Download ABC-Clio American Government Feature Story: Toward Economic

ABC-Clio American Government Feature Story: Toward Economic Recovery?
Overview:
On October 3, 2008, a $700 billion economic bailout plan known as the Emergency Economic Stabilization Act
was approved by Congress and signed by President George W. Bush. The centerpiece of the massive
governmental bailout—the largest intervention since the Great Depression—was the purchase of defaulted
mortgage-backed securities from troubled banks and financial institutions.
Like a fragile house of cards, the American economy began to crumble as early as March 2008 with the failure
of investment bank Bear Stearns and declined precipitously with the folding of the nation's largest insurance
company, American International Group (AIG), by September. Once AIG fell, other seemingly sound
institutions, including Goldman Sachs, Lehman Brothers, Merrill Lynch and Co., Wachovia, and Washington
Mutual, followed suit. The ubiquitous failure of these financial institutions originated with risky investments
known as credit default swapping (CDS) and mortgage-backed securities. When the housing market boomed
around 2004, financial institutions shifted from CDS to mortgage-backed securities, or the purchasing and
bundling of mortgage loans by a range of financial institutions, including commercial banks, investment banks,
hedge funds, and pension funds. Because many of these powerhouse financial institutions conducted business
with each other, once a single entity began to falter, the house of cards collapsed.
Passage of the $700 billion bailout plan offered by Paulson proved to be fractious as the House of
Representatives originally narrowly rejected it. Opponents of that version argued that it lacked specific
oversight for administering the allocation and put few limitations on corporate executive benefits. As a result of
the bill's defeat, the Dow Jones plummeted a record 777 points, causing the Senate to quickly pass a bill two
days later. Finally, on October 3, the House accepted the proposal and Bush signed the bill later that day.
The plan called for creating an independent oversight board to oversee the recovery plan; expanding the
maximum rate that the Federal Deposit Insurance Corporation (FDIC) insures from $100,000 per account to
$250,000; modifying risky mortgage loans; and placing limitations on bank CEO benefits that are subject to
federal bailout. Less than two weeks after the law's approval, the federal government announced that $250
billion would be made available immediately to banks and financial institutions to generate capital and initiate
the loosening of credit. Such action mirrors that of Great Britain and the European Union in the wake of their
declining markets.
Background: Regulating the Evolving Economy
Throughout its history, the U.S. government has struggled to strike a balance between giving financial
institutions the freedom to turn profits and regulating them to prevent reckless speculation. In response to
financial crises, the government has interceded to limit the effects of an unstable economy. In the aftermath,
new legislation and regulatory bodies have been approved to prevent future problems; however, as the recent
economic crisis reveals, such laws and agencies may not adequately protect the ever-changing economy from
peril.
Financial Panic of 1907
In 1789, the Department of the Treasury was established to manage the finances of the U.S. government and
enact policies promoting economic growth. After a series of financial panics in the late 18th century, the U.S.
economy experienced another downturn in 1907 when concern over market conditions—heightened by a failed
copper market scheme that raised questions about trust solvency—drove many fearful individuals to withdraw
their deposits from banks (known as a "bank run" or a "run on a bank"). Because banks are not required to
keep all of the deposits on reserve, numerous banks declared insolvency. Although the Treasury Department
deposited more than $25 million into national banks, the crisis required J. P. Morgan, John D. Rockefeller, and
some private financial groups to deposit millions of dollars to shore up public confidence in the banking
industry.
Amid concerns over the vulnerability of the national banking system, numerous proposals were made to reform
it. In 1913, the Federal Reserve was created as a central bank with powers to regulate banks, set credit
policies, and loan money to any individual or group in "unusual or exigent circumstances." The Federal
Reserve often influences the amount of money in circulation by raising or lowering interest rates for banks who
seek overnight loans from one of the twelve Federal Reserve banks.
The Great Depression (1929–1939)
During the Great Depression, a bank run in 1933 prompted President Franklin D. Roosevelt to declare a "bank
holiday," closing banks until they acquired enough money to cover their deposits (with government assistance,
if necessary). That same year, the Glass-Steagall Act prohibited bank holding companies from venturing into
the securities business in order to prevent them from suffering losses that speculatory banks had faced after
the stock market collapsed in 1929. Additionally, the act established the Federal Deposit Insurance Corporation
(FDIC) to insure bank deposits and monitor commercial banks. To safeguard the stock market, the Securities
and Exchange Commission (SEC) was created to regulate brokerage firms and to prevent fraud in the
exchange of stocks, bonds, and other securities.
