Government Bailouts

In July 2008, Congress passed a major housing bill aimed at providing relief to an economy still struggling from the effects of the subprime mortgage crisis. Many of the nation's largest banks and financial institutions had sold mortgages with adjustable interest rates to borrowers with questionable credit histories--so-called subprime borrowers. Those mortgages often started out with extremely low introductory interest rates that rose substantially over time. After several years, many homes purchased with subprime loans began to go into foreclosure. Borrowers lost their homes, and lenders lost billions of dollars, causing some of the most powerful financial institutions in the country to struggle, and several to collapse.

The housing rescue bill provides billions of dollars for the government to buy mortgages from struggling homeowners, replacing adjustable-rate mortgages with stable, 30-year loans. It also authorizes an unlimited line of credit for Fannie Mae and Freddie Mac, the publicly financed, privately held mortgage companies that own or back about half the mortgages in the U.S.

The housing bill came on the heels of the government's extension of a line of credit to JPMorgan Chase, so that Chase could buy the investment bank Bear Stearns, which was on the verge of collapse; such a collapse would be likely to ripple throughout the U.S. economy, causing substantial financial damage.

Should the government use taxpayers' money to bail out those suffering from the housing crisis? Critics insist that lenders and borrowers consciously chose to make and accept loans, and should be held responsible for their own decisions. The economy, they argue, should be allowed to thrive or suffer without government interference.

Supporters of the bailouts respond that, in most cases, bailouts occur only when absolutely necessary. They contend that if borrowers and lenders do not receive assistance, the effects of the subprime crisis could spread and cause even greater damage to the economy, including to people and businesses who have otherwise stayed clear of the housing bust.
Historical Government Bailouts

One of the most notable historical bailouts, in 1907, was centered not around the government but on the banker J. P. Morgan.

The economy was suffering in the aftermath of the investor F. A. Heinze's speculation in the copper industry. His losses resulted in the failure of his investors, including the Knickerbocker Trust Co. of New York. The bank was so integrated into the financial sector that its failure rippled throughout the economy, resulting in a stock market crash in 1907. The downfall of the financial markets led to a run on banks, to which depositors rushed to withdraw their savings, fearing that if the banks went out of business, their money would be lost. Morgan, one of the most influential bankers in the country, teamed with several other wealthy bankers, as well as the U.S. Treasury, to provide millions of dollars in emergency loans to struggling banks. Morgan's intervention is widely credited with averting a wider economic collapse.

Later bailouts focused on specific companies. In 1971, Congress authorized a $250 million loan for the Lockheed Aircraft Corporation, which was facing bankruptcy after struggling to finish production on a new line of jets. Lockheed lobbied relentlessly for the bailout, arguing that without government assistance, 60,000 workers would lose their jobs and many other companies with strong business ties to Lockheed would suffer huge financial losses. Though the bailout allowed the company to complete production of the new aircraft, Lockheed struggled to compete with other manufacturers, and by the mid-1980s the company had ceased making commercial jets.

In 1980, Congress authorized a much larger loan to the auto manufacturer Chrysler, which was facing bankruptcy. Chrysler's chairman, Lee Iacocca, lobbied for $1.5 billion in government loans to prevent the company from going out of business, which would have cost many auto workers their jobs. President Jimmy Carter (D, 1977-81) signed the legislation authorizing the loan that same year. Chrysler finished paying off the loan in 1983.

There are also some notable instances where the government refused assistance in times of financial crisis. In 1975, New York City, facing a dire credit problem, asked the federal government for a loan; the government refused. To combat the crisis, the city was forced to raise taxes and borrow money from the pension funds of municipal labor unions.

One of the largest financial crises resulting in a government bailout was the savings and loan collapse of the 1980s. The crisis dated back to the 1970s, when savings and loan institutions, which make loans for mortgages and accept savings deposits, began to struggle. Because banks and other financial institutions offered depositors higher interest rates at the time, savings and loan institutions, which were required by law to maintain low interest rates, were unable to compete. As a result, many depositors moved their savings elsewhere.

