18.2 Government Response and Bailouts
4 min read•july 30, 2024
The prompted unprecedented government action. The , acting as lender of last resort, established to stabilize markets and prevent economic collapse. These programs aimed to restore confidence and credit flow, utilizing the Fed's expanded powers under "unusual and exigent circumstances."
Congress authorized the (), initially allocating $700 billion to address the crisis. TARP's focus shifted from purchasing troubled assets to injecting capital into financial institutions and supporting struggling industries. While controversial, these interventions were credited with preventing a complete financial meltdown and shaping future crisis response strategies.
Federal Reserve Emergency Lending
Lender of Last Resort Function
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- Federal Reserve acts as lender of last resort during financial crises
- Establishes temporary credit and liquidity programs supporting credit flow to households and businesses
- Derives emergency lending powers from Section 13(3) of allowing for "unusual and exigent circumstances"
- Aims to restore market functioning, increase confidence, and prevent collapse of
- Effectiveness measured by ability to stabilize markets, lower borrowing costs, and prevent widespread economic damage
Key Emergency Lending Facilities
- (TAF) provided short-term loans to depository institutions
- (PDCF) extended overnight loans to primary dealers
- Term (TSLF) allowed primary dealers to borrow Treasury securities
- Other facilities included (CPFF) and Term (TALF)
- Facilities tailored to address specific market dysfunctions (commercial paper market, asset-backed securities market)
Regulatory Changes and Oversight
- of 2010 modified Federal Reserve's emergency lending powers
- Required additional oversight and restrictions on future emergency lending programs
- Mandated broader disclosure of lending facility details to increase transparency
- Limited Fed's ability to lend to individual firms, focusing on programs with broad-based eligibility
- Enhanced Congressional reporting requirements for emergency lending activities
Troubled Asset Relief Program
Program Structure and Implementation
- Authorized by of 2008, initially allocating $700 billion
- Primary goal restored stability to U.S. financial system by increasing credit flow and addressing
- Implementation shifted from purchasing troubled assets to injecting capital into financial institutions
- Capital injections executed through purchase of preferred stock in participating institutions
- Program expanded beyond initial focus on financial sector to include automotive industry and homeowners
Key TARP Initiatives
- (CPP) provided capital to banking institutions
- supported struggling automakers (General Motors, Chrysler)
- (HAMP) assisted homeowners facing foreclosure
- (PPIP) addressed toxic assets on bank balance sheets
- Targeted Investment Program provided additional support to Citigroup and Bank of America
Effectiveness and Long-term Impact
- Prevented complete financial meltdown according to proponents
- Critics cited concerns and uneven distribution of benefits
- Final cost to taxpayers significantly lower than initial projections
- Treasury Department reported profit on many investments (, bank preferred stock)
- Increased government involvement in private sector
- Changed public perception of financial institutions and government intervention
- Influenced development of future crisis response strategies and financial regulations
Quantitative Easing and Economic Impact
QE Implementation and Mechanics
- Unconventional tool used when traditional methods (lowering interest rates) ineffective
- Federal Reserve implemented three rounds: (2008-2010), (2010-2011), (2012-2014)
- Involved large-scale asset purchases, typically government bonds and mortgage-backed securities
- Increased money supply and lowered long-term interest rates
- Aimed to encourage lending, boost asset prices, and stimulate economic activity
- Reduced borrowing costs for businesses and consumers
Economic Effects and Criticisms
- Lowered yields on Treasury securities and mortgage-backed securities
- Increased stock market valuations and real estate prices
- Weakened U.S. dollar, potentially benefiting exports
- Critics argued QE led to asset bubbles and increased income inequality
- Concerns raised about potential for future inflation and market distortions
- Debate over effectiveness in stimulating real economic growth versus financial asset inflation
Quantitative Tightening and Policy Normalization
- Unwinding of QE presented challenges for normalizing monetary policy
- Federal Reserve began reducing its balance sheet in 2017
- Gradual approach aimed to minimize market disruptions
- Raised questions about long-term impacts of expanded central bank balance sheets
- Influenced global monetary policy, with other central banks adopting similar measures
- Ongoing debate about appropriate size of central bank balance sheet in post-crisis era
Financial Institution Bailouts: Controversy and Decision
"Too Big to Fail" Doctrine and Key Bailouts
- Government justified bailouts using "" doctrine
- Argued failure of certain large institutions would catastrophically affect broader economy
- (AIG) received $182 billion rescue package
- and placed under government conservatorship
- Major banks supported through Capital Purchase Program under TARP
- Selective nature of bailouts sparked debates ( allowed to fail)
Arguments For and Against Bailouts
