Congress's Afterthought, Wall Street's Trillion Dollars
Fed's Bailout Authority Sat Unused Since 1991

By Binyamin Appelbaum and Neil Irwin
Washington Post Staff Writers
Saturday, May 30, 2009

On the day before Thanksgiving in 1991, the U.S. Senate voted to vastly expand the emergency powers of the Federal Reserve.

Almost no one noticed.

The critical language was contained in a single, somewhat inscrutable sentence, and the only public explanation was offered during a final debate that began with a reminder that senators had airplanes to catch. Yet, in removing a long-standing prohibition on loans that supported financial speculation, the provision effectively allowed the Fed for the first time to lend money to Wall Street during a crisis.

That authority, which sat unused for more than 16 years, now provides the legal basis for the Fed's unprecedented efforts to rescue the financial system.

Since March 2008, the central bank's board of governors has invoked its emergency powers at least 19 times: to contain the wreckage of Bear Stearns and ease the fall of American International Group, to preserve Goldman Sachs and Morgan Stanley, to limit losses at Bank of America and Citigroup, to lend more than $1 trillion.

The repeated use of the once-dusty law has surprised and alarmed a wide range of people, including economists and members of Congress. It has even raised worries among presidents of the regional banks that make up the Federal Reserve system.

Many critics are concerned that an institution not accountable to voters is risking vast amounts of public money and choosing which companies get help. Others are concerned that the Fed's new role will interfere with its basic responsibility for regulating economic growth.

There is also a question about the roots of the crisis: Did investment banks take greater risks in the past two decades because they knew the Fed could rescue them?

The 1991 legislation, authored by Sen. Christopher J. Dodd (D-Conn.), was requested by Goldman Sachs and other Wall Street firms in the wake of the 1987 market crisis, and it would save some of them a generation later.

Fed Chairman Ben S. Bernanke and other leaders of the central bank have argued that the emergency authority has allowed it to rescue the financial system and that without it, the economy would be in far worse shape. And they argue that they are using the power as Congress intended.

"This provision was designed as a last resort to make sure credit flows when times are tough and credit isn't being extended," said Scott Alvarez, the Fed's general counsel. "That's exactly what it's being used for today."

Rep. Barney Frank (D-Mass.), chairman of the House Financial Services Committee, said that the actions taken by the Fed have been necessary and important but that those actions should have been taken by an agency accountable to voters. He said he was not aware of the Fed's emergency power until September, and he favored removing much of that authority from the Fed once the crisis has passed.

"This is a democracy, and there is a problem with too much power going to an entity that is not subject to democratic powers," Frank said.

Politics of Independence

The Fed, by law and tradition, is insulated from political pressure. Members of its Board of Governors are appointed to 14-year terms, allowing them to take painful, unpopular actions to help the economy.

That independence has become a valuable political tool for the Bush and Obama administrations, which have worked with the Fed to create vast rescue programs outside the reach of Congress. The most recent example is the Fed's agreement to spur up to $1 trillion in new lending by funding the purchase of securitized loans.

"By necessity, the Fed was the institution everybody looked to because they had the balance sheet and the legal authority to act," said Phillip L. Swagel, an assistant Treasury secretary in the George W. Bush administration who is to become a professor at Georgetown University's business school.

But the government's reliance on the Fed has roused critics.

"There's no accountability," said Walker F. Todd, a former economist at the Federal Reserve Bank of Cleveland whose writings raised some of the earliest questions about the 1991 law. "How much power do you want to concentrate in a few people who are not directly accountable to the political process?"

Those criticisms have been heightened by the Fed's refusal to disclose which firms have benefited from many of the emergency programs, such as the names of the companies that have used the Fed's "commercial paper funding facility" to issue short-term debt.

Fed officials argue that disclosure could spark runs on those firms by alerting investors to the depth of their problems.

Legislation pending before Congress would require the Fed to disclose more information. Other bills would impose additional oversight. The mounting political pressure has alarmed some experts, who worry that the autonomy necessary to make monetary policy will be forever damaged.

"What the Fed has done is almost irreparable," said Allan H. Meltzer, a Carnegie Mellon University economist who is a leading historian of the Fed. "It's going to be hard to get them to unlearn it. Now Congress will look to the Fed every time a constituent has a hard time getting a loan."

