Overview of the New Report on the Financial Bailout

Anger was palpable this fall as Congress scrambled to quell a financial wildfire that began in the overheated home-mortgage market, raged through Wall Street, spread ominously to Main Street and then flared into a global financial catastrophe.

“We were told that markets knew best, and that we were entering a new world of global growth and prosperity,” declared Sen. Charles E. Schumer, D-N.Y., chairman of the Joint Economic Committee. “We now have to pay for the greed and recklessness of those who should have known better.”

Such emotions have been widespread in the wake of the nation’s – and perhaps the world’s – worst financial crisis since the Great Depression. But agreement on the root causes and likely outcome of the crisis has been harder to find.

Early this month Congress overcame bitter ideological differences and passed a $700 billion bailout bill that permitted an immediate infusion of $250 billion into the banking system. Along with other loans, the government’s potential tab for rescuing the American economy totaled at least $1 trillion in mid-October. The federal government also announced on Oct. 23 it would guarantee up to $2.8 billion in debt and money market deposits.

Initially, the bailout’s chief aim was to buy up “toxic” loans on lenders’ books in the hopes of thawing the nation’s frozen credit markets. As the crisis spread overseas, however, European central bankers – led by British Prime Minister Gordon Brown – began infusing their shaky banks with cash. Treasury Secretary Henry M. Paulson Jr. followed suit, committing the government to pumping $250 billion directly into U.S. banks to induce them to begin lending to each other again – vital to easing the nation’s credit woes and bolstering confidence in the financial system.

As policy makers grasped for new options, experts remained divided over how much the plan will ultimately cost taxpayers, who should be held accountable for creating the economic debacle in the first place and whether the rescue plan would prevent a deep recession – an increasingly unlikely prospect.

The financial storm had been brewing for months, but it broke wide open in September with a shocking cascade of events over several tumultuous weeks. In the United States alone:

* Fannie Mae and Freddie Mac were seized by the federal government, which promised to inject up to $100 billion into each firm as concerns grew over the two mortgage titans’ cash reserves;

* The investment bank Lehman Brothers collapsed in the biggest bankruptcy in U.S. history;

* Brokerage house Merrill Lynch narrowly averted Lehman’s fate by selling to Bank of America;

* Global insurer American International Group (AIG) was propped up with an initial $85 billion federal bridge loan (since raised to as much as $123 billion);

* Washington Mutual failed, in the biggest bank collapse in U.S. history;

* Struggling Wachovia Bank planned to sell out to Wells Fargo, and

* Goldman Sachs and Morgan Stanley converted to commercial banks subject to stringent federal regulation, leaving Wall Street without major investment banks.

As the crisis intensified, Federal Reserve Chairman Ben S. Bernanke, Secretary Paulson and President George W. Bush urged quick congressional action. In a prime-time televised speech on Sept 24, Bush warned that without a rescue plan, “ America could slip into a financial panic” and “a distressing scenario” of business failures, job losses and home foreclosures would follow.

But support for a bailout was far from universal, even within the president’s own party. Sen. Jim Bunning, a Kentucky Republican, said spending $700 billion in taxpayer money to “prop up and clean up the balance sheets of Wall Street” is “financial socialism” and “un-American.”

Still, many experts viewed the bailout as painful but necessary. “We have to do something,” said Tony Plath, an associate professor of finance at the University of North Carolina at Charlotte. “We can’t let the American system melt down.”

The crisis has clearly spooked Main Street. A CNN/Opinion Research Corp. poll released on Oct. 6 found that nearly six in 10 Americans thought an economic depression was likely.

How the financial system reached the brink of collapse is a complex story that economists and congressional leaders will be untangling for years. But as the crisis deepened, experts pointed to a variety of likely and alleged culprits, including:

A collapsing real estate market – Spurred by record-low interest rates earlier this decade, lenders fueled a massive housing bubble, betting that borrowers – even ones with bad credit or lacking the documented means to repay – could refinance based on ever-rising home values. That gamble proved catastrophically wrong. When home prices fell, millions of homeowners found themselves owing more than their homes were worth, sparking a flood of mortgage defaults and foreclosures. That squeezed lenders who had made subprime, “Alt-A” and other shaky loans as well as investment banks that borrowed heavily to buy mortgage-backed securities based on such loans.

Fannie Mae and Freddie Mac – Some blame the Federal National Mortgage Association and Federal Home Loan Mortgage Corporation for fueling the market for reckless lending. The government-backed companies own or guarantee $5.4 trillion in mortgage loans – about 45 percent of the nation’s total. Fannie alone bought or guaranteed at least $270 billion in risky loans between 2005 and 2008, The New York Times reported.

Credit-default swaps – Ultimately, many experts say, the crisis was caused by little understood, unregulated, insurance-like contracts that are intended to guarantee against loan defaults. Subprime and other loans were backed by trillions of dollars in credit swaps. When home buyers began defaulting, financial institutions that sold the swaps lacked enough capital to make good on the guarantees, and investors who had purchased risky mortgage-backed securities were left hanging.

Plunging confidence in the financial system – Many major financial institutions, both in the United States and overseas, borrowed heavily to invest in mortgages, and their highly leveraged positions put them at risk of insolvency when defaults rose. As the financial crisis intensified, banks found it harder and harder to raise new capital to avert trouble. Meanwhile, investors and creditors began worrying that all kinds of assets on the books of financial institutions – not just residential real estate – might be grossly overvalued, further eroding confidence. When banks even became leery of lending to each other, consumer and business credit began freezing up.

The failure of government regulators – The 1999 repeal of the Glass-Steagall Act, a Depression-era law that split commercial banking from investment activities, helped set the stage for the current crisis, some experts say. Others cite what they argue was Congress’ failure to rein in Fannie Mae and Freddie Mac. Critics also point to the 2000 Commodity Futures Modernization Act, which prohibited regulation of most swaps. Also under scrutiny is a 2004 Securities and Exchange Commission (SEC) decision to loosen capital rules for brokerage units of investment banks, which freed billions of dollars for investments in mortgage-backed securities, credit derivatives and other instruments.

Whatever the policy roots of the crisis, its resolution has been maddeningly elusive. In the days following the rescue plan’s passage, the Dow Jones Industrial Average suffered its worst single-week decline in its 112-year history. Stock markets around the world also plunged, a grim reminder that the crisis is global and threatens not only major European and Asian economies but emerging markets and poor nations as well.

In the United States, many economists remained skeptical that the infusions of capital and the purchase of toxic assets would lead banks to lend anew and get the economy moving again.

“Rather than jump into this morass again, a lot of commercial banks are going to opt for liquidity on their balance sheets,” says a skeptical Robert Ekelund, professor emeritus of the economics of regulation at Auburn University.

Indeed, many see more pain ahead for the financial system and U.S. economy, including rising defaults on credit cards. “We have to be prepared that it gets a lot worse,” said Jamie Dimon, chief executive of JP Morgan Chase.

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