The credit crisis that began in the spring of 2007 can be characterized by the following two issues:
Money needs to move through the system for the economy to prosper. If banks won't extend credit to individuals or businesses, then liquidity problems exist. This might occur when banks anticipate a recessionary environment or if they are distrustful of the creditworthiness of borrowers or other banks. Both of these conditions existed in the fall of 2008. Banks and other corporations were anticipating a recession. Meanwhile, interbank lending froze up as banks became suspicious of investments they had all made in toxic, mortgage-related debt. These assets, which were held by many Wall Street firms (many of which had 'AAA' ratings upon their issuance), went down in value right along with the value of the real estate market. Wall Street banks were tied toMain Street
The events of September 2008 were of historically significant. The U.S. Treasury's takeover of government-sponsored entities (GSEs) Fannie Mae and Freddie Mac on September 7 2008, created a domino effect that had the Dow Jones Industrial Average (DJIA) down almost 30% for the year by the end of October. (For more on this see, Fannie Mae and Freddie Mac, Boon Or Boom?)
The placement of the GSEs into conservatorship due to capital inadequacy was meant to calm the credit crisis and be the magic bullet that brought things back to "normal". It could have been seen as a positive by the market, except for the effect this move had on Fannie's and Freddie's preferred shareholders. Investors that had holdings in these firms' preferred stock and felt relatively safe due to the implicit guarantee of the government were shocked their investments turned out to be worthless.
A week later, the investor community went into the weekend with baited breath to see whom Lehman Brothers (OTC:LEHPQ), the failing global financial services firm, would be able to strike a deal with. Lehman had no viable suitors and no choice but to declare bankruptcy on September 14, 2008. This bankruptcy was truly felt around the world. Lehman was a major counterparty in many swap transactions. Many financial institutions and funds had exposure to Lehman Brothers and, as a result, their failure actually caused some money market funds to "break the buck". This necessitated the Fed to provide a guarantee to money market funds. (To learn more, read Will Your Money Market Fund Break The Buck?)
Stocks in the financial sector continued to drop severely. Raising capital was necessary to shore up brokers' balance sheets as their stock prices went through the floor and they took huge losses on the Lehman Brothers bankruptcy. Even the investment bank model itself was called into question: If Lehman had such toxic mortgage-related investments and had been so levered, what firm would be next? All of this pressure forced the last two remaining Wall Street investment banks, Goldman Sachs (NYSE:GS) and Morgan Stanley (NYSE:MS), to become bank holding companies on September 21, 2008. Going forward, these will be regulated by the Federal Reserve.
The Hits Just Keep Coming
As if September wasn't dramatic enough, the month ended with Washington Mutual (OTC:WAMUQ) being placed into receivership by the Federal Deposit Insurance Corporation (FDIC). The country's largest savings and loan failed on September 25, 2008, and its assets were subsequently sold to JPMorgan (NYSE:JPM). (For more on the FDIC see, Bank Failure: Will Your Assets Be Protected?)
All of these events had the already jittery markets positively frantic. Investors didn't feel they could safely invest in preferred stocks, money market funds or financial companies. Plus, they feared their cash could be at risk if their bank failed. Panic selling ensued and this, coupled with increasingly grim economic data, caused the equity markets to free fall.
TARP to the Rescue
The sum total of the events of September 2008 brought the market to its knees and pushed the government to explore a bailout for Wall Street. It had to be flexible, it had to get to the heart of the issue and it needed to be passed quickly. The initial proposal for the Troubled Asset Relief Program (TARP) was to allow banks, brokers and insurance companies to sell residential and commercial mortgage-backed assets to the government, establishing a floor for distressed asset prices. The government wanted to get the toxic assets off the balance sheets of banks and financial intermediaries to unclog the credit markets and restore liquidity.
Emergency Economic Stabilization Act of 2008
On October 3, 2008, President Bush signed the $700 billion, Emergency Economic Stabilization Act of 2008 (EESA). Sometimes referred to as the "TARP Act", it included several provisions. One of those provisions gave the U.S. Treasury broad authority to purchase, manage, modify, sell and insure mortgage-related assets as well as any other financial instrument deemed necessary to stabilize financial markets, including equity markets.
The other provisions of EESA were aimed at bolstering the economy and restoring confidence in the banking system. Some of these include:
- Amendment to the HOPE for Homeowners program, so the Treasury can more directly participate in minimizing homeowner foreclosures (For related reading, see Rate Freeze To Cool Mortgage Meltdown.)
- Temporary increase in FDIC insurance from $100,000 to $250,000 (through December 31, 2009)
- Authorization of the Securities And Exchange Commission (SEC) to suspend mark-to-market accounting requirements for any issuer, class, or category of assets (For more insight, check out Mark-To-Market Mayhem.)
