When Congress initially rejected the financial bailout package proposed by the Bush administration in September, Treasury Secretary Henry Paulson lamented that the government did not have sufficient tools in its toolkit to respond to the ongoing economic crisis. When the legislation finally passed a couple of weeks later, Secretary Paulson promised that the government would thereafter use every tool at its disposal. He has certainly kept that promise.
The government's efforts to bolster the nation's financial system have taken many forms, and according to some calculations may be approaching $7 trillion in potential obligations. And indeed the government has been flexible. It began by considering buying mortgage-backed securities, but then rejected that plan and moved to investing directly in banks in a variety of ways. Throughout the process, it has offered guarantees of individual company assets or debts where it deemed those companies sufficiently important, tried various means to shore up money markets, and is now implementing a plan to buy asset-backed securities in the consumer credit market instead of the mortgage market. The government is also considering a bailout of the car manufacturers and has revived its plan to buy mortgage-backed securities. Examining all this, critics have alleged that there doesn't appear to be any comprehensive plan. Indeed, Secretary Paulson has stated that "there is no blueprint" for dealing with a financial crisis like the one we have been experiencing for the last several months. He has emphasized that the government is remaining flexible and reacting to new developments as they arise.
Given the number and the variety of actions that the government has taken over the past several months, it has been challenging to stay abreast of the government's strategy and its results. This article aims to provide some clarity on the current situation by providing an overview of the government's efforts to date, as well as insight on how much it all costs, whether it is doing any good, and what the government may do next.
The Crisis Develops
The government initially began to take steps to bolster the housing market and limit foreclosures in 2007. But it wasn't until the collapse of Bear Stearns in March 2008 that the government began to take a more direct, active response to the financial crisis. On March 16, JP Morgan announced that it was buying Bear Stearns for a fraction of its previous share price, using $30 billion in financing from the Federal Reserve. The Federal Reserve and the Treasury Department justified the intervention as necessary to prevent a chain reaction of collapsing financial institutions. At the time, this intervention was considered remarkable; looking back, it seems relatively mundane.
The financial crisis deepened in the summer. The Treasury Department committed up to $100 billion each to Fannie Mae and Freddie Mac to ensure that they maintained a positive net worth. On July 12, the FDIC seized IndyMac Bank in the second-largest bank failure in American history.
Then, in September, the crisis approached catastrophe. The Federal Housing Finance Agency seized control of Fannie Mae and Freddie Mac, placing them in a conservatorship. The crisis accelerated as Lehman Brothers, Washington Mutual, Merrill Lynch and Wachovia all collapsed or were forced into distressed sales. The Federal Deposit Insurance Corporation assisted JP Morgan's acquisition of Washington Mutual and the government also worked to facilitate a sale of Wachovia, which was ultimately purchased by Wells Fargo. According to Secretary Paulson, Lehman Brothers was allowed to collapse, in part because as a non-bank institution, no federal agency had the authority to do anything about it—in other words, the government needed more tools. Further, on September 16, the Federal Reserve announced that it would loan AIG $85 billion to stave off its collapse, and in return received a 79.9 percent stake in the company in the form of warrants.
In mid-September, facing all these collapses, and the prospect of more, the financial markets essentially froze. Credit markets dried up, and interbank lending virtually stopped. Looking back, Treasury officials described this situation as a tipping point, when the country was facing a significant risk of a complete collapse of the financial system.
The Bailout Bill
In this climate, Secretary Paulson and Federal Reserve Board Chairman Ben Bernanke asked Congress to approve a plan to purchase $700 billion of troubled assets from financial institutions. The original bill they presented was three pages long, and addressed only purchases of "mortgage-related assets," which were defined as residential or commercial mortgages, or securities related to those mortgages.
Over the two weeks it took for the bill to become law, it stretched to over 300 pages (although, to be fair, only the first 100 or so dealt with the actual financial bailout) and greatly broadened the definition of the Treasury Secretary's authority from his original request. The new law, known as the Emergency Economic Stabilization Act of 2008 (EESA), contains several provisions intended to help the economy, but the most significant feature is the "Troubled Assets Relief Program" or TARP. Under TARP, the Treasury Department can spend up to $700 billion in three steps, with the first $250 billion available immediately, the next $100 billion available upon presidential certification of need, and the final $350 billion available upon delivery of a report detailing a plan for its use. Congress reserves the right to withhold the final $350 billion. Under TARP the department may also purchase "troubled assets." Troubled assets are not just "mortgage-related assets" as in the original proposal, but instead are defined to include any "financial instrument . . . the purchase of which is necessary to promote financial market stability."
