What Legal Authority Does the Fed Need During a Financial Crisis

The financial crisis of 2007-2008 exposed gaps in the law that authorizes federal agencies to provide emergency liquidity support. This essay describes the ways in which legal constraints hampered response to the crisis, proposes reforms that would make possible a unified and strong response, and criticizes the Dodd-Frank Act for weakening, rather than strengthening, the crisis-response agencies. During the financial crisis of 2007-2008, the government sought to use aggressive measures to unfreeze the credit markets, but found itself repeatedly blocked by the law. Officials reacted to their legal problems in different ways. During the collapse of Lehman, the Fed refused to issue an emergency loan because of legal hurdles. However, in the cases of Bear and AIG, the Fed violated the law or interpreted it in an extremely narrow way, rather than refrain from the emergency actions that events called for. The Fed and Treasury relied on additional questionable legal interpretations for the numerous credit facilities that they established, and in the bailouts of Freddie Mae, Freddie Mac, General Motors, and Chrysler. In many cases, the agencies evaded the law by engaging in elaborate legal maneuvers that obfuscated their actions. When the Fed and Treasury sought additional legal authority from Congress, Congress initially refused, causing one of the most dangerous moments during the crisis. At the same time, the mainstream view is that most of the government’s actions were good policy. They put an end to a massive liquidity crisis—the worst since the Great Depression, possibly the worst in U.S. history—and spared the country an even more severe downturn than the Great Recession of 2007-2009. Moreover, the failure to rescue Lehman—law or no law— was the Fed’s biggest mistake: the collapse of Lehman introduced the most acute phase of the financial crisis, which until that point seemed manageable. The mismatch between law and policy raises numerous questions. Should the law be updated to permit the policy interventions that the government felt it needed to use? If so, how exactly should the law be changed? It is possible to argue that the law makes little difference. The agencies and their leaders did not pay a price for their legal violations during the crisis; next time around, they may disregard the law again.2 But it is clearly better if the Fed acts lawfully than if it acts illegally. The legal restrictions were not costless. They caused the Fed to act more cautiously than it should have, and have allowed officials to blame their costly failure to rescue Lehman Brothers 1 Kirkland & Ellis Distinguished Service Professor and Arthur and Esther Kane Research Chair, University of Chicago Law School. Thanks to participants at a workshop at the University of Chicago Law School for comments, and to Ethel Amponsah and Hannah Waldman for research assistance. 2 Eric A. Posner & Adrian Vermeule, The Executive Unbound: After the Madisonian Republic (2010); cf. Philip A. Wallach, To The Edge: Legality, Legitimacy, and the Responses to the 2008 Financial Crisis (2015) (arguing that the Fed’s major constraint was that of maintaining legitimacy rather than legality, though the two were related).