Capital Purchase Program
The ability to buy any financial instrument is what allowed the Treasury to implement its first program under TARP, the Capital Purchase Program (CPP). With the CPP, the Treasury purchased equity in banks as a way to inject capital into the banking system. The first $125 billion of the $700 billion approved by Congress was used to bolster capital at large, money-center banks (such as JPMorgan); another $125 billion was used to bolster regional and super-regional banks. The U.S. government's direct investment in banks here is an unprecedented move from a historical perspective and many have argued that for a capitalist country to resort to these measures is a sign of how urgent the situation had become.
For its capital injection, the U.S. Treasury receives "senior perpetual preferred stock" that will pay a 5% dividend for the first five years and a 9% dividend thereafter. These shares are non-voting. The Treasury made these investments to bolster capital at the banks and to unfreeze the credit markets. The banks that received the capital injections were "strongly encouraged" not to hoard the cash, but to use it to make loans (to get money moving).
Banks participating in the CPP are subject to executive compensation restrictions under EESA. These restrictions require the Treasury to ensure that incentive compensation for senior executives does not encourage excessive risk taking that could threaten the value of the institution. In addition, executive bonuses may be forfeited if it is later proved that earnings were materially inaccurate. (For related reading, see Evaluating Executive Compensation.)
TARP Versus Other Bailouts
The size and scale of the TARP program has only a few comparisons in U.S history. The TARP proposal to remove toxic debt from the financial system has been compared to the Resolution Trust Corp. (RTC), which was used to abate the savings and loan (S&L) crisis of the late 1980s and early 1990s. The RTC was set up in 1989 to facilitate the liquidation of S&Ls. It was originally funded with $50 billion, $20 billion of which came from the Treasury; the remainder was raised via by issuing debt. The Resolution Funding Corp. was set up specifically to issue bonds, called REFCORPS that were fully backed by the U.S. government.
TARP was approved for $700 billion, while the total cost of the S&L bailout has been estimated at $150 billion, approximately $124 billion of which was paid for by taxpayers.
Another comparison comes from the Home Owners Loan Corporation (HOLC), which was established during the Great Depression. It was created by the Home Owners' Refinancing Act of 1933, and was part of President Roosevelt's "New Deal". HOLC helped keep people in their homes by offering up to 80% financing to those at risk of losing them.
More to Come
TARP, and all of its related programs, is the government is trying to figure out where to best deploy all the liquidity it is showering on the financial system in an effort to forestall a deep, extended recession. While we don't know exactly what the next program from TARP will look like, we can be sure that there will be more regulation in our future. Bailouts are always controversial, never popular and followed by tons of regulation.
Investing BasicsLearn about some of the largest and most famous companies that have been removed from the Dow Jones Industrial Average (DJIA) over its 119-year history.
InsuranceMedicare is the United States’ health insurance program for those over age 65. Medicare has four parts, but you might not need them all.
InvestingA guide to identifying secular bull and bear markets.
EconomicsFind out why China bothers Donald Trump so much, and why the 2016 Republican presidential candidate argues for a return to protectionist trade policies.
EconomicsFind out when, or if, Russian President Vladimir Putin will ever relinquish control over the Russian government, and whether it matters.
MarketsLast Friday's attacks in Paris are transforming the migrant crisis into an EU security threat, which could undermine the European Union dream.
Investing BasicsLearn how poor management, frauds, scandals or mergers wiped out some of the most recognizable brands in the finance industry in the United States.
BudgetingThe 2016 race to the White House will largely be determined by who can spend the most money. Here is a look at how much it will cost to win the presidency.
EntrepreneurshipAre you hoping to launch your own business and work for yourself? If so, here are the top 10 tips for entrepreneurs.
MarketsMany investors are looking at emerging market (EM) stocks and wonder if it’s time to step back in, while others wonder if we’ll see further declines.
The Federal Deposit Insurance Corporation (FDIC) works as a protector for customers when banks and financial institutions ... Read Full Answer >>
When a third party gains access to your bank account and conducts transactions without your consent, the FDIC does not have ... Read Full Answer >>
The Federal Deposit Insurance Corporation (FDIC) does not cover credit unions. The FDIC only insures deposits in banks and ... Read Full Answer >>
Out of the 2,800 mutual funds that Morningstar, Inc., the leading provider of independent investment research in North America, ... Read Full Answer >>
Bank deposits owned by corporations, partnerships, limited liability companies (LLCs), and unincorporated associations, including ... Read Full Answer >>
Penny stocks are common shares of public companies that trade at a low price per share. These companies are normally small, ... Read Full Answer >>