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Brookings Papers ON ECONOMIC ACTIVITY

BROOKINGS INSTITUTION PRESS

Contents

Editors' Summary..........................................................................................................................viiPHILLIP SWAGEL The Financial Crisis: An Inside View......................................................................................1JOHN Y. CAMPBELL, ROBERT J. SHILLER, and LUIS M. VICEIRA Understanding Inflation-Indexed Bond Markets....................................79CHRISTINA D. ROMER and DAVID H. ROMER Do Tax Cuts Starve the Beast? The Effect of Tax Changes on Government Spending.....................139JAMES D. HAMILTON Causes and Consequences of the Oil Shock of 2007–08...............................................................215RAFAEL DI TELLA and ROBERT MACCULLOCH Why Doesn't Capitalism Flow to Poor Countries?.....................................................285

Chapter One

The Financial Crisis: An Inside View

ABSTRACT This paper reviews the policy response to the 2007–09 financial crisis from the perspective of a senior Treasury official at the time. Government agencies faced severe constraints in addressing the crisis: lack of legal authority for potentially helpful financial stabilization measures, a Congress reluctant to grant such authority, and the need to act quickly in the midst of a market panic. Treasury officials recognized the dangers arising from mounting foreclosures and worked to facilitate limited mortgage modifications, but going further was politically unacceptable because public funds would have gone to some irresponsible borrowers. The suddenness of Bear Stearns' collapse in March 2008 made rescue necessary and led to preparation of emergency options should conditions worsen. The Treasury saw Fannie Mae and Freddie Mac's rescue that summer as necessary to calm markets, despite the moral hazard created. After Lehman Brothers failed in September, the Treasury genuinely intended to buy illiquid securities from troubled institutions but turned to capital injections as the crisis deepened.

This paper reviews the events associated with the credit market disruption that began in August 2007 and developed into a full-blown crisis in the fall of 2008. This is necessarily an incomplete history: events continued to unfold as I was writing it, in the months immediately after I left the Treasury, where I served as assistant secretary for economic policy from December 2006 to the end of the George W. Bush administration on January 20, 2009. It is also necessarily a selective one: the focus is on key decisions made at the Treasury with respect to housing and financial markets policies, and on the constraints faced by decisionmakers at the Treasury and other agencies over this period. I examine broad policy matters and economic decisions but do not go into the financial details of specific transactions, such as those involving the government-sponsored enterprises (GSEs) and the rescue of the American International Group (AIG) insurance company.

I first explain some constraints on the policy process—legal, political, and otherwise—that were perhaps not readily apparent to outsiders such as academic economists or financial market participants. These constraints ruled out several policy approaches that might have appeared attractive in principle, such as forcing lenders to troubled firms to swap their bonds for equity. I then proceed with a chronological discussion, starting with preparations taken at the Treasury in 2006 and moving on to policy proposals considered in the wake of the August 2007 lockup of the asset-backed commercial paper market.

The main development following the events of August was a new focus on housing and in particular on foreclosure prevention, embodied in the Hope Now Alliance. The Treasury sought to have mortgage servicers (the firms that collect monthly payments on behalf of lenders) make economic decisions with respect to loan modifications—to modify loans when this was less costly than foreclosure. This approach involved no expenditure of public money, and it focused on borrowers who could avoid foreclosure through a moderate reduction in their monthly mortgage payment. People whose mortgage balance far exceeded the value of their home—so-called deeply underwater borrowers—would still have an incentive to walk away and allow their lender to foreclose.

But political constraints bound tightly in addressing this situation, since there was little appetite in Congress for a program that would transparently reward "irresponsible" borrowers who had purchased homes they could never have hoped to afford. Even after the October 2008 enactment of the Emergency Economic Stabilization Act of 2008 (EESA) gave the Treasury the resources and authority to put public money into foreclosure avoidance, the need to husband limited resources against worsening financial sector problems ruled out undertaking a foreclosure avoidance program at the necessary scale until after the change in administrations in January 2009. The foreclosure avoidance initiative eventually implemented by the Obama administration in March 2009, which took the form of an interest rate subsidy, was a refinement of a proposal developed at the Treasury in October 2007.

Returning to events on Wall Street, the paper picks up the chronology with the failure of Bear Stearns in early 2008, the rescue of the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac that summer, and the failures of the investment bank Lehman Brothers and AIG the week of September 14, 2008. The run on money market mutual funds in the wake of Lehman's collapse led to a lockup of the commercial paper market and spurred the Treasury to seek from Congress a $700 billion fund—the Troubled Assets Relief Program (TARP)—with which to purchase illiquid assets from banks in order to alleviate uncertainty about financial institutions' viability and restore market confidence. However, as market conditions continued to deteriorate even after the early-October enactment of EESA, the Treasury shifted from asset purchases to capital injections directly into banks, including the surviving large investment banks that had either become bank holding companies or merged with other banks. The capital injections, together with a Federal Deposit Insurance Corporation (FDIC) program to guarantee bank debt, eventually helped foster financial sector stability. Even in late 2008, however, continued market doubts about the financial condition of Citigroup and Bank of America led the Treasury and the Fed to jointly provide additional capital and "ring fence" insurance for some of the assets on these firms' balance sheets. In effect, providing insurance through nonrecourse financing from the Fed meant that taxpayers owned much of the downside of these firms' illiquid assets.

The paper concludes with a brief discussion of several key lessons of the events of the fall of 2008. An essential insight regarding the policies undertaken throughout the fall is that providing insurance through nonrecourse financing is economically similar to buying assets—indeed, underpricing insurance is akin to overpaying for assets. But insurance is much less transparent than either asset purchases or capital injections, and therefore politically preferable as a means of providing subsidies to financial market participants. A second lesson is that maintaining public support is essential to allowing these transfers...