The Emergency Economic Stabilization Act and Recent Financial Turmoil: Issues and Analysis

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The current financial instability became widely apparent in the credit markets in August 2007.
Although initially thought to be limited to subprime mortgages, increasing defaults on prime
mortgages caused losses that rippled through the financial system; the effects have been
particularly severe because U.S. mortgage-backed securities (MBS) had previously been viewed
as low risk investments. Beginning in early 2008, multiple failures in large financial institutions
prompted case-by-case government interventions to address these failures. Dissatisfaction with
these ad hoc responses was cited by the Treasury in proposing a broader response focusing on
government purchase of troubled mortgage-related assets, hoping to stem uncertainty and fear by
removing these assets from the financial system. In early October 2008, Congress passed, and the
President signed, the Emergency Economic Stabilization Act of 2008 (EESA, Division A of H.R. ^th

1424/P.L. 110-343), creating the Troubled Assets Relief Program (TARP). In the 111 Congress,

the TARP Reform and Accountability Act of 2009 (H.R. 384) would enact significant changes.
EESA allows Treasury to buy up to $700 billion in troubled assets from financial institutions. The
scope of the program depends in part on the definition of troubled assets. The original three-page
proposal defined trouble assets as mortgage-related assets, both residential and commercial. As
passed, EESA includes a second definition, which includes any asset that Treasury, in
consultation with the Federal Reserve, believes would contribute to financial stability. EESA also
allows Treasury to insure assets, rather than purchase them. Taxpayers are to be at least partially
protected from losses through the provision of equity or debt considerations and through
insurance premiums. TARP limits the executive compensation of participating institutions. TARP
allows for direct aid to homeowners through provisions promoting mortgage restructuring and
extending tax relief for homeowners who have mortgage debt forgiven.
Following enactment of EESA, the Treasury has purchased or committed to purchase
approximately $350 billion of assets, although none of these have been through the asset purchase
auctions or insurance programs. Through the voluntary Capital Purchase Program (CPP), $250
billion of the TARP funding has been committed for capital injections into financial institutions
through government purchases of preferred shares. Through the Consumer Lending Facility, up to
$20 billion in TARP funding will be used to absorb any losses on a $200 billion Federal Reserve
credit facility intended to assist the credit markets in accommodating the credit needs of
consumers and small businesses. The Treasury has also undertaken several case-by case
interventions including AIG, Citigroup, General Motors/GMAC and Chrysler.
In the 111^th Congress, H.R. 384 was introduced by Chairman Barney Frank on January 9, 2009,
and passed the House with four amendments on January 21, 2009. This bill would amend the
EESA in several ways, including stricter conditions on institutions receiving TARP funds,
requirements and limitations for homeowners assistance, and specific authorization for, and
conditions on, financial assistance for automobile manufacturers.
This report briefly introduces aspects of the current financial instability. Following this, it outlines
the EESA legislation, the steps that Treasury has taken to implement EESA, and current
legislation amending the EESA. Finally, the report concludes with a more in-depth analysis of the
current financial instability, including potential causes of financial instability in general, some
sources of the current instability, and how financial instability may spill over into the broader
economy. It will be updated as warranted by market and legislative events.

