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Monday, February 22, 2010

Government Interventions in Response to Financial Turmoil

Baird Webel
Specialist in Financial Economics

Marc Labonte
Specialist in Macroeconomic Policy

In August 2007, asset-backed securities, particularly those backed by subprime mortgages, suddenly became illiquid and fell sharply in value as an unprecedented housing boom turned to a housing bust. Financial firms eventually wrote down these losses, depleting their capital. Uncertainty about future losses on illiquid and complex assets led to some firms having reduced access to private liquidity, with the loss in liquidity being fatal in some cases. In September 2008, the financial crisis reached panic proportions, with some large financial firms failing or having the government step in to prevent their failure. 

Initially, the government approach was largely an ad hoc one, attempting to address the problems at individual institutions on a case-by-case basis. The panic in September 2008 convinced policy makers that a more system-wide approach was needed, and Congress created the Troubled Asset Relief Program (TARP) in October 2008. In addition to TARP, the Federal Reserve (Fed) and Federal Deposit Insurance Corporation (FDIC) implemented broad lending and guarantee programs. Because the crisis had so many causes and symptoms, the response tackled a number of disparate problems, and can be broadly categorized into programs that (1) increased financial institutions' liquidity; (2) provided capital directly to financial institutions for them to recover from asset write-offs; (3) purchased illiquid assets from financial institutions in order to restore confidence in their balance sheets; (4) intervened in specific financial markets that had ceased to function smoothly; and (5) used public funds to prevent the failure of troubled institutions that were deemed "too big to fail" because of their systemic importance. 

The primary goal of the various interventions was to end the financial panic and restore normalcy to financial markets. By this measure, the programs were arguably a success—financial markets are largely functioning again, although access to credit is still limited for many borrowers over a year later. The goal of intervening at zero cost to the taxpayers was never realistic, at least initially, or meaningful, since non-intervention would likely have led to a much more costly loss of economic output that indirectly would have worsened the government's finances. Nevertheless, an important part of evaluating the government's performance is whether financial normalcy was restored at a minimum cost to the taxpayers. 

Initial government outlays are a poor indicator of taxpayer exposure since outlays were used to acquire or guarantee income-earning debt or equity that can eventually be repaid or sold. For broadly available facilities accessed by financially sound institutions, the risk of default became relatively minor once financial normalcy was restored. At this point, many of the programs that were introduced have either expired or are already shrinking. For these programs, one can estimate with relative confidence approximately how much the programs will ultimately cost (or generate income for) the taxpayers. For a few programs that are still growing in size, and for assistance to firms that are still relying on government support to function, estimates of ultimate gains or losses are more uncertain. The Congressional Budget Office and Office of Management and Budget estimate that most of the government's expected losses are concentrated in a few "too big to fail" firms, such as American International Group (AIG), Fannie Mae, Freddie Mac, and the domestic automakers. Other programs show small expected losses or gains. 

This report reviews new programs introduced and other actions taken by the Treasury, Federal Reserve, and Federal Deposit Insurance Corporation. It does not cover longstanding programs such as the Fed's discount window and FDIC receivership of failed banks.

Date of Report: February 1, 2010
Number of Pages: 44
Order Number: R41073
Price: $29.95