The passage into U.S. law on October 3, 2008, of the $700 billion financial-sector rescue plan is the latest in the long history of U.S. government bailouts that go back to the Panic of 1792, when the federal government bailed out the 13 United States, which were over-burdened by their debt from the Revolutionary War. It also marked the fourth time in 2008 that the government interceded to prevent the ruin of a private enterprise or the entire financial sector. In addition to the $700 billion bailout, this article will look at five financial crunches in the past century that necessitated government intervention:
- The Great Depression
- The savings and loan bailout of 1989
- The collapse of Bear Stearns, an investment bank and brokerage firm
- American International Group (AIG), an insurance colossus with global reach
- Freddie Mac and Fannie Mae, two government-backed mortgage lenders
Bank Rescue of 2008
Officially called the Emergency Economic Stabilization Act of 2008, this bailout bill surpassed any previous government bailout by hundreds of billions of dollars.
The principal mandate of the legislation was to authorize the U.S. Treasury to buy risky and nonperforming debt from various lending institutions. These debts would include:
- auto loans
- college loans
- an ambiguous "other" in the bill, which allows for broad interpretation
Part of the bill authorizes a cash infusion of $250 billion into the banking system to facilitate and encourage bank-to-bank loans and other types of lending. (Read more about the role of the Treasury in The Treasury And The Federal Reserve.)
With the Treasury's purchase of a bank's or mortgage lender's bad debt, the resulting cash infusion will restore liquidity – and hopefully, confidence – to the banking system. Lending between banks and to consumers and business ventures is then expected to resume, thus lubricating the wheels of the U.S.economy. This economy depends heavily on lending to finance many expenditures of the business community, including:
- the purchase of critical goods and services, supplies and commodities
- new hiring
- advertising and marketing
- research and development
- numerous other purchases necessary for the smooth functioning of a business
Funding for the rescue plan is expected to come from a variety of sources. The U.S. will "borrow" some of the money by issuing Treasury bonds and bills with short-, mid- and long-term maturities. The Treasury will also print additional currency, in an amount not yet determined, to help cover costs. (For more on this, read Money Market: Treasury Bills and Basics Of Federal Bond Issues.)
If the amount of the currency printed is not excessive - a term without precise definition - inflation should theoretically not result. (Read more about the relationship between inflation and an increased money supply in The Importance Of Inflation And GDP.)
Taxes for both individuals and businesses may eventually have to be raised to service (pay the interest on) this massive new debt taken on by the government. A restructured tax code for personal, corporate, capital gains and other taxes may also be required to close loopholes and increase revenues. The key federal interest rate is also expected to remain low, or may be cut even further, to encourage a favorable business environment, which theoretically will also help the economy. (Read more about how the federal interest rate can help boost the economy in The Federal Reserve's Fight Against Recession.)
Finally, the news of the passage of the rescue bill was expected to boost consumer confidence – an individual's propensity to spend – and thus further stimulate the economy. (Read more about how consumers impact the economy in Understanding The Consumer Confidence Index.)
The Great Depression
Probably the best-known economic catastrophe in recent history, the Great Depression is the name given to the prolonged period of economic decline and stagnation that followed in the wake of the stock market crash of 1929. (For more on this read, What Caused The Great Depression?)
With the election to the U.S. presidency of Franklin D. Roosevelt in 1933, a number of historically significant, precedent-setting government bailouts and rescue programs were enacted, which were designed to relieve the economic woes that afflicted the country's people and businesses.
As Roosevelt took the oath of office, the national unemployment rate was nearing 25%. Eventually, countless Americans who had lost their jobs lost their homes as well, and the homeless population of the country, especially in urban areas, grew accordingly. (Read about how unemployment numbers affect Wall Street in Surveying The Employment Report.)
To solve this growing problem, The Home Owners' Loan Corporation was created by the government, one of the principal government bailouts of the Depression era. The newly-created government agency purchased defaulted mortgages from banks and refinanced them at lower rates. About one million homeowners benefited from the lower fixed rates on their refinanced mortgages, usually written for a 15-year term, although upwards of two million had applied for help. Because there was no secondary market for packaged mortgages, the government held the mortgages until they were paid off. (Read more about the secondary mortgage market in Behind The Scenes Of Your Mortgage.)
A variety of other government-financed programs were created to solve the severe national economic distress, which by 1933 had affected almost every sector of the economy. While these federal initiatives were not bailouts, strictly speaking, they provided the money and government support to create tens of thousands of new jobs, principally in public works. Some of the projects accomplished under the government programs were as follows:
- The Hoover Dam was built.
- New post office buildings were constructed around the country.
- Writers were put to work writing state guidebooks.
- Visual artists were employed to paint murals in the new post offices.
- Old roads and bridges were repaired; new roads and bridges were built where needed.
- Farmers received government price supports and subsidies for their produce and livestock.
With steady income, the re-employed millions began purchasing again, and the economy began to lurch forward in fits and starts, but it was not yet back to previous levels of vitality.
By 1939, as World War II began in Europe, the Great Depression was beginning to loosen its grip on the economy. When the U.S. entered the war after the bombing of Pearl Harbor in 1941, the great economic recovery began, and it would culminate in the post-war boom of the 1950s. (Learn what weathering tough economic times can teach you in 7 Lessons To Learn From A Market Downturn.)
The Savings and Loan Bailout of 1989
America's savings and loan institutions (S&Ls), originally created to provide mortgage loans to prospective homeowners, were a nationwide group of conservative, fiscally responsible lenders that helped spur the housing boom that followed the end of World War II. The S&Ls usually paid a slightly higher interest rate on deposits than banks and offered premiums and gifts to attract depositor dollars away from banks, the more traditional repositories of cash. (Read about the bodies protecting your bank deposits in Bank Failure: Will Your Assets Be Protected?)
