“Numerous firms deemed insolvent nonetheless got emergency loans, while Lehman alone was denied one before it went bankrupt. Judging by their actions, Fed officials seemed to have defined solvency on a case-by-case basis…
…Consider the testimony of Timothy Geithner, who later served as Treasury secretary. As president of the Federal Reserve Bank of New York when the financial crisis unfolded, Mr. Geithner had to make the crucial determination of which firms under his jurisdiction (which included Wall Street) were solvent and thus eligible for emergency relief. When questioned by David Boies, the lawyer for Mr. Greenberg, Mr. Geithner struggled to define “solvent.”…..The Federal Reserve Act was amended to make it explicit that only solvent firms qualified for loans, and the act further defined “insolvent” to mean “in bankruptcy” or other insolvency proceeding at the time of the loan request. But that definition is so broad as to be all but meaningless. “It’s a huge loophole,” Professor Goodfriend said. By that standard, Lehman Brothers was plainly solvent, since it wasn’t in bankruptcy proceedings when it sought the Fed’s support.”, James B. Stewart, “Solvency, Lost in the Fog at the Fed”, New York Times
Solvency, Lost in the Fog at the Fed
Timothy Geithner in October, after testifying in the lawsuit involving the A.I.G. bailout. Credit Alex Wong/Getty Images
When it comes to the Federal Reserve’s emergency lending powers, the crucial word is “solvent.” That’s because both by tradition and, since the passage of the Dodd-Frank Act, by law, the Fed can use its emergency powers to make loans only to a solvent institution.
In 2008, that’s why Bear Stearns and the American International Group, both deemed solvent by the Fed, were bailed out — while the investment bank Lehman Brothers, said to be insolvent, was left to fail. Or so top officials at the time have said.
But what did “solvent” mean to those officials?
Recent testimony in the continuing litigation over the government’s rescue of the insurance giant A.I.G. — its former chairman and chief executive, Maurice Greenberg, claims that the bailout was unconstitutionally punitive — suggests that solvency had little or nothing to do with the Fed’s decision to lend. Numerous firms deemed insolvent nonetheless got emergency loans, while Lehman alone was denied one before it went bankrupt. Judging by their actions, Fed officials seemed to have defined solvency on a case-by-case basis.
Consider the testimony of Timothy Geithner, who later served as Treasury secretary. As president of the Federal Reserve Bank of New York when the financial crisis unfolded, Mr. Geithner had to make the crucial determination of which firms under his jurisdiction (which included Wall Street) were solvent and thus eligible for emergency relief. When questioned by David Boies, the lawyer for Mr. Greenberg, Mr. Geithner struggled to define “solvent.”
“Even the solvent can be illiquid in that context, and that would make them insolvent,” Mr. Geithner testified. “So, as I said here,” referring to notes he produced as part of the litigation, “complete fog of diagnostic problem.”
But how can a firm be both solvent and insolvent at the same time? And how could such an important determination be a “complete fog” to the president of the New York Fed?
To be fair, Mr. Geithner was backed into something of a corner by Mr. Boies, who as part of the discovery process obtained notes in which Mr. Geithner wrote, without any qualification, “Certainly Citi and Bank of America were insolvent.” Yet both Citigroup and Bank of America received emergency loans from the Fed. Mr. Geithner also agreed that there were serious questions as to A.I.G.’s solvency, and A.I.G., too, received extensive Fed support.
Part of the problem is that the definitions of “insolvent” embrace both the notions of “having liabilities in excess of a reasonable market value of assets held,” and “unable to pay debts as they fall due in the usual course of business,” according to the Merriam-Webster online dictionary. In his testimony, Mr. Geithner implied that he was using “insolvent” in his notes as a “shorthand way” to mean “illiquid.”
As he put it: “Relative to many other institutions getting caught up in that storm, Citi and B of A were at the weaker end of that spectrum. If all were insolvent because they became illiquid, then they were all — they were certainly insolvent.”
By that standard, A.I.G., too, would seem to have been insolvent since it couldn’t pay its obligations as they came due without support from the Fed. “I thought we were taking enormous, unprecedented risks and that there was substantial risk that we would lose billions of dollars, if not tens of billions of dollars,” Mr. Geithner testified about the A.I.G. bailout. But, he continued, “I also believed that there was a reasonable prospect that over time, over a longer period of time, if we were successful in preventing A.I.G.’s failure and if we were successful in averting another global depression, that we had a reasonable chance of recovering our assistance.”
Through a spokeswoman, Mr. Geithner declined to elaborate on his testimony.