In 1980, the government deregulated the industry, removing the interest ceiling for savings and loan associations. The lack of regulations prompted many savings and loan institutions to make reckless investments; by the late 1980s the industry was in tatters. In 1989, Congress passed the Financial Institutions Reform, Recovery, and Enforcement Act, which rescued the troubled industry; the cost to taxpayers was estimated at around $124 billion.

Other recipients of government bailouts have included foreign countries. In 1995 the U.S. lent $50 billion to Mexico to help alleviate a debt crisis. President Bill Clinton (D, 1993-2001), who brokered the deal, argued that it would prevent hundreds of thousands of Americans, whose livelihoods depended on trade with Mexico, from losing their jobs. The Mexican government repaid the loan in 1997, and the U.S. earned $580 million in interest on the loan.

The Housing Crisis and Recent Bailouts

The roots of the current financial crisis date back to around 2001, when the stock market was suffering substantially from the bursting of the "dot-com bubble," in which Internet-related stocks with no real value traded for large sums of money. Additionally, the terrorist attacks of Sept. 11 placed a great strain on the economy. To combat the sluggish economy, the Federal Reserve, which regulates and influences key interest rates, lowered rates substantially, making it easier for financial institutions to borrow money from both the government and each other.

Taking advantage of these low rates, many financial institutions, including mortgage companies tied to some of the nation's largest banks, began making loans with extremely low introductory interest rates. These companies also became far less concerned with customers' credit histories, lending money to so-called subprime borrowers who might have great difficulty making mortgage payments.

Between 2004 and 2006, the economy appeared to recover from its slump, with the stock market reaching new highs and real estate values soaring as a result of the ease of obtaining mortgages. By mid-2007, however, the monthly payments of many adjustable-rate mortgages had begun to increase. Mortgage holders were unable to make their payments, and many of them lost their homes.

The crisis spiraled beyond subprime borrowers and lenders, affecting the entire housing market, and, in turn, the economy. Unemployment began to rise, wages fell, real estate prices plummeted, and the stock market slumped, prompting many experts to suggest the country was in a recession.

One of the hardest-hit companies was Bear Stearns, among the largest investment banks in the world. The bank owned several hedge funds--mostly unregulated investment funds known to involve large risks--that centered around subprime mortgages. When many of those mortgages went into foreclosure, the funds lost all their assets, costing Bear Stearns and its investors millions of dollars.

Bear Stearns fell into financial turmoil. As the company's stock tumbled, financial analysts worried that a Bear Stearns collapse might drag down the rest of the financial markets and, ultimately, the entire economy.

In March 2008, the Federal Reserve lent about $30 billion to Chase bank so that it would be able to buy Bear Stearns and absorb its debt. In doing so, Chase paid $10 per share for Bear Stearns stock, which had traded on the New York Stock Exchange for over $150 per share only a year earlier.

Although the Bear Stearns bailout was engineered to prevent a wider economic collapse, the economy was still reeling from the effects of the subprime loan fallout. Economists soon began to worry that Fannie Mae and Freddie Mac would collapse as a result of the housing crisis.

Both Fannie Mae (the Federal National Mortgage Association) and Freddie Mac (the Federal Home Loan Mortgage Corporation) are government-sponsored enterprises (GSEs). They were established by federal law, though they currently operate as privately owned and held companies. The two companies mainly buy and insure mortgages from other lenders; between them, Fannie and Freddie either own or insure around 50% of mortgages in the U.S.

Although the extent of their involvement with subprime loans has been a matter of debate, Fannie and Freddie have been significantly damaged by the drop in home prices and the slowing of the housing market. Fears that the collapse of the mortgage giants would devastate the economy led to the passage of a sweeping housing bill by Congress in July 2008, providing emergency funding for both lenders and borrowers.

The bill set aside $300 billion for the government to buy mortgages from struggling homeowners. The government would replace their adjustable-rate mortgages with stable, more affordable ones.

The bill also approved an unlimited line of credit for Fannie and Freddie to keep the companies afloat. To ensure the government's ability to pay for all the bill's measures, Congress raised the statutory limit on the national deficit to $10.6 trillion, an increase of $800 billion.
Critics Assail Housing Bailouts

Government bailouts are usually accompanied by controversy, and the current housing bailout has been no exception. Critics argue that if banks and homeowners are bailed out, moral hazard will arise--that is, if borrowers and lenders are shielded from the negative repercussions of their mistakes, they will repeat them.

