Great Leap Forward

LET’S MAKE A DEAL: The Bail-Out of Wall Street in Unusual and Exigent Circumstances

It has been recognized for well over a century that the central bank must intervene as “lender of last resort” in a crisis. In the 1870s Walter Bagehot explained this as a policy of stopping a run on banks by lending without limit, against good collateral, at a penalty interest rate. This would allow the banks to cover withdrawals so the run would stop.

Once deposit insurance was added to the assurance of emergency lending, runs on demand deposits virtually disappeared. However, banks have increasingly financed their positions in assets by issuing a combination of uninsured deposits plus very short-term nondeposit liabilities (such as commercial paper). Hence, the GFC actually began as a run on these nondeposit liabilities, which were largely held by other financial institutions.

And here is where the issue gets complicated. As I argued in a previous GLF blog (, banks and other institutions relied largely on “rolling over” short-term liabilities (often, overnight). But when reports about the quality of bank assets began to surface as subprime mortgage delinquencies rose, financial institutions began to worry about solvency of the issuers of the liabilities. As markets came to recognize what had been going on in the securitization market for the past half-decade, “liquidity” dried up—no one wanted to hold uninsured liabilities of financial institutions.

In truth, it was not simply a liquidity crisis but rather a solvency crisis brought on by all the risky and fraudulent practices.

Not only did all “finance” disappear, but there was also no market for the trashy assets—so there was no way that banks could sell assets to cover “withdrawals” (again, these were not normal withdrawals by depositors but rather a demand by creditors to be paid). As markets turned against one institution after another, financial institution stock prices collapsed, margin calls were made, and credit ratings agencies downgraded securities and other assets. The big banks began to fail.

Government response to a failing, insolvent, bank is supposed to be much different than its response to a liquidity crisis. It has always been the standard view—dating all the way back to Bagehot—that lender of last resort does not apply to an insolvent institution. Indeed, since 1991 the Fed has been prohibited from lending to “critically undercapitalized” institutions without first obtaining explicit prior approval of the Secretary of the Treasury. And no matter what the Fed officials or the banksters claim, the big banks were “critically undercapitalized”, and the Fed did lend to insolvent banks—against the 1991 statute that was enacted precisely to prevent the Fed from avoiding the fiscal discipline of congressional appropriations. (Walker Todd 1997) I’ll have more to say about that in a later blog. But let’s turn to other problems with the bailout.

In addition to injecting capital into troubled institutions, the Treasury conducted a “stress test” that would supposedly find institutions likely to fail. However, these tests set thresholds that were far too lax to identify profoundly troubled institutions. When an institution did face failure, the Treasury and the Fed—usually represented by the New York Federal Reserve Bank—would try to merge the failing institution into another, with Timothy Geithner reprising the Monty Hall role in his own version of “Let’s Make a Deal”.

Often it would be necessary for the Fed to lend to the failing institution for some period while the deal was negotiated (as discussed below, that lending, itself, might violate statutes). In addition, the Fed created a number of special facilities to provide funding for institutions and also to take troubled assets off their books. By purchasing bad assets, the Fed could conceivably turn a failing bank into a solvent bank. It was important to the Fed and Treasury to avoid closing and resolving an institution—that would admit failure and would lead to claims on the FDIC. Since the FDIC’s reserves were far too small to deal with systemic failure, it would have to go to Congress for funds. The Fed and Treasury were deathly afraid of that—recall how Congress treated Hank Paulson when he went with hat-in-hand to ask for money for banksters!

It must be emphasized that the US Treasury and indeed the economic team of the Administration of President Obama was heavily represented by individuals with experience in investment banking. In an interesting article by Davidoff and Zaring (2009), it is argued that the “bail-out” can be characterized as “deal-making through contracts” as the Treasury and Fed stretched the boundaries of law with behind-closed-doors hard-headed negotiations.

It appears that the government did negotiate with a view to keeping its own risk exposure limited; at the same time, it insisted on large “haircuts” to stockholders’ equity but minimal losses to bondholders. It also avoided penalties on bank directors and officers—rarely investigating possible fraud or dereliction of duty. Finally, it avoided “market solutions” in favor of “orderly solutions”. In other words, where markets would shut down an insolvent financial institution the government would instead find a way to keep the institution operating by merger.

The one major exception was Lehman Brothers, as the government allowed the investment bank to fail. Davidoff and Zaring attribute this to an attempt to demonstrate government’s willingness to negotiate tough terms. (Sort of what Germany is doing to Greece now: it is going to let Greece fail and kick it out of the EMU in order to show Spain and Italy its resolve in negotiations.)

