Last resort the financial crisis and the future of bailouts

Last Resort Last Resort The Financial Crisis and t h e F u t u r e of Ba i l o u t s Eric A Posner The University of Chicago Press • C h icag o and L on d on The University of Chicago Press, Chicago 60637 The University of Chicago Press, Ltd., London © 2018 by The University of Chicago All rights reserved No part of this book may be used or reproduced in any manner whatsoever without written permission, except in the case of brief quotations in critical articles and reviews For more information, contact the University of Chicago Press, 1427 East 60th Street, Chicago, IL 60637 Published 2018 Printed in the United States of America 27 26 25 24 23 22 21 20 19 18  1 2 3 4 5 ISBN-­13: 978-­0-­226-­42006-­6 (cloth) ISBN-­13: 978-­0-­226-­42023-­3 (e-­book) DOI: 10.7208/chicago/9780226420233.001.0001 Library of Congress Cataloging-­i n-­P ublication Data Names: Posner, Eric A., 1965– author Title: Last resort : the financial crisis and the future of bailouts / Eric A Posner Description: Chicago ; London : The University of Chicago Press, 2018 | Includes bibliographical references and index Identifiers: LCCN 2017017174 | ISBN 9780226420066 (cloth : alk paper) | ISBN 9780226420233 (e-­book) Subjects: LCSH: Financial crises—United States | Bailouts (Government policy)— United States | Intervention (Federal government)—United States | Global Financial Crisis, 2008–2009 Classification: LCC HB3722 P666 3028 | DDC 338.5/430973—dc23 LC record available at https://lccn.loc.gov/2017017174 ♾ This paper meets the requirements of ANSI/NISO Z39.48-­1992 (Permanence of Paper) Contents Introduction 1 one The Transformation of the Financial System 10 t wo Crisis 41 three The Lawfulness of the Rescue 55 Four The Trial of AIG 75 five six Fannie and Freddie 103 The Bankruptcies of General Motors and Chrysler 126 seven Takings and Government Action in Emergencies 148 eight Politics and Reform 165 Ac k now led gmen t s 185 No t e s 187 Re fer ence s 197 In dex 209 Introduction [The] Federal Reserve was the only fire station in town Henry Paulson If one thing was clear after the financial crisis of 2007–8, it was that the government would no longer bail out helpless financial institutions President Obama said so Congress wrote this principle into the preamble of the Dodd-­Frank Act,2 the major post-­bailout statute All high-­level government officials confirmed this policy There was good reason to The bailouts enraged the public They spawned the Tea Party and Occupy Wall Street Public officials agreed that bailouts were anomalous in a market economy, where people who take risks must be allowed to lose their money Bailouts reward irresponsible rich people for foolish investments that harm ordinary people who nothing wrong They were needed in the financial crisis only because a global economic meltdown would have harmed people even more Or maybe they were not needed at all Financial institutions should have been allowed to immolate in a purifying Götterdämmerung, or perhaps bailouts would not have been needed if people had acted sensibly in the first place Bailing out firms is wrong, or so it seems But the word “bailout” is used by people in different ways, and here is where the trouble starts The Federal Reserve Board—like central banks around the world—possesses a function known as the Lender of Last Resort (LLR) The Fed has had this function since its establishment in 1913 The purpose of the LLR is to lend money to financial institutions that are unable to borrow money during a financial crisis, a systemic withdrawal of credit and hoarding of cash 2 * Introd uct ion across the economy The LLR makes loans to banks and other financial institutions until confidence is restored Then it is paid back, with interest In the financial crisis that began in 2007, the Fed exercised its LLR function just as it was supposed to While the crisis did not take the form of a traditional run on ordinary commercial banks, it did conform to the classic definition of a financial crisis People withdrew their funds first from certain financial entities operated by banks and investment banks, and then from investment banks, money market mutual funds, and other financial institutions, but these “shadow banks” had become so important to the economy that their failure would have caused economic collapse (and taken the regular banking system with them) Because of the unusual nature of the financial crisis, the Fed responded by making credit available to nonbanks as well as banks; later Congress appropriated funds for the US Treasury to boost the financial system Did the Fed “bail out” the financial system? It depends on how one defines a “bailout.” The dictionary says that a bailout occurs when someone provides financial assistance to a person or business that cannot pay its debts But that definition is pretty broad Suppose I don’t have enough money to pay my $1,000 credit card bill, so I go to my local bank and take out a home equity loan, which I use to pay off the credit card bill Then I pay off the home equity loan over the next several years The bank loan qualifies as a “bailout” under the dictionary definition because it saves me from defaulting on my credit card debt But there is nothing wrong with such a loan The bank isn’t doing me a favor; it’s charging me interest and making a profit Suppose instead I go to my rich uncle and explain that I can’t pay my debts My uncle hands me $1,000 in cash and tells me to give it to the credit card company Or he gives me an interest-­free loan, knowing that I’m a deadbeat and unlikely to repay him The uncle not only bails me out according to the dictionary definition He bails me out, some might say, in a morally questionably way He relieves me of responsibility for my debts, perhaps teaching me that there are no consequences to my actions He incurs a loss and does not expect to be paid back Knowing that my uncle will rescue me, I may continue to act in a financially irresponsible manner Now consider a classic LLR loan during a financial crisis A bank or other financial institution cannot borrow money because no one is willing to lend As its bills come due, it faces bankruptcy The bank possesses nu- Intr od uct ion  * 3 merous assets that it could sell off to raise cash to pay its bills But no one wants to buy those assets because everyone is hoarding cash If the bank nonetheless sells them at fire-­sale prices to the handful of hardy souls who have cash and believe that the financial crisis has peaked, it will be driven into insolvency because the fire sales not raise enough