When Congress initially rejected the financial bailout package proposed by the Bush administration in September, Treasury Secretary Paulson lamented that the government did not have sufficient tools to respond to the economic crisis. When the legislation finally passed, Paulson promised that the government would use every tool at its disposal. He seems to have kept that promise.
The government's efforts to bolster the financial system have taken many forms. After abandoning its initial plan to buy mortgage-backed securities, it has invested directly in banks, guaranteed individual company assets and debts, supported money markets, implemented a plan to buy asset-backed securities in the consumer credit market, provided a temporary bailout of car manufacturers, and returned to buying mortgage-backed securities.
Given the variety of actions that the government has taken, it has been challenging to stay abreast of the government's strategy. The following provides an overview of the government's efforts to date, and offers insights on how much it all costs, and what the government may do next.
The Crisis Develops
The government took steps to bolster the housing market in 2007. But it wasn't until the Bear Stearns collapse that the government directly responded to the financial crisis. On March 16, 2008, the Federal Reserve provided $30 billion in financing for JP Morgan to buy Bear Stearns. The Fed and Treasury justified the intervention as necessary to prevent a chain reaction of collapsing institutions.
As the financial crisis deepened in the summer, the Treasury committed up to $100 billion each to Fannie Mae and Freddie Mac to ensure they maintained a positive net worth. On July 12, the FDIC seized IndyMac Bank in the second-largest bank failure in American history.
By September the crisis approached catastrophe. The Federal Housing Finance Agency seized control of Fannie and Freddie, placing both in conservatorship. Soon after, titans like Lehman, WaMu, Merrill, and Wachovia collapsed.
The FDIC helped JP Morgan acquire WaMu, and the government facilitated the sale of Wachovia to Wells Fargo. The Fed loaned AIG $85 billion to prevent its collapse.
By mid-September, facing these collapses and potentially more, financial markets essentially froze. Treasury officials described this situation as a tipping point, with the country facing a complete collapse of the financial system.
The Bailout Bill
Against this backdrop, Secretary Paulson and Fed Chairman Bernanke asked Congress to approve a plan to purchase $700 billion of troubled assets. They presented a three-page-long bill that addressed only purchases of "mortgage-related assets," defined as residential or commercial mortgages or securities related to mortgages.
Over the two weeks between introduction and passage, the bill stretched to over 300 pages (although only about the first 100 dealt with the financial bailout), and broadened the Treasury's discretionary authority over allocated funds. The new law, 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, Treasury was afforded up to $700 billion in three steps, with the first $250 billion available immediately, the next $100 billion available upon presidential certification, and the final $350 billion available upon delivery of a detailed plan. Congress reserves the right to withhold the final $350 billion. Under TARP the Treasury may purchase any "troubled assets," which were broadly defined to include any "financial instrument . . . the purchase of which is necessary to promote financial market stability."
It should be noted that although TARP is central to the government's response to the crisis, it is only one component.
The Government's Actions Post-EESA
Commercial Paper Funding Facility. The government's next major action, taken outside of the EESA, was the Fed's new Commercial Paper Funding Facility, through which the Fed purchases unsecured and asset-backed commercial paper directly from issuers. The program was intended to reinvigorate the short-term commercial paper market, which is needed by many businesses for operating cash.
Around this time, the Fed also provided AIG with an additional $37.8 billion credit line to shore up its securities-lending program, and the FHFA directed Fannie and Freddie to purchase more mortgage-backed securities.
The Capital Purchase Program. The initial plan for TARP was to purchase mortgage-backed securities, thereby removing bad assets from bank balance sheets, and establishing a market price for assets held by financial institutions. In theory, this would restore confidence in these institutions to prevent collapse, and free banks to increase lending.
By early October, Treasury decided that buying mortgage-related assets would not be effective, and shifted its focus to direct capital injections into financial institutions. So Treasury created a Capital Purchase Program, allocating $250 billion of TARP funds to that program. Under this program, the government buys senior preferred shares in participating financial institutions. Participating banks must accept limitations on executive compensation, common stock dividends and equity repurchases.
Treasury aimed the Capital Purchase Program at healthy institutions. The program did not attempt to rescue struggling companies, instead focusing on stabilizing financial markets and increasing capital flow. The program does not require banks to use funds received in any particular way. Treasury officials simply expect banks to put the money to use.
The Capital Purchase Program has been widely utilized by various financial institutions. Treasury has already disbursed over $167 billion of the $250 billion allocated for this purpose.
Temporary Liquidity Guarantee Program. When Treasury announced the Capital Purchase Program, the FDIC announced a Temporary Liquidity Guarantee Program, in an attempt to stabilize financial markets for business accounts. Through this program, the FDIC guarantees newly issued senior secured debt, including promissory notes, commercial paper, interbank funding and unsecured portions of secured debt, and the FDIC insures non-interest-bearing deposit transaction accounts used by businesses for payroll and expenses.