Further, government relied on the two institutions that are least constrained by the law: the Fed and the Treasury. Throughout the crisis, the government would stretch and flex its authority in its “make a deal” approach but would not boldly violate the law. Davidoff and Zaring (2009) argue that the federal government was allowed substantial leeway in its interpretation as state courts were not likely to interfere. Further, the Fed has in the past interpreted its activities as exempt from “sunshine” laws.

In many ways, this “deal-making” approach that was favored over a resolution by “authority” approach is troubling from the perspectives of transparency and accountability as well for creation of “moral hazard”.

The other aspect of the bail-out that is troubling was the unprecedented assistance provided through the Fed’s special facilities created to make loans as well as to purchase troubled assets (and to lend to institutions and even individuals that would purchase troubled assets). To be sure, in a crisis the central bank must act as a lender of last resort. But the Fed’s actions went far beyond “normal” lending.

First, as discussed, it is probable that the biggest recipients of funds were insolvent. We cannot be sure of this because the Treasury’s “stress tests” were wimpy; and while the FDIC is responsible for declaring depository institutions insolvent, it had a strong incentive to avoid doing so: as discussed, its reserves were far too small and it could not risk going to a skeptical Congress to ask for more funding.

Second, the Fed provided funding for financial institutions (and to financial markets in an attempt to support particular financial instruments) that went far beyond the member banks that it is supposed to support. It had to make use of special sections of the Federal Reserve Act, some of which had not been used since the Great Depression. And as in the case of the deal-making, the Fed appears to have stretched its interpretation of those sections beyond the boundaries of the law.

We will not go through all of the facilities nor deeply into an examination of the sections invoked to justify the interventions. Note it would not be accurate to call every intervention by the Fed a “bail-out”. Lending reserves by the Fed to solvent banks that are short of “liquidity” (reserves needed to meet withdrawals or clearing against other banks) is expected to increase sharply in a crisis. Further, the Fed decided to engage in massive “quantitative easing” that saw its balance sheet grow from well under $1 trillion before the crisis to nearly $3 trillion; bank reserves increase by a similar amount as the Fed’s balance sheet grows. Such actions do not necessarily indicate a “bail-out” as they could be consistent with “liquidity provision” to solvent banks.

Still, QE included asset purchases by the Fed that went well beyond treasuries—the usual asset bought by the Fed when it wants to inject reserves into banks. The Fed bought a lot of mortgage-backed securities in its QE, and while some of these were backed by Fannie and Freddie (hence, ultimately were government liabilities) the Fed also bought “private label” MBSs (not government backed). To the extent the Fed paid more than market price to buy “trashy” assets from financial institutions that could be construed to be a “bail-out”.

In any case, the Fed’s actions went far beyond even this—to include highly unusual actions that are reasonably characterized as a “bail-out” of institutions that were probably insolvent. And the volume of such intervention is truly unprecedented. We have already covered that ground, in my reports of the findings of Andy Felkerson and Nicola Matthews (Felkerson 2011). So I will not repeat the discussion of our estimate that the Fed lent and spent (in asset purchases) over $29 trillion cumulatively. Instead we will focus on the most troubling facilities included in that overall number.

However before proceeding note that for comparison, after the “Great Crash” of 1929, the Fed lent to 123 institutions a total of $23 million in today’s dollars between 1932-36. You would need to add six zeroes to the Fed’s response to the Great Crash to get close to its response to the GFC! The word “unprecedented” really does not adequately describe the Fed’s intervention to rescue financial institutions. In the beginning of 2008 the Fed’s balance sheet was $926 billion, of which 80% of its assets were US Treasury bonds; in November 2010 its balance sheet had reached $2.3 trillion, of which almost half of its assets were MBSs. Over the next year it ramped-up its purchases of treasuries (and reduced its use of the special facilities) so that its balance sheet was close to $3 trillion—three times larger than it was on the eve of the crisis.

And still there is no end in sight.

Let’s get back to its special facilities, many of which used “special purpose vehicles” created to buy assets or to make loans. Note the irony:  the creation of SPVs by banks had played a big role in causing the GFC–banks created SPVs to move risky assets off their balance sheets so that they would not need to hold capital, and so that government regulators and supervisors would not see them. This allowed them to take on much more risk and more leverage in an effort to increase profits. In an ironic twist the Fed followed the example set by banks as it created SPVs to subvert constraints written into the Federal Reserve Act.

