In light of the Fed sponsorship of AIG to the tune of $85 billion or more at taxpayer risk (See Nationalization of AIG: Treasury to get 80% stake in return for $85 billion), inquiring minds just might be asking “By what authority can the Fed lend to insurance companies?”

It’s a good question given that the Fed is widely thought to be authorized to lend only to banks. It turns out the Fed can lend to pizza parlors if it wants to, with a questionable interpretation of the Federal Reserve Act.

Let’s start by taking a look at the Fed Sponsored AIG Bailout Press Release.

The Federal Reserve Board on Tuesday, with the full support of the Treasury Department, authorized the Federal Reserve Bank of New York to lend up to $85 billion to the American International Group (AIG) under section 13(3) of the Federal Reserve Act. The secured loan has terms and conditions designed to protect the interests of the U.S. government and taxpayers.

The Board determined that, in current circumstances, a disorderly failure of AIG could add to already significant levels of financial market fragility and lead to substantially higher borrowing costs, reduced household wealth, and materially weaker economic performance.

The purpose of this liquidity facility is to assist AIG in meeting its obligations as they come due. This loan will facilitate a process under which AIG will sell certain of its businesses in an orderly manner, with the least possible disruption to the overall economy.

The AIG facility has a 24-month term. Interest will accrue on the outstanding balance at a rate of three-month Libor plus 850 basis points. AIG will be permitted to draw up to $85 billion under the facility.

The interests of taxpayers are protected by key terms of the loan. The loan is collateralized by all the assets of AIG, and of its primary non-regulated subsidiaries. These assets include the stock of substantially all of the regulated subsidiaries. The loan is expected to be repaid from the proceeds of the sale of the firm’s assets. The U.S. government will receive a 79.9 percent equity interest in AIG and has the right to veto the payment of dividends to common and preferred shareholders.

Section 13(3) Explored

Inquiring minds not satisfied with the above press release are looking into Section 13. Powers of Federal Reserve Banks

3. Discounts for Individuals, Partnerships, and Corporations

In unusual and exigent circumstances, the Board of Governors of the Federal Reserve System, by the affirmative vote of not less than five members, may authorize any Federal reserve bank, during such periods as the said board may determine, at rates established in accordance with the provisions of section 14, subdivision (d), of this Act, to discount for any individual, partnership, or corporation, notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal Reserve bank: Provided, That before discounting any such note, draft, or bill of exchange for an individual, partnership, or corporation the Federal reserve bank shall obtain evidence that such individual, partnership, or corporation is unable to secure adequate credit accommodations from other banking institutions. All such discounts for individuals, partnerships, or corporations shall be subject to such limitations, restrictions, and regulations as the Board of Governors of the Federal Reserve System may prescribe.

[12 USC 343. As added by act of July 21, 1932 (47 Stat. 715); and amended by acts of Aug. 23, 1935 (49 Stat. 714) and Dec. 19, 1991 (105 Stat. 2386.]

Five Members Of The Board

Click here to see information about the Fed Board of Governors.

Two positions on the board are vacant. It’s too bad another one isn’t. Although I strongly question the actual intention of section 13(3), a literal interpretation allows the Fed to lend to insurance companies, pizza parlors, casinos, houses of ill repute, or to anyone else the Fed damn well pleases as long as it can muster five votes. Was this really the intent of the bill?

Serious Problem With Regulation

The above points out a serious problem with regulation. The problem is that regulation is never tight enough or it is too tight, or some mind boggling combination of both depending on unique circumstances.

Please remember that is was regulation that created Fannie Mae and Freddie Mac. Also note that regulatory loopholes allowed Citigroup to hide over $1 trillion in off balance sheet SIVs. I am sure the SIV loophole and the creation of Fannie and Freddie seemed innocuous at the time.

When seemingly innocuous regulation can cause such damage, it is imperative to ask if the problem is in the regulation, or if the problem lies in the very existence of the Fed, GSEs, and fractional reserve lending itself.

In light of this fiasco, one can only be terrified of what other loopholes in the Federal Reserve Act that Bernanke may have discovered.

Mike “Mish” Shedlock
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