1. Credit Crisis: Introduction
  2. Credit Crisis: Wall Street History
  3. Credit Crisis: Historical Crises
  4. Credit Crisis: Foundations
  5. Credit Crisis: What Caused The Crisis?
  6. Credit Crisis: Bird's Eye View
  7. Credit Crisis: Government Response
  8. Credit Crisis: Market Effects
  9. Credit Crisis: Lessons Learned
  10. Credit Crisis: Conclusion

By Brian Perry



The credit crisis has represented the gravest threat to the global financial system since the 1930s. Fortunately, policymakers have been proactive in their efforts to mitigate the effects of the crisis. This chapter will provide an overview of some of the government's most important actions.

Mitigating Financial Crises
The principles for mitigating financial crises were established more than 100 years ago in the book "

Lombard Street
: A Description of the Money Market" (1873) by Walter Bagehot. In his book, Bagehot stressed that in order to stop a panic, the central bank should give the impression that "though money may be dear, still money is to be had." Bagehot went on to say that the central bank should "lend freely, boldly, and so that the public may feel you mean to go on lending." Central bankers continue to follow this prescription, which is why they usually lower interest rates when a financial crisis occurs. (For more insight, see Formulating Monetary Policy.)

A second important principle for minimizing the effects of a financial crisis is to maintain confidence in the safety of the banking system. This prevents a "run on the bank" in which consumers rush to withdraw their deposits. Confidence in the banking system is often secured by providing government guarantees on bank deposits, such as the U.S.FDIC insurance program.

It is also important for policymakers to react swiftly when a crisis strikes. Indeed, the earlier policy-makers recognize and react to a crisis, the more effective their actions are likely to be. If adequate liquidity is quickly provided and confidence in the banking system is maintained, the effects of a crisis can be mitigated.

The Federal Reserve
The Federal Reserve (Fed) has been extremely active in making sure that the financial system continues to function properly during the credit crisis. The Fed lowered its key federal funds rate to provide additional liquidity to the financial system, expanded the range of collateral it would willing to accept in return for loans, and provided direct lines of credit to a broader variety of financial institutions (previously only commercial banks could borrow directly from the Fed.) When Bear Stearns was on the verge of bankruptcy, the Fed also guaranteed a large portion of Bear Stearns' liabilities in order to facilitate a takeover by JPMorgan. The actions that the Fed took helped to maintain confidence and liquidity in the financial system as part of efforts to mitigate the effects of the credit crisis. (To learn more see, The Treasury And The Federal Reserve.)

The Government Rescues Prominent Financial Firms
The executive branch of the government has also been closely involved in maintaining stability in the financial system. These efforts have included direct aid to a number of prominent financial firms. On September 7, the Federal Housing Finance Agency (FHFA,) in conjunction with the Treasury Department, placed Fannie Mae and Freddie Mac under conservatorship as part of a four-part plan to strengthen the housing agencies. In addition to conservatorship, the Treasury pledged to inject up to $100 billion into each agency if needed to maintain a positive net worth, provide unlimited short-term liquidity if required and purchase mortgage-backed securities in the open market. In return for this support, the government received warrants to purchase 79.9% of Fannie Mae and Freddie Mac for a nominal sum.

The government took these actions in order to provide stability to the financial markets, support the availability of mortgage finance, and protect taxpayers from excessive losses. (For more on government help, read Top 6 U.S. Government Financial Bailouts.)

Following the rescue of Fannie Mae and Freddie Mac, the government chose not to rescue Lehman Brothers, instead allowing it to file for bankruptcy on September 15. However, on September 16, the government granted AIG (NYSE:AIG) an $85 billion emergency loan in exchange for warrants for 80% of the company. The government chose to intervene based on its perception that an AIG bankruptcy could present a systemic risk to the financial system, while a Lehman bankruptcy would not. Subsequently, the government increased its financial support for AIG to well in excess of $100 billion.

Despite the Fannie Mae, Freddie Mac and AIG bailouts, conditions continued to deteriorate throughout September 2008, and it became increasingly clear that the financial system was approaching the brink of complete collapse.

The "Bailout Plan"
Faced with the possibility of a systemic collapse of the financial system, the Treasury proposed a $700 billion plan that would involve the government's purchase of impaired assets from the balance sheets of banks. The Treasury would hold the impaired assets until the market improved and then resell them, perhaps even earning a profit. The U.S. House of Representatives initially refused to pass the bill granting the Treasury authority to implement the plan, which sent the S&P 500 into its sharpest decline since Black Monday in 1987. The Treasury subsequently revised its proposal, and spurred by rapidly worsening financial market conditions, the House voted to pass the bill on October 3, 2008. (For more on past market crashes, see our Crashes Feature.)

Following passage of the Emergency Economic Stabilization Act of 2008 (the "bailout plan"), financial market conditions continued to deteriorate, which prompted the Treasury to decide that it would be faster and more efficient to invest directly in companies as opposed to purchasing assets from their balance sheets. To that end, the Treasury invested $125 billion in nine of the largest U.S. banking institutions and made an additional $125 billion available to smaller firms. The Treasury also received preferred stock in exchange for its capital infusions, with the expectation of being repaid in full, with interest.

Firm $ Amount (Billions) Firm $ Amount (Billions)
AIG 40.00 KeyCorp 2.50
JPMorgan 25.00 Comerica 2.25
Citigroup 25.00 Marshall & Iisley 1.70
Wells Fargo 25.00 Northern Trust 1.50
Bank of America 15.00 Huntington Bancshares 1.40
Merrill Lynch 10.00 Zions Bancorp 1.40
Goldman Sachs 10.00 First Horizon 0.866
Morgan Stanley 10.00 City National 0.395
PNC Financial 7.70 Valley National 0.330
Bank of NY Mellon 3.00 UCBH Holdings 0.298
State Street 2.00 Umpqua Holdings 0.214
Capital One 3.55 Washington Federal 0.200
Fifth Third 3.45 First Niagara 0.186
Regions Financial 3.50 HF Financial 0.025
SunTrust Banks 3.50 Bank of Commerce 0.017
BB&T Corp 3.10
Figure 3: Treasury equity investments as of November 10, 2008
Source: Reuters

Other government programs to mitigate the crisis have included an increase in FDIC bank deposit insurance from the previous $100,000 to the current $250,000, a plan that is designed to allow financial firms to issue short-term bonds that would carry FDIC insurance, and a government guarantee for some deposits in money market funds.

In an effort to stimulate the market for short-term lending among corporations, the government has also offered to directly purchase commercial paper from highly rated issuers unable to raise money in the private market. Finally, the government also proposed a fiscal stimulus package designed to provide a boost to economic activity. This willingness to use deficit spending to boost the economy during an economic downturn is an improvement over policy makers' actions during the 1930s, when it was generally believe that budgets should be balanced even during economic slowdowns.

The combination of these measures is designed to restore liquidity and confidence to the marketplace and ease the financial crisis. Similar plans have been implemented globally as part of efforts to stabilize financial systems and stimulate economic activity.

Conclusion
Following the stock market crash of 1929, policy makers committed a trio of errors. They tightened monetary policy, restricted fiscal spending and failed to enhance confidence in the banking system. It is widely believed that these mistakes exacerbated the effects of the depression that followed.

Policymakers have learned from these mistakes, and those lessons were put to good use during the credit crisis of 2008, during which the Fed provided enormous amounts of liquidity to the financial system. The government also increased its spending, thereby providing fiscal stimulus to the economy. Finally, the government took extraordinary measures to secure confidence in the financial system through a variety of guarantees, insurance programs, loans and direct investments.

Credit Crisis: Market Effects
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