Over the next several weeks, the Treasury Department turned this broad authority into a veritable Swiss Army knife of economic tools. And although TARP is the centerpiece of the government's response to the financial crisis, it is not the only tool the government is using.
The Government's Actions Post-EESA
Commercial Paper Funding Facility. The government's next major action after passage of the EESA was the Federal Reserve's new Commercial Paper Funding Facility. The Fed announced this program, under which it purchases three-month unsecured and asset-backed commercial paper directly from issuers, on October 7. The Fed created this program to reinvigorate the short-term commercial paper market, which had also frozen with the mid-September market crisis. Many businesses use the commercial paper market for operating cash, including making payroll, paying suppliers and buying inventory. The next day, October 8, the Fed provided AIG with an additional $37.8 billion credit line to shore up its securities-lending program, and the Federal Housing Finance Agency directed Fannie Mae and Freddie Mac to increase purchasing of mortgage-backed securities.
The Capital Purchase Program. At the same time that the Federal Reserve announced the Commercial Paper Funding Facility, the Treasury Department was preparing to implement TARP. In Secretary Paulson and Chairman Bernanke's original proposal, and as discussed in the negotiations over the EESA, the initial plan was to purchase mortgages and mortgage-backed securities. The theory was that this would remove some bad assets from the balance sheet of banks, freeing them to make more loans. This also would hopefully establish something of a market price for those assets, so that the actual value of financial institutions that held the assets would be known, thus reducing the possibility of a collapse of confidence in these institutions, which was seen as part of the cause of the Bear Stearns and Lehman Brothers collapses.
However, by early October, the Treasury Department determined that buying distressed mortgage-related assets would not be effective enough, quickly enough. As a result, the Treasury Department shifted focus to injecting capital directly into financial institutions. On October 14, the Treasury Department announced that it was creating a Capital Purchase Program under TARP and allocating $250 billion of the available funds to that program. Under this program, the Treasury Department buys senior preferred shares from banks with a dividend rate of 5 percent for the first five years, and 9 percent thereafter. The government also receives warrants to purchase common stock with a market price of 15 percent of the senior preferred investment. Participating banks must also adopt the EESA's standards for executive compensation and must accept limitations on common stock dividends and repurchases of equity. The preferred stock is redeemable at par after three years.
The Treasury Department emphasized that the Capital Purchase Program is aimed at healthy institutions. That is, the program is not designed primarily to rescue doomed companies, but instead is intended to stabilize the financial market and get capital flowing again. In fact, some institutions that received capital from the program have announced that they are using the funds to purchase other institutions. Although the program does not require banks to lend or otherwise use the funds received, banking regulators and Treasury officials have repeatedly stated that they expect banks to use the money they receive and not just sit on it.
To date, the Treasury Department has initiated a Capital Purchase Program for public and privately held banks and bank holding companies, and anticipates allowing S corporations and mutual institutions to participate in the future. The program has been widely utilized by financial institutions: The Treasury Department has already disbursed over $167 billion, and has indicated that it is processing more applications. A number of companies reportedly converted to bank holding companies in order to become eligible, although it is not clear whether any of these companies have received funds under the program.
Temporary Liquidity Guarantee Program. The same day that Treasury announced the Capital Purchase Program, the FDIC announced a new Temporary Liquidity Guarantee Program. Under this program, the FDIC guarantees certain newly-issued senior secured debt, including promissory notes, commercial paper, interbank funding and unsecured portions of secured debt. Qualifying debt must be issued by June 30, 2009, and the coverage will only extend to June 30, 2012. Under the same program, the FDIC will fully insure non-interest-bearing deposit transaction accounts, including certain NOW accounts with interest rates that will not exceed 0.5 percent. These are mainly payment processing accounts used by businesses for payroll or other expenses. Before the program, insurance was capped at $250,000 per depositor.
By taking these steps, the FDIC is attempting to stabilize the financial market for business accounts by reducing the risk associated with day-to-day cash flow financing.
Support for Money Market Funds. On October 21, the Federal Reserve announced it would provide up to $540 billion to buy troubled assets from money market mutual funds so the funds could satisfy demand for redemptions. This followed Fed action in September to insure money market mutual funds if the fund agreed to pay a fee, in essence an insurance premium. The program, in some respects, is similar to the FDIC's deposit insurance program.
