Remember when the Federal Reserve loaned money to insurance giant AIG (AIG) - Get Report to prevent its collapse in the fall of 2008? Or earlier the same year, when the central bank loaned $29 billion to enable the buyout of imperiled investment bank Bear Stearns by JPMorgan Chase?
Regulators said the credit lines were necessary to prevent significant damage to the U.S. economy, but critics -- including some candidates in the 2016 presidential campaign -- argued that the loans carried the appearance of favoritism and rewarded imprudent management, while average Americans were forced to pick up the tab.
Well, there's no need to worry about a repeat occurrence. The Federal Reserve Board adopted a rule Monday that prohibits emergency lending to individual firms or to insolvent companies, in keeping with the Dodd-Frank financial industry reform law of 2010. That bill limited the central bank's emergency lending authority to "broad based" programs and required the approval of the Treasury Secretary.
Dodd-Frank took away the Fed's authority "to lend for the purpose of aiding a failing firm or preventing a firm from entering bankruptcy or another resolution process, such as was done with loans to Bear Stearns and AIG," Fed Chair Janet Yellen said before the meeting.
The central bank's remaining ability "to engage in emergency lending through broad-based facilities to ensure liquidity in the financial system is a critical tool for responding to broad and unusual market stresses," she said.
Under the Fed's new rules, broad-based lending is defined as programs geared to specific markets or sectors of the financial system, rather than an individual company, and in which at least five organizations are eligible to participate.
Insolvent companies include not only firms that are bankrupt but those that have failed to pay their bills during the previous three months or determined by the Fed to be unsustainable on some other basis.
The Dodd-Frank law's restrictions on the Fed's lending ability followed a number of emergency measures intended to prop up the U.S. economy during the financial crisis of 2008. Financial markets froze that September when global investment bank Lehman Brothers declared bankruptcy after the collapse of the housing market rendered securities based on high-risk mortgages worthless.
Companies like AIG, which had provided insurance on mortgage-backed securities, as well as banks like Citigroup and Bank of America, found themselves threatened.
In response, the Fed agreed in September 2008 to lend as much as $85 billion to AIG, according to the central bank's records. It later agreed to backstop New York-based Citigroup, which had won protection from the Treasury Department and the Federal Deposit Insurance Corp. on the possibility of "unusually" large losses on $306 billion in real estate loans, and Bank of America.
The Charlotte, N.C.-based company obtained protection from Treasury and the FDIC on $118 billion worth of loans, most of which were acquired with its purchase of investment bank Merrill Lynch.
Future emergency loans will still require that the Fed's board find that "unusual and exigent circumstances exist" and include a penalty rate -- one that's a premium to the market rate in normal circumstances -- designed to encourage borrowers to repay the debt as quickly as possible. The new rule takes effect Jan. 1, the Fed said.