Emergency Economic Stabilization Act of 2008

United States Department of the Treasury

Following the bankruptcy of Lehman Brothers and the sale of Merrill Lynch to Bank of America on September 14, 2008, and the sudden bailout of American International Group by the Federal Reserve on September 16, 2008—events considered part of the on-going financial crisis of 2007–2008—the U.S. Treasury Secretary Henry Paulson proposed his Troubled Asset Relief Program on September 20 As originally proposed, the plan would give absolute and un-reviewable authority to purchase up to US$700 billion of mortgage backed securities from financial institutions for the purpose of stabilizing the market.

The plan was just three pages long and included notable provisions such as the authority to enter into contracts for services, including employing consultants, "without regard to any other provision of law regarding public contracts"; and an assertion that "decisions by the Secretary... may not be reviewed by any court of law or any administrative agency."

The plan was presented by Henry Paulson and Ben Bernanke on September 23 to the Senate Banking Committee who rejected it as not acceptable. As of 28 May 2024, consultations over amendments to the plan are on-going.

US Congressmen have called this change an extremely and surprisingly sudden one, a shock, "Bush financial crisis", and "a gun to our head" tendency by the administration to stifle debate, as was the case with the funding of the War on Terror followed by the multi-billion Iraq War for non-existent WMDs. However, many sources have reported that there are other less-risky and more-profitable solutions to use the taxpayers' funds as well. Denver Post proposed:

Instead of the taxpayers buying $700 billion of bad loans from the banking system, why doesn’t the federal government offer to loan capital to banks at a 10 percent interest rate and the ability to buy additional stock equal to the recapitalization loan at a 20 percent discount to the current trading value of the company’s stock? Of course, this is about the same as Warren Buffet’s deal to recapitalize Goldman Sachs. I think most taxpayers would be happy with this proposal. It would solve the problem at the expense of banks in trouble, and the taxpayer would win. The best solutions are the simplest.

Many sources have called this plan "unpopular" and have questioned the administration's authority to go on with a taxpayers-funded plan that is opposed by the taxpayer itself.

Background

Main articles: Subprime mortgage crisis, Financial crisis of 2007-2008, and Economic crisis of 2008

A serious turmoil in the banking system and financial markets due to the subprime mortgage crisis reached a critical stage during September 2008, characterized by severely contracted liquidity in the global credit markets and going-concern threats to investment banks and other institutions. In response, the U.S. government announced a series of comprehensive steps to address the problems, following a series of "one-off" or "case-by-case" interventions such as the $85 billion AIG bailout on September 16.

President Bush meets with Congressional members, including John McCain and Barack Obama, at the White House to discuss the bailout, September 25, 2008

Consultations by the Secretary of the Treasury Henry Paulson, the Chairman of the Federal Reserve Ben Bernanke, and the Chairman of the U.S. Securities and Exchange Commission Christopher Cox with Congressional leaders and President George W. Bush, moved forward efforts to draft a proposal for a comprehensive solution to the problems created by illiquid assets, and other measures, resulted in some stock, bond, and currency markets stability on September 19, 2008.

At the close of the week the Secretary of the Treasury Paulson and President Bush announced a proposal for the federal government to buy up to US$ 700 billion of illiquid mortgage backed securities with the intent to increase the liquidity of the secondary mortgage markets and reduce potential losses encountered by financial institutions owning the securities. The draft proposal was received favorably by investors in the stock market, but caused the US dollar to fall against gold, the Euro, and oil. The plan was not immediately approved by Congress; debate and amendments were seen as likely before the plan was to receive legislative enactment.

Throughout the week of 20-26 September there was in fact very contentious wrangling among Senators and congressmen over the terms and scope of the bailout, amplified by continued failures of institutions like Washington Mutual the fact that there would be a national election coming up on 4 November.

• On September 21, 2008, Treasury Secretary Henry Paulson announced that the original proposal, which would have excluded foreign banks, had been revised to include foreign financial institutions with a presence in the US. The US administration pressured other countries to set up similar bailout plans.

• On September 24, 2008, President George W. Bush addressed the nation on primetime television, describing how serious the financial crisis could become if action was not taken promptly by Congress.

This plan, sometimes dubbed "The Paulson Proposal" in the media is not to be confused with Henry Paulson's earlier 212 page plan known as the Blueprint for a Modernized Financial Regulatory Reform, which was released on March 31, 2008 and condemned as "a wild pitch. ... not even close to the strike zone" by Senator Chris Dodd, the same head of the Senate Banking Committee.