Systemically Significant Failing Institutions Program. On November 10, the Treasury Department announced a new tool in its TARP toolkit. Under the Systemically Significant Failing Institutions Program, the Treasury Department determines on a case-by-case basis whether an institution is systemically significant and at substantial risk of failure. If so, the department can inject TARP funds in a variety of ways.
The same day, not coincidentally, the Treasury Department announced that it was purchasing $40 billion in preferred stock from AIG. AIG was determined to be systemically significant because of its deep connections throughout the financial markets. This purchase was on more onerous terms than the Capital Purchase Program, with a higher premium and more restrictions. The capital injection allowed the Federal Reserve to reduce the total amount available under the credit facility it earlier extended to AIG. However, at the same time, the Federal Reserve established two additional lending facilities for AIG to relieve pressure on its portfolio of resident mortgage-backed securities and the credit default swaps that AIG has written on collateralized debt obligations in multiple sectors of the economy. To date, AIG is the only company to officially receive payments under the Systemically Significant Failing Institutions Program.
The Treasury Department also announced assistance to Citigroup, beyond the $25 billion investment Citigroup received through the Capital Purchase Program, on November 23. Although this assistance would seem to fall under the Systemically Significant Failing Institutions Program, in its report to Congress on implementing the EESA, the Treasury Department described its Citigroup actions as unique and not under any particular TARP program. However it classified its actions, the Treasury Department, along with the Fed and the FDIC, guaranteed potential losses on Citigroup's pool of mortgage-backed securities. (Although Secretary Paulson had said days earlier that the Treasury Department would not buy mortgage-backed securities, apparently that did not preclude guaranteeing them). The Treasury Department will purchase an additional $20 billion in Citigroup preferred stock, but with higher dividends than the Capital Purchase Program preferred and with more restrictions, including prohibitions on payment of dividends and more stringent executive compensation limits. The guarantees apply to a $306 billion pool, with Citigroup absorbing the first $29 billion in losses and 10 percent of any additional losses. The government guarantees the rest, split among TARP funds (the first $5 billion), the FDIC (the next $10 billion) and the Federal Reserve (a non-recourse loan for the rest). As a fee for the guarantee, Citigroup will issue $7 billion in additional preferred stock with an 8 percent dividend, with $4 billion of the stock going to TARP and $3 billion going to the FDIC.
Term Asset-Backed Securities Loan Facility. On November 12, Secretary Paulson announced that the Treasury Department was exploring ways to use TARP funds to reinvigorate the consumer credit market. In October, the market for asset-backed securities collateralized by student loans, auto loans, credit card loans, and Small Business Administration-guaranteed loans froze, much like the interbank lending market and commercial paper markets had in September. This threatened the availability of consumer credit and small business loans. The Treasury Department and the Federal Reserve announced their plan for the consumer credit market on November 25. The new program, the Term Asset-Backed Securities Loan Facility, is designed to restart the consumer credit and small business loan markets by lending up to $200 billion on a non-recourse basis to holders of newly issued AAA-rated asset-backed securities. The Treasury Department is contributing $20 billion of TARP funds to this program, which will begin operating in January 2009.
Purchases of Mortgages and Mortgage-Backed Securities. In his November 12 press conference announcing that the Treasury Department was going to use TARP to bolster the consumer finance market, and again in his November 18 testimony before the House Committee on Financial Services, Secretary Paulson stated that the Treasury Department was not going to buy any mortgages or mortgage-backed securities with TARP funds, thus putting an end to the original purpose of the EESA. He stated that Treasury had achieved its first goal, which was to immediately stabilize the financial market. Secretary Paulson further commented that to be effective, any mortgage asset purchase program would require more funds than they had available. Finally, he indicated that the Treasury Department had determined it would be prudent to maintain the final $350 billion in reserve for use by the Obama administration or for unforeseen contingencies.
Nevertheless, on November 25, the Federal Reserve revived the plan to buy mortgages and mortgage-backed securities, announcing that it will initiate a program to purchase up to $500 billion of mortgage-backed securities backed by Fannie Mae, Freddie Mac and Ginnie Mae, as well as $100 billion of direct obligations of those entities. On December 16, along with its announcement that it was cutting the Federal funds rate to a target of 0 to 0.25 percent, the Fed indicated it would be willing to expand this program if necessary. Echoing Secretary Paulson, the Fed's Open Market Committee released a statement that "the Federal Reserve will employ all available tools to promote the resumption of sustainable economic growth and to preserve price stability."