Indeed, the government's rescue of Bear Stearns angered many who felt that the bank's reckless behavior did not warrant its being rescued. New York Times columnist Gretchen Morgenson noted that Bear Stearns had "often operated in the gray areas of Wall Street and with an aggressive, brass-knuckles approach." The bank, she noted, had extensive relationships with nefarious lenders, including New Century, the second-largest subprime mortgage company in the country. Morgenson asked, "What are the consequences of a world in which regulators rescue even the financial institutions whose recklessness and greed helped create the titanic credit mess we are in?"

Critics also argue that past bailouts allowed companies that had acted negligently to continue their reckless ways. In a column for MSN Money in March 2008, hedge fund manager Bill Fleckenstein wrote that over the past several decades, "bailouts became bigger and bigger--as the Fed tried to solve the problems created by too much easy money with more easy money." Fleckenstein has argued that those bailouts empowered their recipients to the point where they grew so big that they could make demands of their benefactors. According to Fleckenstein, the financial system "has devolved to the point where Bear Stearns, teetering on the edge of bankruptcy, was in effect able to tell the Fed: You can't hurt us anymore, but we can hurt you if the deal collapses, so we demand more money."

The Republican presidential nominee, Sen. John McCain (R, Ariz.), voiced a more measured response to the housing crisis, announcing that while he might back some government assistance to the parties involved, neither irresponsible borrowers nor irresponsible lenders should receive help. The McCain campaign released the following statement on the subject in March 2008:

I have always been committed to the principle that it is not the duty of government to bail out and reward those who act irresponsibly, whether they are big banks or small borrowers. Government assistance to the banking system should be based solely on preventing systematic risk that would endanger the entire financial system and the economy.

Other, mainly liberal, critics focus on the lack of financial regulation that led to the housing crisis. They argue that it is more important for the government to take steps to regulate financial institutions before they fail than to bail them out afterward. One such critic, Nobel Prize-winning economist Joseph Stiglitz, has said, "Defenders of the bailout argue that these institutions are too big to be allowed to fail. If that is the case, the government had a responsibility to regulate them so that they would not fail."

Indeed, the lack of financial regulation leading up to the housing crisis has become a significant factor in arguments against the bailing out of Fannie and Freddie. In the Village Voice, journalist Wayne Barrett detailed how Fannie and Freddie had been increasingly deregulated in the 1990s, so as to accommodate as many new homeowners as possible. This push, initiated by Andrew Cuomo, then Housing and Urban Development secretary during the Clinton administration, and continued by his successors during the administration of President Bush (R), allegedly encouraged nefarious practices, including the purchase of subprime mortgages, to make loans to as many new homeowners as possible. Additionally, the New York Times reported in August 2008 that Freddie Mac's chief executive, Richard Syron, ignored warnings dating back to 2004 about bad loans that his company was backing. As Stiglitz has said, "It sets an example for other countries of what not to do. The same administration that failed to regulate, then seemed enthusiastic about the Bear Stearns bailout, is now asking the American people to write a blank check."

Stiglitz has also observed that "regulations themselves have not kept pace with innovations in financial markets." Speaking of Bear Stearns, he told the Times, "It is one thing to gamble with one's own money--but these bankers were gambling with other people's money--and with the government backstopping any losses. This is unconscionable."

Some bailout critics have questioned whether the rescues of Freddie and Fannie mean that the government will never again allow a large company to fail. New York investment manager Peter Siris writes:

Where and how do we draw the line? Are we better off bailing out entities too big to fail? Right now, everyone is answering yes. But think back to the '70s when the city was teetering on the edge of bankruptcy and, as the Daily News famously editorialized, President Ford's reaction was "Drop Dead." New York had help, but it did not get bailed out. Instead, we sacrificed, fixed the problems and returned the city to decades of unrivaled prosperity. Would the same have happened if we were rescued by the government?