Components of the plan

Mortgage asset purchases

A key part of the proposal is the federal government's plan to buy up to US$ 700 billion of illiquid mortgage backed securities (MBS) with the intent to increase the liquidity of the secondary mortgage markets and reduce potential losses encountered by financial institutions owning the securities. The draft proposal of the plan was received favorably by investors in the stock market. Details of the bailout remain to be approved by Congress.

This plan can be described as a risky investment, as opposed to an expense. The MBS within the scope of the purchase program have rights to the cash flows from the underlying mortgages. As such, the initial outflow of government funds to purchase the MBS would be offset by ongoing cash inflows represented by the monthly mortgage payments. Further, the government eventually may be able to sell the assets, whether at a gain or loss remains to be seen. While incremental borrowing to obtain the funds necessary to purchase the MBS may add to the U.S. public debt, the net effect will be considerably less as the incremental debt will be offset to a large extent by the MBS assets.

A key challenge would be valuing the purchase price of the MBS, which is a complex exercise subject to a multitude of variables related to the housing market and the credit quality of the underlying mortgages. The ability of the government to offset the purchase price (through mortgage collections over the long-run) depends on the valuation assigned to the MBS at the time of purchase. For example, Merrill Lynch wrote down the value of its MBS to approximately 22 cents on the dollar in Q2 2008. Whether the government is ultimately able to resell the assets above the purchase price or will continue to merely collect the mortgage payments is an open item.

As the primary investor owning the securities, the government would be in a better position to systematically modify mortgage terms quickly, helping homeowners keep their homes. At present, the pace of foreclosures is exceeding the capacity of programs such as the Hope Now Alliance to assist homeowners, in part because a myriad of investors and complex MBS contracts must be consulted as part of the refinancing process.

Support money market funds

Loans to banks for Asset-Backed Commercial Paper

How Money Markets Fund Corporations

During the week ending 19 September 2008, money market mutual funds had begun to experience significant withdrawals of funds by investors. This created a significant risk because money market funds are integral to the ongoing financing of corporations of all types. Individual investors lend money to money market funds, which then provide the funds to corporations in exchange for corporate short-term securities called asset-backed commercial paper (ABCP). However, a potential bank run had begun on certain money market funds. If this situation had worsened, the ability of major corporations to secure needed short-term financing through ABCP issuance would have been significantly affected. To assist with liquidity throughout the system, the Treasury and Federal Reserve Bank announced that banks could obtain funds via the Federal Reserve's Discount Window using ABCP as collateral.

Insurance scheme for money market mutual funds

To stop the potential run on money market mutual funds, the Treasury also announced on September 19 a new $50 billion program to insure the investments, similar to the Federal Deposit Insurance Corporation (FDIC) program.

Temporary exception to bank regulations

Part of the announcements included temporary exceptions to section 23A and 23B (Regulation W), allowing financial groups to more easily share funds within their group. The exceptions expire on January 30, 2009, unless extended by the Federal Reserve Board.

Sweeping powers

If approved as originally proposed, the plan would grant the Secretary of the Treasury unprecedented powers, proofing his or her actions against congressional or judicial review. Section 8 of the Paulson financial rescue plan states: "Decisions by the Secretary pursuant to the authority of this Act are non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency."

Rationale for the bailout

Government officials

In his testimony before the U.S. Senate, Treasury Secretary Henry Paulson summarized the rationale for the bailout:

• Stabilize the economy: "We must...avoid a continuing series of financial institution failures and frozen credit markets that threaten American families' financial well-being, the viability of businesses both small and large, and the very health of our economy."
• Improve liquidity: "These bad loans have created a chain reaction and last week our credit markets froze – even some Main Street non-financial companies had trouble financing their normal business operations. If that situation were to persist, it would threaten all parts of our economy."
• Comprehensive strategy: "We must now take further, decisive action to fundamentally and comprehensively address the root cause of this turmoil. And that root cause is the housing correction which has resulted in illiquid mortgage-related assets that are choking off the flow of credit which is so vitally important to our economy. We must address this underlying problem, and restore confidence in our financial markets and financial institutions so they can perform their mission of supporting future prosperity and growth."
• Immediate and significant: "This troubled asset relief program has to be properly designed for immediate implementation and be sufficiently large to have maximum impact and restore market confidence. It must also protect the taxpayer to the maximum extent possible, and include provisions that ensure transparency and oversight while also ensuring the program can be implemented quickly and run effectively."
• Broad impact: "This troubled asset purchase program on its own is the single most effective thing we can do to help homeowners, the American people and stimulate our economy."

