Excuse Me?

Here’s a disturbing story:

“The financial world was fixated on Capitol Hill as Congress battled over the Bush administration’s request for a $700 billion bailout of the banking industry. In the midst of this late-September drama, the Treasury Department issued a five-sentence notice that attracted almost no public attention.

But corporate tax lawyers quickly realized the enormous implications of the document: Administration officials had just given American banks a windfall of as much as $140 billion.

The sweeping change to two decades of tax policy escaped the notice of lawmakers for several days, as they remained consumed with the controversial bailout bill. When they found out, some legislators were furious. Some congressional staff members have privately concluded that the notice was illegal. But they have worried that saying so publicly could unravel several recent bank mergers made possible by the change and send the economy into an even deeper tailspin.

“Did the Treasury Department have the authority to do this? I think almost every tax expert would agree that the answer is no,” said George K. Yin, the former chief of staff of the Joint Committee on Taxation, the nonpartisan congressional authority on taxes. “They basically repealed a 22-year-old law that Congress passed as a backdoor way of providing aid to banks.” (…)

The change to Section 382 of the tax code — a provision that limited a kind of tax shelter arising in corporate mergers — came after a two-decade effort by conservative economists and Republican administration officials to eliminate or overhaul the law, which is so little-known that even influential tax experts sometimes draw a blank at its mention. Until the financial meltdown, its opponents thought it would be nearly impossible to revamp the section because this would look like a corporate giveaway, according to lobbyists.

Andrew C. DeSouza, a Treasury spokesman, said the administration had the legal authority to issue the notice as part of its power to interpret the tax code and provide legal guidance to companies. He described the Sept. 30 notice, which allows some banks to keep more money by lowering their taxes, as a way to help financial institutions during a time of economic crisis. “This is part of our overall effort to provide relief,” he said.”

The WSJ covered this a few weeks back (h/t publius.)

Here’s the relevant section of the Internal Revenue Code. It provides that “The Secretary shall prescribe such regulations as may be necessary or appropriate to carry out the purposes of this section and section 383”. I am not a lawyer, still less a tax lawyer, but offhand, I would not have thought that rescinding a law counts as promulgating a regulation necessary or appropriate to carry out its purposes. And if it doesn’t, it’s not clear where Secretary Paulson gets the authority to give banks a twelve-figure tax break.

Meanwhile, in other news, Treasury seems to be about to shovel around $40 billion more at AIG:

“Under the terms ironed out late Sunday, the government would give AIG more money, including $40 billion from the U.S. Treasury’s $700 billion Troubled Asset Relief Program. It would also receive less interest than on the bulk of the original loan, while freeing AIG from exposure to some of the risky financial instruments that nearly caused it to file for bankruptcy protection.”

So: they get tens of billions of dollars, they pay less interest, and they get to transfer some of their riskiest assets to — guess who? — us!

Yves Smith:

“This is the essence of AIG’s latest proposal:

Man walks into pawn broker. He says to the person behind the counter, “You know that watch I brought in two weeks ago? I know you lent me $85, but now I need another $50. And I will tell you why you will give it to me. I have a gun with me. I will blow my brains out here, right now. With your nice carpet, I guarantee it will cost you more than $50 to clean up your store. And that’s before we get into the cost of keeping your store closed while you clean my grey matter off your walls and what my suicide might do to your store’s reputation.”

Oh, and we forgot to mention that the man in the story above pulled the same trick last week and it worked like a charm.”

More from Yves here: AIG: The Looting Continues. Felix Salmon is similarly underwhelmed, and Willem Buiter thinks it might be “time to pull the plug on AIG”. (Either that or just nationalize and have done with it.)

This is all above my pay grade. However, a few thoughts:

First, when you’re spending hundreds of billions of taxpayer dollars, it seems to me to be really important to target them well. In the case of the bailout, that would seem to mean deciding which firms to try to recapitalize and which to let fail. (And it ought to be possible to arrange for this failure to be less cataclysmic than the Lehman failure was, given any kind of advance notice.) One of the things that really worries me about all this is that I can’t see any sign at all that we’re making these kinds of distinctions, as opposed to just bailing out everyone in sight (except, of course, for homeowners and other non-corporate persons.) This is bad: it’s wasteful, and it also produces moral hazard.

Second, on the first story: as I said, I’m not a lawyer, so I can’t tell whether Treasury acted illegally. Regardless of whether they had the legal authority to do what they did, though, they should have gone to Congress before rescinding a statute at a cost of over $100 billion. If Congress does not agree with his action, it should undo it. The Post story claims that they’re afraid they’ll destabilize the market if they say that Paulson’s actions were illegal. If so, then they should figure out what a good resolution would be, go to Paulson quietly, and tell him that if he doesn’t sign on, they will undo his action publicly. If he cares about market stability, he’ll sign on.

Third, giving banks a huge unilateral tax break is the sort of thing that might as well have been designed to deprive the bailout of whatever popular support it might ever have had. We live in a democracy. People’s opinions matter. The Treasury should remember that, and act accordingly.

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