In order to understand how we have gotten to the point where government intervention is needed to save our financial markets, it is necessary to look back and examine the many causes that lead to this situation we are in today. The economic crisis we are dealing with cannot be blamed on one cause; however there is a situation that is still unraveling that has played a very significant role. The rise of subprime lending in the late 90 s and early 2000 s and its subsequent fallout have crippled the US financial markets. By examining the elements of the subprime mortgage crisis, and its effects on our economy as a whole, it becomes clear why government intervention is necessary. Starting in the late 90 s and early 2000 s interest rates were relatively low and banks had large amounts of cash on hand. At the same time the housing market in the US was doing very well, with many markets seeing large increases in home values year after year. With increasing home values and low interest rates, home ownership became very attractive. People who did not own homes were looking at home ownership, and many of those who did own homes were looking to upgrade. This increased demand for new mortgages increased competition among mortgage lenders. Looking for ways to capitalize on the increased demand for home loans and avoid competitors, many lenders began to lend to people with less than perfect credit ratings, a practice known as subprime lending. Most of these sub-prime borrowers had a higher chance of defaulting on their loans. To account for the added risk, financial institutions had to charge higher interest rates. One of the ways they did this was by using adjustable rate mortgages (ARM or ARM s). These mortgages had lower interest rates in the first couple of years but higher interest rates in later years. During the beginning of the subprime mortgage crisis banks were making money and people were becoming homeowners. To the American public, this validated the use of subprime lending and increased the number of people who sought to use this practice as a way to home ownership. Beginning in 2006 the number of foreclosures started to increase dramatically as home values started to decline. Many people with adjustable rate mortgages began to realize the higher interest rates built into their mortgages and could not make their mortgage payments. While this was happening, subprime lenders who had issued the loans sold them to investors. Attracted by the high yields of these loans, many mutual funds and hedge funds purchased bundled investment products that consisted of subprime loans. This meant that a large percentage of the investing public in America now owned these subprime loans as investments. As many of these loans began to default, those who owned these loans as investments saw their investments decline in value. Mortgage lenders started to fail or go bankrupt, and the mutual funds and hedge funds that invested in subprime loans lost millions. Many financial firms made enormous investments in these mortgage backed securities and began to realize billions in losses. Large names such as Merrill Lynch and Bear Sterns, financial firms that had been in existence since the turn of the century, either merged or closed their doors completely. The financial firms that remained tightened their lending practices extremely, which led to the scarce credit market we are in today. This scarcity of credit has crippled our economy. Businesses depend on long-term and short-term credit to run their businesses and people depend on credit to run their everyday lives. By mid-2008 financial markets were in full blown crisis, shut down by the lack credit and the panic of
investors. This is when the US government decided intervention might be necessary. In September of 2008 the US government introduced the idea of a $700 billion bailout plan to save US financial markets. The idea of this bailout was to save US financial firms by buying these toxic investments, taking the investments off the balance sheets of investment firms and freeing them up to lend money again with the hopes of relaxing the credit market. The idea was controversial for many Americans who believed the bailout was savings those on Wall Street who had made bad financial decisions. Proponents of the bailout claimed it was necessary to save these financial firms in order to save the US economy as a whole. This is where we are today. The bailout has been passed by the US government but many are asking the question, is government intervention justified in order to save the US financial system? The federal government, through the Senate and the House of Representatives recently approved a $700 billion bailout plan to stabilize the financial markets. The core of the plan authorizes the Treasury secretary to buy as much as $700 billion in bad assets from financial companies in a bid to get credit flowing to consumers and businesses. It allows the Federal Deposit Insurance Corp. to raise its deposit-insurance cap to $250,000 from $100,000 and also requires government agencies to modify troubled mortgages. The bill allows regulators to suspend certain accounting rules for securities that some argue have contributed to the credit crisis. The Federal Reserve has also lowered interest rates and pushed an unprecedented amount of liquidity into financial markets since the credit crunch first surfaced in August 2007. All the various programs are designed to manage the liquidity in financial markets; that is, the amount of cash or nearcash equivalents that can be used for transactions, reserves or for lending. By increasing liquidity, the federal government hopes to prevent the seizing up of daily market operations due to banks and other financial institutions hoarding liquid assets. The Federal Reserve Bank and The Treasury Department have also bailed out large corporations facing meltdowns. Such companies include AIG; with an $85 billion loan coming from the Federal Reserve, and a $30 billion buyout of Bear Stearns' assets as part of the fire-sale to JP Morgan. The Treasury has also seized control of Fannie Mae and Freddie Mac taking an equity stake in the company. The full impact of these measures is not expected to be felt immediately with the Government hoping to effectively make functional the $700 billion bailout plan in a couple of weeks. Economists predict that the country may not see any signs of improvement until well into the second half of 2009, until then a very slow economy is the best expectation. The $700 billion bailout bill which was passed by the House of Representatives on Friday October 3, 2008 and then subsequently signed into effect by President Bush is considered by some as an unprecedented act by our federal government. The bill establishes the Troubled Asset Relief Program, which gives the Department of Treasury the funds to buy up toxic mortgages, securities and related assets that have undermined the nation's financial architecture. In order to implement the bill the Department of Treasury will hire nearly two dozen full-time employees, such as lawyers, asset managers, accountants, and others with financial-market experts, to conduct the purchasing of assets.