Flush with funds, numerous savings and loan institutions ventured into commercial real estate.
Government regulatory restraints on S&L lending policies were lax. Many of the S&L investments were ill-advised, and went sour. (Read about the risks and rewards of this investment sector in Find Fortune In Commercial Real Estate.)
Adding to the developing woes of the nation's S&Ls, the Federal Reserve raised interest rates, and the S&Ls had to pay more interest on deposits than their return on the fixed-rate, lower-interest loans they held. (For more on the role of the Fed, read Formulating Monetary Policy.)
As a result, approximately half of America's S&Ls, more than 1,600, failed from 1986 through 1995. Total loan defaults ran into the billions of dollars. Additional billions in federally-insured deposits had to be covered by the government. (To read about Charles Keating, a specific example of a S&L gone wrong, see A Nightmare On Wall Street.)
To address the crisis, and the nationwide economic damage it was causing, Congress enacted the Financial Institutions Reform, Recovery and Enforcement Act of 1989, pumping some $293.3 billion into the floundering industry, one of the most costly and extensive government bailouts of all time.
Founded in 1923, Bear Stearns flourished through the stock market crash of 1929 and the Great Depression. Yet the subprime mortgage disaster of 2007-2008 caused the giant investment bank and brokerage firm, with billions of dollars in assets, to collapse. In April of 2008, the U.S. government, through the Federal Reserve Bank of New York, rescued Bear Stearns by lending $29 billion to JPMorgan Chase to buy the financially troubled firm. (For more on the mortgage crisis, see The Fuel That Fed The Subprime Meltdown.)
JPMorgan Chase, another huge financial services firms specializing in banking, investments and insurance, among other areas, bought Bear Stearns at about $10 per share. The 52-week high of Bear Stearns stock was a lofty $133.20, and so the rock-bottom sale price represented a huge loss for shareholders.
Nevertheless, both Treasury Secretary Henry Paulson and Fed Chairman Ben Bernanke defended the sale, predicting devastating damage to the U.S. economy if the firm - one of the world's largest securities companies - were allowed to go bankrupt. (For further reading, see Dissecting The Bear Stearns Hedge Fund Collapse.)
Fannie Mae and Freddie Mac
In the late summer of 2008, the U.S. government committed up to $200 billion to save these two giant mortgage lenders from collapse. The federal government seized control of these private, yet government-sponsored, enterprises and guaranteed $100 billion in cash credits to each of them to prevent their bankruptcies. (For historical insight into this, read Fannie Mae And Freddie Mac, Boon Or Boom?)
Freddie Mac and Fannie Mae were also victims of the subprime mortgage disasters. When Fannie Mae became a private enterprise in 1968, its charter permitted it to sell shares to public investors, who assumed that it had government backing. Fannie Mae was therefore able to borrow money at very favorable rates only slightly higher than the rate afforded U.S. Treasury debt.
Freddie Mac, created in 1970 to market mortgages offered by federal savings and loan institutions, was also eventually permitted to sell shares to the public in an arrangement with the government similar to that of Fannie Mae.
What brought down both these giants were mortgage loans to unqualified borrowers who secured inexpensive credit with minimal oversight by the lenders and, in too many cases, without income verification. When these loans became delinquent or defaulted, Fannie and Freddie sank deeper into financial trouble, and eventually the government had to bail them out. (Read about another victim of the subprime mortgage disaster in The Rise And Demise Of New Century Financial.)
The American International Bailout
In mid-September 2008, the U.S. government took control of American International Group (AIG), one of the world's largest insurance companies. Private lenders declined to loan money to the financially troubled firm, prompting the federal government to take control of the company and guarantee to loan it up to $85 billion.
In return for the two-year, interest-bearing loan, the government took a 79.9% equity position in AIG. Collateralized by AIG assets - principally the company's hefty insurance revenues - the government's risk was somewhat diminished. Provisions of the loan also require AIG to sell several of its marginal or unprofitable businesses, boosting the company's cash position and divesting it of some nonperforming debt.
The federal seizure of AIG represents the first time ever that a private insurance firm was controlled by the government. This historic "first" was implemented when the Federal Reserve invoked a provision of the Federal Reserve Act, which authorizes loans to non-banks in certain specified emergency or unusual situations. The chief executive officer (CEO) of AIG was forced to leave the company under the conditions of the bailout. (Read how a bad CEO can bring down a company in Pages From The Bad CEO Playbook.)
Can the U.S. government continue to bail out troubled businesses such as Bear Stearns and AIG, and government-backed institutions such as Freddie Mac and Fannie Mae? Many economists say no; by 2008, the U.S. had become over-extended, with trillions of dollars in debt, that it may not have the resources to fund such huge bailouts in the future.
The bailouts of 2008 have also been politically unpopular, with many critics insisting that government should not intercede in the dynamics of a free market. (For more on government intervention, see Economic Meltdowns: Let Them Burn or Stamp Them Out?)
Economics can be unpredictable, and no one can say what the future will bring in an ever-changing world in which the economies of emerging nations - especially China and India - can have major impacts on the economy of the U.S. But with new regulatory legislation and more vigilant oversight, bailouts of the dollar magnitude that characterized the rescues of 2008 may never again be necessary. Their impact, as well as the full effect of the $700 billion rescue plan on domestic economic problems, have yet to be determined.