cash to pay its debts Instead, the bank applies for a loan from the LLR, using its assets as collateral The LLR can lend because it has an infinite time horizon It doesn’t matter how long it takes for the bank to pay it back because the LLR can keep itself in business by printing money—subject to some vague macroeconomic and political limitations If all goes well, the bank will either pay back the LLR with interest or lose its collateral to the LLR, which the LLR can resell to the market once the crisis ends The scenario is much closer to my first example than to my rich-­uncle case The only difference is that in the first example, I go to a private bank, while in the financial crisis, the financial institutions sought loans from the government But they did so only in the sense that if someone’s house is on fire, that person calls the fire department rather than looks for a private company to douse the fire No such private company exists The government is a kind of credit monopolist during a financial crisis; if the LLR is operated correctly, the government should make rather than lose money—as, in fact, it did during the crisis of 2007–8 Of course, it need not work out this way If the LLR makes loans to insolvent institutions and against inadequate collateral, it will lose money, possibly a great deal of money Economists distinguish between the pure type of liquidity support of solvent banks, which I have just described, and the rescue of banks that have been badly managed and driven into insolvency Such banks make bad loans that are not repaid During the S&L crisis of the 1980s, many savings and loans made bad commercial loans and were shut down The government paid their depositors Because the liability to depositors greatly exceeded the value of the banks’ loans, the government lost billions of dollars The S&Ls were not bailed out and the government lost billions of dollars; the banks in distress in 2007–8 were bailed out and the government made billions of dollars.3 And while people were angry about the S&L crisis, the anger was not remotely as sharp and politically damaging as their anger after the 2007–8 bailouts What accounts for the rage? At least among the public, hardly anyone knows that the government Reference s  * 205 Policies to Combat the Financial Crisis.” Address presented at the Federal Reserve Bank of Kansas City’s Annual Economic Symposium, August 21 McCulley, Paul A 2007 “Teton Reflections.” PIMCO Global Central Bank Focus, September https://www.pimco.com/insights/economic-­and-­market-­commentary/global-­central -­bank-­focus/teton-­reflections McDonald, Robert, and Anna Paulson 2015 “AIG in Hindsight.” Journal of Economic Perspectives 29 (2): 81–106 McLean, Bethany 2015 Shaky Ground: The Strange Saga of the U.S Mortgage Giants New York: Columbia Global Reports Mehra, Alexander 2010 “Legal Authority in Unusual and Exigent Circumstances: The Federal Reserve and the Financial Crisis.” University of Pennsylvania Journal of Business Law 13 (1): 221–74 Mehrling, Perry 2011 The New Lombard Street: How the Fed Became the Dealer of Last Resort Princeton, NJ: Princeton University Press Merrill, Thomas W., and Margaret Merrill 2014 “Dodd-­Frank Orderly Liquidation Authority: Too Big for the Constitution?” University of Pennsylvania Law Review 163 (1): 165–247 Mian, Atif, and Amir Sufi 2012 “The Effects of Fiscal Stimulus: Evidence from the 2009 Cash for Clunkers Program.” Quarterly Journal of Economics 127 (3): 1107–42 ——— 2014 House of Debt: How They (and You) Caused the Great Recession, and How We Can Prevent It from Happening Again Chicago: University of Chicago Press Mian, Atif, Amir Sufi, and Francesco Trebbi 2010 “The Political Economy of the US Mortgage Default Crisis.” American Economic Review 100 (5): 1967–98 ——— 2014 “Resolving Debt Overhang: Political Constraints in the Aftermath of Financial Crises.” American Economic Journal: Macroeconomics (2): 1–28 Minsky, Hyman P 1994 “Financial Instability Hypothesis.” In The Elgar Companion to Radical Political Economy, edited by Philip Arestis and Malcolm Sawyer, 153–57 Brookfield, VT: Elgar Morgenson, Gretchen 2016a “Documents Undercut U.S Case for Taking Mortgage Giant Fannie Mae’s Profits.” New York Times, April 12 http://www.nytimes.com/2016/04/13 /business/fannie-­mae-­suit-­bailout.html?hp&action=click&pgtype=Homepage&click Source=story-­heading&module=first-­column-­region®ion=top-­news&WT.nav=top -­news&_r=0 ——— 2016b “Fannie, Freddie and the Secrets of a Bailout with No Exit.” New York Times, May 20 http://www.nytimes.com/2016/05/22/business/how-­freddie-­and-­fannie-­are-­held -­captive.html Morrison, Edward R 2009 “Chrysler, GM and the Future of Chapter 11.” Columbia Law and Economics Working Paper No 365 Nelson, William R., and Roberto Perli 2007 “Selected Indicators of Financial Stability.” In Risk Measurement and Systemic Risk: Fourth Joint Central Bank Research Conference, 8–9 November 2005, in cooperation with the Committee on the Global Financial System, 343–72 Frankfurt, Germany: European Central Bank Obama, Barack 2013 “Remarks on Signing the Dodd-­Frank Wall Street Reform and Consumer Protection Act, July 21, 2010.” In Public Papers of the Presidents of the United States: Barack Obama, 2010, Book II—July to December 31, 2010, 1087–89 Washington, DC: US Government Printing Office Oh, Seung-­Youn 2014 “Shifting Gears: Industrial Policy and Automotive Industry After the 2008 Financial Crisis.” Business & Politics 16 (4): 641–65 206 * Reference s Olegario, Rowena 2016 The Engine of Enterprise: Credit in America Cambridge, MA: Harvard University Press Opp, Christian C., Marcus M Opp, and Milton Harris 2013 “Rating Agencies in the Face of Regulation.” Journal of Financial Economics 108 (1): 46–61 Pagano, Marco, and Paolo Volpin 2010 “Credit Ratings Failures and Policy Options.” Economic Policy 25 (62): 401–31 Paulson, Henry M 2010 On the Brink: Inside the Race to Stop the Collapse of the Global Financial System New York: Business Plus Porter, Thomas O 2009 “Federal Reserve’s Catch-­22: A Legal Analysis of the Federal Reserve’s Emergency Powers.” North Carolina Banking Institute 13 (1): 483–514 Posner, Eric A 2015 “How Do Bank Regulators Determine Capital-­Adequacy Requirements?” University of Chicago Law Review 82 (4): 1853–95 Posner, Eric A., and Adrian Vermeule 2010 The Executive Unbound: After the Madisonian Republic New York: Oxford University Press Pozsar, Zoltan 2011 “Institutional Cash Pools and the Triffin Dilemma of the U.S Banking System.” IMF Working Paper No 11/190 ——— 2014 “Shadow Banking: The Money View.” Office of Financial Research