August 12, 2015

One Last Lap around Lehman

Posted by Philip Wallach

Many thanks to David for inviting me to grace the distinguished pages of the Conglomerate, which was a great help to me in understanding the corporate law controversies surrounding the government’s crisis responses as I wrote my book. And many thanks for the kind words he has for my book in his New Rambler review, as well as for the criticisms, some of which I will address here in the coming days.

Before getting to those, in this first post I want to revisit a discussion that David has previously noted, about the Fed’s controversial claim that it faced insuperable legal obstacles to rescuing Lehman Brothers back in September 2008. Peter Conti-Brown and I went back and forth (and back and forth) on this question. We also inspired some interesting posts from Carolyn Sissoko (here and here) and Brad DeLong (here and here). Peter recently stepped back and extracted lessons from this exchange, but rather than graciously let him have the last word I will do the same.

As I see it, the debate goes something like this. I say that we have to at least take seriously the Fed’s claim that when it looked at Lehman Brothers, it saw a hopelessly insolvent financial institution—one that did not possess sufficient collateral to secure a loan of the magnitude apparently needed “to the satisfaction of the Federal Reserve Bank.” Given that factual judgment (or estimate, really) about Lehman, it is clear that § 13(3) of the Federal Reserve Act says that they may not extend a loan.

Peter and some other respondents all seem to think that I am being far too literal in reading the law as we try to make sense of what the Fed’s Lender of Last Resort role practically entails. By their lights, the whole notion of “solvency” apart from having the support of the central bank is too indeterminate to be of any use, and by extension the same is true of the “satisfactoriness” of an institution’s collateral. (I think the logic is: If the central bank decides to throw its full support behind the institution, it will survive and return to profitability, and thus loans will get repaid with interest eventually.) Thus the law doesn’t actually provide any real guidance to the Fed in figuring out which institutions it should save, and when the Fed decides not to save an institution, it oughtn’t be allowed to blame that choice on the law. Its pronouncements doing so in the case of Lehman are to be understood as disingenuous excuses.

If I’m being honest, I have to admit that I don’t know enough about how bankers (central or otherwise) think about collateral adequacy to get inside the heads of the New York Fed officials charged with making sense of this statutory language. (Sadly, Fed officials and lawyers have not been forthcoming in clarifying their thinking in the nearly seven years since their momentous decisions.) I’d be delighted if readers with some practical experience would enlighten me. But in my ignorance, I continue to believe that Peter’s take renders a statutory constraint a nullity in a way that does not sit well with accepted practices of statutory interpretation. To put it bluntly, I think he is counseling a bad reading of the law.

Now, you might think that sounds insulting—and I suppose it does, especially since Peter has an excellent J.D. and legal experience and I just play a legal analyst in Belt-wonk-o-land—but I really don’t mean it to be! Sometimes, willfully misreading statutory language may be the right thing to do; after all, most of us think that following the law is ultimately only instrumentally valuable, and for central banks to be truly efficacious in fending off crises they may need to transcend the legal limitations that their legislative creators unwisely saddled them with. “What did the Fed’s underlying statutes require of it?” and “What should the Fed have done, given its sense that the financial system was hanging on by a thread?” need not have the same answer.

That’s what I take away from Brad DeLong’s intervention, too. Brad notes that it is important to remember that the Federal Reserve Banks are not government agencies, but government-chartered corporations, and ones that are perhaps expected to act ultra vires during crises—preferably with the tacit or, better, explicit consent of the government itself, such that no nasty legal consequences ought to flow from those legally problematic actions. He sees that this creates something a puzzle baked into the institutional and legal structure of central banks:

Robert Peel’s remarks around the Recharter of 1844 about just why they were writing the Recharter to forbid the Bank of England to do things in a crisis that they did, in fact, hope it would assume responsibility and do are, I think, very interesting…

He likewise notes that “the Legal Realists” would be dubious of seeing any such requirement, expected to be waived rather than enforced, as a genuine legal constraint.

To the extent there’s any disagreement, it’s largely terminological. I don’t have any objection to the idea that the Fed could have gotten away with making a loan to Lehman—it would have been well-nigh unthinkable for a judge to step into the middle of that transaction in any time frame that matters, even if anyone had standing, which probably they wouldn’t. (I’m sure the AIG case is popping into many people’s heads now, and I promise I’ll get to it later in my stint here). I am very ready to agree that the language in § 13(3) was almost certainly not an enforceable, effective legal constraint. I just don’t understand why that should make us pretend that the law is, in its very language, devoid of meaning or irrelevant to the situation. If the Fed’s powerful lawyers said that, given a negative assessment of Lehman’s collateral quality, the Fed was not authorized by the statute to lend, I think that would have been a correct interpretation of the statutory language. Which, to belabor the point, wouldn’t necessarily be the same as saying that the loan should not be made, all things considered.

Perhaps more substantively, I also insist that clear-eyed, all-things-considered decision-makers will take the law into account even if they don’t treat it as determinative. The law structures expectations rather than controlling actions. In this case, by setting collateral requirements, it specified exactly how far the Fed would be sticking its neck out when making a loan to a potentially failing financial institution. And that is really the right metaphor, because the question is always about whether the independent central bank is going to get its head chopped off for dutifully playing the role of financial crisis savior. Whether rightly or wrongly, Americans don’t want to live with a central bank empowered to do, literally, anything to fight off financial crises, though they surely want the crises fought off. In a sense, the law is there to make it politically risky for the central bank to embrace its awesome powers too enthusiastically.

The more I think about the problem in this way, the more enthusiastic I am about Dodd Frank § 1101 and its requirement, now 12 U.S.C. 343(3)(B)(iv), that the Fed get the Treasury Secretary’s approval for any emergency non-bank lending. The Treasury Secretary in such a situation should not be allowed to prevaricate while the Fed sticks its neck out and takes all the risk. He should either support the Fed, and in doing so bring along the President’s legitimating blessing, or clearly prevent the Fed from putting itself in a politically untenable situation in which its future depends on the public’s devotion to the idea of a non-governmental independent central bank. For better or worse, in our twenty-first century democracy, the Fed needs a sturdier base of institutional support than that.

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