In his testimony before the U.S. Senate on September 23, 2008, Fed Chairman Ben Bernanke also summarized the rationale for the bailout:

• Investor confidence: "Among the firms under the greatest pressure were Fannie Mae and Freddie Mac, Lehman Brothers, and, more recently, American International Group (AIG). As investors lost confidence in them, these companies saw their access to liquidity and capital markets increasingly impaired and their stock prices drop sharply." He also stated: "Purchasing impaired assets will create liquidity and promote price discovery in the markets for these assets, while reducing investor uncertainty about the current value and prospects of financial institutions. More generally, removing these assets from institutions’ balance sheets will help to restore confidence in our financial markets and enable banks and other institutions to raise capital and to expand credit to support economic growth."
• Impact on Economy and GDP: "Extraordinarily turbulent conditions in global financial markets...these conditions caused equity prices to fall sharply, the cost of short-term credit--where available--to spike upward, and liquidity to dry up in many markets. Losses at a large money market mutual fund sparked extensive withdrawals from a number of such funds. A marked increase in the demand for safe assets--a flight to quality--sent the yield on Treasury bills down to a few hundredths of a percent. By further reducing asset values and potentially restricting the flow of credit to households and businesses, these developments pose a direct threat to economic growth."

Journalists

According to Jim Cramer, large corporations and institutions are pulling their money out of bank money market funds, in favor of government backed Treasury bills. This move is slowly robbing banks of the capital reserves they so desperately need. Cramer called it "an invisible run on the banks," one that has no lines in the lobby but pushes banks to the breaking point nonetheless. Bank runs are taking place under the radar, he said. Chief financial officers, lawyers, the wealthy – they’re all pulling their money from savings accounts and asking for T-bills. As a bank’s deposits evaporate, so too does its ability to lend and correspondingly make money. This will continue until Congress agrees on a bailout deal. “The lack of confidence inspired by Lehman’s demise, the general poor health of many banks, this is going to turn this into an intractable moment,” Cramer said, “if someone in the government doesn’t start pushing for more deposit insurance.”

Regarding the $700 billion number, Forbes.com quoted a Treasury spokeswoman: "It's not based on any particular data point. We just wanted to choose a really large number."

Congressional proposals

Congressional leaders, including both presidential candidates, are working with the Bush Administration and the Treasury department on key negotiation points as they work to finalize the plan. Key open items under discussion include:

• Additional foreclosure avoidance and homeowner assistance
• Executive pay limits
• Government equity interests in firms participating in program, to provide additional taxpayer protection
• Judicial review, Congressional oversight and right to audit
• Structure and authority of the entities that will manage the program

Markets opinion on effects of bailout on economy and markets

Markets reacted to the Bush bailout speech as investors moved their money in the days after the announcement.

Dollar falls against Euro, British Pound, and Japanese Yen

Dollar fell as the plan for a US bailout of banks is announced by Bush speech. [1] [2] See chart at yahoo finance [3]

Oil prices rise sharply on bailout proposal and the end of the October Contracts

Oil spiked more than $25 a barrel during the day Monday, ending the day up over $16. This was a record for the biggest one-day gain. . However, there are other factors that caused the massive spike in oil prices. Traders who got "caught" at the end of the October contract session were forced to purchase oil in large batches to cover themselves, adding to the surge in prices.

Mortgage rates rise after bailout plan is announced

Interest rates on the 30 Year Fixed Mortgage rose from 5.86% to 5.99% (on September 26, 2008 compared to average rate a week earlier). Interest rates on the 30 Year Jumbo Fixed Mortgage rose from 7.01% to 7.18% (on September 26, 2008 compared to average rate a week earlier) This data is from bankrate.com and yahoo.com [4] [5]

Potential effects of the proposed $700 Billion Bailout

Potential tax increase for US taxpayers or more borrowing or printing $700 billion

According to NBC6 (south Florida television station 6) the cost of $700 billion bailout is "$2,295 estimated cost per American" (305 million estimated number of Americans) or "$4,635 per working American" (151 million estimated work force (excluding retirees, kids, etc.)). [6] The bailout does not specify whether the $700 billion will come from increase federal borrowing, increased taxes, or printing money.

Impact on federal budget

The federal budget next year, in 2009, (see United_States_federal_budget#Total_Outlays_in_Recent_Budget_Submissions ) is $3,100 billion and the bailout is $700 billion, a 23% increase.

Commentary

Costs

It has been argued that $700 billion dollars is excessive. Of the $1.26 trillion in sub-prime mortgages, $743 billion is already either owned or guaranteed by Fannie Mae and Freddie Mac, companies that were shored up by a government rescue earlier in September 2008. Given Fannie Mae and Freddia Mac's share of the mortgages, only $521 billion remains. This figure is significantly less than the Treasury’s $700 billion proposal. Secretary Paulson, however, has indicated that the plan may include other types of assets, not just MBS.