Working Paper No 14–04 Pozsar, Zoltan, Tobias Adrian, Adam Ashcraft, and Hayley Boesky 2012 “Shadow Banking.” Federal Bank of New York Staff Reports No 458 Rajan, Raghuram G 2005 “Has Financial Development Made the World Riskier?” NBER Working Paper Series No 11728 ——— 2010 Fault Lines: How Hidden Fractures Still Threaten the World Economy Princeton, NJ: Princeton University Press Rattner, Steven 2010 Overhaul: An Insider’s Account of the Obama Administration’s Emergency Rescue of the Auto Industry Boston: Houghton Mifflin Harcourt Reinhart, Carmen M., and Kenneth S Rogoff 2010 “Growth in a Time of Debt.” American Economic Review 100 (2): 573–78 Republican Staff of the Committee on Financial Services, U.S House of Representatives, 113th Congress, Second Session 2014 Failing to End “Too Big to Fail”: An Assessment of the Dodd-­Frank Act Four Years Later Washington, DC Rexrode, Christina, and Andrew Grossman 2014 “Record Bank of America Settlement Latest in Government Crusade.” Wall Street Journal, August 21 http://www.wsj.com /articles/bank-­of-­america-­reaches-­16–65-­billion-­settlement-­1408626544 Ritholtz, Barry 2009 Bailout Nation New York: John Wiley & Sons Roe, Mark J., and David Skeel 2010 “Assessing the Chrysler Bankruptcy.” Michigan Law Review 108 (5): 727–72 Romer, Thomas, and Barry R Weingast 1991 “Political Foundations of the Thrift Debacle.” In Politics and Economics in the Eighties, edited by Alberto Alesina and Geoffrey Carliner, 175–214 Chicago: University of Chicago Press Romero, Alan 2006 “Reducing Just Compensation for Anticipated Condemnations.” Journal of Land Use & Environmental Law 21 (2): 153–99 Samples, John 2010 “Lawless Policy: TARP as Congressional Failure.” Policy Analysis No 660 Schiff, Peter D., with John Downes 2007 Crash Proof: How to Profit from the Coming Economic Collapse Hoboken, NJ: John Wiley & Sons Schularick, Moritz, and Alan M Taylor 2012 “Credit Booms Gone Bust: Monetary Policy, Reference s  * 207 Leverage Cycles, and Financial Crises, 1870–2008.” American Economic Review 102 (2): 1029–61 Schwarcz, Daniel 2015 “A Critical Take on Group Regulation of Insurers in the United States.” UC Irvine Law Review (3): 537–58 SEC (US Securities and Exchange Commission) 2008 “SEC’s Oversight of Bear Stearns and Related Entities: The Consolidated Supervised Entity Program.” Report No 446-­A ——— 2016 “SEC Enforcement Actions: Addressing Misconduct that Led to or Arose from the Financial Crisis.” Last modified January 14, 2016 http://www.sec.gov/spotlight /enf-­actions-­fc.shtml Selgin, George 2013 “Misunderstanding Financial History.” Alt-­M: Ideas for an Alternative Monetary Future, July 11 http://www.alt-­m.org/2013/07/11/misunderstanding-­financial -­history/ Serkin, Christopher 2005 “The Meaning of Value: Assessing Just Compensation for Regulatory Takings.” Northwestern University Law Review 99 (2): 677–742 SIGTARP (Special Inspector General for the Troubled Asset Relief Program) 2009 “Factors Affecting Efforts to Limit Payments to AIG Counterparties.” SIGTARP Report No 10–003 Silva, Joseph W 2015 “Altering the Deal: The Importance of GSE Shareholder Litigation.” North Carolina Banking Institute 19:​109–34 Sjostrom, Jr., William K 2009 “The AIG Bailout.” Washington and Lee Law Review 66 (3): 943–94 ——— 2015 “Afterward to the AIG Bailout.” Washington and Lee Law Review 72 (2): 795– 828 Sorkin, Andrew R 2014 “DealBook: A.I.G Bailout, Revisionists’ Version.” New York Times October http://dealbook.nytimes.com/2014/10/06/a-­i-­g-­bailout-­revisionists-­version /?_r=0 Stanton, Richard, and Nancy Wallace 2011 “The Bear’s Lair: Index Credit Default Swaps and the Subprime Mortgage Crisis.” Review of Financial Studies 24 (10): 3250–80 Stewart, James B., and Peter Eavis 2014 “Revisiting the Lehman Brothers Bailout that Never Was.” New York Times, September 30, A1 Strahan, Philip E., and Basak Tanyeri 2015 “Once Burned, Twice Shy: Money Market Fund Responses to a Systemic Liquidity Shock.” Journal of Financial & Quantitative Analysis 50 (1/2): 119–44 Taylor, John B 2009 “The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong.” NBER Working Paper Series No 14631 Tschinkel, Sheila 2015 “Congress Auditing the Federal Reserve is a Truly Frightening Idea.” Quartz, March 13 http://qz.com/362155/congress-­auditing-­the-­federal-­reserve-­is-­a -­truly-­frightening-­idea/ Tucker, Paul 2014 “The Lender of Last Resort and Modern Central Banking: Principles and Reconstruction.” In Re-­thinking the Lender of Last Resort, BIS Papers No 79, 10–42 US Department of the Treasury 2008 “Treasury Announces Guaranty Program for Money Market Funds.” Press release, September 19 https://www.treasury.gov/press-­center/press -­releases/Pages/hp1147.aspx ——— 2009a “Commitment to Purchase Financial Instrument and Servicer Participation Agreement.” https://www.treasury.gov/initiatives/financial-­stability/TARP-­Programs /housing/mha/Documents_Contracts_Agreements/bankunited_Redacted.pdf ——— 2009b “Treasury Department Releases Details on Public Private Partnership In- 208 * Reference s vestment Program.” Press release, March 23 https://www.treasury.gov/press-­ center /press-­releases/Pages/tg65.aspx ——— 2009c “Public-­Private Investment Program.” White paper, March 23 https://www treasury.gov/press-­center/press-­releases/Documents/ppip_whitepaper_032309.pdf Veronesi, Pietro, and Luigi Zingales 2010 “Paulson’s Gift.” Journal of Financial Economics 97 (3): 339–68 Vyas, Dushyantkumar 2011 “The Timeliness of Accounting Write-­Downs by U.S Financial Institutions During the Financial Crisis of 2007–2008.” Journal of Accounting Research 49 (3): 823–60 Wall Street Journal 2008 “Paulson’s Bazooka: A Weapon to Be Remembered?” Real Time Economics (blog), Wall Street Journal, September 24 http://blogs.wsj.com/economics /2008/09/24/paulsons-­bazooka-­a-­weapon-­to-­be-­remembered/ Wall, Larry D 2014 “Have the Government-­Sponsored Enterprises Fully Repaid the Trea‑ sury?” Federal Reserve Bank of Atlanta: Notes from the Vault, March https://www.frbatlanta org/cenfis/publications/notesfromthevault/1403.aspx Wallach, Philip A 2015 To the Edge: Legality, Legitimacy, and the Responses to the 2008 Financial Crisis Washington, DC: Brookings Institution Press Wallison, Peter J 2015 Hidden in Plain Sight: What Really Caused the World’s Worst Financial Crisis and Why It Could Happen Again New York: Encounter Washington Post 2008 “The Breakdown of the Final Bailout Bill.” Washington Post, Sep‑ tember 28 http://www.washingtonpost.com/wp-­ dyn/content/article/2008/09/28/AR 2008092800900.html Wessel, David 2009 In Fed We Trust: Ben Bernanke’s War