- Proponents argued bailouts necessary to prevent systemic collapse and mitigate economic downturn
- Bailouts aimed to stabilize financial markets and restore confidence in banking system
- Critics contended bailouts created moral hazard by encouraging excessive risk-taking
- Concerns raised about privatizing profits while socializing losses
- Debate over fairness and criteria for determining "systemically important" firms
- Public outrage stemmed from perception of Wall Street rescue at Main Street's expense
Long-term Consequences and Policy Implications
- Increased regulation of financial sector (Dodd-Frank Act, Basel III capital requirements)
- Changes in corporate governance practices and executive compensation policies
- Ongoing debates about appropriate role of government in managing economic crises
- Influenced development of new resolution mechanisms for failing financial institutions
- Shaped public attitudes towards financial industry and government economic intervention
- Led to calls for breaking up large banks and addressing "too big to fail" problem
- Impacted political landscape, contributing to rise of populist movements
Key Terms to Review (32)
2008 financial crisis: The 2008 financial crisis was a severe worldwide economic downturn that originated in the United States, triggered by the collapse of the housing bubble and high-risk mortgage-backed securities. This crisis led to significant failures within the banking and financial sectors, prompting widespread reforms to prevent future occurrences, extensive government interventions including bailouts for major financial institutions, and substantial repercussions across various sectors of the economy.
AIG: American International Group (AIG) is a multinational insurance corporation that became one of the largest recipients of government assistance during the 2008 financial crisis. Known for its involvement in various insurance and financial services, AIG's near-collapse was primarily due to its exposure to risky financial products, particularly credit default swaps, which ultimately led to a significant government bailout to prevent systemic risk in the economy.
American International Group: American International Group (AIG) is a global insurance and financial services corporation that provides a wide range of products, including property-casualty insurance, life insurance, and retirement services. AIG played a pivotal role during the financial crisis of 2008, becoming one of the largest recipients of government bailouts to prevent its collapse and stabilize the economy.
Asset-Backed Securities Loan Facility: An Asset-Backed Securities Loan Facility (ABS LF) is a financial mechanism that allows institutions to borrow against a pool of asset-backed securities, which are financial instruments backed by cash flows from various assets like loans or leases. This facility was established as part of the government response during economic crises, providing liquidity to financial markets and supporting the economy by enabling lending and investment.
Automotive industry financing program: The automotive industry financing program refers to a series of financial assistance measures implemented by the government aimed at stabilizing the automotive sector during economic downturns. These programs are designed to provide loans, grants, and incentives to manufacturers and consumers to encourage production and sales, ultimately ensuring the survival of auto companies and preserving jobs in the industry.
Capital Purchase Program: The Capital Purchase Program (CPP) was a component of the Troubled Asset Relief Program (TARP) created in response to the financial crisis of 2008. It involved the U.S. Treasury Department purchasing equity stakes in banks to stabilize the financial system, encourage lending, and restore confidence in the banking sector. By providing capital directly to financial institutions, the program aimed to improve their balance sheets and ensure they could continue to operate during the economic downturn.
Commercial Paper Funding Facility: The Commercial Paper Funding Facility (CPFF) is a program established by the Federal Reserve to provide liquidity to the commercial paper market during times of financial stress. This facility allows eligible issuers to sell their commercial paper to the Federal Reserve, which helps stabilize the market by ensuring that businesses can continue to access short-term funding. By bolstering confidence in the commercial paper market, the CPFF aims to prevent disruptions in the broader economy during periods of crisis.
Dodd-Frank Wall Street Reform and Consumer Protection Act: The Dodd-Frank Wall Street Reform and Consumer Protection Act is a comprehensive piece of financial reform legislation enacted in 2010 in response to the 2008 financial crisis. It aims to increase regulation of financial institutions, improve consumer protections, and prevent the kind of risky behavior that led to the economic meltdown. The Act established new agencies and oversight mechanisms to monitor financial markets and protect consumers from unfair lending practices.
Emergency Economic Stabilization Act: The Emergency Economic Stabilization Act is a law enacted in 2008 in response to the financial crisis, aimed at stabilizing the economy by allowing the federal government to purchase or insure up to $700 billion in troubled assets. This act was pivotal in addressing the immediate issues faced by financial institutions and restoring confidence in the financial markets, ultimately contributing to the broader government response and bailouts during this period.
