I’ll return to my previously scheduled programming (about Treasury’s audacious money market fund rescue) next time, and spend this post returning Peter’s fire on the question of the Fed’s role in Lehman’s demise and clarifying what exactly we disagree about. We do have somewhat divergent views about the Fed’s crisis powers, but at some points I think we’ve been talking past each other or getting hung up on semantics.

On the meaning of the law, it looks like we’ve been misunderstanding each other. Contrary to my earlier assertion, Peter does not think that the Fed can give out loans that it believes will never be repaid under its § 13(3) emergency lending power. Rather, we seem to agree about what the “satisfaction” language is doing there. As usual, Peter is very helpful in reminding us that the Fed is a cluster of entities rather than a monolith, and so the operative actors here are the Board of Governors (who must sign off on all § 13(3) actions) and the relevant Federal Reserve Bank—in the case of Lehman Brothers, the Federal Reserve Bank of New York (FRBNY). And it is the Federal Reserve Bank that must be satisfied by the adequacy of the collateral offered to secure the loan. We further agree that the statute doesn’t offer a specific recipe for satisfaction but instead leaves such determinations to the discretion of the reserve bank.

Here is where we differ: I read that discretion as limited to making a good faith judgment of the facts. This is not a narrow or trivial function: Congress has given its agent the responsibility of making sense of fast-moving financial crisis realities, because the legislature (sensibly) assumes that it could offer no formulaic rule for understanding collateral adequacy in crises. But merely because discretion in understanding the world enters into things does not mean law drops out. Law still constrains: the reserve bank is not given discretionary power tout court, or even discretionary power checked only by internal governance (as Peter argues later in his post). There is a legal proscription on loans that the bank judges are inadequately secured and therefore likely to end in losses.

I’m not sure Peter would disagree with this, exactly, but it seems he thinks it becomes pretty meaningless in the midst of a systemic crisis. Why?

First, the reason the systemic crisis exists at all is because the line between illiquidity and insolvency has become a mirage. And second, whatever line is left is endogenously determined: what the central bank does in response to the crisis has immediate consequences on both liquidity and solvency.”

…

The point is that “satisfaction,” in the midst of a financial crisis, is an entirely discretionary concept.

If I’m understanding him correctly here, Peter means to put in the Fed’s mouth some version of an infamous 2004 pronouncement of a Bush administration aide: “when we act, we create our own reality.” Amidst the chaos of crisis, it is for the Fed to decide which firms are solvent and which kinds of assets are really valuable as collateral and, whatever they decide, the markets will follow, allowing the central bank to benefit its own balance sheet and the larger financial system through self-fulfilling optimistic prophecy. As they forge this new reality, making the security on loans satisfactory to themselves will be the least of their miracles.

Teasing aside, I think that’s far from crazy, but one can get carried away. It can’t be the case that the Fed is capable of rescuing any institution through this kind of heroic thinking: if a firm is in a downward spiral, and the only collateral it has is rotten, then the Fed does not have the legal authority to funnel money into it. Doing so would require making a bad faith judgment about the loan’s security—in other words, treating the § 13(3) statute as a gateway into a world of pure discretion without any regard for the facts on the ground.

So what about Lehman Brothers specifically? Does it fit into the last paragraph’s generic description of a firm beyond saving? This is what the Fed has argued, when it says that it found itself legally unable to offer Lehman Brothers any help. Peter’s critique is that this is an incoherent claim, almost a category error, given his understanding of how § 13(3) empowers the Fed as a discretionary and indeed transformative actor in crises. Under my understanding of the statute, though, the claim that the Fed ran into legal constraints is perfectly coherent and possibly true.

Only possibly, though, for two reasons. First, there is the question of whether the FRBNY’s judgment of the facts was good. If you ask Dick Fuld, the Fed was craving a big carcass to deliver to the public to show them that moral hazard had not run rampant, and Lehman ended up treated scandalously unfairly as a result. If you believe the New York Times account, there were staffers within the FRBNY itself who were prepared to vouch for the quality of Lehman’s assets and the bank’s survival chances, and their information was not incorporated into the ultimate decision—a real failure of the institution’s ability to form a sound judgment under time pressure. And so for all I know Fuld could be right, and the Fed’s judgment might have been made in bad faith. Based on my priors and assessments of the character of the principal actors involved I doubt it, but it will take the work of some historian far better versed in the factual record than I am to render a definitive judgment.

Second, while I think there really must be clear-cut cases in which a reserve bank could make an easy judgment about a firm’s ability or inability to adequately secure a loan, there must also be a gray area. In these intermediate cases, central bankers must weigh risks just as regular bankers do, and I suppose one could argue that as the Fed looked to the wider political context as it weighed the risks of helping Lehman it was engaging in thinking that wasn’t really legal at all.

Fair enough, and perhaps I am idiosyncratic in my willingness to see legal and policy and political considerations as often inextricable. But here is how I would put it. On September 14, when they decided they couldn’t help Lehman, the Fed’s officials allowed their legal constraints to weigh heavily upon them. Those constraints were a big part of their thinking in deciding not to offer direct support (remembering that they were willing to provide some kind of indirect support through loans to a purchaser).

On September 15, when things looked much worse, Fed officials were far more inclined to think that their interpretation of the law needed to go to the edge of what it could possibly support. I believe that they believed that the particular balance sheets of Lehman and AIG made this change in posture more than just a response to a rapid change in the political winds—though it would be foolish to pretend that such a response wasn’t part of their thinking.

From what I can tell, Peter thinks it would have been self-evidently legal for the Fed to help Lehman on Sunday, just as it was self-evidently legal for the Fed to help AIG on Monday. My position is that both of these massive aid packages—the one that never was, and the one that awaits a judgment on alegal challenge to this very day—were very legally awkward. As I understand it, the Fed found the loans to Lehman more legally awkward because the firm’s collateral was worse. Too, the Fed was more willing to do legally awkward things once Lehman’s bankruptcy filing sent market confidence into freefall.

I’ll let Peter have the last word on Lehman if he wants it, and next time onto the question of what kind of legal awkwardness the Treasury proved willing to tolerate in order to save the global financial system.