on the Great Panic New York: Crown Business White, Lawrence H 2013 “The Federal Reserve and the Rule of Law.” Testimony before the House Committee on Financial Services, September 11 http://www.cato.org/publica tions/testimony/federal-­reserve-­rule-­law White, Lawrence J 1992 The S&L Debacle: Public Policy Lessons for Bank and Thrift Regulation New York: Oxford University Press Wojtowicz, Marcin 2014 “CDOs and the Financial Crisis: Credit Ratings and Fair Premia.” Journal of Banking & Finance 39 (February): 1–13 YCharts 2016a “Fannie Mae (FNMA) Income Statement.” Accessed July http://finance yahoo.com/q/is?s=FNMA+Income+Statement&annual ——— 2016b “Federal Home Loan (FMCC) Income Statement.” Accessed July http:// finance.yahoo.com/q/is?s=FMCC+Income+Statement&annual Zaring, David 2014 “Litigating the Financial Crisis.” Virginia Law Review 100 (7): 1405– 81 Zywicki, Todd 2011 “The Auto Bailout and the Rule of Law” National Affairs (Spring): 66–80 Index Page numbers in italics refer to illustrations adjustable-rate mortgages, increasing availability of, 26, 27 Administrative Procedure Act (APA), 115 Amen v City of Dearborn, 155, 157, 158, 159, 162 American International Group (AIG), before and leading up to crisis of 2007–8, 76–81; AIG Financial Products (AIG FP), 75; collateral calls by Goldman and other firms, 79–80, 99, 100; exit from CDS market in 2005, 75, 94; holding company oversight by Office of Thrift Supervision (OTS), 79; involvement in CDS market, 75, 76–77; posting of cash collateral on CDOs, 77; purchase by insurance subsidiaries of residential MBSs using proceeds of securitieslending business, 77–78, 94, 191n4; securities-lending business, 75, 192n7; subsidiaries regulated by state insurance commissions, 79; was refused aid from Fed in summer of 2008, 80 American International Group (AIG), rescue of: Credit Agreement, 82, 86, 88, 89; emergency loan from Fed in return for 79.9 percent of equity, 4, 44, 52, 61, 75, 81–82; Fed’s establishment of special-purpose vehicle (Maiden Lane II) to finance purchases of MBSs from insurance subsidiaries, 61, 82; Fed’s establishment of special-purpose vehicle (Maiden Lane III) to buy underlying CDOs insured by AIG, 61, 74, 82, 86, 88, 89, 99–101, 115, 168; government ability to gain control over, after failure to rescue Lehman, 8, 124, 159; government use of as conduit for macroeconomic support, 124; and moral hazard, 94–95, 159; reasons for Fed’s actions, 81; reverse stock split, 83, 86, 88, 89, 192n10; Treasury investment of TARP funds in AIG, 76, 82, 193n26; trust agreement, 83 American International Group (AIG), results of rescue: conclusion of solvency of AIG during crisis, 84, 192n24; critics’ labeling of rescue as “backdoor bailout,” 82; joint profit of $22.7 billion earned by Fed and Treasury on rescue, 84; lawsuit against government agencies (see Starr International, lawsuit against US government); lessons from, 101–2; public assumption that AIG acted recklessly, 78; public demand that government refuse to honor AIG’s commitments to pay employee bonuses, 99 210 * Index Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF), 61–62 asset-backed securities (ABSs), 16 assets: fundamental value of, 96, 102, 117, 123; “real” and “market” values, distinction between, 21, 48–50, 65, 109, 163; and value of during a liquidity crisis, 24, 48, 80, 118, 122, 141, 142, 179, 183 auto dealers, takings claims against government, 126–27, 143–45, 164 auto manufacturers (GM and Chrysler): and financial crisis, 129–30; recovery from crisis, 135 See also Chrysler bankruptcy; General Motors (GM) auto manufacturers (GM and Chrysler), rescue of, 126, 128, 130–32; benefits of creditors from TARP investments and Fed loans, 142, 146; bridge loans from government, 130–31; cash-for-clunkers plan, 146; claims of government use of lending power to redistribute wealth from disfavored to favored constituencies, 148–49; government demand for restructuring of operations, 131–32; government insistence on transfers to workers, 126, 136; government loss of money on, 135–36; justifications for, 134–36; legality of use of TARP funds for rescue, 145–46; and question of holding auction, 139–41; and rights of creditors, 5, 136–39; 363 transactions, 137–39; undervaluing of assets during crisis, 142 See also Chrysler bankruptcy; General Motors (GM) automobile industry, US: decline of, 127, 127–29; manufacture of nearly 95 percent of cars sold in US in 1950s by Detroit Three (GM, Ford, and Chrysler), 127–28; and oil crisis of 1973, 128; recovery of, 134–36 Auto Task Force, 131, 133, 137, 145 Badawi, Adam, 115–16 Bagehot, Walter: inadequate guidance for financial crises, 178; Lender of Last Resort (LLR) principles, 41, 46–51, 63, 101, 183; Lombard Street, 46; and penalty rate, 189n6; and requirement of evenhandedness, 149 bailouts: broad definition of, 2; need to be formulated and embodied in law, 36; problem of hoarding of cash by firms that receive emergency funds, 7; pure types of liquidity support versus support of insolvent institutions, 3; reluctance of firms to receive emergency funds because of stigma, 7, 43; vs liquidity support, 158 bailouts of 2007–8 See American International Group (AIG), rescue of; auto manufacturers (GM and Chrysler), rescue of; GSEs (government-sponsored entities), rescue of Bair, Sheila, 5, 168, 170–71, 195n6 Baker, Dean, 39 bank holding companies (BHCs), risk management of, 30–31 banking system: and banking networks, 12–13; division into savings and loans and commercial banks, 14; and financial regulatory system, 13, 32–33; fragility of, 11, 18–19; and generation of economic value, 11; and government guarantee of deposits, 13, 14 (see also FDIC [Federal Deposit Insurance Corporation]); and Lender of Last Resort (LLR) function, 13; and process of maturity transformation, 11, 18–19; and runs on banks, 12 See also financial institutions Bank of America, 22, 42, 95; bailout package for, 46; settlement with Department of Justice for wrongdoing arising from crisis, 78 Bank of England, 47 bankruptcy law, 132–33, 139–41; absolute priority rule, 132, 143; and liquidity crisis, 141–43; proceedings for liquidation and extension of rights to all stakeholders, 126, 137; sub rosa rule, 141; and 363 transactions, 139–41 Barclays, 22 Bear Stearns: federal rescue of, 4, 39, 40, 50, 51, 98–99, 167; liquidation of hedge funds in 2007, 41 Bernanke, Ben, 10; acknowledgment of high housing prices before the crisis, 19; and Bagehot principles, 46, 93; call on Congress to help with crisis, 45, 66–67; claim that legal restrictions prevented Fed from rescuing Lehman, 65; facetious apology on behalf of Fed