As discussed above, there is no problem with Fed lending to member banks to stop a run. It is a bit more problematic to lend to insolvent member bank. But in “unusual and exigent” circumstances, the Fed is free to go much farther under Section 13(3) of the Federal Reserve Act, although as Mehra (2009) explains, the bar is still high. It can lend to individuals, partnerships and corporations at a discount if they are unable to secure adequate credit from other banks. Further it must lend against indorsed or secured assets.

But here’s the problem with the Fed’s invocation of this section during its bail-out of Wall Street: it created SPVs and then lent to them so that they could buy troubled assets. In other words it financed the purchase of an asset, rather than making a loan. In most cases its loan was to its own SPV, and not to the party that needed assistance. In some cases the loans were not technically “discounts” and were not against endorsed assets (the SPVs owned no assets until they got the loans so they could buy them); and in most cases the beneficiaries could have obtained loans from other banks, albeit at higher interest rates. In all these respects, the law was “stretched” if not subverted. In all those respects this looks like “bail-out” and not “liquidity provision”.

And the volume of Fed assistance of questionable legality was very large. If we take the four SPVs that were created to get around the 13(3) restrictions, they accounted for a cumulative total lending of almost $2 trillion of the $29 trillion. In addition the Fed made a lot of loans that were not “discounts” (ie,  lending against equities is not permitted by 13(3)) or that were not to troubled parties that needed the assistance (for example, TALF, Term Asset-Backed Securities Loan Facility, and AMLF, Asset Backed Commercial Paper Money Market Mutual Fund Liquidity Facility lent to buyers of troubled assets). The total of inappropriate loans was over $9 trillion.

Hence, it looks like at least $11 trillion of cumulative lending that had been justified by section 13(3) probably did not meet the restrictions. That’s more than a third of the total funds spent or lent by the Fed to rescue the financial sector. And most of the funds went to the biggest banks (as I’ll show in a later blog).

There is little doubt that the GFC posed “unusual and exigent” circumstances that had to be met with a huge response by the Fed (and Treasury). It is not clear, however, that the response actually mounted was legal. It was certainly not transparent. It has left us with a highly troubled financial sector, dominated by even bigger too-big-to-fail institutions. It has created massive moral hazard. And those responsible—including our public stewards—have not been held accountable.


Regulation by Deal: The Government’s Response to the Financial Crisis BY Steven M. Davidoff David Zaring Reprinted from Administrative Law Review Volume 61, Number 3, Summer 2009.

Alexander Mehra, “Legal Authority in Unusual and Exigent Circumstances: The Federal Reserve and the Financial Crisis”, University of Pennsylvania Journal of Business Law, Vol 13, 3/2/2011, (updated after publication)

James Felkerson, “29,000,000,000: A Detailed Look at the Fed’s Bailout by Funding Facility and Recipient”, Levy Economics Institute of Bard College, Working Paper No. 698, December 2011,

Walker Todd, “Central banking in a democracy: The problem of the lender of last resort”, for Western Economic Association International Annual Meeting, July 11, 1997.

6 Responses to “LET’S MAKE A DEAL: The Bail-Out of Wall Street in Unusual and Exigent Circumstances”

DDDFebruary 16th, 2012 at 9:57 pm

All insolvency presents itself as a freeze-up in liquidity. Thus the central bank is always covered when it provides liquidity hand over fist (essentially being the bid in a market with otherwise no buyers). Legality is ultimately dependent on the society. Anytime society deems whatever law is no longer valid or appropriate, the laws will be changed. Frankly, from the lack of response from the private sector towards the bailout (yes people marched, camped out, and called Congress, but no investigations, no arrests, no real outrage), maybe we just don't care, at least in the short term.

j0wnFebruary 17th, 2012 at 4:28 am

"Every time the Federal Reserve protects a financial instrument it legitimizes the use of this instrument to finance activity. This means that not only does Federal Reserve action abort an incipient crisis, but it sets the stage for a resumption in the process of increasing indebtedness-and makes possible the introduction of new instruments. In effect, the Federal Reserve prepares the way for the restoration of the type of financing that is a necessary, but not a sufficient condition, for an investment boom that is brought to a halt by financial crises."

(Minsky, 1986, SUE p. 106)

"Since the intervention by the authorities tends to validate the new ways, the central bank sets the stage for a broader acceptance and use of the new financial instruments in subsequent expansions."

(Minsky, 1986, SUE p. 281)

The Fed is setting precedent for the future lengths, mechanisms, vehicles, and means it will take during future crises. Great observation … can't wait … what? I feel safer (yeah, right).

SergioFebruary 19th, 2012 at 5:57 pm

It is difficult to believe that the FED is neutral in its activities. Now that we have weathered the storm, there will be greater speculation because if you get in trouble, the FED can bail out failing institutions.