Emergency lending facilities: Emergency lending facilities are financial mechanisms established by central banks to provide liquidity to financial institutions in times of crisis. These facilities are designed to stabilize the financial system by enabling banks to access short-term loans during periods of severe stress or uncertainty, helping to prevent a complete collapse of the banking sector. They often come with specific terms and conditions to ensure that they are used appropriately and to mitigate moral hazard.
Fannie Mae: Fannie Mae, officially known as the Federal National Mortgage Association, is a government-sponsored enterprise (GSE) established to expand the secondary mortgage market in the United States. By buying mortgages from lenders, Fannie Mae provides them with liquidity, enabling more loans to be issued, and thus plays a crucial role in supporting homeownership and stability in the housing market.
Federal Reserve: The Federal Reserve, often called the Fed, is the central banking system of the United States, established in 1913 to provide the country with a safe and flexible monetary and financial system. It plays a critical role in regulating the nation's monetary policy, supervising and regulating banks, maintaining financial stability, and providing financial services to depository institutions and the federal government.
Federal Reserve Act: The Federal Reserve Act, enacted in 1913, established the Federal Reserve System as the central bank of the United States. This legislation was designed to provide the country with a safer and more flexible monetary and financial system, particularly in response to financial panics that had previously plagued the economy.
Fiscal Policy: Fiscal policy refers to the government's use of spending and taxation to influence the economy. It aims to manage economic fluctuations by adjusting public spending and tax policies, impacting overall economic activity, inflation, and employment levels. Effective fiscal policy can address issues such as stagflation and can also play a crucial role during financial crises, prompting government responses to stabilize the economy.
Freddie Mac: Freddie Mac, officially known as the Federal Home Loan Mortgage Corporation, is a government-sponsored enterprise (GSE) established in 1970 to expand the secondary mortgage market in the United States. It provides liquidity, stability, and affordability to the housing market by purchasing mortgages from lenders and selling mortgage-backed securities to investors. Its role is crucial during economic downturns when private lending institutions might tighten credit availability, making it a significant player in government responses and bailouts in the housing sector.
Home Affordable Modification Program: The Home Affordable Modification Program (HAMP) was a federal initiative launched in 2009 aimed at helping struggling homeowners avoid foreclosure by modifying their mortgage loans to make them more affordable. This program was part of the broader government response to the 2008 financial crisis and sought to stabilize the housing market by providing assistance to homeowners facing financial difficulties. HAMP helped many individuals by reducing monthly payments through loan modifications, thereby impacting various sectors of the economy as it aimed to prevent a cascade of foreclosures.
Lehman Brothers: Lehman Brothers was a global financial services firm that played a significant role in the American investment banking landscape until its collapse in 2008. As one of the largest bankruptcy filings in U.S. history, its failure is often cited as a pivotal moment in the onset of the financial crisis, highlighting systemic weaknesses in the financial sector and triggering widespread economic turmoil.
Monetary policy: Monetary policy refers to the actions taken by a nation's central bank to manage the money supply and interest rates, aiming to achieve macroeconomic objectives like controlling inflation, consumption, growth, and liquidity. It is a crucial tool for influencing economic activity and can be expanded or contracted depending on the economic conditions. Understanding monetary policy is essential when analyzing financial reforms, economic crises, and responses to inflationary pressures.
Moral Hazard: Moral hazard refers to the situation where one party takes risks because they do not have to bear the full consequences of their actions, often due to the presence of insurance or bailouts. This concept is crucial in understanding how financial institutions or individuals may engage in reckless behavior, knowing they will be shielded from potential losses. In many cases, moral hazard can lead to negative outcomes, especially during financial crises when the safety nets provided by governments create an environment where irresponsible actions are incentivized.
Primary Dealer Credit Facility: The Primary Dealer Credit Facility (PDCF) is a program established by the Federal Reserve that provides overnight loans to primary dealers, which are financial institutions authorized to trade government securities directly with the Fed. This facility aims to enhance the liquidity of the financial system, especially during times of economic distress, by enabling primary dealers to meet their funding needs more easily. By supporting these key players in the financial markets, the PDCF plays a crucial role in stabilizing the economy during crises.