The Evolving Banking Industry
In the 1970s, brokerage firms began offering such banking services as money market accounts, checks, and
credit and debit cards. Enticed by rising market interest rates, many people withdrew their bank deposits and
put them into investment accounts for higher returns. By the 1980s, banking lobbyists began pushing for
leeway against restrictions under the Glass-Steagall Act.
In the 1990s, government officials and lobbyists continued to argue that regulatory laws prevented U.S. banks
from competing in the global economy. According to some financial experts at the time, permitting commercial
banks to engage in the securities and insurance industries would reduce their risks by diversifying their
investments in different markets and save consumers money by combining those services. With support from a
bipartisan Congress, the Financial Services Modernization Act (1999) allowed banking, brokerage, and
insurance firms to merge under the regulatory jurisdiction of the Federal Reserve with additional oversight by
the SEC in areas of securities and by the state in areas of insurance.
The Commodity Futures Modernization Act (2000) further deregulated the market by limiting oversight of
derivatives, or assets purchased by investors who anticipate a future rise in price due to the market principles
of supply and demand. The credit derivative market included lucrative—but highly risky—investments in credit
default swaps and subprime mortgages that were particularly in demand during the housing bubble of the
1990s. Many experts—including officials in charge of financial regulatory bodies—believed that a derivatives
market free from government interference would provide an arena for investors who could afford the risk.
The Banking Crisis (2008)
By 2007, the derivatives market hit $516 trillion. Without strict oversight, credit derivatives were frequently
exchanged in private. Banks would hire credit rating agencies to rate the risk of individual derivative
investments, but the actual values were difficult to assess, particularly without outside analysis. Financial
institutions took short-term loans to invest along with their own profits in cycles of buying, selling, and extending
credit—a common function in the banking system. However, many of these arrangements lacked the
precautions of commercial banks, which are required to have a certain percentage of reserves on hand to
cover customer deposits and which are FDIC-insured. With the burst of the housing bubble and the rise of
credit card debt beginning in 2007, many financial institutions lost billions of dollars on "toxic" derivatives they
could not sell; moreover, they faced insolvency because they were unable to repay their loans or secure credit
for additional loans.
Government Intercession
Attempting to shore up confidence in the stock market and loosen the tightening of credit, in the spring of 2008,
some investment firms facing collapse received loans from the Federal Reserve or were bought by other
companies in FDIC-brokered takeover deals. Nevertheless, numerous financial institutions in the United States
and abroad continue to post huge losses.
On September 19, the SEC imposed a temporary ban on short selling (the sale of borrowed shares with the
intention of purchasing them back when the price decreases) of financial stocks in an effort to protect the
stocks of troubled companies. That same day, Secretary of the Treasury Henry Paulson proposed a $700
billion plan to purchase toxic mortgage loans from troubled financial firms. The controversial bailout was
eventually approved by Congress with measures to limit executive pay and raise the FDIC's guarantee of
deposits from $100,000 to $250,000 per account in order to prevent customers from withdrawing their money
from banks. On October 14, the Treasury Department unveiled a plan to spend $250 billion on new preferred
stocks of the nine largest banks as well as larger regional banks; in exchange, the plan requires banks to
extend loans to smaller banks and limit executive compensation. The move was intended to stimulate the flow
of money between banks, businesses, and individuals.
In the subsequent days, government officials warned that the effects of these economic plans would require
time. Meanwhile, the world stock markets have continued to fluctuate widely between sharp gains and steep
losses—another indication that economic stability is far from certain and may be a long way off. When it
appeared that consumer credit markets in the United States still remained tight, on November 12, Paulson
announced a departure from the original plan to buy defaulted mortgage-backed securities and instead
discussed potential plans for a consumer credit program among other options under consideration by the
Treasury Department.
—Jane Messah
[Updated November 14, 2008]
FURTHER READING
Herszenhorn, David M. "Bailout Plan Wins Approval; Democrats Vow Tighter Rules." The New York Times,
October 3, 2008; Labaton, Stephen. "Congress Passes Wide-Ranging Bill Easing Bank Laws." The New York
Times, November 5, 1999; Northrup, Cynthia Clark, ed. The American Economy: A Historical Encyclopedia.
Santa Barbara, CA: ABC-CLIO, 2003; Schwartz, Nelson D., and Julie Creswell. "Searching for the cause of the
crisis on Wall Street." International Herald Tribune, March 24, 2008.