Conflict of interest

Criticism of Paulson stems from the fact that his plan has a conflict of interest, as until May 2006 he was CEO of Goldman Sachs, potentially one of the largest beneficiaries of the bailout.

Constitutionality

Joshua Rosner, managing director of Graham Fisher & Co, questioned the constitutionality of Paulson's plan. Rod Smolla pointed out that the Paulson plan would establish policy decisions made by the Secretary of the Treasury as "non-reviewable...by any court of law."

Balancing Taxpayer and Wall Street Interests

In an Opinion piece in the Wall Street Journal, Senator Hillary Clinton has advocated addressing the rate of mortgage defaults and foreclosures that ignited this crisis, not just bailing out Wall Street firms: "If we do not take action to address the crisis facing borrowers, we’ll never solve the crisis facing lenders." She has proposed a new Home Owners’ Loan Corporation (HOLC), similar to that used after the Depression, which was launched in 1933. The new HOLC would administer a national program to help homeowners refinance their mortgages. She is also calling for a moratorium on foreclosures and freezing of rate hikes in adjustable rate mortgages.

Valuation of securities purchased

The valuation of the purchase price paid for mortgage-backed securities (MBS) is a key open question. Market value is affected by the ability to sell the MBS, not just the present value of future cash collections related to the MBS. The government must balance the assistance it intends to provide to the financial institution with its fiduciary responsibility to taxpayers. If the government pays the (lower) market value as opposed to the (higher) present value, it may not be enough to assist the banks. For the plan to work, Treasury may have to pay closer to the present value, offering a subsidy to financial institutions at the expense of taxpayers.

Politics

After the President's announcement of the bailout plan on Wednesday, Sept. 24, there were negotiations on altering the proposal, and declarations of fundamental understanding between the White House and the congressional leaders having been reached were made already on Thursday morning. This apparent eagerness of the Democratic Party politicians to reach an early accommodation with the Bush administration created (in light of persistent reports of popular opposition to the bailout program) a propaganda vacuum and opportunity, into which the House Republicans quickly moved, raising objections, refusing to support the deal and presenting themselves as defenders of the ordinary taxpayer's interests. The negotiations then continued throughout Friday, when some politicians predicted a conclusion by the end of the weekend, while others indicated willingness to take their time and work on the package until it's ready.

Opinions

Protests

• Los Angeles: Spontaneous street corner protests against bailout with hand made signs in Los Angeles, Santa Monica, Hollywood, Pasadena by people from various political parties. [7]
• Rochester, NY – A protest started Thursday in front of the Federal Building. Television channel 13: [8]
• New York City: Teachers, machinists, transit workers protest on steps of New York Stock Exchange. [9]

On September 25, 2008, several hundred labor union members organized by New York Central Labor Council protested outside of the New York Stock Exchange against the bailout. Other grassroots groups such as TrueMajority have planned rallies to protest against the bailout.

Polls

• In a survey conducted September 19-22 by the Pew Research Center, by a margin of 57 percent to 30 percent, Americans supported the bailout when asked "As you may know, the government is potentially investing billions to try and keep financial institutions and markets secure. Do you think this is the right thing or the wrong thing for the government to be doing?"
• In a survey conducted September 19-22 by Bloomberg/Los Angeles Times, by a margin of 55 percent to 31 percent, Americans opposed the bailout when asked whether "the government should use taxpayers' dollars to rescue ailing private financial firms whose collapse could have adverse effects on the economy and market, or is it not the government's responsibility to bail out private companies with taxpayers' dollars?".

• Senator Sherrod Brown said he had been getting 2,000 e-mail messages and telephone calls a day, roughly 95 percent opposed.
• Through late Thursday, Sen. Dianne Feinstein's (D-Calif.) offices had received a total of 39,180 e-mails, calls and letters on the bailout, with the overwhelming majority of constituents against it.

Views from Officials/Lawmakers/Politicians

• Henry M. Paulson, Jr., Secretary of the Treasury proposed the plan.
• British prime minister Gordon Brown supported the plan, saying that it was essential to restore stability to the markets.
• "This plan is stunning in its scope and lack of detail," said Connecticut Sen. Christopher Dodd, chairman of the Senate Banking Committee. "It does nothing in my view to help a single family save a home."
• "I am concerned that Treasury's proposal is neither workable nor comprehensive, despite its enormous price tag," said Alabama Senator Richard Shelby, the ranking Republican on the committee.
• "This massive bailout is not a solution. It is financial socialism and it's un-American," said Sen. Jim Bunning, R-Ky.
• Democratic presidential candidate Barack Obama said any bailout must include plans to recover the money, and protect working families and big financial institutions and be crafted to prevent such a crisis from happening again.
• Texas Representative and former Presidential candidate Ron Paul publicly opposes any bailout and calls for further reforms to remedy the crisis.

