A framework for bailout regulation.

• Author: Casey, Anthony J.
• Position: III. Case Studies E. 2008-2009 Financial Crisis Bailouts through Conclusion: The Paradox of Bailout Regulation, with footnotes and table, p. 506-536

5. 2008-2009 Financial Crisis Bailouts

   The financial crisis of 2008 resulted in a large number of bailouts of institutions. We cannot describe all of them in the space we have, and so will limit ourselves to a few of the most important.

   The immediate cause of the financial crisis was the collapse of housing prices, but the severity of the crisis was due to financial innovations that had concentrated risk in major financial institutions. (124) Most financial institutions were exposed in various ways to collateralized debt obligations (CDOs) and related securities whose value was a function of underlying mortgages on houses and other secured loans. Some institutions held these securities on their books; many institutions also used them as collateral for short-term loans in the repo market; still others guaranteed them. Although sophisticated investors understood that housing prices could not rise forever, they did not understand that the models used to predict the value of the CDOs were based on excessively optimistic assumptions about housing prices, with the result that people could not calculate the value of the CDOs when mortgages began to default at a rate that no one anticipated.

   Other factors played a role as well. Investors had sought safe, high-yielding investments and CDOs offered higher rates than similarly rated securities. Ratings agencies gave CDOs high ratings because they, too, did not understand the assumptions underlying them. The demand for CDOs drove mortgage originators to lower underwriting standards so that they could sell more mortgages, and mortgage packagers to accept these high-risk mortgages. Meanwhile, investment banks and other financial institutions took on ever more leverage.

   The financial crisis was a classic downward spiral. As mortgage defaults increased, and people realized that many CDOs would default, lenders refused to accept them as collateral except at a steep discount. Financial firms that borrowed in the repo market could continue to borrow only by posting higher levels of collateral or finding more liquid collateral like treasuries. The most highly leveraged firms ran out of collateral, and could no longer borrow. This meant that they had to sell their CDOs and related assets in fire sales, which drove down their prices. Indeed, all firms facing liquidity shortages sought to unload their CDOs, but because everyone was acting the same, there were no buyers.

   As the most highly leveraged firms collapsed, the panic spread to safer firms. Even banks, which depend mostly on deposits rather than the repo market, began to experience runs. Lenders (including bank lenders) were afraid of lending to a firm exposed to CDOs because they could not determine whether the CDOs would default or not, and thus whether potential borrowers would be able to repay. AIG, an insurance company, faced bankruptcy because it had guaranteed CDOs and had invested in mortgage-related securities. At the height of the crisis, banks refused to lend to each other or anyone else. The crisis ended when the Fed, FDIC, and other government agencies made loans to the market. Some of the toxic assets were taken onto the balance sheets of these agencies, which have been able to hold them to maturity.

   During the financial crisis, in the fall of 2008 and winter of 2009, the press reported that the government was engaging in numerous "bailouts." In fact, many of the transactions that were labeled bailouts were not bailouts. Let us distinguish several types of transactions.

   1. Fannie/Freddie

      The Federal National Mortgage Association (better known as Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac) are hybrid public-private entities often referred to as Government Sponsored Entities or GSEs. (125)

      The two entities, chartered by acts of Congress but privately owned,126 provide support to the secondary market for mortgages. They purchase mortgages from lenders, put them into pools, and sell securities backed by those pools. The securities entitle the holders to a cash flow based on the principal and interest payments due on the underlying mortgages. Fannie and Freddie then guarantee those cash flows, providing insurance against defaults. In exchange, they charge a guarantee fee. Separately, Fannie and Freddie held large investment portfolios including mortgages and mortgage-based assets. The result of these activities was to provide liquidity to the mortgage market and, thus, at least in theory, fulfill their missions of providing stability and promoting access to mortgage markets.

      When the housing market collapsed in 2007 and 2008, Fannie and Freddie began to experience record-setting losses. As mortgage defaults mounted, the entities were hit by escalating obligations on the guarantees. By the summer of 2008, each entity had lost billions of dollars. Default by Fannie and Freddie became a real possibility.

