Bailout Package Role in the Stabilization of the Economy

Introduction

Much has been written about the bailout package and the stimulus packages announced by the US government to provide relief to the banks and financial institutions having toxic assets on their balance sheets. Since the beginning of the housing market crash in the fall of 2006 and the systemic crisis in 2007 and 2008, the government has been active in devising strategies to meet the capital and liquidity requirements of the banks.

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Matters came to a head in September 2008 when Lehman Brothers filed for bankruptcy and other banks had to be bailed out under the Emergency Economic Stabilization Act of 2008, otherwise known as the bailout of the US financial system. This act gave sweeping powers to the Fed and the Treasury secretary to help troubled banks and financial institutions with up to $700 Billion of liquidity made available to them. The origins of this crisis began in the housing market when the sub-prime borrowers or the borrowers with poor credit history were given access to cheap credit and mortgages to finance their home purchases.

As the value of the homes depreciated and the housing market began to bottom out, banks were left with billions of dollars worth of mortgages that were foreclosed resulting in losses to the banks. And because these assets were bundled together and repackaged as securities and then sold to different investors, who in turn created derivatives on top of these assets, there was a systemic component to the whole crisis. Hence, what started in the Housing market quickly spread to the rest of the global financial system and posed a systemic risk to the global economy.

With the US economy undergoing a crisis of epic proportions, several sectors suffered from the credit crunch and were left without access to credit that they were previously used to. Further, the corporations made several bad loans and resorted to business practices that led to them being in dire straits as far as the financials are concerned once the crisis broke out. The bad state of the economy is cited as one of the reasons for the victory of Barack Obama in the presidential elections of 2008. After his election, there was a lot of hope and anticipation regarding the kind of stimulus package that his administration would provide to the beleaguered sectors of the economy.

The crisis and the steps taken by the government

The very public demise of investment bank Bear Stearns, dating back to March 2008, set the roller coaster in motion. After that, from September through October 2008, the world’s stock exchanges were battered and torn. In early October, the S & P 500, the broad U.S. stock index, lost 22 percent of its value in just six trading sessions! On September 24, 2008, U.S. Federal Reserve chief, Ben Bernanke, and then-Treasury Secretary Henry Paulson petitioned the U.S. Congress to support a $700 billion bailout plan (officially known as H.R. 1424: the Emergency Economic Stabilization Act of 2008). “Despite the efforts of the Federal Reserve, the Treasury, and other agencies,” Bernanke told the lawmakers, “global financial markets remain under extraordinary stress” (Reuters, 2008). Ten days later, in an emergency meeting called by the heads of the four largest European economies to deal with the looming crisis, Jean-Claude Trichet, head of the European Central Bank, stated, “Nothing in the past resembles what we are currently seeing. We are in the presence of events that we have not seen since World War II. This is a period of absolutely exceptional uncertainty [that] calls for responses that match the events from both the public and private sector” (Green Ville Online, 2008). The historic $700 billion bailouts of the banking industry in the United States were matched by the European Central Bank’s collective $1.3 trillion bailouts of its banking industry and followed by similar actions by central banks in Australia, Canada, Japan, Singapore, and many more countries. Hungary and Iceland lined up seeking rescue from the IMF, and others even sought direct help from cash-rich nations such as China and Russia. But September 29, 2008, is the day that will live in financial infamy. On this day, Wall Street saw the Dow Jones Industrial Average drop by more than 776 points in a session that is going to be remembered for a long time. The immediate trigger for this was the US House of Representatives failing to pass the bailout bill. It is said that the Treasury Secretary, Henry Paulson personally besieged the lawmakers to pass the bailout package. As a consequence, the credit markets froze with banks refusing to lend to other customers and each other as well. The eight consecutive days of losses totaled an estimated $2.4 Trillion.

Banks found it hard to borrow as the cost of funds went up drastically and investors preferred the traditional safety net of Treasury bills. This was even though the government assured investors that it would take equity stakes in the troubled banks to stem the credit crisis. The cost of borrowing shot up for even blue-chip companies: IBM agreed to pay 8 percent interest on $4 billion of thirty-year bonds, twice the rate that the federal government borrows money. Then, on October 10, the roller-coaster ride abruptly ended when “the market made a U-turn, surging higher with the Dow climbing nearly 900 points in less than forty minutes.” While the rebound momentarily allayed fears in the U.S., it set off a selling frenzy for the global financial community. Suddenly, previous boastful talk of nations decoupling from the U.S. economy seemed rather sardonic. Reports worldwide were grim. Global stocks had fallen sharply in one of the worst days of trading in thirty years, despite ongoing government efforts to stem the crisis. On October 24, 2008, when the world’s stock exchanges dropped around 10 percent in most indices, Bank of England deputy governor Charles Bean warned, “This is a once-in-a-lifetime crisis, and possibly the largest financial crisis of its kind in human history” (Daily Mall, 2008).