Other critics have specifically assailed the bailout of subprime homeowners, insisting that they should have assessed all possible risks before taking out the mortgages. Financial journalist Jon Markman comments:

Individuals who make bad choices--from Gulf Coast residents who build homes in the path of hurricanes to low-income citizens who take out expensive loans for overpriced real estate--are rescued time after time in well-intentioned but misguided programs such as the one the Bush administration has cooked up for the foreclosure-facing mortgage holders and their lenders.

Critics of the homeowner bailout often bemoan the rescue of housing speculators, who bought multiple homes with questionable loans, intending to sell them at a later date. Wall Street Journal writer Brett Arends describes this tendency, known as "flipping" real estate: "Many homeowners who borrowed too much to buy a home they could not afford can now qualify for a brand-new 90% mortgage, underwritten by the taxpayer. Heads you win, tails you get to, um, flip again."

Mohamed El-Erian, of the world's largest bond investor, PIMCO, has applauded the Bear Stearns bailout, but has noted that rescuing home buyers would invalidate the contracts they signed and set a bad example. He writes that a bailout "critically undermines the sanctity of contracts and, at the very minimum, leads to a persistent increase in the risk premiums that lenders impose on all borrowers. In addition, there may be unintended consequences that erode the integrity of the market system."

One of the central arguments against bailouts is that they are antithetical to free-market capitalism, in which entrepreneurial risk can lead to either success or failure. Siris writes, "We are at a crossroads in the history of American capitalism. Following the savings and loan crisis and the subprime crisis, the government showed that capitalism means big spenders win and taxpayers lose because the people who broke the rules got bailed out."

Critics also assail the notion that economic hardship stemming from crises such as the housing bubble is necessarily a bad thing. Describing the bailout of Bear Stearns, Fleckenstein wrote in March 2008, "The insidious and dangerous unspoken corollary to all this: Financial pain is now unacceptable. Those in trouble demand to be rescued, and the government seems to agree that the 'creative destruction' component of capitalism must not be allowed to do its work." Decrying what he terms "crybaby capitalism," in an August 2008 column, Fleckenstein criticizes wealthy executives who seek bailouts for their banks, claiming, "Bailouts are terrible for the country and terrible for everyone's kids. Why should the reckless make millions along the way, then have the public pay for their mess?"
Defenders Cite Bailouts as Crucial for Economic Recovery

Fears of a wider economic collapse were the government's primary defense for its rescue of Bear Stearns, as well as the primary rationale for a potential bailout of Fannie Mae and Freddie Mac. According to a recent editorial in the New York Times, "A bailout is justified when remedial assistance averts even greater harm to the economy."

Defenders insist that Bear Stearns was such a dominant force on Wall Street that, had it gone bankrupt, many other financial institutions that dealt with it would have suffered immeasurably. Ultimately, bailout advocates argue, the entire economy would have been affected, including working-class and poor Americans. Timothy Geithner, the president of the Federal Reserve Bank of New York, told Congress during hearings on the Bear Stearns bailout, "Absent a forceful policy response, the consequences would be lower incomes for working families, higher borrowing costs for housing, education, and the expenses of everyday life, lower value of retirement savings, and rising unemployment."

Roger Steel, Treasury under-secretary for domestic finance, also justified the bailouts, telling Congress, "Our focus was not on this specific institution, but on the more strategic concern of the implications of a bankruptcy.... The failure of a firm that was connected to so many corners of our markets would have caused financial disruptions beyond Wall Street." Geithner, in addition, argued that by preventing a greater disaster for the financial community, the government's actions benefited banks that had behaved prudently but were suffering nonetheless as a result of the housing crisis.

Shortly after the bailout, Treasury Secretary Henry Paulson, who supported the move, admitted that moral hazard--the notion that mistakes that go unpunished will be repeated--was a concern, but of lesser importance than stabilizing financial markets. He argued, "The priority in a time like this has got to be the stability of our financial system and minimizing the likelihood that this disruption spills over into the real economy."

Princeton University professor and New York Times columnist Paul Krugman supports the Bear Stearns bailout, despite his criticism of the company's actions during the subprime housing boom. He points out, "Fed officials knew that they were doing a bad thing, but believed that the alternative would be even worse. As Bear goes, so will go the rest of the financial system."