      Such a default was likely to create a feedback loop that accelerated losses. The default of Fannie and Freddie would directly reduce the liquidity in the mortgage market and signal that further liquidity support was unlikely. Banks would then originate fewer mortgages, resulting in fewer home sales and a further decline in housing prices, and further defaults on mortgages guaranteed by Fannie and Freddie.

      This had systemic implications. Because Fannie and Freddie had such massive holdings in the secondary mortgage market, many commentators believed that their failure would significantly deepen the housing market collapse. As events would turn out to reveal, creditors and counterparties were massively exposed to mortgage derivatives, and thus, if Fannie and Freddie failed, would suffer enormous losses that would reduce liquidity outside of the mortgage market. (127)

      At the same time, there was an open question about whether the government had guaranteed the debt of Fannie and Freddie in the first place. Although no explicit guarantee had been made, market participants generally operated under the assumption that the government would back Fannie and Freddie if they defaulted and the debt traded at a discount that reflected at least some level of guarantee. (128) For our analysis, this fact places the case somewhere between ex ante insurance and a true bailout. On the one hand, an explicit guarantee is no different from ex ante insurance. But this guarantee was uncertain. The legal basis for enforcing it was weak at best. (129) It is probably more accurate to characterize the status quo as an expectation that a bailout would be provided rather than as an actual legal entitlement. And--even if an entitlement to the implicit guarantee existed--its contours and the mechanism for implementing it were unstated and subject to discretion.

      Given the implicit promise, many worried that a default by Fannie and Freddie would send a major negative signal about government creditworthiness (or, more specifically, its willingness to selectively default) on its general obligations. This ended up being a major reason given by the government for launching a bailout. (130)

      The overall transaction occurred in several steps. The first step was intended to be a preventative move to avoid the need for further bailouts. In June of 2008, Congress passed the Housing and Economic Recovery Act of 2008 (HERA), which gave Treasury the power to make investments to shore up Fannie and Freddie. (131) It also created the Federal Housing Finance Agency (FHFA) and gave it the power to place Fannie and Freddie into conservatorships or receiverships. (132)

      Just a few months later, the FHFA--working with Treasury and the Fed--exercised its power to place the entities into conservatorship and Treasury used its new investment power to inject massive capital in the form of preferred equity. The documents governing the bailout evolved through amendment as the crisis unfolded, but ultimately Treasury made a commitment to provide unlimited funds to guarantee liabilities through 2012. (133) The plan also included repayment terms and a requirement to shrink the investment portfolios of the entities. As part of the repayment, Fannie and Freddie had to pay a quarterly dividend at a 10% annual rate on the amount that Treasury had invested. In August of 2012, the terms were amended again to replace the dividend payment with a "net-income sweep." This meant that instead of paying Treasury a 10% dividend on its investment, each firm pays a dividend equal to that firm's positive net worth (defined as total assets less total liabilities). (134) The effect is that all net income gets paid to Treasury every quarter. That essentially wiped out the remaining interest of all equity holders. (135)

      The various stages represent some of the different types of bailouts and bailout-like actions that the government can use to address the financial difficulties of systemically important institutions.

      The law as it stood before HERA provided vague conservatorship authority that might be viewed as a grant of bailout authority. (136) While the government denied that it would bail out Fannie or Freddie, the market seems to have assumed either that the law provided bailout authority or that Congress would act if necessary.

      By contrast, HERA was an ex post bailout statute. Once the crisis was imminent, Congress took ex post actions to limit the impact of the crisis. To be sure, HERA did not implement a bailout; rather it authorized the government to implement a bailout. The statute signaled that the government was standing behind the debt of Fannie and Freddie. (137) In this way, the Congressional authorization can be viewed as correcting for Congress's ex ante failure to create sufficient bailout authority.

      The crucial aspects of the bailout were the injection of capital through preferred equity that had repayment priority junior to all debt but senior to equity and the imposition of federal control through the FHFA appointed conservator. (138) These...