In Uncategorized on March 4, 2009 at 03:03


In the fall of 2008, the credit crunch, which had emerged a little more than a year before, ballooned into Wall Street’s biggest crisis since the Great Depression. As hundreds of billions in mortgage-related investments went bad, mighty investment banks that once ruled high finance have crumbled or reinvented themselves as humdrum commercial banks. The nation’s largest insurance company andlargest savings and loan both were seized by the government. The channels of credit, the arteries of the global financial system, have been constricted,cutting off crucial funds to consumers and businesses small and large.

In response, the federal government adopted a $700 billion bailout plan meant to reassure the markets and get credit flowing again. But the crisis began to spread to Europe and to emerging markets, with governments scrambling to prop up banks, broaden guarantees for deposits and agree on a coordinated response.


The roots of the credit crisis stretch back to another notable boom-and-bust: the tech bubble of the late 1990’s. When the stock market began a steep decline in 2000 and the nation slipped into recession the next year, the Federal Reserve sharply lowered interest rates to limit the economic damage.

Lower interest rates make mortgage payments cheaper, and demand for homes began to rise, sending prices up. In addition, millions of homeowners took advantage of the rate drop to refinance their existing mortgages. As the industry ramped up, the quality of the mortgages went down.

And turn sour they did, when home buyers had to leverage themselves to the hilt to make a purchase. Default and delinquency rates began to rise in 2006, but the pace of lending did not slow. Banks and other investors had devised a plethora of complex financial instruments to slice up and resell the mortgage-backed securities and to hedge against any risks — or so they thought.

The Crisis Takes Hold

The first shoe to drop was the collapse in June 2007 of two hedge funds owned by Bear Stearns that had invested heavily in the subprime market. As the year went on, more banks found that securities they thought were safe were tainted with what came to be called toxic mortgages. At the same time, the rising number of foreclosures helped speed the fall of housing prices, and the number of prime mortgages in default began to increase.

The Federal Reserve took unprecedented steps to bolster Wall Street. But still the losses mounted, and in March 2008 the Fed staved off a Bear Stearns bankruptcy by assuming $30 billion in liabilities and engineering a sale to JPMorgan Chase for a price that was less than the worth of Bear’s Manhattan skyscraper.

Sales, Failures and Seizures

In August, government officials began to become concerned as the stock prices of Fannie Mae andFreddie Mac, government-sponsored entities that were linchpins of the housing market, slid sharply. On Sept. 7, the Treasury Department announced it was taking them over.

Events began to move even faster. On Sept. 12, top government and finance officials gathered for talks to fend off bankruptcy for Lehman Brothers. The talks broke down, and the government refused to step in and salvage Lehman as it had for Bear. Lehman’s failure sent shock waves through the global banking system, as became increasingly clearin the following weeks. Merrill Lynch, which had not been previously thought to be in danger, sold itself to the Bank of America to avoid a similar fate.

On Sept. 16, American International Group, an insurance giant on the verge of failure because of its exposure to exotic securities known as credit default swaps, was bailed out by the Fed in an $85 billion deal. Stocks dropped anyway, falling nearly 500 points.

The Government’s Bailout Plan

The bleeding in the stock market stopped only after rumors trickled out about a huge bailout plan being readied by the federal government. On Sept. 18, Treasury Secretary Henry M. Paulson Jr. publicly announced a three-page, $700 billion proposal that would allow the government to buy toxic assets from the nation’s biggest banks, a move aimed at shoring up balance sheets and restoring confidence within the financial system.

Congress eventually amended the plan to add new structures for oversight, limits on executive pay and the option of the government taking a stake in the companies it bails out. Still, many Americans were angered by the idea of a proposal that provided billions of dollars in taxpayer money to Wall Street banks, which many believed had caused the crisis in the first place. Lawmakers with strong beliefs in free markets also opposed the bill, which they said amounted to socialism.

President Bush pleaded with lawmakers to pass the bill, but on Sept. 29, the House rejected the proposal, 228 to 205, with an insurgent group of Republicans leading the opposition. Stocks plunged, with the Standard & Poor’s 500-stock index losing nearly 9 percent, its worst day since Oct. 19, 1987.

Negotiations began anew on Capitol Hill. A series oftax breaks were added to the legislation, among other compromises and earmarks, and the Senate passed a revised version Oct. 1 by a large margin, 74 to 25. On Oct. 3, the House followed suit, by a vote of 263 to 171.

When the bill passed, it was still unclear how effective the bailout plan would be in resolving the credit crisis, although many analysts and economists believed it would offer at least a temporary aid. Federal officials promised increased regulation of the financial industry, whose structure was vastly different than it had been just weeks before.

The first reactions were not positive. Banks in England and Europe had invested heavily in mortgage-backed securities offered by Wall Street, and England had gone through a housing boom and bust of its own. Losses from those investments and the effect of the same tightening credit spiral being felt on Wall Street began to put a growing number of European institutions in danger. Over the weekend that followed the bailout’s passage, the German government moved to guarantee all private savings accounts in the country, and bailouts were arranged for a large German lender and a major European financial company.

