Credit Crisis Triggers
Worst debt turmoil since Depression sparks government action
By David Cho and Neil Irwin
The Washington Post
Post" -- 08/08/08
-- Since the credit crisis
erupted a year ago, the Bush administration has presided over
one of the broadest expansions of the government into private
lending in U.S. history, risking public money to prop up
financial firms both large and small.
The administration has transformed federal agencies into
dominant players in such diverse realms as student lending and
mortgage finance while exposing itself to trillions of dollars
The scope of these commitments demonstrates the unprecedented
nature of the challenge facing the nation. Not since the Great
Depression have so many debt markets been in turmoil at the same
time, financial historians say. During the savings and loan
crisis of the late 1980s and early 1990s, for example, the
financial upheaval was largely contained to banks and thrifts,
though the real estate market also felt the impact.
Now, the contagion has rapidly spread from mortgages to bonds
and exotic securities, student and corporate lending, credit
cards and home equity loans, and residential and commercial real
estate. The disruption has buffeted investment and commercial
banks, mortgage finance agencies, and insurance firms of
"We have a banking crisis and an agency crisis and a mortgage
crisis and a coming credit card crisis. We've never seen
anything like that before. And it all seems to be coming home to
roost at the same time. That's never happened either," said
Charles Geisst, professor of finance at Manhattan College. He
said the Great Depression was the last time financial markets
were hammered by such a variety of factors. "But we did not even
have credit cards in the 1930s; there were no such thing as
student loans," he added.
The breadth and speed of events have sent federal officials
scrambling to plug leaks in the financial system. In the
process, the government has bound taxpayers to the fate of a
wide variety of banks and borrowers and could ultimately be
responsible for losses in the tens of billions of dollars or
more, according to estimates by congressional reports and
interviews with regulators.
But the government may also end up paying nothing at all,
largely because it received collateral in return for backing
much of these debts and could recoup some money if borrowers
stop making their interest payments. No one knows for sure
because much of the government's response involved novel
programs designed to contain an unpredictable crisis.
As the credit crisis worsened, Treasury Secretary Henry M.
Paulson Jr., a strong proponent of free markets and the
architect of much of the administration's response, began to
push initiatives that enlarged the government's involvement on
Wall Street and in the housing industry.
"What I've said is that I'm playing the hand that was dealt and
that my responsibility is to protect the U.S. economy and the
American people," Paulson said in an interview.
The pace of these interventions accelerated as the credit crisis
spread across the capital markets.
At first, the administration avoided programs that exposed
taxpayers to potentially large losses. The Federal Housing
Administration, for instance, offered struggling mortgage
holders a chance to refinance into low-cost loans backed by the
government with any losses borne by the agency's insurance fund.
Last summer, Paulson also pressed private mortgage lenders to
form an alliance called Hope Now to rework mortgages. The
initiative did not require public funds, except to set up a
hotline, and it may have prevented lawmakers at that time from
pursuing more expensive initiatives, he said.
Within months, however, Paulson was directing more significant
intrusions into the markets. In March, he strongly endorsed the
Fed leaders' decision to put $29 billion in public money on the
line to facilitate the takeover of the crippled investment firm
Bear Stearns by Wall Street bank J.P. Morgan Chase.
In April, Paulson helped the Department of Education set up
emergency programs to ensure students could get loans as private
lenders fled the business because of trouble in the credit
markets. Education officials ramped up their direct lending,
which some analysts say could reach $75 billion, and got new
authority from Congress to buy loans outright from lenders.
Then, last month, Paulson pushed for new authority to lend or
invest in mortgage giants, Fannie Mae and Freddie Mac, which the
Congressional Budget Office said could impose a wide range of
costs to taxpayers, from nothing to more than $100 billion.
Along the way, the Fed was injecting money into the banking
system, including through several new, unusual programs.
At times, Paulson acted by interpreting Treasury's powers
broadly and encouraging other agencies he worked with to expand
their authorities. In other cases, such as the rescue plan for
Fannie Mae and Freddie Mac, he needed congressional approval.
That forced him to reluctantly accept a major Democratic
proposal that authorized FHA to spend up to $300 billion to help
homeowners who, because of falling prices, owe more than their
homes are worth. The expected cost to taxpayers of this program
is $1.7 billion, the Congressional Budget Office said. "There
were parts of this legislation that just got passed that a
number of us found objectionable, unnecessary, extraneous, too
much government involvement," Paulson said.
Even helping the mortgage finance companies, was "an unpleasant
task," he said. "But I found it a simple decision to do so
because there was no other good alternative," he added.
Martin Neil Baily, who chaired the Council of Economic Advisers
in the Clinton administration and now is at the Brookings
Institution, said he found the administration's actions "very
"Paulson and his colleagues philosophically are free market
people. But when things go wrong you just don't have a lot of
choice," he said. "There has been a change in perception, that
the government needs to play a more active role when we get into
a financial crisis. . . . The question is to what degree do you
say we won't do this again."
Paulson raised similar concerns in an interview. He warned that
if the government always tries to bail out failing banks and
companies, they will be motivated to take excessive risks.
Others won't push themselves to succeed because they can rely on
the government to bail them out.
Yet despite these convictions, Paulson said his hand was forced
after the markets fell dangerously "out of balance" due to the
credit crisis. Backing Fannie and Freddie, the country's two
largest and most important financiers of mortgages, was the only
way to keep the housing market from falling into turmoil, he
said. Allowing Bear Stearns to fail could have led to a string
of collapses at other huge Wall Street firms.
In negotiations over the Bear Stearns rescue, the Fed agreed to
back $30 billion worth of risky mortgage assets but persuaded
J.P. Morgan to absorb the first $1 billion of any losses. At the
end of July, the portfolio was worth $29.1 billion, according to
the central bank. Because the Fed can be patient and sell the
assets gradually over time, officials believe taxpayers are
highly unlikely to lose more than a couple billion dollars and
the central bank may ultimately make some money.
The Fed has also made extensive efforts to inject cash into the
financial system, and at the end of July had $167 billion in
loans extended to banks. But those debts are unlikely to incur
losses since the Fed requires borrowers to put up collateral.
Taxpayers face more risk from novel Fed initiatives to help
investment banks weather the financial crisis. In one program,
the Fed lets investment firms swap highly rated mortgage-backed
securities for Treasury securities.
Meanwhile, the Education Department may end up taking on far
more loans than it ever has in its history. Last year it issued
$14 billion in federally guaranteed loans directly to students.
It has the ability to double that capacity in the coming
academic year, according to the officials, though outside
analysts predict it may have lend out $35 billion or more with
the help of contractors.
The department may also be forced to take over much of the
market that consolidates federally guaranteed loans for
post-graduates, according to Mark Kantrowitz of FinAid.org, a
Web site that provides financial information for students. This
$47.4 billion business allows borrowers to combine all of their
student loans into one package with a single, relatively low
Education Department Under Secretary Sara Martinez Tucker, who
oversees higher education, said as early as April the department
"began to get nervous" about whether enough loans would be
available to students in the fall. Department officials met with
President Bush on April 19. "We told him we think we need to
have an intervention," she said. The president agreed.
Some programs are not expected to cost taxpayers significantly,
regulators said. Since last summer, the initiative called FHA
Secure has helped 290,000 homeowners who hold $46.8 billion of
mortgages. But taxpayers won't have to bear the cost if these
homeowners default, unless the agency's $18.6 billion insurance
fund is depleted.
"It's a good example of what government should be doing," FHA
Commissioner Brian Montgomery said.
© 2008 The Washington Post Company
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