for Great Depression, 35; and FDIC during crisis, 168; and Fed’s security require- Index  * 211 ment, 64–65; and Lehman, 66, 167; management of crisis response, 5, 50; perception of role of LLR, 168–69; and rescue of AIG as “windfall” for shareholders, 157; testimony in Starr lawsuit against government, 94, 96, 97 Bignon, Vincent, 51, 189n6 Black, Justice Hugo, 152 BlackRock, 50 BNP Paribas redemptions, 38, 42, 57 Borges, Jorge Luis, 10 Born, Brooksley, 33 Boyd, Roddy, 80 Bretton Woods era, 27–28 British Bankers Association, 23 Bush administration, 108, 130, 167, 171 capital adequacy rules/capital requirements, 33–34, 174, 175 capital controls, 27–28 capitalism, and financial instability, 36–37 Capital Purchase Program (CPP), 46, 74 Casey, Anthony, 115–16 cash-for-clunkers plan, 146 Cerberus, 133 Cheng, Ing-Haw, 31 Chrysler bankruptcy, 132–33; and Chrysler Financial, 146; “New Chrysler,” 133 Chrysler rescue See auto manufacturers (GM and Chrysler), rescue of Citigroup, 22, 78, 95, 170; bailout package for, 46; effects of repo market on, 188n9 Clinton, William Jefferson (Bill), 32 collateralized debt obligations (CDOs), 16; AAA-rated, 76–77; CDO-squared, 29; decline in market value due to liquidity crisis, 41, 75, 80–81, 81; dependence on housing values being uncorrelated, 19; ratings of, 31–32 commercial and investment banks: customers’ withdrawal of funds from, 23; cuts in interbank lending, 22–23; heavy borrowing in repo market, 22; packaging of subprime mortgages into CDOs, 78 Commercial Paper Funding Facility (CPFF), 46, 62–64 Commitment to Purchase Financial Instrument and Servicer Participation Agreement, 69 Community Reinvestment Act (CRA), 25 Congress: and Emergency Economic Stabilization Act (EESA), 8; pressure for use of TARP funds on foreclosure relief, 169–70; requirement that GSEs expand mortgages to low-income home buyers, 25; restrictions on LLR as result of financial crisis, 175 (see also DoddFrank Act) Continental Illinois, 39 Countrywide, collapse of, 42 credit default swap (CDS): and AIG FP, 75; and counterparty risk, 16, 28; and decline in underwriting standards, 29; role in financial crisis of 2007–8, 16–17, 29 credit-rating agencies: downgrading of mortgage-backed securities (MBSs), 41; inaccurate ratings of structured bonds, 18, 31–32 credit rationing argument, in government’s defense of actions, 96–97 credit risk argument, in government’s defense of actions, 95–96 currency swaps of 1940s and 1950s, 27–28 Daimler, 133 Debt Guarantee Program (DGP), under TLGP, 70–71 debtor-in-possession (DIP) financing, 132 DeMarco, Edward, 115 deposit insurance, 33 See also FDIC (Federal Deposit Insurance Corporation) deregulation, 32–34 derivatives, 30 Detroit Three (GM, Ford, and Chrysler), manufacture of nearly 95 percent of cars sold in US in 1950s, 127–28 Deutsche Bank, 22 discount-window lending, 51, 56, 190n10 Dodd-Frank Act, 173–75; and curtailing of agency powers to rescue troubled institutions, 1, 173–75; elimination of OTS, 179; and ex ante regulations, 174; and Financial Stability Oversight Council (FSOC), 174, 179; and moral hazard theory, 181; restrictions on the Fed, 56– 57; restrictions on the LLR, 8, 183; and too-big-to-fail institutions, 53–54; and Volcker rule, 174 dot-com bubble, 20 Drexel Burnham Lambert bankruptcy, 53 due process clause, of US Constitution, 212 * Index due process clause (continued ) 88 See also Starr International, lawsuit against US government Ellul, Andrew, 30–31 Emergency Economic Stabilization Act (EESA): authorization of Treasury to spend $700 billion to rescue financial system, 45–46, 56, 73, 169, 171; discretion granted to Treasury, 67, 68; and TARP loans to automobile companies, 131, 145–46, 194n19 Engelmayer, Judge Paul A., 125 “equity kickers,” 93–94 ex ante regulation, 174, 176–77, 182; and ex post response, 176, 180, 182 Exchange Stabilization Fund (ESF), 68 “Failing to End ‘Too Big to Fail’: An Assessment of the Dodd-Frank Act Four Years Later,” 174 fair value accounting, and financial crises, 80, 192n6 Fannie Mae (Federal National Mortgage Association), 15; authorized by Treasury to pay loan servicers to modify mortgage contracts in favor of homeowners, 69; conversion to private company in 1968, 104; market capitalization on July 1, 2008, 193n9; original purpose of supporting depressed housing industry in 1938, 104 See also GSEs (government-sponsored entities) FDIC (Federal Deposit Insurance Corporation): conversion into a general LLR that can rescue any company, 72; creation of Temporary Liquidity Guarantee Program (TLGP), 70–72, 168; guarantee of all of Wachovia’s creditors, 45; illegal participation in public-private investment program, 72–73; lawbreaking during crisis, 6, 70–73; no jurisdiction over nonbanks before Dodd-Frank, 57; refusal to pay off Washington Mutual creditors not covered by insurance, 45; role as preserver of deposit insurance fund and supervisor of banks, 57, 72; takeover of Indy Mac, 44 Federal Deposit Insurance Act, section 13(c), 71–72 Federal Deposit Insurance Corporation Improvement Act of 1991, 190n11 Federal Home Loan Banks, 58 Federal Housing Finance Agency (FHFA), 104, 108, 109, 114–16, 118, 170 Federal Reserve Act: amended by DoddFrank Act, 174; authority of Fed to address problems in shadow banking system under section 13(3), 59; authority of Fed to adjust the target federal funds rate by trading securities on the open market under section 14, 58; authority of Fed to make emergency loans to banks under section 10B, 56–57, 86; authority of Fed to make emergency loans to nonbanks under section 13(3), 90; authority of Fed to make loans to anyone during emergencies under section 13(3), 93, 96, 169; constraints on Fed in section 13(3), 98; lack of explicit authorization of Fed to own equity in a firm, 93 Federal Reserve Bank of New York (FRBNY ): and Bear Stearns loan, 59; belief of some officials that Lehman was solvent, 66; constraints on emergency loans under section 13(3) of Federal Reserve Act, 98; loan to Maiden Lane III, 99–100; power to issue emergency loans in crisis conditions to nonbank institutions under Section 13(3), 86; recipient of large profits from Maiden Lane transactions, 100 Federal Reserve Board, and financial crisis of 2007–8: and Bagehot tradition, 51, 57; claim that legal restrictions prevented rescue of Lehman, 65–67; conversion from LLR into asset buyer and insurer of last resort, 51; criticized for encouraging recklessness, 53; criticized for failure to rescue Lehman, 35; criticized for inflationary monetary policy leading to crisis, 35; cutting of discount rate and purchase of government securities, 42; line