And even as the United States began to execute its bailout plan, the tactics continued to shift, with the Treasury announcing that it would spend some of the funds to buy commercial paper, a vital form of short-term borrowing for businesses, in an effort to get credit flowing again.

Continued Volatility

When stock markets in the United States, Europe and Asia continued to plunge, the world’s leading central banks on Oct. 8 took the drastic step of a coordinated cut in interest rates, with the Federal Reserve cutting its two main rates by half a point.

And after a week in which stocks declined almost 20 percent on Wall Street, European and American officials announced coordinated actions that included taking equity stakes in major banks, including $250 billion in investments in the United States. The action prompted a worldwide stock rally, with the Dow rising 936 points, or 11 percent, on Oct. 13.

But as the prospect of a severe global recession became more evident, such gains were impossible to sustain. Just two days later, after Ben S. Bernanke, the Federal Reserve chairman, said there would be no quick economic turnaround even with the government’s intervention, the Dow plunged 733 points.

The credit markets, meanwhile, were slow to ease up, as banks used the injection of government funds to strengthen their balance sheets rather than lend. By late October, the Treasury had decided to use its $250 billion investment plan not only to increase banks’ capitalization but also to steer funds to stronger banks to purchase weaker ones, as in the acquisition of National City, a troubled Ohio-based bank, by PNC Financial of Pittsburgh.

The volatility in the stock markets was matched byupheaval in currency trading as investors sought shelter in the yen and the dollar, driving down the currencies of developing countries and even the euro and the British pound. The unwinding of the so-called yen-carry trade, in which investors borrowed money cheaply in Japan and invested it overseas, made Japanese goods more expensive on world markets and precipitated a steep plunge in Tokyo stock trading.

Oil-producing countries were hit by a sudden reversal of fortune, as the record oil prices reached over the summer were cut in half by October because of the world economic outlook. Even an agreement on a production cut by the Organization of the Petroleum Exporting Countries on Oct. 24 failed to stem the price decline.

Stock markets remained in upheaval, with the general downward trend punctuated by events like an 11-percent gain in the Dow on Oct. 28. A day later, the Fed cut its key lending rate again, to a mere 1 percent. In early November, the European Central Bank and the Bank of England followed with sharp reductions of their own.

Federal officials also moved to put together a plan to aid homeowners at risk of foreclosure by shouldering some losses for banks that agree to lower monthly payments. Detroit’s automakers, meanwhile, hard hit by the credit crisis, the growing economic slump and their belated transition away from big vehicles, turned to the government for aidof their own, possibly including help in engineering a merger of General Motors and Chrysler.

The leaders of 20 major countries, meanwhile, agreed to an emergency summit meeting in Washington on Nov. 14 and 15 to discuss coordinated action to deal with the credit crisis. The group agreed to work more closely, but put off thornier questions until next year, in an early challenge for the Obama administration.

The Crisis and the Campaign

The credit crisis emerged as the dominant issue of the presidential campaign in the last two months before the election. On Sept. 24, as polls showed Senator John McCain’s support dropping, heannounced that he would suspend his campaign to try to help forge a deal on the bailout plan. The next day, both he and Senator Barack Obama met with Congressional leaders and President Bush at the White House, but their efforts failed to assure passage of the legislation, which went down to defeat in an initial vote on Sept. 29, a week before itultimately passed.

The weakening stock market and growing credit crisis appeared to benefit Mr. Obama, who tied Mr. McCain to what he called the failed economic policies of President Bush and a Republican culture of deregulation of the financial markets. Polls showed that Mr. Obama’s election on Nov. 4 was partly the fruit of the economic crisis and the belief among many voters that he was more capable of handling the economy than Mr. McCain.

As president-elect, Mr. Obama made confronting the economic crisis the top priority of his transition. Just three days after his election, he convened a meeting of his top economic advisers, including the billionaire investor Warren Buffett; two former Treasury secretaries, Lawrence H. Summers and Robert E. Rubin; Paul A. Volcker, a former Federal Reserve chairman; and Eric E. Schmidt, the chief executive of Google. After their Nov. 7 meeting, he called quick passage of an economic stimulus package, saying it should be taken up by the the lame-duck Congressional session, and that if lawmakers failed to act, it would be his main economic goal after assuming office Jan. 20.

Mr. Obama also faced a host of other demands as president-elect, including calls to bail out the auto industry, particularly General Motors, whichwarned that it would run out of cash by mid-2009. And some economists and conservatives questioned whether, given the economic crisis, he could still meet some of his pledges from the campaign, like rapidly rolling back the Bush tax cuts, which some felt would hurt demand, and pushing ahead with his planned expansion of health care coverage, which could greatly increase a soaring deficit.