Support for Money Market Funds. On October 21, the Fed 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. The program, in some respects, is similar to the FDIC's deposit insurance program
Systemically Significant Failing Institutions Program. On November 10, Treasury announced the Systemically Significant Failing Institutions Program, through which the Treasury assesses whether institutions are systemically significant and at substantial risk of failure. If so, TARP funds may be injected.
The same day, Treasury announced it was purchasing $40 billion in preferred stock from AIG. AIG was deemed systemically significant because of its deep connections throughout financial markets. This capital allowed the Fed to reduce the credit facility it previously extended to AIG. But the Fed established two additional lending facilities for AIG, one for residential mortgage-backed securities, and one for credit default swaps AIG wrote on collateralized debt obligations. To date, AIG is the only company to officially receive payments under the Systemically Significant Failing Institutions Program.
In late November, Treasury provided more assistance to Citigroup, beyond the funds Citigroup received through the Capital Purchase Program. Treasury, along with the Fed and the FDIC, guaranteed potential losses on Citigroup's pool of mortgage-backed securities. The guarantees apply to a $306 billion pool, with Citigroup absorbing the first $29 billion in losses and 10 percent of additional losses.
The government guarantees the rest, split among TARP, FDIC and the Fed. As a fee for the guarantee, Citigroup will issue preferred stock to TARP and the FDIC. Treasury also purchased an additional $20 billion in Citigroup preferred stock. Although this assistance would seem to fall under the Systemically Significant Failing Institutions Program, Treasury described this action as unique and not under any particular TARP program.
Term Asset-Backed Securities Loan Facility. On November 25, Treasury and the Fed announced the Term Asset-Backed Securities Loan Facility, designed to restart the consumer credit and small business loan markets by lending up to $200 billion to holders of newly issued AAA-rated asset-backed securities. This program uses $20 billion of TARP funds and is scheduled to begin in January 2009.
Purchases of Mortgages and Mortgage-Backed Securities. On multiple occasions in November, Secretary Paulson stated that TARP funds would not be used to buy mortgages or mortgage-backed securities, apparently putting an end to the original stated purpose of the EESA. Secretary Paulson commented that to be effective, any mortgage asset purchase program would require more funds than they had available.
On November 25, the Fed revived the plan to buy mortgages and mortgage-backed securities, announcing a program to purchase up to $500 billion of mortgage-backed securities backed by Freddie Mac, Fannie Mae, and Ginnie Mae, and to make $100 billion of direct obligations of those entities.
Car Manufacturer Bailout. Secretary Paulson had resisted calls to use TARP funds for car manufacturers. But when Congress failed to pass a separate auto industry bailout backed by the President and congressional leadership, Treasury seemed to acquiesce, and has agreed to provide loans to American automakers using TARP funds.
How Much Has It Cost So Far, and What's Next?
Of the $350 billion of TARP funds available so far, Treasury has allocated $335 billion, excluding loans to car manufacturers. However $80 billion of the funds allocated to date are undistributed under the Capital Purchase Program and could presumably be reallocated. Outside of TARP, the FDIC and the Fed have made trillions of dollars in guarantees and loans.
It is impossible to know the ultimate cost to taxpayers. The various guarantees and loan commitments may never be called on. At least some portion of loans will likely be repaid. The government will receive dividends on its TARP capital investments and should recover principal from preferred stock redemptions. Simply tracking expenditures and exposure is not a sufficient accounting.
Whatever our investment, what have we gotten in return? Secretary Paulson argues that the aggressive actions of the Treasury, the Fed and the FDIC pulled us back from the edge of economic disaster. He heralds the following metrics: interest rate spreads for interbank lending have decreased significantly, and the prices of credit default swaps are moving lower.
What is next? The Treasury has potentially $350 billion of additional unallocated TARP funds available. But the Bush administration has announced no plans for these remaining TARP funds, and the President-elect Obama transition team has not announced any plans for these funds or other potential bailout actions.
The Treasury and the Fed were reportedly working on plans to reduce mortgage interest rates. And there have been repeated public statements by members of Congress, presidential candidates and others about mortgage relief and various plans to provide such relief. Banks have been modifying loans on their own, the FDIC is championing a program, and several major institutions have announced voluntary moratoriums on foreclosures. Despite such pronouncements, mortgage foreclosure relief programs have not seen heavy use.
As a practical matter, it is difficult to modify existing mortgages because many are packaged in pools which have been split into many parts and sold to multiple investors. But despite the hurdles, members of Congress, including Speaker Pelosi and Congressman Frank, have increasingly criticized the Bush 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. Foreclosure relief seems a likely future priority.
But stay tuned. The government may change course.
About the authors: Michael P. Carlson is a partner in the finance and restructuring practice at Faegre & Benson. He provides comprehensive counseling regarding financial services, data privacy and payment systems. Stephen M. Mertz, also a partner in the finance and restructuring practice, practices in the areas of bankruptcy, business reorganization and commercial finance. Nathaniel J. Zylstra is an associate in the litigation practice concentrating on litigation for financial institutions and other businesses in complex financial transactions.