of credit to money market mutual funds, 45; made credit available to nonbanks as well as banks, 2, 4; made customized loans to specific firms, 2, 4, 7; program to buy MBSs backed by GSEs, 46, 112 See also Lender of Last Resort (LLR) function Federal Reserve Board and the law, actions stretching or violating the law during crisis, 59–64; acceptance Index  * 213 of low-rated or unrated collateral through PDCF, 60–61; actions involving Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility (AMLF), 61–62; actions involving Commercial Paper Funding Facility (CPFF), 62–64; actions involving Money Market Investor Funding Facility (MMIFF), 62; purchasing rather than lending against toxic assets, 5–6, 60, 61; question of emergency loans “secured to the satisfaction” of the Fed, 60, 63–65; and special-purpose vehicle (SPV), CPFF LLC, 62–63; and special-purpose vehicle (SPV), Maiden Lane, 59–61; and special-purpose vehicles (SPVs), Maiden Lane II and Maiden Lane III, 61, 74, 84; taking of AIG equity in return for loan, 5, 52, 61 See also financial crisis of 2007–8, and the law Federal Reserve Board and the law, actions within its authority during crisis, 57–59; lowering of interest rate for discountwindow loans and extension of term of loans, 57; lowering of target federal funds rate, 57–58; and Primary Dealer Credit Facility (PDCF), 44, 59; and Term Asset-Backed Securities Loan Facility (TALF), 61; and Term Auction Facility (TAF) for auctioning off of emergency loans, 43, 58; and Term Securities Lending Facility (TSLF), 43, 59 See also financial crisis of 2007–8, and the law Federal Saving and Loan Insurance Corporation (FSLIC), 166 Fiat, 133 financial crises: almost always lead to recessions, 24; and collapse of credit market, 161–62; and need for more power for regulators, 173; and principles of fair market accounting during, 80; as psychological phenomena, 176; as temporary disruptions in markets, 163; theories of causation, 23–24, 35–36, 188n19 financial crisis of 2007–8: bankruptcies of subprime mortgage lenders, 41; BNP Paribas redemptions, 38, 42; downgrading of mortgage-backed securities (MBSs), 41, 43; during fall 2008 to winter 2009, 44–46; government takeover of GSEs, 44; Lehman bankruptcy, 7, 21, 40, 44; from mid-2007 to mid-2008, 41–44; run on money market mutual funds, 44; spread to commercial banking system, 44; takeover of Merrill Lynch by Bank of America, 44 See also Federal Reserve Board, and financial crisis of 2007–8 financial crisis of 2007–8, and the law: difficulties caused by legal division of authority between government agencies, 56; gaps in authority of government agencies, 73–74; government ability to gain control of hybrid public-private entities, 7–8; government agencies’ evasion of or disregard for the law in some of the rescue actions, 8, 55; government agencies’ lack of sufficient power to rescue the financial system, 8; government agencies’ use of power as debtorin-possession financier to manipulate payoffs, 70; “regulation by deal,” 74; violations of law, 5–6 See also GSEs (government-sponsored entities), litigation resulting from rescue; Starr International, lawsuit against FRBNY; Starr International, lawsuit against US government; specific government agencies financial crisis of 2007–8, causes and nature of: and capitalism and globalization, 36–37; and deregulation, 32–34; failure of experts to predict, 37–40; failure of financial institutions due to subprime mortgages and mortgage-related securities, 24; feedback loop in asset prices, 21–22; hoarding of cash by financial institutions, 7, 22; and housing policy, 25–27; and interaction between housing bubble and financial activity, 19–23; and mismanagement of financial institutions, 30–32, 37; mistakes by the Fed and other government agencies, 34–36; nature of crisis, 19–25 See also financial innovation and derivatives; financial system, transformation of; politics, constraints on Federal agencies during crisis financial crisis of 2007–8, public response to: belief that taxpayers were the victims of bailouts, 6, 51–52; lack of awareness that government made money, 214 * Index financial crisis of 2007–8 (continued ) 3–4; perception that Fed made loans to insolvent firms, 4; perception that government supported firms that acted recklessly, 4, 52; perception that Wall Street firms received more favorable treatment than other firms, financial crisis of 2007–8, results of: Congressional restrictions on LLR, 175 (see also Dodd-Frank Act); enforcement actions against entities and individuals for wrongdoing, 78; fines paid to government by ratings agencies, 79; government gain of billions of dollars, 3–4, 52, 76; Great Recession of 2007–9, 25, 46; Orderly Liquidation Authority (OLA), 175; political damage due to legal violations by government agencies, 8; possible government liability for damages from legal violations, 8; and reform, 173–83; settlements made by major banks to government and plaintiffs in private litigation, 78–79 financial innovation and derivatives, 27–30; currency swaps of 1940s and 1950s, 27– 28; interest rate swaps and credit default swaps, 28, 29; lack of awareness by economists and investors of threat to financial system, 29–30, 33; opacity of the derivatives market, 33, 166; and regulatory arbitrage, 37 See also collateralized debt obligations (CDOs); credit default swap (CDS); mortgage-backed securities (MBSs) financial institutions: mismanagement of, and crisis of 2007–8, 30–32; off-­balance sheet entities, 37; refusal to lend money during crisis, 58, 96; reluctance to receive emergency funds because of stigma, 7, 43, 124, 172, 178; securitization, 37; “securitization agents,” 31 Financial Institutions Reform, Recovery, and Enforcement Act, 150 financial networks, “robust-yet-fragile,” 30 financial regulatory system, 13, 32–33; failure to maintain capital requirements for financial institutions, 33–34; lack of understanding of changes in finance, 33 Financial Stability Oversight Council (FSOC), 174, 179 financial system, classical: banking as backbone of, 11 See also banking system financial system, transformation of, 10–19; and changing needs of borrowers and savers, 10; and changing technology, 10; costs for financial institutions created by legal structure, 10; and creation of new risks of financial crisis, 11; and problems of overregulation, 13–14; and response to demand for highly liquid and safe assets, 14; transformation within the industry, 14 Fink, Larry, 50 Flandreau, Marc, 51, 189n6 “flippers,” 19–20 Ford, 129 Frame, W Scott, 112–13, 118 Frank, Barney, 173 Freddie Mac (Federal Home Loan Mortgage Corporation), 