Deeper Problems, Dramatic Measures

With credit markets still locked up and investors getting worried about the big banks, Wall Street marked a grim milestone in late November when stock markets tumbled to their lowest levels in a decade. In all, the slide from the height of the stock markets had wiped out more than $8 trillion in wealth. The markets inched back in the weeks that followed as investors looked forward to a new administration and a huge economic stimulus package, but key indicators of the economy only got worse.

In December, an obscure group of economists confirmed what millions of Americans had suspected for months: the United States was in a recession. The economy had actually slipped into recession a year earlier, a committee of economists said, putting the current downturn on track to be the longest in a generation. Unemployment rose to its highest point in more than 15 years. Trade shrank. Home prices fell farther. As inflation virtually halted, economists began to worry about deflation, the vicious cycle of lower prices, lower wages and economic contraction.

Retailers suffered one of the worst holiday seasons in 30 years as worried consumers cut back, raising the likelihood that dozens more would join stores like Sharper Image, Circuit City and Linens ‘n Things in bankruptcy.

On Dec. 16, the Federal Reserve entered uncharted waters of monetary policy by cutting its benchmark interest rate to nearly zero percent and declaring that it would deploy its balance sheet and essentially print money to fight the deepening recession and locked credit markets. Investors cheered, sending the Dow up more than 300 points, but many economists began to worry about the world’s appetite for hundreds of billions of dollars in new Treasury debt.

Other countries followed the Fed with rate cuts of their own. Britain’s central bank a wave of refinancing that nevertheless skipped many homeowners.

But as Mr. Obama took office, investors were just as worried as ever, as evidenced by Wall Street’s worst Inauguration Day drop ever. The fourth-quarter corporate earnings season was marked by billion-dollar losses and uncertain outlooks for 2009. The economy showed no sign of turning around. And many lawmakers and analysts began to wonder whether the first $350 billion in bailout money had any effect at all. Banks that received bailout fundssat on their money, rather than lend it out to consumers or home buyers.

And bailout recipients such as Citigroup and Bank of America were forced to step forward for additional lifelines, raising one of the most uncomfortable questions a new president has ever had to address: Would the government nationalize the American banking system?

A New Administration

The initial steps taken by the new Treasury secretary, Timothy F. Geithner, did not venture that far. In formulating the Obama administration’s response to the crisis, he was reported to haveprevailed in discussions with presidential aides in opposing tougher conditions on financial institutions, like dictating how banks would spend their rescue money, or replacing bank executives and wiping out shareholders at institutions receiving aid. On Feb. 10, he outlined a sweeping overhaul and expansion of the government’s rescue effort, seeking to marshal as much as $2 trillion from the Treasury, private investors and the Fed.

The plan included a public-private rescue fund, often described as a “bad bank” for holding toxic assets, that would start with $500 billion with a goal of eventually buying up to $1 trillion in assets. There would also be direct capital injections into banks, which would come out of the remaining $350 billion in the Treasury’s rescue program. And the Treasury and Federal Reserve would expand a program aimed at financing consumer loans. The two agencies had originally announced their intention to finance as much as $200 billion in student loans, car loans and credit card debt. Instead the program would be expanded to as much as $1 trillion, and the Fed said it could broaden the plan to include both commercial and residential mortgage-backed securities.

But Mr. Geithner left major questions unanswered about the workings of many components of the new plan, and officials acknowledged that they had yet to decide many of the thorniest issues. So it remained unclear whether the Obama administration would be able to attract the large volume of private investment that Mr. Geithner sketched out in his speech. And the lack of specifics was also blamed for a negative reaction among investors, who sent stocks down nearly 5 percent.

After two weeks of declines on Wall Street marked by rumors of bank nationalization, the Obama administration came back with more details of their plans to perform “stress tests” on 19 of the country’s largest banks, to see whether they had a large enough capital cushions to withstand further declines in the economy. Regulators plan to examine how banks will fare if the economy performs close to the consensus views (which are not good) and under a “worst case” scenario, in which the economy shrinks 3.3 percent in 2009 and home values fall an additional 22 percent. Any bank that fails the assessment would have six months to raise additional capital privately, or would have to take it from the government in the form of preferred shares that could be converted to common stock.

With Wall Street’s gaze glued to the banks, Mr. Obama shifted his attention back to the housing crisis and unfurled a $275 billion plan to help as many as nine million families refinance their mortgages or avoid foreclosure. The plan, which won praise from consumer advocates, offered incentives to homeowners who are current on their payments and to lenders who lower interest rates on home mortgages. “This plan will not save every home, but it will give millions of families resigned to financial ruin a chance to rebuild,” Mr. Obama said in announcing it on Feb. 18. But analysts cautioned that Mr. Obama’s plan would not help millions of homeowners who are “underwater,” owing much more than the current value of their homes. And it inspired a populist invective by Rick Santelli of CNBC that encapsulated the frustration of people who believe the government’s bailouts are doing little else than rewarding bad behavior by investors and homeowners.


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