September 16, 2008
Can the Government Buy an Insurance Company for Cheap?
Posted by David Zaring

Apparently so.  Good news if you have stock in the United States - boy can that country buy low.  Anyway, as you've all probably read, the Fed opened the discount window for AIG in exchange for 80% of its stock.  Amazing dilution. No, I can't recall the government having ever done this before.  And yes, this sort of invitation to trade credit for equity is utterly unprecedented in the Fed's use of section 13 of the Federal Reserve Act.  The below analysis of this administrative action reserves all M&A questions to other corporate experts.

There's really no statutory authority for the AIG takeover (the Fed and Paulson went to the Hill, and got nothing, not that they possibly could have in a couple of Tuesday evening hours).  I won't bother noting that the DC Circuit, were it to sit in judgment on whether the Fed could buy the world's largest insurer, would undoubtedly conclude that the plain language of its governing statute (which is to make emergency loans, not require takeovers in exchange) would not permit the takeover under Chevron USA v. NRDC.

And I will wait for others to opine on whether the Fed got a good deal.  Legally, the basis for Fed action - not that it is reviewable - would be that the acquisition of the petitioner is a reasonable interpetation of its ability to open the discount window to anyone. 

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.

The usual reason why government agencies can't so act has something to do with settled expectations - if a government agency has never done it, and never done anything like it, then it usually can't do it, no matter how broad the grant of Depression era authority. 

But, in the Fed's legal defense, maybe, just maybe, the settled expectations are different here, based on the government's takeovers of Fannie and Freddie, and the pleading by AIG for government involvement.  Does the very fact that the insurer hoped for Fed action suggest that the Fed could act?

Hmmm.  The other defense would be that emergencies are emergencies, and when that happens the rules go out the window, and hopefullly regular elections mean that the officials the people trust are dealing with the emergency.  Abraham Lincoln adopted that reasoning, and he won the Civil War.  I suspect we're at the "anything goes in an emergency" stage of things.  But maybe reasonable minds could disagree.

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Comments (21)

11. Posted by Nico on September 17, 2008 @ 10:38 | Permalink

My guess is that this is structured as a voluntary sale by the management of AIG. That is, if there is civil liability here, it's the AIG management's, not the Federal government's. That is, AIG needed money or else they'd go bankrupt, so they asked the Fed, and the Fed said "sure, for an 80% stake" -- AIG could have chosen to file for bankruptcy, but took the deal instead.

Looked at it that way then this is not remotely comparable to the EPA deciding to nationalize some industry on environmental protection grounds. That's because that scenario involves an agency action against the wishes of a private company's owners and/or management. Whereas here the company in question took a deal offered to it by the Fed because it was better than the alternative and, crucially, the alternative wasn't the pre-ordained result of a Fed action (well, there's fodder for conspiracy theorists!).

So if there's a question of legality, there are two obvious such questions: a) did the AIG board act properly in selling the company to the Fed? b) does the Fed have the right to place conditions on its emergency loans?

I'm sure the answer to (b) has got to be a resounding "yes." That leaves (a). No doubt some AIG shareholders will sue. But if the alternative was quite plainly a bankruptcy with little chance of working it out, then the shareholders were toast anyways, and that's something that a court can no doubt figure out on its own.

12. Posted by fedgovernor on September 17, 2008 @ 11:28 | Permalink


I did not say that "making appointments is the only role the government has" with the Fed.

What I said was that the President appoints the chairman of the Federal Reserve. The Congress, obviously, authorizes its existence.

However, that does not make the Fed the government. It only makes it legal for it to be a non-government organization, the officers of which are, by law, appointed by the President.

The President cannot tell the Fed what to do, because the FED is not the government. It is a private organization of bankers.

It distributes money that the US Mint prints at its sole behest. The government doesn't distribute money, the FED does, at whatever amount and at whichever time, its members decide to.

People should remember this when they claim that they are economists, and they allege that the government has just purchased AIG.