15; created to provide competition to Fannie Mae, 105; market capitalization on July 1, 2008, 193n9 See also GSEs (governmentsponsored entities) Friedman, Milton, 34–35 Fuld, Richard, Jr., 64 Fuster, Andreas, 112–13, 118 Garn-St Germain Depository Institutions Act, 166 Geithner, Timothy: and abnormal returns of firms with ties to, 102; on AIG deal, 75, 95, 101; and auto-rescue task force, 194n5; and Bagehot principles, 93; and Bear rescue, 50; claim that AIG needed to be punished for reckless behavior, 94; Congressional questioning of, 5; disagreement with Bair over sale of Wachovia, 170–71; and Dodd-Frank, 174; and FDIC, 168; and FHFA, 170; and Lehman bankruptcy, 65, 190n27, 191n28; under pressure from Congress to use TARP funds on foreclosure relief, 169–70; on probability of financial crises, 175; and rescue of GSEs, 115 General Accounting Office (GAO), 71–72 General Motors (GM): Ally Financial, 146; bankruptcy, 133–34; insolvency, 133–34, 135; “New GM,” 134; return to profitability after crisis, 129 See also auto manufacturers (GM and Chrysler), rescue of Glass-Steagall Act, 32 Goldman Sachs: became bank holding Index  * 215 company, 45; collateral calls against AIG, 99–100; effects of repo market on, 188n9 Goolsbee, Austan D., 135 Gorton, Gary B., 188n19 Gramm-Leach-Bliley Act, 32–33 Great Depression: blamed on speculation in stock market, 34; caused by failure of Fed to increase money supply, 34; and idea that the LLR should be limited to banking system, 48; and subsidized housing, 25 Greenspan, Alan, belief that financial innovation improved stability, 33 GSEs (government-sponsored entities): contribution to financial crisis, 103, 107–8; entry into subprime market, 25, 107; financing of activities by selling debt to public, 103–4; increase in share of mortgage market, 105; losses in second half of 2007, 108; market share of residential mortgage debt outstanding, 106, 108; not permitted to invest outside of real estate, 106; partisan political support, 107; public purpose of facilitating mortgage lending, 103, 104; required to subsidize safe loans for most of history, 107; securitization of mortgages, 105; and underwriting standards for mortgages, 25–26, 105; viewed as “too big to fail,” 106 GSEs (government-sponsored entities), litigation resulting from rescue: claims of plaintiffs, 113–14; lessons, 122–25; and the net worth sweep, 114, 120–22; procedural irregularities, 114–16; and questions of solvency, 117–18, 122–23; and September 2008 credit transaction, 117–20; and takings claim, 121–22, 194n21 GSEs (government-sponsored entities), rescue of, 108–12; government power to maintain and operate indefinitely, 113; government restrictions on ability of stakeholders to sue, 113; government use of as conduits for macroeconomic support, 124; justification of rescue, 112–13; litigation by shareholders, 113–14; loss by shareholders of nearly all value of shares, 104; “net worth sweep” by Treasury, 5, 104, 109–11, 113, 114; parallels to AIG bailout, 122; payments received from Treasury as of January 2017, 111; placed in conservatorships by FHFA, 44, 104, 108, 114, 117; recovery in 2013, 111 Home Affordable Modification Program (HAMP), 68 homeowner relief programs, 172–73, 181 Housing and Economic Recovery Act (HERA), 108, 113, 114–16, 167 housing bubble of 2007–8: economists’ predictions of effects of bursting, 39; historically unprecedented, 20; and interaction with financial activity as cause of financial crisis, 19–23; peak of in 2006, 41 housing policy, and excessive mortgagebased consumer debt, 25–27 housing price variations: investor betting against, 38; “real” sources of versus psychological factors, 19–20 illegal exaction, 90–91 IndyMac, collapse of, 44 interest rate swaps, 28, 29 Johnson, Simon, 171–72 JP Morgan, 22, 98–99, 190n16 “just compensation,” and takings clause, 151 Klier, Thomas, 128 Krueger, Alan B., 135 Kwak, James, 171–72 Lamberth, Judge Royce C., 120–21 Laufer, Steven, 27 Laux, Christian, 192n6 Lehman bankruptcy of September 15, 2008, 7, 21, 40, 44, 112, 130; government’s failure to rescue, 8, 35, 39, 51, 55, 65–67, 124, 157, 167, 190n27, 191n28; loans from Fed under PDCF, 65–66; political and operational reasons for government allowing failure, 66–67 Lender of Last Resort (LLR) function, 1–2, 33, 37; ability to make loans without raising capital, 52; Bagehot principles governing during liquidity crisis, 46–48, 149; and banking system, 13; classic loan during a financial crisis, 2–3; conventional view that loans 216 * Index Lender of Last Resort (LLR) function (continued ) should go to banks only, 4; insufficient authority to address the financial crisis, 8, 165; and interest rate during liquidity crisis, 95; law of, 56–57; and moral hazard theory, 48, 51, 181–82; need for authority to force firms to borrow and to enter financial transactions during liquidity crisis, 178; quasi-monopoly over credit during liquidity crises, 52; shared by Fed and FDIC, 56; too slow to react to financial crisis of 2007, 178; underreaction to liquidity crisis of 1930s, 178; use of power to limit political opposition to actions during crisis, See also Dodd-Frank Act; reform Leuz, Christian, 192n6 Lewis, Michael, The Big Short, 38–39 LIBOR benchmark, 23, 42, 188n10 Liddy, Ed, 82, 102 liquidity crisis: asset valuation during, 24, 48, 80, 118, 122, 141, 142, 179, 183; and Bagehot principles, 46–49, 149; and bankruptcy law, 141–43; effect on price of AAA-rated subprime mortgages packaged in 2006, 80–81, 81; financial crisis of 2007 as, 24; government as credit monopolist, 116, 141–42, 147; interference with normal bankruptcy procedure, 139; and market value of collateralized debt obligations (CDOs), 41, 75, 80–81, 81; as an unraveling over time, 43 See also Lender of Last Resort (LLR) function Lockhart, James, 115 Long-Term Capital Management, 39 Maiden Lane, 59–61 Maiden Lane II, 61 Maiden Lane III: purchase of CDOs from AIG’s counterparties, 61, 74, 99–100; removal of CDOs from portfolios of financial institutions to be sold off when market recovered, 101; special-purpose vehicle established by Fed to buy underlying CDOs insured by AIG, 61, 74, 82, 86, 88, 89, 168; use of funds to settle AIG’s CDSs, 100 McCain, John, 167 McDonald, Robert, 84, 95, 192n24 Merrill Lynch, takeover of by Bank of America, 44 MetLife, 78, 189n14 Mian, Atif, 27, 171, 172–73, 181, 194n9 Minsky, Hyman P., 37 Money Market Investor Funding Facility (MMIFF), 61, 62 money market mutual funds: and collapse of Countrywide, 42; heavily invested in debt of investment banks, 21 monoline insurance companies, 16, 43 moral hazard: and AIG rescue, 94–95, 159; charge