Public-private investment program: A public-private investment program is a government initiative that seeks to stimulate economic growth by leveraging private capital to purchase distressed assets, particularly in times of financial crises. This type of program aims to restore stability in financial markets and promote economic recovery by creating partnerships between the government and private investors, encouraging them to collaborate in investing in troubled assets while sharing risks and rewards.
QE1: QE1, or Quantitative Easing 1, refers to the first round of monetary policy implemented by the Federal Reserve in response to the 2008 financial crisis. This unconventional monetary policy aimed to increase liquidity in the economy by purchasing long-term securities, which was crucial in stabilizing financial markets and promoting economic recovery during a period of severe recession.
QE2: QE2, or Quantitative Easing 2, refers to the second round of monetary stimulus implemented by the Federal Reserve in response to the financial crisis of 2007-2008. This unconventional monetary policy involved the purchase of long-term government securities and mortgage-backed securities to increase liquidity in the financial system, stimulate economic growth, and lower unemployment rates. It aimed to support the economy during a period of stagnation by lowering interest rates and encouraging lending and investment.
Qe3: QE3, or Quantitative Easing 3, refers to the third round of a monetary policy strategy implemented by the Federal Reserve to stimulate the U.S. economy following the financial crisis of 2008. This policy involved the central bank purchasing large quantities of financial assets, such as government bonds and mortgage-backed securities, with the aim of lowering interest rates and increasing liquidity in the financial system. QE3 was a response to persistent economic challenges and aimed to support job growth and boost consumer spending.
Quantitative easing: Quantitative easing is a non-traditional monetary policy tool used by central banks to stimulate the economy by increasing the money supply through the purchase of government securities and other financial assets. This strategy aims to lower interest rates, promote lending, and support economic growth, particularly during periods of economic downturn or when conventional monetary policy has become ineffective. By injecting liquidity into the financial system, quantitative easing can have significant implications for government responses and the overall impact on various sectors of the economy.
Securities Lending Facility: A securities lending facility is a program that allows financial institutions to borrow securities, typically to meet short-term needs or to facilitate trading. This facility can help stabilize the financial system by providing liquidity during times of market stress, allowing institutions to cover short positions or meet delivery obligations. By ensuring that securities are available for borrowing, it supports overall market functioning and helps prevent systemic disruptions.
Subprime mortgage crisis: The subprime mortgage crisis was a financial downturn that occurred in the late 2000s, triggered by a surge in high-risk mortgage loans given to borrowers with poor credit histories. This crisis highlighted systemic issues in the housing market and financial institutions, leading to widespread foreclosures, loss of home values, and a global economic recession.
Systemically important institutions: Systemically important institutions are financial entities whose failure could trigger a widespread economic crisis due to their interconnectedness within the financial system. These institutions are often deemed 'too big to fail' because their collapse can lead to a domino effect, impacting banks, markets, and economies globally. Regulators monitor these institutions closely to prevent failures that could destabilize the economy.
TARP: The Troubled Asset Relief Program (TARP) was a government initiative created in 2008 to purchase toxic assets and provide financial assistance to banks during the financial crisis. This program aimed to stabilize the financial system by preventing the collapse of major financial institutions, which could have led to a deeper economic downturn. TARP represented a significant government response to the crisis, showcasing the need for intervention to restore confidence in the banking sector and ensure liquidity in the economy.
Term Auction Facility: The Term Auction Facility (TAF) was a program initiated by the Federal Reserve during the financial crisis of 2007-2008, allowing banks to borrow funds for a set term through an auction process. This facility was designed to enhance the liquidity of the banking system and support financial stability by providing banks with access to short-term funding at competitive rates, helping to prevent further disruptions in credit markets.
Too big to fail: The term 'too big to fail' refers to financial institutions or corporations that are so large and interconnected that their failure would have catastrophic consequences for the economy. This idea gained prominence during financial crises when governments and regulators decided to intervene, often through bailouts, to prevent the collapse of these entities, as their failure could lead to widespread economic turmoil and loss of jobs.
Troubled Asset Relief Program: The Troubled Asset Relief Program (TARP) was a financial rescue plan initiated by the U.S. government in 2008 to stabilize the economy during the financial crisis. TARP aimed to purchase distressed assets and provide financial support to banks and other institutions to prevent their collapse, ultimately aiming to restore confidence in the financial system. This program marked a significant government intervention in the economy, with far-reaching implications for various sectors and future regulatory measures.