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Bailout package

The bailout package announced by the government was for all the banks and the Wall Street majors that had the “toxic assets” on their balance sheets. Of particular importance was the bailout of AIG that cost the US Government nearly $85 Billion. This was an act of congress to save the insurance giant from collapsing. These funds were made available to AIG and other banks under the TARP (Troubled Asset Relief Program) that enabled the banks to write off their troubled assets and continue in business.

AIG was a special case as the insurance giant was thought of as being “too big” to fail and hence needed to be bailed out. Thus, the government made all possible efforts to save the troubled insurer with billions of dollars in bailout packages. In all cases where the government bailed out the banks, it was by taking stock as collateral and ensuring that the taxpayers get a return on the money that has been invested in these banks and financial institutions.

Hence, the government did underwrite some banks and change the rules for the financial system and the banks in particular that were being bailed out. All these acts that provided for the bailouts were by special acts of congress and under the emergency spending procedures and programs.

In effect, what the government was doing was to buy all the bad debt in the system and the so-called toxic assets to ensure that the banks could carry on business. There was a time in September 2008 when the entire financial system looked like collapsing and the government’s intervention saved the day for the financial system. The American Recovery and Reinvestment Act of 2009 is a stimulus package that was passed by the Obama administration to kick start the economy.

This act provided for unemployment benefits, lower tax rates on income, and spending on a social welfare program. This act was along the lines of the Keynesian economists who argued that government has a role to play in times of recessions by spending money. Whereas the TARP was a bailout package, the Recovery and Re-investment act was a stimulus package. The notable difference between the two is that one is for cleaning up the mess whereas the other is for ensuring that the economy is put on a track again. Hence, the actions of the government did indeed provide for stabilizing the banking sector and for kick-starting the economy.

These two acts covered both the flanks for the recovery of the economy.

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Conclusion

It is apparent that because of reckless lending and business practices followed by the banking giants, the whole US economy and the global economy were caught in a tailspin in 2008. The efforts of the US government in stabilizing the unstable US economy seem to have had some results, though nothing to cheer about just now. As many commentators have put it, “green shoots” are appearing in the economy and it is hoped that they would blossom into a healthy recovery for the economy. The very reasons for the demise of the banking and the financial system need to be looked into if future crises are to be averted and hence the government needs to increase the regulatory mechanisms and devise fail-proof methods for the banks.

In conclusion, the government has done a commendable job in stabilizing the economy. However, what needs to be done as well is that the government needs to ensure that the financial sector is fixed on the malpractices and unethical behavior that is at the root of the global economic meltdown. Hence, instead of rewarding the very bankers who caused the credit crisis with fat bonuses and perks, maybe it is time for the government to take a tough stance against excessive speculation and rein in some of the aggressive business practices followed by the banks and financial institutions. There are some signs of recovery and it would be prudent to take steps to avoid a repeat of the crisis. I end this paper with the hope that the “green shoots” would turn into full fledged recovery and that stricter regulation would protect Wall Street as well as Main Street.

Sources

  1. U.S Boosts AIG bailout package”. NPR. Org. 2008. Web.
  2. Huffington, Arianna. “Remember the whole thing about fixing our financial system”. Huffington Post Website. 2009. Web.
  3. Philips, Kevin. Bad Money. Simon and Schuster: London, 2008.
  4. Patrick M. Fitzgibbons, “Bernanke offers bleak outlook,” Reuters. 2008.
  5. “Financial crisis needs unprecedented responses,” GEO World.
  6. Tim Paradis, “Dow Climbs More Than 900 Points,” KUTV Online. 2008.  Web.
  7. Whiplash Ends a Roller Coaster Week,” New York Times. 2008.  Web.
  8. Fear grips global stock markets,” BBC. 2008. Web.
  9. Worst financial crisis in human history: Bank boss’s warning as pound suffers biggest fall for 37 years,” Daily Mail. 2008.

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"Bailout Package Role in the Stabilization of the Economy." NerdyTom, 12 Nov. 2021, nerdytom.com/bailout-package-role-in-the-stabilization-of-the-economy/.

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