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Spreading Credit Woes Cause Government Intervention

When it comes to the financial markets, September was a startling and unsettling month that Americans may never forget. We have witnessed the collapse and/or government rescue of financial services giants that are household names. The financial fears of the public and the resulting stock and bond market volatility have prompted the Federal Reserve and the U.S. Treasury to resort to bailouts and backstops on a historic scale.

What does it all mean for the future of our financial system? While cringing at the potential expense, some experts seem to agree with government officials that intervention is most likely necessary, and that the costs of these measures outweigh the potential risk of doing nothing in the midst of a crisis of confidence.

Here’s a look at what may have prompted this situation, what has transpired recently in the financial sector, and how the government has acted to stem the negative effects of these corporate failures.

Drowning in Debt

It’s certainly not news that housing prices in many areas of the country have fallen in recent years, and the rate of foreclosures continues to rise. However, the effects on the economy and our financial sector have been more widespread than expected.

Obviously, banks have suffered losses and subsequently have had to write down an estimated $600 billion in mortgage assets. As it turns out, banks were not the only institutions affected. The reselling of bad loans in the form of mortgage-backed securities and other complicated investment products has resulted in losses for a variety of large investment banks, securities firms, and insurance companies.

Ultimately, a crisis of confidence descended on the industry. The fear that any number of large financial firms could possibly be exposed to housing-related losses helped cause credit to dry up. As a result, some firms that were dependent on credit to run their businesses were unable to raise the capital they needed to survive on their own.

Far-Reaching Effects

Fannie & Freddie: On September 7, the federal government seized mortgage giants Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac), replaced their leadership, and moved their operations into a conservatorship. The Treasury Department made plans to buy $100 billion of each institution’s stock to help ensure liquidity in the mortgage markets. The reason why it was such big news when these institutions went into conservatorship was because they were each originally created by Congress to help provide stability and liquidity in the U.S. mortgage markets. These institutions are unique in that they are shareholder owned but subject to government oversight.

AIG: It’s difficult to fathom that one of the world’s largest insurers would find itself against the ropes. The government was compelled to step in and bail out American International Group with an $85 billion loan, in exchange for 80% of the company’s stock.

Investment banks: As available credit froze, even the strongest of the independent investment banks were affected. To avert bankruptcy, Bear Stearns was bought out by commercial bank JPMorgan Chase. (JPMorgan Chase also bought the bulk of Washington Mutual’s operations after the Seattle thrift failed.) Lehman Brothers filed for bankruptcy, and Merrill Lynch was purchased by Bank of America. Finally, Morgan Stanley and Goldman Sachs were granted permission to convert to traditional commercial banks. The move gives the two firms more flexibility to take advantage of the Fed’s safety net, while subjecting them to the additional government regulations associated with commercial banks.

Money market fund guarantees: The Treasury Department has also said it will issue government insurance for existing investments in money market funds to reassure investors that their assets will remain safe in those accounts. President Bush himself reassured investors, saying that, “For every dollar invested in an insured fund, you’ll be able to take a dollar out.”

Crisis Cleanup

President Bush, Treasury Secretary Henry Paulson, and Federal Reserve Chairman Ben Bernanke worked with Congress to approve the federal government’s purchase of illiquid assets, such as troubled mortgages, from banks and other financial institutions at below-market rates. The intent of the program was to address the underlying weakness throughout the financial system, take these loans off the books of banks, and free up liquidity so the markets could start moving again.

Despite the staggering numbers attached to recent government actions and proposals, no one knows for sure how much the bailouts will end up costing American taxpayers. In the meantime, the interest on the borrowed billions will be added to the national debt.

Paulson argued that specific intervention in the markets was necessary to help overcome the crisis and allow the economy to move forward. “The biggest help we can give the American people is to stabilize our financial system right now and to prevent the system from clogging up, because if it does clog up, this is going to have an adverse effect on people’s abilities to get jobs, on their budgets, on their retirement savings, on lending for small businesses.”

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