Hal S. Scott, a professor at Harvard Law School and the author of “The Global Financial Crisis,” says the bottom line is, “Solvent is pretty much whatever the Fed says it is.” He added: “I have a lot of sympathy for what Geithner was trying to say. It’s difficult in the middle of a run or a panic to determine whether something is insolvent, because you don’t know how to value the assets. At the end of the day, it’s an art, not science. The issue of how does a lender of last resort determine whether an institution is, or isn’t, solvent has been one of the most difficult problems for a very long time.”
Marvin Goodfriend, a professor at the Carnegie Mellon Tepper School of Business who spent 12 years as a policy adviser at the Federal Reserve Bank of Richmond, agreed. “It’s hard to define insolvency in a financial crisis, since it depends on the behavior of the entire financial system,” he said. “Solvency is only well defined when a particular firm is in trouble but the rest of the economy is O.K. When you come to a systemic problem, where the Fed’s very action has a bearing on whether those firms are solvent or not, you have a Catch-22 problem that can’t be solved.”
The Fed seems to have been well aware of the issue. In a legal memo from 1999 produced at the A.I.G. trial, a lawyer at the New York Fed, Joseph H. Sommer, cautioned that the Fed’s emergency lending “must be an exercise in on-the-fly policy making.” And he posed two questions that, in light of the financial crisis, seem prescient: “Does the lending bank have enough time to make a reasoned decision?” and “Does the lending bank understand the procedural consequences of its actions?”
After the financial crisis, and facing persistent questions as to why some firms were bailed out and others weren’t, Congress sought to clarify the Fed’s emergency lending powers as part of the Dodd-Frank Act. The Federal Reserve Act was amended to make it explicit that only solvent firms qualified for loans, and the act further defined “insolvent” to mean “in bankruptcy” or other insolvency proceeding at the time of the loan request. But that definition is so broad as to be all but meaningless. “It’s a huge loophole,” Professor Goodfriend said. By that standard, Lehman Brothers was plainly solvent, since it wasn’t in bankruptcy proceedings when it sought the Fed’s support.
A spokeswoman for the Federal Reserve in Washington and a spokesman for the New York Fed declined to comment.
The Federal Reserve’s friends and foes alike seem to agree that the current state of affairs is untenable and that the nation is ill prepared for another crisis. They argue that either the Fed should have broad discretion to lend in an emergency, without being hobbled by technical definitions of solvency and ambiguous limits to its powers, or it shouldn’t have any discretion at all.
Those wanting to curb the Fed’s powers “don’t really want a better definition of solvency,” Professor Scott said. “They want the function of lender of last resort itself taken away. I think that would be a disaster. The Fed was created to be a lender of last resort to curb panics. Its monetary function came later.”
Professor Goodfriend said, “Either you give the Fed all the tools it needs, which I call the monarchist approach, or you give the fiscal authorities,” meaning Congress, “the responsibility under the rule of law so the Fed doesn’t get itself into impossible situations like A.I.G. and Lehman. I call that the republican approach, meaning republican in the classic sense, with a small ‘r.’ ”
The issue is almost certain to heat up now that Republicans, with a capital “r,” have taken control of the Senate and expanded their majority in the House, since some of the most ardent critics of the Fed’s emergency powers are Republicans (among them, Senator Rand Paul of Kentucky, a possible presidential candidate). But the issue doesn’t break along traditional party lines. Liberal Democrats, including Senator Elizabeth Warren of Massachusetts, have criticized what they deemed the Fed’s bailout of wealthy Wall Street bankers. Senator Warren has joined a Republican senator, David Vitter of Louisiana, in calling for more curbs to the Fed’s emergency lending powers.
Whatever the political outcome, testimony in the A.I.G. case has further undermined the Fed’s claim that it acted consistently during the financial crisis, rescuing only those firms that were solvent while letting an insolvent Lehman fail.
“In my opinion, A.I.G. was clearly insolvent, but they lent to them anyway,” Professor Scott said. “And Lehman, whether it was insolvent or not, that wasn’t the issue. The Fed and Treasury were getting hammered on a daily basis for bailing out Bear Stearns, and they decided they had to teach Lehman a lesson.”
Professor Goodfriend agreed that the Fed and the Treasury Department acted “inconsistently” in their handling of the solvency question during the financial crisis: “There was ambiguity about the extent to which the Fed could support the fiscal system. That was deadly because they ran afoul of the fiscal authorities in Congress, and then there was open warfare. That took us from a serious downturn into the Great Recession.”
A version of this article appears in print on November 8, 2014, on page B1 of the New York edition with the headline: Solvency, Lost in the Fog at the Fed.