Free Term Paper on Bank Bailouts

Bank BailoutsA “bank bailout” occurs when a regulatory or government authority provides assistance to a bank that is failing and on the path to insolvency. In a bank bailout, either a regulatory or government authority provides the funds needed for the bailout, or the authority orchestrates assistance of the failing bank by private parties, essentially rescuing or assisting a bank that would otherwise fail and go bankrupt. The people who have deposited their money with the bank (depositors) are otherwise likely to lose all of the money they thought they were depositing for safekeeping.

Outline

I. Introduction

II. History of Bank Bailouts

III. The Recent Financial Crisis and Bank Bailouts

IV. Conclusion

Introduction

Bank bailouts are conducted in one of two ways: Either a bank that is on the verge of insolvency is prevented from failing by an infusion of capital that helps the bank continue in operation, or the failing bank is allowed to fail but the party providing the bailout helps the bank liquidate and guarantees repayment to the depositors.

In recent U.S. history, major bank bailouts have only occurred at four distinct times:

  • 1930s: many banks were bailed out after the stock market crash of 1929.
  • 1984: bailout of Continental Illinois National Bank, then the nation’s seventh largest bank.
  • 1985–1999: approximately 1,043 savings and loan institutions were bailed out.
  • 2008–2009: bailouts included Bear Stearns, Fannie Mae and Freddie Mac, Lehman Brothers, AIG, Citigroup, and Bank of America.

Bank bailouts in the United States are controversial, in part because they come at a cost to taxpayers, they represent failure in an industry populated by highly paid executives, and they implicate what economists refer to as a “moral hazard problem,” meaning that some believe that bailing out banks creates an incentive for bank managers to behave in a risky manner, since they know that their banks will be bailed out if their banks run into financial trouble. Yet bank bailouts have an emotional appeal, in part because bailouts of major banks are often preceded by urgent clamors that the failing bank needs to be assisted because it is “too big to fail.” The too-big-to-fail theory posits that, if a large bank is allowed to fail, there could be catastrophic ripple effects in the economy, as parties with whom the bank was dealing will lose money on transactions or deposits they had with the failed bank, such that these other banks will be compromised and will not be able to continue robust lending to businesses, such that businesses will not be able to expand or will need to lay off employees, and unemployed consumers will then cut back on purchases, such that demand for goods and services will decrease, which will result in businesses laying off more employees, and a vicious and devastating economic cycle will be created.

That said, bailouts generate populist anger, and, in his first state of the union address, during the beginning of the 2008 bank bailouts, President Barack Obama noted that “if there’s one thing that has unified Democrats and Republicans—and everybody in between—it’s that we all hated the bank bailout. I hated it.” Still, the president observed that the bailouts were “necessary,” much like a root canal.

History of Bank Bailouts

The modern history of bank bailouts in the United States began in the 1930s, after the stock market crash of 1929. When the stock market began crashing, large numbers of people began withdrawing their money from banks. This compromised the ability of banks to pay depositors who wanted to withdraw their money, since banks only keep a limited amount of cash on hand, instead maintaining the rest of their money in less liquid assets such as investments and insurance. The inability of banks to immediately pay every depositor who wanted to withdraw her money raised concerns about whether banks would be able to repay all of their depositors, which led to panicked “bank runs.” In order to repay depositors, banks needed to liquidate assets, but, given the declining economic climate, banks were forced to sell assets at gravely depressed prices. Therefore, many banks were unable to raise enough cash to pay all of their depositors, and some banks became insolvent. Fear of insolvency exacerbated the bank runs, which put an even greater strain on the available cash remaining and forced even more asset sales, which further depressed the prices at which assets could be sold by banks, such that bank runs became contagious and accelerated the failure of banks that had run out of money.

The Federal Reserve, which was created by legislation passed in 1913, had the authority to provide assistance to troubled banks, but its mandate extended only to member banks, which did not include the majority of the smaller failing banks. Moreover, the Federal Reserve would only make temporary loans on good collateral, which banks failing in the midst of the Great Depression did not have. Bank failures soared, with 2,294 occurring in 1931 (Kennedy 1973, 1), and almost 13 percent of the nation’s remaining banks suspending operations by 1933 (Meltzer 2003, 402n153).

Overall, the economic climate was dismal: the stock market had crashed, so many investors lost everything. Moreover, banks were failing such that depositors were losing their remaining savings, borrowing money was nearly impossible, and bank runs were commonplace. Pervasive panic and a crisis of public confidence compounded the problems. Therefore, the government decided to act.