The government hasn't purchased AIG. The Fed purchased AIG, with money the Fed told the US Mint to print for the Fed's private use. It is free to do that. Congress authorizes the Fed to print up however much money the Fed wants to print up for its private use.

The Fed isn't the government. It's an organization of private bankers.

13. Posted by Bruce Boyden on September 17, 2008 @ 13:10 | Permalink

Dave, interesting post. Who would have standing to challenge the loan conditions? AIG, obviously, but I doubt they're going to squawk. And AIG's other shareholders, perhaps. Are any of them squawking?

14. Posted by Bruce Boyden on September 17, 2008 @ 13:20 | Permalink

Fedgovernor, the Federal Reserve Board of Governors was established and has enumerated powers under an act of Congress, 12 U.S.C. 248. It's a government agency.

15. Posted by Morgenstern on September 17, 2008 @ 13:39 | Permalink

Is it Zaring's opinion that the plain language of the statute does or does not permit the receipt of the warrants at issue here in return for the loan? Paragraphs 2 and 4 of the post seem in tension to me, to say the least. Is Zaring really saying that the text authorizes the takeover but the DC Circuit would conclude otherwise? If so, why?

16. Posted by David Zaring on September 17, 2008 @ 14:49 | Permalink

Yeah, I know there's a tension in the post - perhaps hasty drafting. I think plain language couldn't support this. I meant to say that you're in the world of reasonable interpretations of language, and the question is whether putting conditions like stock-as-collateral would be a reasonable inference to the power to make loans. And though surely the Fed can condition loans on something, it's not clear to me that they could condition them on stock transfers.

17. Posted by on September 17, 2008 @ 15:32 | Permalink

Thanks - that certainly makes sense. I take it there are no express grants of authority governing the Fed's acquisition of equity or other securities?

18. Posted by Morgenstern on September 17, 2008 @ 17:32 | Permalink

I wonder whether the language of 12 USC 343 (aka 13(3)) to the effect that the Fed may lend when the notes discounted are "indorsed or otherwise secured to the satisfaction of the Federal reserve bank" plays a role here.

I have literally no idea what this language means but it seems to (1) allow the Fed to place some sort of ancillary conditions on loans, and (2) potentially limit the types of conditions that can be placed.

19. Posted by Jake on September 17, 2008 @ 19:29 | Permalink

The Federal Reserve's authority to acquire AIG aside, why should the Federal government be in the business of picking winners (AIG) and losers (Lehman)? That is the truly disturbing aspect of the current events. We come to expect this from governments of Third World nations, but our own?

20. Posted by MattJr on September 17, 2008 @ 19:37 | Permalink

I posted this on a finance site last night, since I couldn't get to the crux of the law, perhaps you people can:

"But seriously, how does Sec13(3) apply here? Could arguably meet the tests of unusual and exigent circumstance, albeit not according to most of the commentators here... but the legal pivot is presumably the "adequate" credit accommodations line. According to whom? The party in distress or the Fed?? I don't get it.


Sec 13
3. Discounts for Individuals, Partnerships, and Corporations
In unusual and exigent circumstances, the Board of Governors of the Federal Reserve System, by the affirmative vote of not less than five members, may authorize any Federal reserve bank, during such periods as the said board may determine, at rates established in accordance with the provisions of section 14, subdivision (d), of this Act, to discount for any individual, partnership, or corporation, notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal Reserve bank: Provided, That before discounting any such note, draft, or bill of exchange for an individual, partnership, or corporation the Federal reserve bank shall obtain evidence that such individual, partnership, or corporation is unable to secure adequate credit accommodations from other banking institutions. All such discounts for individuals, partnerships, or corporations shall be subject to such limitations, restrictions, and regulations as the Board of Governors of the Federal Reserve System may prescribe.

It applies to individuals too. Why? How? Precedent??"

NB this article was invoked after a private sector solution was turned down.

Prima facie, the language in the article permits anything. Doesn't look like good law.

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