In his columns, Krugman has espoused essentially the same position regarding Fannie and Freddie. He has derided the way the mortgage giants were organized, noting that the combination of private ownership and public sponsorship "means that profits are privatized but losses are socialized. If Fannie and Freddie do well, their stockholders reap the benefits, but if things go badly, Washington picks up the tab. Heads they win, tails we lose." Nevertheless, Krugman asserts that "Fannie and Freddie can't be allowed to fail. With the collapse of subprime lending, they're now more central than ever to the housing market, and the economy as a whole."

Lawrence Summers, the former Treasury secretary, has argued that a rescue of Fannie and Freddie is essential because the companies no longer have the confidence of investors and will not be able to recover without government aid. Summers advocates temporarily making the mortgage giants wholly public companies owned not by stockholders but by the government.

Fortune magazine's Colin Barr has noted that many investors and political conservatives--who would usually decry government intervention--have favored recent government bailouts. Barr has speculated that their embrace of what they would otherwise denounce as socialism was precipitated by a desire to see the stock market return to its seemingly endless upswing. Barr described the 1987 stock market crash and the slump after Sept. 11th as episodes that "popularly came to be seen as little more than excellent buying opportunities along a road that has taken the Dow Jones Industrial Average

For many bailout advocates, rescuing homeowners was a far more important step than saving financial institutions. They insist that many subprime mortgages were sold by duplicitous lenders and brokers. Barrett, for example, has detailed in Vanity Fair the use of yield-spread premiums, in which brokers manipulate borrowers into taking out mortgages with interest rates far higher than they qualify for. The lending institutions that employ the brokers then pay the brokers the difference between the lowest rate for which the borrower qualified and the rate that the broker convinced them to sign up for.

Steven Davidoff, a law professor at Wayne State University in Detroit, Mich., agreed that the Bear Stearns bailout may have been necessary, but added:

It galls me that on Friday, President Bush asserted that we must go slow in helping the millions of struggling American homeowners. He stated that "we got to be careful and mindful that any time the government intervenes in the market, it must do so with clear purpose and great care." I live in Michigan and drive every day past the many foreclosures and for-sale signs. It breaks my heart that these people are struggling to keep or sell their houses, and the Fed just awarded this boon [to Bear Stearns].

Sen. Barack Obama (D, Ill.), the Democratic candidate for president in 2008, has strongly supported the housing bill and its rescue of subprime home buyers. When its passage was all but assured, his campaign issued a statement noting, "In the months since this housing package was announced, nearly a million additional families have faced foreclosure, and our economy has continued to deteriorate. We cannot wait for a million more foreclosures before taking additional action to help struggling families and strengthen our economy." Nevertheless, several of Obama's Democratic colleagues in Congress who likewise supported a homeowner bailout argued that, if anything, the housing bill did too little to help working-class Americans. Rep. Marcy Kaptur (D, Ohio) lamented, "We are bailing out Wall Street, and there is only a pittance for Main Street."
Bailouts and the Future of the Economy

The full economic impact of the recent government bailouts remains uncertain, along with the future direction of the economy. In August 2008, the unemployment rate rose to 5.7%, a four-year high. Around the same time, however, the price of oil, one of the contributing factors to the current economic slowdown, fell, leading to a slight recovery in the stock market, which had fallen throughout the spring and early summer.

Meanwhile, also in August, Fannie Mae and Freddie Mac both reported major quarterly losses. The reports dashed hopes that the worst of the housing crisis was over, prompting some fears that, if the economy continues to suffer, prime mortgage holders--who, unlike subprime borrowers, had previously been able to afford their mortgages--will have trouble making payments as well. The reports also sparked worries that Fannie and Freddie would need the expensive bailouts recently authorized by Congress.

Sources:

Arends, Brett. "What the Housing Bailout Means to You." Wall Street Journal, August 5, 2008, www.wallstreetjournal.com.

"B Is for Bailout, C Is for..." New York Times, September 10, 2007, www.nytimes.com.

Barr, Colin. "Why We Tolerate Bailouts." CNN Money.com, July 24, 2008, money.cnn.com.