Rescue rebuke

A federal judge recently handed down a very odd ruling in one of the few serious legal challenges to the massive bailouts of 2008 and 2009. Shareholders of AIG, the giant insurance company that collapsed in September 2008, sued the U.S. government, arguing the government illegally took control of the company when it bailed out AIG. Judge Thomas C. Wheeler of the U.S. Court of Federal Claims agreed but said the shareholders were not entitled to recover any damages.

Usually when a judge issues a ruling like this—you win, but you don’t get anything—the judge is saying the person who sued is right as a matter of law but never should have sued. I think the message in this case is different. Wheeler’s opinion strongly and rightly criticizes the government’s conduct. He doesn’t seem to think the lawsuit was a mistake at all.

The supposed legal authority for the government’s $85 billion bailout of AIG was a provision that authorizes the Federal Reserve to make loans to troubled financial institutions under extraordinary circumstances. The key word there is “loans.” The AIG bailout didn’t look like a loan at all. The government forced AIG to fork over new stock that gave the government 79.9 percent voting control of AIG in return for the $85 billion (later increased to $182 billion) that kept AIG afloat. This transaction shrank the old AIG shareholders’ interest down to 20.1 percent.

Prior to Wheeler’s ruling, courts had pretended that the government’s behavior during the crisis was perfectly legitimate. When Chrysler and General Motors were bailed out in bankruptcy in 2009, the judges insisted nothing was amiss, even though the Chrysler transaction violated basic bankruptcy principles. In an earlier challenge to the AIG bailout, a federal judge in New York suggested there was no credible basis for questioning the intervention. With Wheeler’s rebuke, a judge has finally acknowledged that the government abused the rule of law during the crisis.

The AIG shareholders won only a moral victory because Wheeler didn’t think the government’s illegal behavior made the shareholders worse off. Without the bailout, AIG probably would have filed for bankruptcy, and Wheeler concluded the shareholders might have lost everything if AIG had not been bailed out. Although Wheeler’s conclusion is defensible, I think he could have given the AIG shareholders at least a portion of the more than $40 billion they asked for. We can’t be absolutely sure the shareholders would have been wiped out in bankruptcy. And the government might not have been willing to let AIG fail, even if it had complied with the law.

Unfortunately, Wheeler’s opinion won’t discourage the government from bailing out giant financial institutions in the future. Some experts are calling for Congress to seize this opportunity to impose more oversight on the Fed. I don’t think it’s either desirable or possible to ban bailouts altogether, and the proposals for shackling the Fed in other ways seem misguided. Making bailouts less necessary is a more realistic goal. Late last year, the House (but not the Senate) passed legislation to make bankruptcy laws better able to handle the bankruptcy of a large financial institution. These changes might help to wean the Fed from its assumption that bailouts are the only option in a crisis.

Even if the AIG decision doesn’t spur Congress to action, at least one federal court was finally willing to admit that the government ran roughshod over the rule of law in 2008-2009. Admitting you have a problem is the first step toward finding a solution.