posner’s response therefore misses the point entirely. The question isn’t whether or not Congress may grant Fed officials unlimited power. It’s whether it ought to grant them so much power. Posner thinks it should. I don’t know about you, but I hope Congress puts more weight on the advice of John Locke, David Hume, and John Adams.
Posner himself (p. 30) recognizes that Congress had reasons for not awarding the Fed unlimited last-resort lending powers. However, he notes that the reasons have been “mostly political, including distrust of the Fed, and popular resentment of the bailouts of Wall Street firms,” and appears to dismiss them simply for that reason. As for the moral hazard problem — the sole non-“political” reason he recognizes for limits upon the Fed’s last-resort lending power — Posner dismisses it as well, claiming that it can be adequately contained by means of “ex ante regulation such as capital requirements, which are independent of the LLR’s power.” But as Richard Fisher has argued,
Requiring additional capital against risk sounds like a good idea but is difficult to implement. What should count as capital? How does one measure risk before an accident occurs? And how does one counteract the strong impulse of the regulated to minimize required capital in highly complex ways? History has shown these issues to be quite difficult. While we do not have many examples of effective regulation of large, complex banks operating in competitive markets, we have numerous examples of regulatory failure with large, complex banks.
Nor is it clear that even the strictest capital requirements can suffice to rule out excessive risk taking when its the case, as it would be under Posner’s proposed regime, that regulatory authorities need not hesitate to bail out, not only firms’ uninsured creditors, but their shareholders.