By hiring professionals like veteran asset managers, the federal government is reducing its risk of overpaying for securities that are going to be extremely hard to value. The Treasury will likely start its purchasing of assets by purchasing securities. Assets will be bought through a reverse auction system where institutions will bid to compete to sell their assets. In this reverse auction system, the federal government will set a price for assets. Financial firms will then place bids to sell their securities to the federal government. The federal government will then buy the securities from the lowest bidder taking them off the balance sheets of financial firms. Along with purchasing distressed securities, the Federal Reserve is taking further steps to free up the credit market. The central bank announced Monday that it will begin paying interest on the reserves of commercial banks that are deposited with the central bank. They are also expanding their loan program to distressed banks in order to free up credit available to businesses. One of the steps necessary in determining if government intervention is necessary is to look at what has happened in the past. While many consider this bailout unprecedented, it is not the first time the federal government has stepped into the private sector to help economy. The first time the federal government stepped into the private sector was in 1933 when it established the Home Owners Loan Corporation during the great depression, this was a program that purchased delinquent mortgages at a discount and worked with homeowners to restructure their mortgages into more manageable terms. At the time of HOLC s construction many thought it was going to be an extremely costly project; however when it was disbanded in the early 1950 s the program actually returned a small profit to the federal government. Another instance when the federal government stepped in to help the private sector was during the savings and loan crisis of the 1980 s.this was brought on by the Federal Savings and Loan Insurance Corporation approaching insolvency because of the failure of member savings and loan institutions, also known as thrifts. Working together, congress and President George H. W. Bush established the Resolution Trust Corporation, which was funded by the Resolution Funding Corporation. The Resolution Trust Corporation went on to make an estimated $394 million for the federal government. Those who support the bailout package claim it is an investment. Judging on past experiences, the government could turn a profit on its participation in the US financial markets. Warren Buffett, an expert on investment products in the US said, There is no one who can leverage up like the United States government. If they do it right, and I think they will do it reasonably right they ll make a lot of money. The goal of the bailout is to save US financial markets and avert an economic crisis similar to The Great Depression. This will be done by creating a market for illiquid mortgage-backed securities so they can be valued and traded. The bailout bill will also setup regulatory oversight on how these toxic assets are valued and disposed of. By creating controls and oversights on the trading market for mortgagebacked securities, there will be increased confidence by investors in the trading market and increased efficiencies in trading these securities. Also by taking mortgage backed securities off the balance sheets of financial firms, it frees them up to lend money again to consumers, businesses, and other banks.
Furthermore, by removing these distressed assets off the balance sheets of financial firms investors will feel more confident in investing in these firms, hopefully strengthening the financial sector in equity markets. Another necessary step in determining whether or not government intervention is justified is to address what would happen if the government hadn t intervened with the $700 billion bailout package? Would problems have fixed themselves through market conditions or would it have lead to a collapse of the American economy. There are several possible repercussions that need to be addressed if the government had not intervened. Following an announcement last week that Congress might not pass the bailout package, the Dow Jones Industrial Average dropped over 700 points. Many investors were scared and without the expectation of the bailout, fled from equity markets last week. Other investors have stayed on the sidelines, waiting for better news before making any new investments. The US stock market needs the bailout in order to increase investor confidence and stabilize the market. Top experts in stock market agree the bailout is necessary to avoid a crisis. Warren Buffett said last Wednesday the bailout package is absolutely necessary to avoid an economic Pearl Harbor. Accompanying the lack of confidence in the stock market is a lack of credit available to businesses. This credit crunch has crippled business in America. A lack of credit seriously impairs the ability of businesses to function. Companies require short and long term credit to pay for inventories, rent, and payrolls. Without access to credit to run their businesses, many companies face the real possibility of going out of business. GDP could decrease and unemployment could increase, creating a favorable environment for a recession. Without government intervention the possibility of a recession is much higher. Markets across Europe and the rest of the world are also dependent on government intervention, whether through the bailout package here in the United States or through actions of their own governments. Europe is also struggling with a credit crunch and declines in their equity markets. Few believe the bailout package can solve the credit problems in Europe, but without it there is less credit available to US companies who conduct business or invest in Europe and the rest of the world. European central banks are also paying close attention to what the Federal Reserve is doing and may follow in the Feds footsteps with regard to intervening in their own financial markets. Many European governments have recently raised guarantees on personal savings accounts to calm fears of those with deposits at banks in Europe. The current condition of the US financial system is a very serious one and desperately in need of government intervention. The consequences of doing nothing are collapsed equity and credit markets and recessionary conditions in the economy. Many claim government intervention is not justified and the bailout package is saving those on Wall Street who made bad investment decisions. While this may be the case, government intervention is not only justified but necessary to save our financial system and the economy. The implications are far too important and far too reaching for the US government to do nothing.