Fed Innovated to Replace a Failed Banking System

In 2008, Federal Reserve Chair Ben Bernanke used innovations to allow the Fed to shore up the failed financial system. In March, the Fed launched the Term Auction Facility. It made short-term loans available to cash-strapped banks who wouldn’t lend to each other. In October, the Fed made $540 billion in loans to bail out money market funds. In November, the Fed agreed to buy $800 billion in mortgage-backed securities in an attempt to lower interest rates.

Bear Stearns Bailout

In March, the Federal Reserve held the first emergency weekend meeting in 30 years to try to save the investment bank, Bear Stearns. It was in danger of going bankrupt thanks to bad MBS and other collateralized debt obligations. The Feds were afraid, and rightly so, that the failure of Bear Stearns would have spread to other over-leveraged investment banks. This included Merrill Lynch, Lehman Brothers, and Citigroup. In fact, that’s what later happened with Lehman’s bankruptcy. By the end of 2008, Citigroup also needed a bail-out, even though it was a supposedly less-risky commercial bank.

Freddie Mac and Fannie Mae Bailout

In September 2008, mortgage companies Fannie Mae and Freddie Mac became government agencies again. They held or guaranteed more than $5 trillion, or half, of the nation’s mortgages. The U.S. Treasury Department bought $100 billion in preferred stock and MBS. The action came after Wall Street’s panicked selling caused Fannie’s and Freddie’s shares to tumble. That made it impossible for these private companies to raise additional capital themselves. As a result, the Fannie and Freddie bailout cost the American taxpayer $187 billion. In August 2012, the Treasury decided it would send all Fannie and Freddie profits into the general fund. Since then, the bailout has been paid back with $58 billion in profit. Fannie remitted $147 billion and Freddie paid $98 billion.

Lehman Brothers Bankruptcy Triggered Global Recession

Treasury Secretary Paulson couldn’t have known that his action would lead to a global recession. In September, he said no to government protection for Lehman’s $60 billion in uncertain mortgage assets. It occurred during a weekend negotiation with potential buyers Barclay’s and Bank of America. At the time, he thought the amount was too much. He was also being pressured to keep the government off the hook.

Fed Nationalized the American International Group

In September, the Federal Reserve bought shares in insurance giant, AIG. Why was AIG worth saving? Because it insured credit default swaps. They insured loans and mortgages against default. If AIG went under, so would all of these loans. Financial institutions around the world owned them. That included money market funds, pension funds, and retirement accounts. In November, the Fed increased the bailout from $85 billion to $150 billion.

Credit Markets Froze

In September, banks withdrew $160 billion from ultra-safe money market accounts. Banks hoarded cash to write down bad mortgages and withdrawals in bank runs. By the end of the week, banks held $190 billion in cash. That was opposed to a $2 billion reserve. Hoarding led to an increase in the benchmark Libor. That raised the price of $360 trillion in loans and credit card assets. The credit freeze led to a cash shortage for many businesses. In response, the Federal Reserve lowered interest rates to zero, reducing Libor. Still, banks continued to hoard cash.

End of Investment Banking

In November, Goldman Sachs and Morgan Stanley became regular commercial banks. They had been two of the most successful investment banks on Wall Street. That ended an era of deregulation and high risk.

Stock Market Crash

By the end of 2008, the Dow was down 34%, closing at 8,816.62. Other indices performed even worse. Standard & Poor’s 500 ended at 907.22, a 38% decline. The MSCI Europe Index was down 45%, and the MSCI Asia Pacific Index dropped 43%. The Dow fell 25% in October alone, from 10,831 on October 1 to 8,175 on October 27. It reached its low of 7,552 on November 20, a 46% decline from its October 2007 high of 14,164.

$700 Billion Bailout

On October 3, the Senate passed the $700 billion bailout bill, now called the Troubled Asset Relief Program. The program was initially designed to purchase toxic mortgages from banks, freeing up cash for more loans, but it took too long to implement. On October 14, the Treasury used $350 billion for the Capital Repurchase Program. It bought preferred stock in major banks. That gave the government ownership. By November, the funds were also used to keep credit card companies in business. By the end of the year, Citigroup and the auto industry also received bailouts.

Obama Won Presidency

Barack Obama won the presidency on November 3, 2008. He promised to provide sorely needed hope to jumpstart the stalled economy. His proposals helped restore confidence in financial markets. He streamlined regulatory agencies, improved transparency for financial disclosure, and cracked down on manipulative trading activities. His first priority was to pump $800 billion into the economy through tax cuts and job programs.