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Government Bailout Plans – the Struggle against the Crisis

No one would disagree that the current economic crisis is severe. It has gotten to a point when it affects everyone - no matter whether you work on Wall Street or on Main Street.

We have witnessed so many unprecedented things in such a short period of time. Who could predict just a year ago that:

  • The Federal Government would pump nearly $30 billion to prevent a major financial default by the nation's fifth largest investment bank Bear Stearns and that the US treasury secretary in a Republican administration, Henry Paulson, would defend this decision
  • Fannie Mae and Freddie Mac would be nationalized and their liabilities would be taken over
  • money market funds would be insured with several trillion dollars in assets against "breaking the buck"
  • the federal government would essentially take over an equity position of 80% in one of the largest insurance companies American International Group Inc (AIG) in return for a draconian terms $85 billion loan
  • the federal government would essentially propose to buy 700 billion dollars worth of unknown assets that were held by the banking system in return for unknown equity claims in the US banks.
  • the US government would announce the largest bailout in history, the bailout of Citigroup, in order to rescue the company from bankruptcy while giving the government a major say in its operations.

There is a lot of criticism against the recent unprecedented intervention in the financial markets by the government. President Bush stated that such interventions are necessary because of the dire times and that he has been warned that if the government did not act the consequences could be worse than the Great Depression in the 1930s.

On October 3, 2008, President Bush signed the $700 billion bailout package. The US treasury secretary Henry Paulson said that this money would be used to buy distressed mortgage backed securities from banks. $250 billion of the $700 billion bailout were going to be used to inject capital into the banks. The largest banks (Bank of America Corp., Citigroup Inc., Bank of New York Mellon Corp., JPMorgan Chase & Co., Merrill Lynch & Co. Inc., Goldman Sachs Group Inc., Morgan Stanley, State Street Corp., and Wells Fargo & Co.) were going to receive $125 billion from this amount.

The Bear Stearns Bailout and Sale to JPMorgan Chase in March 2008

Prior to its sale to JPMorgan Chase the Bear Stearns Companies, Inc. was one of the largest investment banks in the world and one of the largest securities trading and brokerage firms. It was just "too big to fail" and the government attempt at salvaging it marked a new era in the development of the US financial crisis.

In March 2008 Bear Stearns received an emergency loan by the Federal Reserve Bank of New York in order to prevent the collapse of the firm and a potential market crash. Up to that moment the Bear executives repeatedly denied that the company lacked sufficient funds to operate and faced a liquidity crisis. However, Bear's stock was in a free fall and this act was just not enough to save the firm.

Thus, JPMorgan Chase seemed like the only solution. Originally, Bear Stearns was going to be sold for as low as 2 dollars per share. However, the deal was revised and a new agreement raised JPMorgan Chase's offer to 10 dollars per share, which was still less than 10 percent of Bear Stearns' market value. As part of the agreement, the Fed put up 30 billion dollars to guarantee the Bear's riskiest investments.

In a series of interviews, US treasury secretary, Henry Paulson, defended the Federal Reserve's intervention and stated that the government was prepared to do whatever it needed to minimize the damage to the US economy and turmoil in the financial system.

The so called "bailout" for Bear Stearns was rather a bailout for the financial system. If Bear Stearns had been allowed to collapse it would trigger a dangerous wave of defaults since many other Wall Street firms were tightly interconnected with Bear Stearns.

The Fannie Mae and Freddie Mac Federal Takeover in September 2008

In September 2008, the Federal Housing Finance Agency (FHFA) announced their decision to place Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation) into conservatorship (or nationalisation). This decision was fully supported by the US treasury secretary Henry Paulson and the Federal Reserve Bank chairman Ben Bernanke.

The goal of the conservatorship was to restore the confidence in these two Government sponsored enterprises (GSEs), alleviate the systemic risk, which contributes to the instability in the market and enhance their capacity in order to fulfill their mission. FHFA assumed the power of the Board and management.

In an effort to stabilize the secondary mortgage market Fannie and Freddie would increase their holdings of MBS through the end of 2009. Till the end of that year the Treasury Department has also established a new secured lending credit facility which would serve as an ultimate liquidity backstop.

Then, in 2010 they would need to cut back their direct mortgage holdings in order to reduce the systemic risk.

The Treasury Department would also buy GSE MBS to help keep the market healthy.

Furthermore, in order to make sure that the two companies would have capital and would be able to pay off their private debt, the Treasury Department and the FHFA have established Preferred Stock Purchase Agreements under which the Treasury would buy up to $100 billion in preferred stock from the conserved entities.