Car Manufacturer Bailout. With Secretary Paulson's announcements that the Treasury Department would not use TARP funds to buy mortgage-backed securities, it appeared that the Bush administration's Treasury Department was essentially finished with new TARP programs and would leave the next major policy steps to the Obama administration. It would continue operating the Capital Purchase Program, and although it keeps open the option of coming to the aid of systemically significant financial institutions, in recent interviews Secretary Paulson said that he did not anticipate the need to do so.
Then, Congress failed to act on the auto industry bailout backed by the administration and Congressional leadership. Although Secretary Paulson had resisted earlier calls to use TARP funds for the car manufacturers, the Bush administration announced on December 12 that it was considering using TARP funds for that purpose, and in the following week more or less promised that it would provide some type of assistance to American car makers. Although speculation about what the administration will do is rampant, the details of any program for the car makers have not been announced.
How Much Has It Cost So Far, and What's Next?
If you have found it difficult to track everything that the government has done to bolster the economy in the past few months, you are not alone. For those trying to keep score, the first $250 billion of TARP funds was available once the authorizing legislation was signed, and President Bush certified the need for the next $100 billion—but the administration has not submitted the report necessary to unlock the remaining $350 billion. Of the $350 billion available so far, the Treasury Department has allocated $335 billion of its TARP funds, excluding any program for the car manufacturers. Over $80 billion of the funds allocated to date are undistributed under the Capital Purchase Program and could presumably be reallocated if they are not used. The FDIC and the Federal Reserve have made trillions of dollars in guarantees and loans.
It is impossible to know exactly what this all is costing the taxpayers, because simply tracking the expenditures and potential exposure does not reflect the various programs' structures. The government's various guarantees and loan commitments may never be called on. And at least some portion of the loans made by the government will likely be repaid. The government also will receive dividends on its TARP capital investments and should recover much or all of its principal investment when the preferred stock is redeemed. The Treasury Department has publicly reported that one of its reasons for investing only in healthy institutions is to protect these returns.
Whatever our investment, what have we gotten in return? Secretary Paulson argues that the aggressive actions of the Treasury Department, the Federal Reserve and the FDIC pulled us back from the edge of economic disaster. He justifies this position using the following metrics: Interest rate spreads for interbank lending have decreased significantly from their historically high levels in mid-September, and the prices of credit default swaps are moving lower. So although some may argue that Secretary Paulson has not pursued a clear plan, his "every tool in the toolbox" approach arguably has kept the economy out of even worse conditions.
So what is next? The first thing to be announced is likely to be whatever auto industry program the administration creates. At one time, the Treasury Department and the Fed were reportedly working on plans to reduce mortgage interest rates to as low as 4.5 percent, rates not seen since the 1960s. Recent indications are that Treasury has abandoned this plan, at least for now. The Treasury Department has potentially $350 billion available for new tools to accomplish this or other goals. The current administration has announced no plans for the remaining TARP funds, and appears inclined to leave them for the next administration. Thus the Obama administration likely will have $350 billion at its disposal for a wide range of potential actions, from further investment in banks to bailouts of other industries. The Obama transition team has not announced any plans for these funds or other potential bailout actions.
Notably, this discussion of the government's actions included no analysis of mortgage relief for homeowners. This is because, despite repeated public statements by members of Congress, Secretary Paulson, the presidential candidates and others about the need for mortgage relief and about various plans to accomplish that task, the government has actually accomplished little foreclosure relief. At the same time, banks have been modifying loans on their own: According to reports, the 14 largest banks and thrifts modified 187,000 loans in the first half of 2008 and several major institutions have announced voluntary moratoriums on foreclosures to provide time to reach out to troubled borrowers. Although the government has established several mortgage foreclosure relief programs, they have not seen heavy use. This may be a result of a number of factors, including that the Treasury Department has been focused on stabilizing the overall financial system. Also, as a practical matter, it is difficult to modify mortgages because they often are packaged in pools which in turn are split in many ways and sold to multiple investors. Accordingly, there are many interested parties that have to agree to allow mortgage modifications. Members of Congress, including Speaker of the House Nancy Pelosi, however, have increasingly criticized the administration for not using TARP funds for mortgage foreclosure relief and have intimated that Congress will withhold the final $350 billion of TARP funds if the plan does not include it. If this pressure continues, and with the new administration soon to take office, mortgage foreclosure relief seems a likely future priority.
In short, stay tuned. Where there is $350 billion available, the government is likely to find some way to spend it. And as we have seen over the past few months, the government can pull a new tool from its kit at any time.
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