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Financial Panic

The financial turmoil experienced a brief respite in summer 2008. The weak economy got a lift from the rebate checks taxpayers received as part of the first economic stimulus package quickly cobbled together by the Bush Administration and the Democratic Congress. A few large financial institutions reported decent earnings, suggesting perhaps that with the resolution of Bear Stearns, the coast was clearing. Unfortunately, it was the proverbial calm before the storm.

Things took a dramatic turn for the worse when in early September, policymakers stumbled badly, beginning with the government takeover of Fannie Mae and Freddie Mac. Fannie and Freddie were publicly traded companies with a federal government charter to promote homeownership by providing ample and cheap credit to minorities and other disadvantaged groups. This became difficult to do during the height of the housing boom because subprime lenders were willing to provide even more—and cheaper—credit. Fannie and Freddie’s share of mortgage lending fell sharply. The companies fought back; they had to, given the requirements of their charters and the demands of their profit-hungry shareholders. They didn’t push all the way into the subprime market, but by the peak of the housing bubble, they had become sizable players in risky parts of the mortgage market. And although the dollar amount of this lending was small compared to the rest of their operations, it was large compared to their capital base. The companies’ regulator had historically not required them to hold a lot of capital because they had made only safe mortgage loans; they didn’t increase their capital commensurately when they moved into riskier lending.

As losses at Fannie and Freddie began to mount, their stock- and bondholders—including some of the largest and bluest of blue-chip institutional investors in the world—grew increasingly nervous. Fannie’s and Freddie’s stock prices fell, and their borrowing costs began to rise, increasing mortgage rates for home buyers. By the first week of September 2008, the Bush Administration felt it had no choice but to take over Fannie Mae and Freddie Mac. The Treasury Department put them into conservatorship. Shareholders were wiped out, and although bondholders were protected, the action crystallized in the minds of global investors that all financial institutions, no matter how large, were at significant threat of failure. Fannie and Freddie probably would have been considered insolvent if their assets and liabilities were valued at market prices, but they still had sufficient regulatory capital, the amount of capital necessary to satisfy regulatory requirements. In past financial crisis, policymakers had showed forbearance to large institutions in similar situations—Citigroup was likely insolvent during the early 1990s Savings & Loan crisis but was not taken over by regulators—so as not to unnerve investors. Treasury Secretary Paulson didn’t show the same forbearance with Fannie and Freddie, and this spooked investors.

Investors’ fears boiled over when policymakers allowed broker-dealer Lehman Brothers to fail one week later. Lehman’s problem wasn’t a lack of cash—it could use the credit facility the Fed had established after the Bear Stearns collapse for just such a purpose. But no other financial institution wanted to do business with a firm that could soon be out of business. Hedge funds that had used Lehman to execute their trades no longer did so, and other, bigger financial institutions forced Lehman to put up more funds as collateral just in case something went wrong. A year earlier, Lehman Brothers had been at the center for the financial system, but in what seemed like just a few days, the system had shut Lehman out. The company was careening toward bankruptcy.

The Treasury and the Federal Reserve worked feverishly to find a buyer for Lehman, as they had done for Bear Stearns, but no one stepped forward. Lehman’s fate was in the hands of the Treasury and the Fed. The Fed argued that it couldn’t help because Lehman didn’t have enough assets to provide the collateral necessary to get a Fed loan; by its charter, the Fed could provide only a fully collateralized loan. The Treasury also said no, arguing that it couldn’t bail out everyone, and the financial system had plenty of time, given the Bear collapse, to prepare for a Lehman failure.

Not forestalling a Lehman bankruptcy was a mistake; not everyone was prepared. The Reserve Primary Fund, one of the nation’s oldest and largest money market funds, had invested heavily in Lehman debt. Lehman’s bankruptcy forced them to write off that investment. The resulting losses caused them to break the buck: The value of the fund’s assets fell below what it owed its investors. This was too much to bear for many mom-and-pop investors, who thought a money fund was as safe as putting their money in the mattress; they began withdrawing their funds. Money funds that are large investors in commercial paper—the short-term IOUs of major businesses—had no choice but to stop buying CP. What’s more, they were forced to sell CP to meet the redemptions. Large businesses were immediately scrambling for ways to finance their basic operations. Equity investors realized that no business was immune from the fallout of the mounting credit crunch, and stock prices plunged.

The entire financial system was on the precipice of collapse. A rattled Treasury Secretary Paulson and Fed Chairman Bernanke came before Congress with a plan to save the system. The idea was for taxpayers to put up $700 billion in a Troubled Asset Relief Fund to buy the banking system’s toxic assets. Neither the need for the $700 billion TARP nor how the money was to be used and overseen was well explained. Confusion circulated over just how purchasing distressed mortgage loans and securities would be conducted and why this would quell the financial panic. With taxpayers incensed that they were being asked to bail out bankers who had made terrible mistakes, in late September, Congress failed to muster enough votes to pass the TARP legislation. Financial markets were roiled. Congress passed TARP a few days later because they couldn’t ignore the market turmoil, but the collective psyche had been badly damaged. There was no longer time to begin asset purchases, and the TARP monies were used instead to make direct capital infusions into the teetering financial institutions. Taxpayers now owned big stakes in the nation’s biggest financial institutions.

Although TARP funds weren’t being used for asset purchases, it was widely expected that they eventually would be. Investors were thus shocked when Secretary Paulson announced in November 2008 that the TARP fund would not be used for this purpose after all. Depressed asset prices fell even more. If the government wasn’t going to buy these assets, no one would. The collateral damage from this decision was the near-collapse of Citigroup, which held hundreds of billions in these bad loans and securities. Ironically, the only way to avert this calamity was for the Federal Reserve to guarantee Citi’s troubled assets, the same assets the Treasury had decided not to buy.

A string of policy errors had turned a severe yet manageable financial crisis into an inherently unpredictable and even uncontrollable financial panic. The longer the panic continued, the darker the economic outlook became.

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