It is interesting to note that prior to the takeover Fannie Mae's leverage ratio (meaning total assets to capital) was about 20:1 and Freddie Mac's leverage ratio was about 70:1. These numbers may seem striking but they would increase even more if all of the mortgage-backed assets they guaranteed are included. In comparison, investment banks leverage around 30:1.

Two months after the takeover, Fannie Mae was losing money really fast and reported a record $29 billion loss for the third quarter. As for Freddie Mac, its third-quarter net loss exceeded $25 billion, forcing the company to seek government funds. Freddie Mac's net worth is already a negative 13.8 billion.

The AIG Bailout Plan in September 2008

After the US government essentially pulled the plug on the big investment bank Lehman Brothers Holdings Inc., and allowed it to go under by not providing financial support, that same government decided that AIG was another company that was "too big to fail".

AIG suffered a liquidity crisis in September 2008 following the downgrade of its credit rating. It forced the firm to post $14.5 billion in collateral in order to bolster its credit rating. It had more than that in assets, but it was just not possible to get cash quickly enough in order to satisfy the collateral demands.

The attempt to raise the huge loan it needed from private-sector banks failed and after there were no other options the federal government's decision to help AIG came.

The Federal Reserve provided an emergency loan of $85 billion secured by the assets of AIG subsidiaries, in exchange for a 79.9 stake in the firm, along with the right to suspend dividends to previously issued common and preferred stock. The terms of the two-year loan were steep - it carried an interest rate of Libor plus 8.5 percentage points. As part of the deal, the AIG's chief executive, Robert Willumstad, had to step aside and was replaced by Edward Liddy.

Till early November the firm's credit-default spreads continued to rise steadily, implying that AIG was heading for default. In October AIG borrowed an additional $37.8 billion and in November, when the federal bailout already totaled about $150 billion, many financial experts began to fear whether the federal government's attempt to rescue the company would work at all.

The Citigroup Bailout in November 2008

In November 2008, US government announced a massive bailout of Citigroup, which used to be the largest bank in the world in 2007, worth over $300 billion. Citigroup was also considered to be "too big to fail" and its bailout was nearly five times larger than AIG's.

The bailout of Citigroup made many people in New York angry, more than any of the other big government rescues of financial institutions in 2008. Furthermore, many economists were not pleased by the way the bailout was structured and others even argued that Citigroup was not "too big to fail" but rather "too big not to fail".

Yet, President Bush supported the dramatic rescue of Citigroup, stating that it was needed in order to help the economy recover and safeguard the financial system.

The bailout package totaled $306 billion. Citigroup would absorb the first $29 billion in losses. Additionally, it would also assume 10% of all losses beyond the first $29 billion; 90% of the losses on the $335-billion portfolio would be covered by the Treasury Department, the Federal Reserve and the FDIC.

In return, Citigroup would issue to government regulators $7 billion of preferred stock. Also, the government would buy $20 billion of preferred stock.

As part of the deal, the government obtained wide powers over banking operations, executive salaries were capped and the bank agreed to try to modify mortgages in an attempt to keep as many homeowners as possible in their homes.

Other Bailouts

  • General Motors Corporation (GM)

    In late 2008 General Motors became dependent on government loans to avoid bankruptcy. A bailout plan was approved in December, 2008, by President Bush, and General Motors, along with Chrysler, were given $13.4 billion in financing from the Troubled Assets Relief Program (TARP). Another $4 billion were designated to be withdrawn later.

    In March, 2009, President Obama announced that General Motors are given 60 days to prove their viability. Only then they will receive more government aid. If they fail, Washington will walk away from the automaker and leave them to collapse.

  • Chrysler LLC

    In December 2008 Chrysler announced that it might not survive past 2009 and that it would close its plants for at least a month and that was the time when President Bush announced the $13.4 billion bailout for the American automakers, including Chrysler.

    In March 2009 the White House announced that Chrysler will be given another $6 billion if within 30 days they manage to wrap up their deal with Fiat. Otherwise, Washington will walk away from the company.

  • Bank of America Corporation

    Bank of America was considered one of the healthiest survivors of the 2007 financial crisis. However, after its purchase of Merrill Lynch, it just plunged in market value. At that time (the fall of 2008) it received $25 billion through TARP as part of the deal to help Bank of America absorb the losses incurred by its merger with the troubled Merrill Lynch.

    In January 2009 Bank of America was given $20 billion in federal bailout.

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