Since the Great Depression of 1929-30, the worst financial crisis was witnessed during the end of 2008. Numerous American and European banks declared going into loss by the end of 2007. Later, Lehman Brothers, the 158-year old investment bank went bankrupt; Merill Lynch, the investment bank and the stock-broking firm was taken over; Goldman Sacks and Morgan Stanley seek the status of bank to receive protection against bankruptcy. It was during the same week that the other four investment banks on the Wall Street collapsed.
The global financial crisis of 2008 was one of the most critical ones in the history of the global economy. Each crisis had something unique in its triggering events. The only commonality is found in the way the governments have intervened in the period of crisis to help the financial sectors out (Bayazitova & Shivdasani, 2012). The financial markets collapsed leading to a sharper decline in the real economy; the world was exposed to inevitable stagnation of the economy and the most critical financial shock.
The financial markets play a very significant role in the modern economies. The credit institutions direct the capital to generate maximum levels of profit by coordinating networks. In a credit crunch, the banks stop lending practically as there is a sudden reduction in liquidity available in the financial markets and uncertainty rises regarding money ownership. During such a situation, it is only the government that can intervene and pour in billions of dollars into the private banks so that lending and borrowing starts again. But there is greater risk to government intervention; with the nationalization of the banks, the debt gets bigger and bigger. Since the 1930s, the most dramatic intervention of the US government has been made during the economic catastrophe of 2008 in the financial markets; to ward off the economic crash, the US banking sector was infused with hundreds of billions of dollars.
The government rescue plan for the banks of the United States during the financial crisis of 2008 was started by President George W. Bush known as the Troubled Asset Relief Program; it included the purchase of equity and assets from the financial institutions so that the sector could be strengthened. Around $250 billion was injected into the financial institutions that included nine of the largest banks of the nation, guaranteeing the issue of new debts and deposit accounts.
NATIONALIZATION OR NOT?
In case of a bank failure, there are three options available to the FDIC: closure/liquidation, merger, or nationalization. What exactly is meant by the nationalization of banks? The general belief is that when the government takes complete control of the bank, it is known as nationalization. The interests of the private investors are completely wiped; at times, the nationalization is also a form of rescuing the banks. It is common in USA where each bank failure leads to nationalization of bank as the FDIC takes control and then sells the bank to other entity (Solomon & Paletta et al., 2008). It is not similar to socialization; in reality, the government takes control as a commercial entity but the intention is to sell the organization back to the private sector. The government gives protection to the funds and the taxpayers from the institutions that have been poorly capitalized.
TARP was the main instrument for directly supporting the banks and was established when the crisis of 2008 was at its peak. It was considered to be an essential component of the Emergency Economic Stabilization Act. Considering the case of Citigroup, it had become practically impossible for the government to intervene properly without taking a major share in the institution. The Bank of America received an aid package of $138 billion while Citigroup received a $300 billion package for the purpose of injecting capital. The banks were liberated by the government from the most threatening assets. But as Christopher Whalen, the managing partner at Institutional Risk Analytics said, that the underlying reality was the government taking majority shares in Citigroup. The government support of the banks provide protection to the common stockholders. The Troubled Asset Relief Program has been aimed at the troubled assets and created with a $700 billion bailout bill; the Treasury Department was authorized to acquire the bad assets of the financial institutions including the banks.
The main focus of the TARP was to stabilize the banking sector through capitalization. The TARP also aimed at reducing the excessive risk taking that was also one of the reasons of the financial crisis (Black & Hazelwood, 2013). Although the financial institutions were saved with the bailout but the TARP money also gave control to the federal government over the banks. If the $700 billion issued by the Congress is considered to be insufficient for the purpose of bank rescue, the federal control could even be strengthened to become full nationalization. In the article, “Rescue of Banks Hints at Nationalization” written in the New York Times, it was stated that “the new ground rules laid down by Mr. Obama’s top economic advisers for the second half of the $700 billion bailout fraud, as explained in a letter submitted to Congresscall for the government to play an increasing role in the major activities of the banks, from the dividends they pay to shareholders to the amount they can pay executives.”
REASONS FOR GOVERNMENT INTERVENTION
Though the general belief is that the economy flourishes when the government does not intrude into the private sector. But there are many times when the government needs to take certain protective measures for the economic growth. It had become crucial for the government to take decisive action during the economic dip of 2008-2010 so that a second Great Depression could be avoided. The financial system was struggling when the first half of this TARP money was injected in the banks (Taibi, 2013).
Subprime mortgage loans lead to the collapse of the financial powerhouses in 2008; they became riskier as the mortgage loans were packaged into securities that could be sold and brought by investors. When these loans were defaulted, the banks also faltered while the powerhouses that insures the mortgages blew catastrophically. It was then that the federal government intervened; it brought the faulty loans and the mortgage-backed securities through TARP. Though the government expressed its intent to privatize the businesses back but through TARP, it almost acquired the organizations.