Without a Net?

The Fed has always served as a lender of last resort for commercial banks.

During the Depression, it was authorized by Congress to lend on an emergency basis to other companies that couldn't get money anywhere else. From 1932 to 1936, it made only 123 loans. A broader program launched in 1936 was more successful, and the Fed would make thousands of loans to businesses before Congress terminated the program in 1958.

The original authority survived, but by then, a new generation of Fed officials had lost the will to lend.

Intermittently, other parts of the government would press the Fed to dust off its powers -- to save the Penn Central Railroad in 1970, to rescue New York City in 1975, to rescue property and casualty insurers in the 1980s -- but in each case, the Fed demurred out of concern for its independence.

Ernest T. Patrikis, former general counsel at the Federal Reserve Bank of New York, recalled that in some cases the Fed went so far as to conduct legal research into its options, but never further than that.

"We always knew about it, but we always knew it would only be used in extreme cases," said Patrikis, now a partner at the law firm White & Case.

The wind shifted in the late 1980s. During the stock market crash of October 1987, some commercial banks had refused to lend money to investment banks. A few years later, the collapse of Drexel Burnham Lambert, then the nation's fifth-largest investment bank, renewed concerns about the absence of a safety net beneath Wall Street.

Rodgin Cohen, a partner at Sullivan & Cromwell, suggested to several of his clients the idea of modifying the 1932 law to allow lending to investment banks, according to people involved in the discussions. Cohen is a legendary figure on Wall Street, building a career as perhaps the preeminent legal adviser on banking mergers, in part through his command of the minutiae of federal regulations.

Dodd, at the time chairman of the securities subcommittee of the Senate Banking, Housing and Urban Affairs Committee, agreed to insert the language into a bill whose primary purpose was to reform the Federal Deposit Insurance Corp., which guarantees commercial bank deposits.

Dodd declined to comment for this story, but at the time, he said the legislation gave the Fed "greater flexibility to respond in instances in which the overall financial system threatens to collapse."

During a meeting to discuss the bill's final language, a representative of the Federal Reserve was asked to comment. Donald L. Kohn, then the director of the Fed's Division of Monetary Affairs, said the agency had no objections, according to people in attendance that day.

The Fed has extensive regulatory authority over commercial banks, to keep them from needing its safety net. But after Dodd's language passed into law, the Fed did not seek new regulatory authority over investment banks, nor did Congress move to provide new authority.

Instead, over the next two decades, federal officials would emphasize that investment banks had an incentive to be cautious because they were operating without a safety net.

'Opening That Window'

Sixteen years later, Kohn, now the Fed's vice chairman, appeared on March 4, 2008, before the Senate Banking Committee. Dodd, now the chairman, asked whether the Fed was considering using its emergency authority to help restore the flow of money through the capital markets. Kohn responded that he "would be very cautious" about lending Fed money to institutions other than banks or, as he put it, "opening that window more generally."

But by then, the Fed already was on the verge of invoking the emergency lending authority for the first time since the 1930s. Fed lawyers had started to dust off past research on the emergency-powers law during the fall of 2007, shortly after the earliest indications that the financial system was breaking down. Initially, the goal was to understand how the power might be used in a crisis, without any specific company or lending program in mind.

By March, however, the Fed was focused on a particular program. Wall Street firms once again were struggling to borrow money. Lenders were charging much higher interest rates if borrowers pledged mortgage-backed securities rather than Treasurys.

On March 11, the Fed's Board of Governors invoked the emergency-powers law for the first time since the Great Depression, allowing firms to swap their securities for Treasurys, preserving their ability to raise money without requiring them to sell the securities at large losses.

The Fed's biggest concern: Invoking a law that could be used only in a financial crisis might deepen the fear in the markets. The answer: The Fed, in its press release announcing the facility on March 11, didn't mention where the legal authority came from.

Three days later, on a bright Friday morning, the Fed governors and staff gathered again in a giant, formal conference room built during the Great Depression. They were bleary-eyed, having stayed up all night grappling with the deterioration of the investment bank Bear Stearns. The markets were soon to open.

Moments later, the four governors present voted unanimously to support the sale of Bear Stearns to J.P. Morgan Chase, breaking the fall of an investment bank for the first time.

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