In 1932, the government established the Reconstruction Finance Corporation (RFC) to help distressed banks, and, in 1933, the Emergency Banking Act of 1933 authorized the RFC to bail out banks directly by purchasing preferred stock from distressed banks to infuse new capital into these banks, backed by the United States Treasury. The RFC purchased roughly $782 million in bank preferred stock and $343 million in bank bonds, resulting in the bailout of nearly 6,800 banks. The RFC ceased operations in 1953, but the Federal Deposit Insurance Corporation (FDIC), an independent agency of the federal government established by the Banking Act of 1933, continued to exist and conduct bank bailouts.

The FDIC was created in order to address the public confidence crisis that led to the catastrophic bank runs after the stock market crash of 1929 and to prevent future confidence crises. The FDIC preserves public confidence by insuring deposits in banks to eliminate depositor worries about losing deposits and by monitoring and addressing both systemic risk and deposit-related risk. The FDIC is funded by insurance premiums that banks pay for deposit insurance and from earnings on investments in U.S. Treasury securities. The Federal Deposit Insurance Act of 1950 gave the FDIC the power to bail out a failing bank if that bank was judged essential to the community.

After the bank bailouts in the 1930s, the next major bank bailout was in May 1984, when the FDIC bailed out the Continental Illinois National Bank and Trust Company (Continental Illinois), the seventh largest bank in the United States as measured by deposits. Continental Illinois was struck a fatal blow in part due to bad loans compounded by a bank run, and bank regulators intervened because of a concern that grave damage could be done to the banking system as a whole otherwise. Specifically, many other banks had invested heavily in Continental Illinois, and regulators feared that if Continental Illinois were allowed to fail, banks that lost their investments in Continental Illinois would then fail, with a grievous public confidence impact that would lead to economic disaster (Federal Deposit Insurance Corporation 1997, 250–251). Therefore, the FDIC provided over $4 billion in various forms of assistance to Continental Illinois.

The savings and loan bailout in the 1980s was next. Savings and loans financial institutions (S&Ls) were financial institutions that specialized in residential lending and home mortgages (White 1991, 82–89). They took in money from depositors to whom they then paid high interest rates, and they lent out that deposited money to home buyers needing mortgages. S&Ls began failing in the 1980s as real estate markets began to soften. The value of the assets secured by the mortgages fell, and the S&Ls’ ability to pay depositors disappeared. A wave of S&L failures exhausted the available funds in the government-established industry insurance organization, the Federal Savings and Loan Insurance Corporation (FSLIC), which functioned much like the FDIC.

Concerned about how the collapse of the S&L market might undermine the economy, Congress authorized the creation of a new agency, the Resolution Trust Corporation (RTC), to bail out the S&Ls by way of bailing out the FSLIC so that the FSLIC could repay S&L depositors. The RTC, as created by the 1989 Financial Institutions Reform, Recovery, and Enforcement Act, oversaw the sale of assets of failed S&Ls and repayment of S&L depositors. From 1986 to 1995, over 1,000 S&Ls with assets of more than $500 billion failed, costing an estimated $153 billion in bailout money, $124 billion of which came from U.S. taxpayers (Curry and Shibut 2000, 33).

The next major bank bailouts began in 2008, when the U.S. banking system experienced a liquidity crisis (Congressional Oversight Panel 2009, 4–6), banks began failing, and some feared that the economy was being destabilized. Although the precise cause of the banking crisis is still under debate, as described below, the response that followed included massive bank bailouts coupled with a related legislative overhaul.

The Recent Financial Crisis and Bank Bailouts

The bank bailouts that began in 2008 were part of what some viewed then and continue to regard as the worst financial crisis since the Great Depression. The cracks in the U.S. economy infrastructure that led to the crisis and the bailouts started to show in 2006 and 2007, however. Specifically, until approximately 2006, the U.S. housing market experienced what some would call a “bubble.” Driven by subprime lending—lending to borrowers who traditionally had been viewed as undesirable due to, for example, having little or no money available as a deposit—and facilitated by securitization and derivative financial products, housing prices escalated as housing borrowing and sales skyrocketed (Congressional Oversight Panel 2009, supra note 9, at 8). Housing prices increased at an average of 12 percent per year from 1999 to 2006 (Congressional Oversight Panel 2009, supra note 9, at 8).

In 2006, however, housing prices began a modest decline that spiraled into a doubledigit percentage decline by 2008 (Congressional Oversight Panel 2009, supra note 9, at 8). This led to a rash of mortgage defaults by subprime borrowers and a spate of home foreclosure sales by banks, and banks found themselves unable to sell at a price high enough to recoup what they had lent. Foreclosure sales accelerated the decline of real estate prices, and a dismal financial free fall eclipsed the beginning of 2008. The carnage from this lending and housing implosion was magnified by widespread use of derivatives and securitization products by banks; therefore, even financial institutions that did not hold mortgages but held instead, for example, credit default swaps or other mortgage-related derivative products suffered from the market decline as well (Congressional Oversight Panel 2009, supra note 9, at 9).