James Gattuso stated that the TARP helped to unfreeze the credit markets: “It served a critical function in terms of providing liquidity at a time that it was needed to counter a panic in financial markets.” If the government had not intervened, the financial crisis would have become greater. With the TARP, the Treasury Department estimated that around 8.5 million jobs were saved in America. It was the run on money markets that triggered the bailout bill for banks. During that time, money market funds were being sold; banks became panicked and started hoarding cash avoiding any lending or even asset purchase (Taibi, 2013).
Usually, the financial entities keep around $2 billion cash in hand but by last week of 2008, it was a record cash of $190 billion. According to the AMG Data Services, a record $144.5 billion was pulled out by investors while just a week ago, there was $7.1 billion in the industry. Due to the lack of participation of these funds, the commercial-paper market worth $1.7 trillion shrank by $52.1 billion. Paul Schott, the President of Investment Company Institute mutual-fund trade group says that without the commercial paper, “factories would have to shut down, people would lose their jobs and there would be an effect on the real economy.” In such a situation, it was only the federal government that could step in.
EFFECTS OF THE TARP
The cost of TARP to the taxpayers was only fifty billion; this cost is 85% lesser than the estimated cost of $356 billion by the Congressional Budget Office. The reduction in cost was due to the effective management by the Treasury and the stronger-than-expected performance of the banks. Zandi and Alan Binder conducted a study identifying that if TARP had not been enacted, the rate of unemployment would have risen by 4.0 points in 2010 while the growth of GDP would have been declined by 4.7% (Bolton & Mehran et al., 2010). It was also due to TARP funds that the auto industry survived; one million jobs in the auto industry could have been wiped out along with the devastating shutdown of Ford.
As the government gains ownership of the banks, the financing of bigger projects may be facilitated that could otherwise not be supported by private banks. The risk taking increased for the larger banks but decreased for the smaller banks. The bank lending increased with the TARP funds as government ownership encouraged lending. The small businesses are heavily dependent on the loans by banks. Though the biggest banks have repaid the funds with interest, almost 300 community banks still have to repay their loans. The government provided strict guidelines that the executives at the bailed-out firms should not be paid more than their peers in similar companies. But 63% of the top executives at AIG, GM, and Ally Financial were still being paid higher (Bolton & Mehran et al., 2010). It has been identified by the American University Review that the banks that received TARP fund raised the pay of their employees more as compared to those banks that did not receive the funds. The USA Today article (Yip, 2011) states:
- “The amount of loans outstanding to businesses and individuals fell 9.1% for the 12 months ending Sept 30, 2009, at banks that participated in TARP compared with a 6.2% drop at banks that didn’t.”
- “Average pay at banks aid rose 9.4% in the program’s first year. By contrast, non-TARP banks increased salaried 1.8%.”
Troubled Asset Relief Program was a hasty effort by the US government to rescue the collapsing financial sector. Considering the scenario, had the intervention of government be late, the recession would have been more serious and long-lasting. TARP saved the banks but also gave the federal government complete ownership and the right to control the banks. The reason for the TARP funds was to jump-start the money. The government helped the banks by liberating them from their threatening assets and infusing capital. With the TARP funds, the risk-taking increased in the banks and so did the lending of loans. . With nationalization, the equity of the stockholders is diluted. The FED took the right step when the major banks were going bankrupt. Though the purpose of the government has been to secure the banks and sell them at a later point to the private sector, the initiative taken was near to nationalization.
Bayazitova, D. & Shivdasani, A. (2012). Assessing Tarp. Review Of Financial Studies, 25 (2), pp. 377--407.
Black, L. K. & Hazelwood, L. N. (2013). The effect of TARP on bank risk-taking. Journal Of Financial Stability, 9 (4), pp. 790--803.
Bolton, P., Mehran, H. & Shapiro, J. (2010). Executive compensation and risk taking.
Harris, O., Huerta, D. & Ngo, T. (2013). The impact of TARP on bank efficiency. Journal Of International Financial Markets, Institutions And Money, 24 pp. 85--104.
Solomon, D., Paletta, D., Hilsenrath, J. & Luchetti, A. (2008). U.S. to Buy Stakes in Nation's Largest Banks. [online] 14th Oct. Retrieved from: http://online.wsj.com/news/articles/SB122390023840728367 [Accessed: 29 Mar 2014].
Taibi, M. (2013). Secrets and Lies of the Bailout. [online] 4th Jan. Retrieved from: http://www.rollingstone.com/politics/news/secret-and-lies-of-the-bailout-20130104 [Accessed: 29 Mar 2014].
Yip, J. (2011). The Bank Bailout in Perspective. [online] 24th Oct. Retrieved from: http://harvardpolitics.com/arusa/the-bank-bailout-in-perspective/ [Accessed: 29 Mar 2014].