The New York Fed and the Rule of Law

In Sunday’s New York Times, business columnist Gretchen Morgenson reported a piece of investigative journalism that is transcendently important, but whose complexity may have obscured that. It concerns secret dealings of the Federal Reserve Bank of New York. Morgenson explains the importance of her topic in terms of the threatened erosion of social trust that can occur when central banking officials engage in dubious behavior.

I would add that her topic, dubious dealings of central bankers, is of vital importance because those who run the FRBNY have enormous power in the field of banking regulation. They oversee the largest banks and provide direct input into the Financial Stability Oversight Council, the interagency government organization created by the Dodd Frank Act to oversee the financial system. It is empowered to intervene when the next financial crisis occurs, which could be later this year or five years or ten or what have you.

As with the financial crisis of 2008, these government actors, dominated by the FRBNY, will call all the shots about which institutions to save, sell or seize, on the one hand, and which creditors and shareholders to pay, wipe out or shortchange, on the other. How they exercise these powers is thus a matter of the utmost national interest. How they exercised them in the 2008 crisis remains both obscure and questionable.

Morgenson’s piece focuses on a secret deal arising out of one aspect of the FRBNY’s 2008 dealings with American International Group (AIG). At that time, AIG had insured various mortgage securities of all the major banks, such as Bank of America and Goldman Sachs. One reason the 2008 crisis occurred was that such banks had misrepresented such securities, to AIG and others, as being of higher quality than they were.

When the FRBNY and Treasury seized control of AIG, the FRBNY acquired, through a conduit called Maiden Lane, a bunch of these securities, including a large volume created and sold by BofA. Years later, AIG sued BofA, alleging fraud in connection with the purchase and sale of those securities, seeking damages of about $7 billion.

BofA’s defense asserted that the FRBNY owns any right to sue. It disclosed that the FRBNY had in July 2012 made a secret deal with BofA agreeing to relinquish those claims as part of settling a related dispute in which BoA paid the FRBNY $43 million. That agreement also required the FRBNY to defend any claims made against BofA, which it has done by affidavits filed by a senior executive and deputy general counsel.

Once the secret deal was uncovered, AIG’s lawyers called the FRBNY’s agreement to help BofA and harm AIG “disturbing,” a strange role for a governmental agency to take picking winners in private lawsuits. The FRBNY explains it as part of an overall negotiating strategy that helped it secure a favorable settlement which, it said, promoted the interests of the government (which it called the “taxpayers”). Ed Kane, a finance professor at my former employer, Boston College, aptly observed in Morgenson’s piece:

The Fed seems to have thrown off all restraints on its behavior in just trying to get through the crisis and the aftermath of the crisis. It’s like a slippery slope, and they just keep sliding a little further.

[Not discussed in Morgenson’s piece, but a prominent example of what Prof. Kane refers to is worth mentioning. In September 2008, credit markets were frozen and no one knew the value of the insurance (“credit default swaps”) AIG had written to cover mortgage securities. Although it was widely known that the swaps were worth far less than 100 cents on the dollar, the FRBNY paid 100 cents on the dollar to settle them, using $62 billion of the funds allocated to “bail out” AIG. As commercially unsound as that was from AIG’s perspective (Tim Geithner, then FRBNY president, subsequently testified before Congress that he was acting not for AIG but for the system), more bizarre was that the FRBNY caused AIG to release Goldman and others from any fraud liability arising from misrepresentations about the securities!]

Morgenson’s piece concludes on woeful notes about the damage that has been done to the reputations of American financial institutions, reputational damage that she now sees afflicting the FRBNY too. A diminished reputation for that institution will further erode the social trust that is vital to healthy markets, Morgenson points out.

As noted, I’d go further: we continue to be in a dangerous situation. When a systemic financial crisis occurs, unelected and unaccountable governmental officials, advised by lawyers and bankers who will face inherent conflicts of interest during the hurly-burly, will make hair trigger decisions about the rights and duties of millions of people.  Morgenson’s piece really shows that, far more than social trust, the rule of law is at stake.

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