The first major bank bailout in 2008 was that of Bear Stearns, the fifth largest U.S. investment bank and the leading trader of mortgage-backed bonds. In early 2008, Bear Stearns reported that it was highly exposed to the unstable subprime mortgage market. Alarmed, Bear Stearns clients withdrew their funds from Bear Stearns, and within three days in March 2008, Bear Stearns’s available capital fell by 90 percent (Ritholtz 2009, 187). This prompted Federal Reserve and Treasury officials to try to arrange for a bailout of Bear Stearns. The bailout resulted in JPMorgan Chase buying Bear Stearns upon the agreement of the Federal Reserve Bank of New York to guarantee $29 million in Bear Stearns’s riskiest assets, which led to reported losses of billions of dollars for the Federal Reserve Bank within months of participating in this bailout.

Shortly thereafter, Lehman Brothers, another banking behemoth, began to fail. While many clamored for a bailout for Lehman Brothers, it was instead allowed to fail completely and file for bankruptcy in September 2008, after the Federal Reserve and the Treasury made clear that they hoped never again to need to rescue a bank the way they rescued Bear Stearns (Ritholtz 2009, 190–192).

Lehman’s failure spurred fears that other big banks and financial institutions would soon fail and the entire economy would be destabilized. Concern focused on American International Group (AIG), the world’s largest insurer. AIG was deeply involved in the international derivatives market, and, in September 2008, as it became clear that many of AIG’s investments were tied to failing mortgage-related assets, regulators decided that the world’s largest insurer and a key participant in the international derivatives market must not be allowed to fail, because its failure could have far-reaching economic effects. The Federal Reserve and Treasury purchased a majority stake in AIG stock for $68 billion, thereby providing much-needed capital to AIG, and the government continued to make additional loans and purchases of stock so that, by March 2009, the government had infused roughly $175 billion into AIG (Ritholtz 2009, 208).

September 2008 also saw the government takeover and bailout of the Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Association (Freddie Mac). These two government-sponsored enterprises (GSEs) had been established by Congress to participate in the mortgage market and foster the accessibility of home loans. As the subprime mortgage market deteriorated, Fannie Mae and Freddie Mac became financially compromised, and Congress adopted legislation to provide for the government takeover of both GSEs in addition to the Federal Reserve infusing well over $100 billion into the GSEs.

Also in 2008, Citigroup, a Wall Street titan that had combined commercial banking with investment banking and a brokerage house, became a focus of concern. Citigroup held billions of dollars in mortgage-related securities whose value plummeted as the housing and mortgage markets crashed. The Treasury and Federal Reserve refused to risk a fatal blow to the already precarious banking system by allowing the largest financial institution on Wall Street to fail, so a complex deal valued at hundreds of billions of dollars to stabilize Citigroup was struck (Ritholtz 2009, 217).

The Citigroup bailout and later bailouts (including bailouts in the automotive industry) were a product of legislation—the Emergency Economic Stabilization Act (EESA)—hastily adopted on October 3, 2008, in the wake of the expanding financial crisis. EESA established the Troubled Assets Relief Program (TARP)—the bailout program. The program authorized the secretary of the Treasury, in consultation with the chairman of the Federal Reserve, to purchase up to $700 billion in “troubled assets,” such as subprime mortgage-based securities, in order to promote financial market stability by removing toxic assets from the banks’ balance sheets.

By the end of 2009, the Treasury had disbursed over $350 billion under TARP (General Accounting Office 2009). For example, pursuant to TARP, the FDIC, Treasury, and Federal Reserve entered into an agreement with Bank of America in January 2009 to purchase $20 billion in preferred stock from Bank of America and provide protection against loss for approximately $118 billion in assets. Banks that participated in TARP or received bailouts pursuant to TARP included some of the biggest and previously strongest banks, such as Citigroup, JPMorgan Chase, Wells Fargo, Bank of America, Goldman Sachs, and Morgan Stanley, and the top nine participants in TARP represent 55 percent of all U.S. bank assets.

Conclusion

Bank bailouts are not a new phenomenon, but the massive bailouts in 2008 and 2009 have forced both politicians and bankers to revisit the necessity of bailouts, the advisability of bailouts in general, and the reasons why, in less than a century, the United States has needed two massive rounds of bank bailouts. Is there a way to restructure the banking system to avoid the need for bailouts? What would have happened if no bailouts were provided in the 1930s and in 2008–2009? Would the billions of dollars spent on bank bailouts be better spent on a different facet of banking?

These are some of the obvious questions raised by reflecting on the major bank bailouts in recent U.S. history. It remains to be seen whether the common themes underlying these bailouts repeat again or whether valuable lessons can be learned from reflecting on these bailouts and finding ways to avoid the need for bailouts in the future.

 

Elizabeth A. Nowicki

 

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