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November 12, 2008
Rescuing the U.S. Economy:
A Look at the Federal Bailout Plan and Its Implications
Editor's Note: The content of this article was current as of the original date of publication and does not reflect any government action, new legislation or other related developments that have occurred since November 12, 2008. The attorneys of Much Shelist are monitoring these issues closely and will help our clients and friends stay informed by distributing periodic updates.
Most people understand that by enacting the Emergency Economic Stabilization Act of 2008 (EESA) and its companion legislation on October 3, 2008, Congress and the President committed the federal government and its vast treasury to the task of bailing this country out of the worst financial crisis it has faced since the Great Depression. Less obvious, however, is how the bailout is intended to work, and what effect it is likely to have on our nation's financial institutions, business community and, ultimately, the average citizen.
In a speech delivered in October of this year, John C. Dugan, the current Comptroller of the Currency, listed the many problems that have beset the United States. Taken alone, any one of these issues could have delivered a serious blow to the economy, but the compound effect—as noted by former Chairman of the Federal Reserve Board Alan Greenspan—is nothing short of an economic tsunami.
Among the problems Dugan listed as either initiating or exacerbating the damage to the economy were:
- The first nationwide annual decline in house prices;
- Severe losses on subprime loans;
- Record levels of foreclosures;
- The liquidity freeze for asset-backed commercial paper;
- The large write-down of concentrated positions in senior tranches of collateralized debt obligations;
- Sharply reduced liquidity in interbank funding markets and the inability to sell mortgages to anyone other than GSEs;
- The implosion of the auction rate securities market;
- The freefall in the stock market; and
- The significant decline in credit quality of a broad range of assets held by businesses and consumers alike.
These problems, in turn, led to an unprecedented string of adverse consequences, such as:
- The decline of Countrywide Financial, the nation's largest mortgage lender, and its takeover by Bank of America;
- The run on Bear Stearns and its subsequent takeover by JPMorgan Chase;
- The opening of the Fed's discount window to investment banks;
- The takeover of IndyMac by the FDIC, together with a continuing string of other bank failures;
- The government takeovers of Fannie Mae and Freddie Mac;
- The failure of Lehman Brothers, the sale of Merrill Lynch to Bank of America and the conversion of Morgan Stanley and Goldman Sachs to bank holding companies;
- The government takeover of AIG;
- The failure of Washington Mutual (the largest depository institution failure in U.S. history) and its takeover by JPMorgan Chase; and
- The proposed merger of Wachovia and Wells Fargo.
As Dugan summed it up, "By any measure, the scale and speed of these events have been stunning, mind-boggling, earth-shaking, eye-popping—you pick the adjective—but to be honest, even these words of hyperbole don't adequately capture what's happened."
The U.S. Government Responds
In light of such dramatic events, how did the federal government respond? With uncharacteristic speed, Congress approved and the President signed EESA, one of the most far-reaching pieces of economic legislation ever. In addition, the various federal banking regulators moved to take advantage of existing statutory authority to adopt or enhance numerous other programs aimed at complementing the principal thrust of EESA, which was to unfreeze U.S. credit markets and get money back in the hands of the businesses and individuals who need it the most.
Under the terms of EESA, the Secretary of the Treasury has been given vast new powers to reshape the U.S. financial system and thaw out credit markets frozen by an overabundance of toxic mortgage-related assets. Because mortgagees were having a difficult time meeting their financial obligations to their lenders, the flow of funds that had been expected by the lenders was substantially curtailed and the affected institutions lost the ability to fully meet their own obligations. Those institutions also started to run short of the cash they needed to continue their own business operations at levels of maximum efficiency. When creditors saw the trouble that those institutions had gotten themselves into, they no longer felt safe making loans, which put the institutions in danger of failing. Furthermore, because so many U.S. financial institutions are tied together by complex financial arrangements (such as credit default swaps and other financial derivatives), it was feared that as one institution failed, others would be dragged down with it.
Blame for this problem has been laid at the feet of the loan originators and securitizers that bundled the mortgage packages, the credit-rating agencies that neglected their own standards in evaluating the packages, the hedge funds that promoted the use of the exotic securitized derivatives, the corporate executives who displayed unparalleled greed by emphasizing short-term returns over long-term growth and value, the homeowners who knew they could not afford to repay the loans they took out, and the regulators who were egregiously lax in their oversight.
The broad purpose of EESA, therefore, is to overcome these massive problems by providing the Secretary of the Treasury with the authority and facilities necessary to restore liquidity and stability to the U.S. financial system in a manner that protects home values, college funds, retirement accounts and personal savings; preserves homeownership; promotes job growth; maximizes overall returns to U.S. taxpayers; and provides public accountability. While outlining specific programs that the Secretary can utilize, EESA does not go into great detail about how those programs should be implemented.
Congress wisely chose to give the Secretary a relatively free hand, subject to several layers of federal oversight. Once the money starts flowing again, Congress and the President believe that the economy will heal itself and that American businesses, including the severely wounded financial institutions, will again be able to function normally.
Although free to fill in the blanks with appropriate operational details, the Secretary is nevertheless required to keep several key objectives in mind. He is obligated to:
- Protect the interests of the taxpayers;
- Provide stability and prevent disruption of financial markets;
- Help families keep their homes and stabilize their communities;
- Determine the long-term viability of financial institutions involved in the new programs he establishes;
- Ensure that all financial institutions are eligible to participate in these programs without discrimination;
- Provide assistance to financial institutions whose capital may have been impaired in some manner by the current crisis;
- Ensure stability for public entities (such as cities and counties) that may have suffered from the crisis;
- Protect the retirement security of Americans; and
- Determine whether to also make purchases of real estate, or real-estate-backed mortgages, relating to multifamily properties.
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