of against bailouts, 4–5, 175–76; and LLR function, 48, 51, 181–82 Morgan Stanley: became bank holding company, 45; effects of repo market on, 188n9 mortgage-backed securities (MBSs), 15–16; decline in ratings of, 41, 43; decline in sales of, 20–21, 41; priced using mathematical models, 18, 20, 28–29 Nader, Ralph, 128 “net worth sweep,” 109–10 New Century Financial, bankruptcy of, 41 9/11 attacks, emergency powers and, 159–60 Obama, Barack, 1, 130, 147, 167, 168, 174 Occupy Wall Street, Office of Federal Housing Enterprise Oversight, 107 Office of the Comptroller of the Currency: permitted banks to take “equity kickers” in return for loans, 93; primary regulator of national banks and federal S&Ls, 170 Office of Thrift Supervision (OTS), 79, 95; elimination under Dodd-Frank, 179; primary regulator of national banks and federal S&Ls, 170 Orderly Liquidation Authority (OLA), 175, 181 Ordoñez, Guillermo, 188n19 Paulson, Anna, 84, 95 Paulson, Henry, 1, 50, 171; and AIG rescue, 192n24, 193n26; “bazooka” prediction, 44, 108, 121; and Bear Stearns rescue, 98–99, 167; call on Congress to help with crisis, 45, 169; and FDIC, 168; and legal cover for Fed loans, 169; and Index  * 217 Lehman, 65, 66; management of crisis response, 5, 44, 169, 195n4; and rescue of GSEs, 115; testimony in AIG lawsuit, 94, 98; ties to Goldman, 102; wish to avoid “Mr Bailout” label, 66, 165, 167 Paulson, John, 17 penalty rates, 47–48, 50, 95, 101, 189n6, 189n7 Perry Capital LLC v Lew, 115, 120–21 “per se takings,” 151–52 politics, constraints on Federal agencies during crisis, 71, 165–73; and division of authority between government agencies, 56, 170; failure to rescue Lehman due to fears about political reaction, 167; need for more regulatory power in financial crises, 167, 173; opposition of politicians and public to bailouts, 167; and political influence of banks, 171– 72; and populist opposition to “Wall Street,” 168; and Tea Party movement, 168; terms of AIG rescue as reaction to public opinion, 168 Pozsar, Zoltan, 14, 187n4 Primary Dealer Credit Facility (PDCF), 44, 59, 60–61 prime mortgages, and credit crisis, 26, 27, 44, 189n1 Public-Private Investment Funds (PPIFs), 72–73, 168 Raina, Sahil, 31 Rajan, Raghuram, 37, 39, 187n2 Rattner, Steven, 131, 135, 138, 140, 143, 147, 194n5 Reagan administration, and S&L crisis of 1980s, 166 reform: administrative organization of LLR, 180–81; authority needed by LLR, 177–78; centralization and independence of LLR, 181–83; Dodd-Frank Act, 173–75; need to extend LLR into shadow banking system, 181; protections against LLR powers, 178–80 regulatory arbitrage, 10, 14, 37, 196n16; shadow banking system as form of, 18 “regulatory takings,” 151 repo market and transactions, 17–19, 21, 43, 58–59 Reserve Primary Fund, 44 reverse stock splits, 83, 86, 88, 89, 192n10 Roe, Mark, 142 Roubini, Nouriel, 39 “rule of law,” claims of violation against LLR, 182 Schwartz, Anna, 34–35 Securities and Exchange Commission (SEC), response to crisis: enforcement actions brought against entities or individuals for wrongdoing, 78; loosening of capital requirements for broker-­ dealers, 34; use of emergency powers to implement short-sale ban, 170, 196n17 “securitization agents,” 31 shadow banking system, 15, 17–18; engagement in maturity transformation, 19; failure of investors and institutions to see problems of, 33; as form of regulatory arbitrage, 18; growth of from 1990s to 2007, 18; and mortgage-derived securities (MDSs), 18, 19; as source of financial crisis of 2007–8, 2, 58–59 Shiller, Robert, 38, 39 short-term Treasury bond, 17 Skeel, David, 142 S&L crisis of 1980s, 14; caused by bad loans, 23–24; and embarrassment to Reagan administration, 166; Federal refusal to rescue institutions, 3, 4; and Federal Saving and Loan Insurance Corporation (FSLIC), 166; and financial innovations, 29; and Financial Institutions Reform, Recovery, and Enforcement Act, 150; and regulatory forbearance, 187n3; and “supervisory goodwill,” 150; unpopular response of government, 151; and Winstar litigation, 150–51 socialism, 36 Starr International, lawsuit against FRBNY, 76, 84–88; claim that FRBNY violated Delaware protection of shareholders, 83, 84; claim that Maiden Lane III transferred assets from AIG to its counterparties, 85; claim that reverse stock split prevented stockholders from blocking transfer of equity to government, 83, 85; court opinion as expression of deference to government in time of emergency, 87, 98; grounds 218 * Index of court’s rejection of Starr’s argument, 85–87, 162–63 Starr International, lawsuit against US government: claim of illegal extraction, 90–91; claim of violation of unconstitutional conditions doctrine, 89–90; claims of violation of takings clause and due process clause of Constitution, 85, 88–89, 90–92, 102; claim that Fed must use discretion in loans consistent with Bagehot principles, 93; claim that terms of offer were changed after AIG’s acceptance, 81–82; court’s dismissal of unconstitutional conditions claim, 91; court’s holding with Starr on illegal extraction claim, 93, 195n3; government’s credit rationing argument, 96–97; government’s credit risk argument, 95–96; government’s moral hazard argument, 94–95; government’s windfall avoidance argument, 97–98; and Maiden Lane III issue, 99–101; suit’s focus on policy reasons for equity transfer, 92–94; and Tucker Act, 192n17 subprime mortgage market: backloading of mortgage payments, 26; default rates, 22, 27, 28; effect of liquidity crisis on prices, 21, 41, 80–81, 81; effects on credit crisis, 189n1; excessive amount of debt taken on by buyers, 27; little data availability on, 18; offering of adjustablerate mortgages, 27; small part of credit market, 24, 28; violations of underwriting standards, 78; waiving of borrower documentation, 26–27 subsidized housing, 25 Sufi, Amir, 27, 171, 172–73, 181, 194n9 Summers, Larry, 187n2, 194n5 takings clause, of US Constitution: and auto dealers’ claims against government in automaker bailout, 126–27, 143–45; and government discretion over prop- .. .Last Resort Last Resort The Financial Crisis and t h e F u t u r e of Ba i l o u t s Eric A Posner The University of Chicago Press • C h icag o and L on d on The University of Chicago... During and after the financial crisis, Congress grilled the top officials who managed the crisis response These officials included Ben Bernanke, the Fed chief; Timothy Geithner, the president of the. .. who understood the problems in the housing market—anticipated the financial crisis The prices of houses and other assets, like stocks and bonds, are set by the laws of supply and demand Restrictive