Views from financiers

• Investor Warren Buffett said he wholeheartedly supported the plan. However, Mr. Buffet is not a disinterested third party in that his company owns financial companies which might benefit directly or indirectly.
• Alan Greenspan, former Chairman of the Federal Reserve, endorsed Paulson’s plan on September 19.
• Investor George Soros is opposed to the original Paulson plan – "Mr Paulson’s proposal to purchase distressed mortgage-related securities poses a classic problem of asymmetric information. The securities are hard to value but the sellers know more about them than the buyer: in any auction process the Treasury would end up with the dregs. The proposal is also rife with latent conflict of interest issues. Unless the Treasury overpays for the securities, the scheme would not bring relief." – but calls Barack Obama's list of conditions for the plan "the right principles".
• Investor Carl Icahn described the bailout as "crazy and inflationary hell".
• Joshua Rosner, managing director of Graham Fisher & Co., says there is plenty of liquidity out in the open market to purchase these securities when the price becomes cheap enough and the people shorting the securities will buy them at that point.
• Investor Jim Rogers called the plan "astonishing, devastating, and very harmful for America".

Views from economists

• In an open letter sent to Congress on September 23, over 100 university economists expressed "great concern for the plan proposed by Treasury Secretary Paulson". The letter has been described as "the emerging consensus from academic economists". Its authors described three "fatal pitfalls" they perceived in the plan as it was initially proposed:

"1) Its fairness. The plan is a subsidy to investors at taxpayers’ expense. Investors who took risks to earn profits must also bear the losses. [...] The government can ensure a well-functioning financial industry [...] without bailing out particular investors and institutions whose choices proved unwise."

"2) Its ambiguity. Neither the mission of the new agency nor its oversight are clear. If taxpayers are to buy illiquid and opaque assets from troubled sellers, the terms, occasions, and methods of such purchases must be crystal clear ahead of time and carefully monitored afterwards."

"3) Its long-term effects. If the plan is enacted, its effects will be with us for a generation. For all their recent troubles, America's dynamic and innovative private capital markets have brought the nation unparalleled prosperity. Fundamentally weakening those markets in order to calm short-run disruptions is desperately short-sighted."

As of September 25, the open letter had been signed by 192 economists from American universities.

Views from journalists

• The Economist magazine said that although "Mr Paulson’s plan is not perfect ... it is good enough" and that "Congress should pass it—and soon."
• "The deal proposed by Paulson is nothing short of outrageous. It includes no oversight of his own closed-door operations. It merely gives congressional blessing and funding to what he has already been doing, ad hoc." - Robert Kuttner

• Economist and New York Times columnist Paul Krugman wrote "Instead of purchasing the assets, equity capital could be provided to the banks directly in exchange for preferred stock. This would strengthen the financial position of the banks, encouraging them to lend. Dividends would be paid to the government on the preferred shares. This would be similar to what happened during the S&L crisis and with the GSE bailout. This avoids the valuation questions involved in the direct purchase of MBS."

Expectations and forecasts

Despite the unresolved issues, President Bush predicted the Democratic-controlled Congress would soon pass a "a robust plan to deal with serious problems."

See also

• Financial crisis of 2007-2008
• Economic crisis of 2008
• January 2008 stock market downturn
• List of entities involved in 2007-2008 financial crises
• Bear Stearns subprime mortgage hedge fund crisis
• Federal takeover of Fannie Mae and Freddie Mac
• Bankruptcy of Lehman Brothers
• Federal Reserve bailout of AIG

• Bankruptcy of Washington Mutual
• Savings and Loan crisis
• Subprime mortgage crisis
• Subprime crisis impact timeline
• Subprime lending
• Mortgage backed securities
• United States housing market correction

The world housing bubble

• Chinese property bubble
• Indian property bubble
• Irish property bubble
• Japanese asset price bubble
• Russian property bubble
• Spanish property bubble
• United States housing bubble
• United Kingdom housing bubble

References

• Free market bailed out, 700 billion dollar Wall St bailout by Bush administration; 35 years of neo-liberalism crashes - Ron Blackwell and Ellen Frank at The Real News, September 22, 2008
• Bailout plan not embraced, Top officials push for speed in passing bailout package but many are skeptical - Nomi Prins at The Real News, September 24, 2008

External links

• http://www.whitehouse.gov/infocus/economy/