WASHINGTON — A little noticed 1991 amendment to a Depression-era law, written by a securities industry lawyer and pushed by Sen. Christopher Dodd, D-Conn., allowed AIG to post tens of billions of dollars in shaky mortgage securities as collateral for taxpayer loans.
In rescuing the insurance giant and several Wall Street firms in the fall of 2008, top government officials wrestled with how to deal with so-called "toxic" securities tied to the risky home loans at the root of the subprime mortgage meltdown.
Their solution, amounting to a transfer of about $90 billion in mostly subprime mortgage securities from major financial institutions to American taxpayers, is likely to remain one of the most controversial aspects of the massive federal response to the crisis.
Critics contend that the Federal Reserve Bank of New York failed to protect taxpayers sufficiently when it paid $29 billion for toxic assets in saving the foundering investment house Bear Stearns and about $60 billion to settle AIG's liabilities for investments in subprime mortgage securities. The Fed wound up lending $43.8 billion to take possession of those securities.
William Ford, a former president of the Federal Reserve Bank of Atlanta, voiced support for senior Fed officials' decisions to serve as a lender of last resort in the heat of the crisis, but called it "dangerous" to accept subprime mortgage securities as collateral. A government watchdog says that the Fed engaged in a bit of legerdemain to make it appear that taxpayers have profited from the toxic securities.
Defenders say that all of the Fed's actions were legal and averted a disaster, thanks to sweeping emergency powers granted by Congress in the 1991 revision to the 1932 Federal Reserve Act governing the nation's central bank.
At the behest of the securities industry, Dodd added the amendment to a broad banking bill during a committee markup 19 years ago, with little debate.
In a speech shortly before Senate passage, Dodd said that he offered the change to empower the Fed "to respond in instances in which the overall financial system threatens to collapse," as in the stock market crash of 1987. He also assured his colleagues that any Fed loans would be "fully secured."
In fact, the amendment to Section 13(3) of the Federal Reserve Act allows the Fed to accept any collateral to its "satisfaction" for loans to "non-banks" such as AIG, as opposed to typical Fed loans to banks requiring investment-grade collateral.
One person who was present during the legislative process, but declined to be identified for fear of damaging relationships, called it "fascinating, the whole way this thing gets slipped in. No one really understood what was happening, and boom, it's in the law."
Rodgin Cohen, a prominent Wall Street lawyer, said he drafted the amendment, with help from others. While he's represented Goldman Sachs and AIG for years, Cohen said he wasn't acting on a client's behalf.
He described the October 1987 crash, in which the stock market lost 20 percent of its value, as "a terrible period of time for a couple hours when everything froze and . . . the whole system was careening off the rails."
Under the revision, loans only could be made to systemically important institutions that, in a national emergency, couldn't obtain private credit. Five members of the Federal Reserve Board were required to vote in favor.
Cohen said that the loan security had to be sufficient that there would be "a legitimate expectation" that the Fed would be repaid.
Treasury Secretary Timothy Geithner has said that the borrower must be "solvent," or capable of meeting is financial obligations.
Even so, the 1991 revision's grant of unfettered power to the Fed so disturbed Walker Todd, an economist for the Federal Reserve Bank of Cleveland, that he wrote an article warning of the dangers. Todd said in phone interviews that, at the time, the Federal Reserve Board cleared all articles prior to publication and rejected 21 drafts over the next year.
Finally, Todd said, officials at the Federal Reserve Bank of Minneapolis and his Cleveland bosses decided in 1993 that to publish his 22nd version. On the night it was rolling off the presses, an aide to Director Donald Kohn of the Fed's Division of Monetary Affairs phoned the Cleveland bank in a futile attempt to halt publication, he said.
A Federal Reserve Board spokesman declined to comment on the episode.
Officials of the New York Fed contend that, while taxpayers are losing about half a billion dollars on the securities from Bear Stearns, which was purchased by J.P. Morgan Chase in a hastily arranged deal in March 2008, the government is reaping up to $7 billion in profits on those acquired via AIG.
However, Neil Barofsky, the special inspector general tracking the use of bailout money challenges the Fed's accounting, stressing that government loans enabled AIG to make upward of $20 billion in partial payments to various banks even before buying the securities. Barofsky said that, in truth, taxpayers got securities worth about half the $62 billion paid for them.
Since committing as much as $182 billion in loans to AIG for the securities and a 79.8 percent stake in the insurer, the New York Fed and Treasury Department have engaged in seeming contortions to ensure that taxpayers continue to hold adequate loan security.
In March 2009, the New York Fed announced a new $8.5 billion loan to AIG, to be repaid with net cash flows from company life insurance policies. Objections from regulators scuttled that plan. An official of one state insurance department said privately that the deal "compromised the interests of policyholders."
Since then, the loans gradually have been shifted to the Treasury Department.
Todd called the Fed's use of the 1991 provision "the greatest abuse of the Federal Reserve's monetary policy powers in recent decades."
Without congressional checks and balances, he said, "Why should citizens ever suspect anything other than that 'friends of the king' would receive the Section 13(3) loans?"
San Diego lawyer Michael Aguirre, who's attempting to sue AIG on behalf of policyholders, said that nothing in the 1991 law allows the Fed to buy assets "with nothing but a hope and a dream that they'll turn into the value that was paid for them."
Dodd, who's retiring from Congress this year, received $41,625 in campaign donations in 1991 and 1992 from Goldman Sachs, Bear Stearns, J.P. Morgan and three other big Wall Street firms that would benefit from the 2008 bailout. Since then, those banks donated another $883,800 to his political committees, according to Federal Election Commission records.
Justine Sessions, a spokeswoman for the Senate Banking Committee, which Dodd chairs, said that while the response to the Wall Street meltdown "has not been perfect," the 1991 law prevented a total economic collapse.
(Sananda Sahoo contributed to this article.)
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