Introduc tion ..................................................................................................................................... 1
The Troubled Assets Relief Program...............................................................................................2
Executive and Congressional Proposals....................................................................................2
Provisions of TARP as Enacted.................................................................................................3
Asset Purchase Program.....................................................................................................3
Asset Insurance Program ...................................................................................................3
Size of the Programs...........................................................................................................3
Private Equity and Debt Considerations.............................................................................4
Oversight Provisions ..........................................................................................................4
Assistance to Homeowners.................................................................................................4
Executive Compensation....................................................................................................5
Mark-to-Market Accounting...............................................................................................5
Increase in Deposit Insurance.............................................................................................6
Assistance to Financial Institutions Holding Fannie Mae/Freddie Mac Preferred
St ock .......................................................................................................................... ...... 6
Duration of Program...........................................................................................................6
Treasury Implementation of TARP...........................................................................................6
Asset Purchase....................................................................................................................7
Asset Insurance...................................................................................................................8
Capital Purchase Program...................................................................................................8
Systemically Significant Failing Institutions Program (AIG).............................................9
Targeted Investment Program (Citigroup and Bank of America).....................................10
Consumer Lending Facility................................................................................................11
U.S. Automobile Manufacturers........................................................................................11
Homeowners’ Assistance..................................................................................................12
111^th Congress...............................................................................................................................12
TARP Reform and Accountability Act of 2009 (H.R. 384).....................................................12
Participating Institutions Reporting Use of Funds............................................................12
Mergers and Acquisitions..................................................................................................13
Voluntary Withdrawal from TARP....................................................................................13
Executive Compensation..................................................................................................13
New Lending.....................................................................................................................13
Warrants and other Taxpayer Protections..........................................................................13
Smaller Institutions...........................................................................................................14
Oversight ...................................................................................................................... ..... 14
TARP Foreclosure Mitigation Plan...................................................................................14
Auto Industry Provisions..................................................................................................15
Clarification of Troubled Assets (Consumer Loans, Municipal Securities,
Commercial Real Estate)...............................................................................................15
Changes to Hope for Homeowners Program....................................................................15
Home Buyer Stimulus and GSE Securities Program........................................................16
FDIC Provisions...............................................................................................................16
Additional Amendments to H.R. 384................................................................................16
Potential Causes of Financial Instability.......................................................................................16
Confidence and the Credit Cycle............................................................................................17
Information Asymmetries........................................................................................................18

Moral Hazard..........................................................................................................................19
Network Externalities..............................................................................................................19
Collective Action.....................................................................................................................19
Sources of Recent Market Turmoil................................................................................................20
Expectations, Mortgage Defaults, and Asset Prices................................................................20
Liquidity and Uncertainty.......................................................................................................23
Capital Adequacy and Leverage..............................................................................................23
Too Complex to Fail?..............................................................................................................24
Evidence of the Real Effects of Financial Market Turmoil...........................................................25
Wealth Effect?.........................................................................................................................26
Bank Balance Sheets and Tightening Credit Markets.............................................................27
Reinforcing Delinquencies and Foreclosures in Housing Markets.........................................28
Difficulties of Using Debt Financing to Fund Purchases........................................................28
Conclusion ..................................................................................................................................... 28
Figure 1. Index of ARM Foreclosure Rates, 2001=100 Prime ARMs Have Unexpectedly
High Foreclosure Rates..............................................................................................................21
Figure 2. Index of FRM Foreclosure Rates, 2001=100 Fixed-Rate Subprime Loans Have
Unexpectedly Low Foreclosure Rates........................................................................................22
Figure 3. Spread Between Commercial Paper and One-Month Treasuries..................................26
Appendix. Glossary of Terms Related to Disruption of Financial Markets..................................29
Author Contact Information..........................................................................................................31

The Emergency Economic Stabilization Act (EESA)¹ became law on October 3, 2008. Intended
to restore stability to the U.S. financial system, the act created a Troubled Assets Relief Program ²
(TARP). TARP included two primary programs: a troubled asset purchase program and a
troubled asset insurance program. This report briefly introduces characteristics of current
financial instability. It also outlines the EESA legislation, the steps that Treasury has taken to ^th
implement EESA, and legislation in the 111 Congress amending EESA. Next, the report
provides an in-depth analysis of financial instability, including potential causes of instability in
general, and how it may spill over into the broader economy. Finally, the report assesses the
causes of this period of financial instability. This report will be updated as warranted by market
and legislative events.
Starting in the 1980s, non-bank lenders have originated increasing shares of U.S. mortgages.
These non-bank lenders obtained their own funds through the conversion of mortgages into
marketable securities (securitization), rather than by accepting consumer deposits as in the ³
traditional banking model. In most cases, once a mortgage was made, the entity that originated
the loan sold it to another institution, which then pooled a large number of these loans together.
From this pool of loans, the institution then issued securities whose returns were based on the
payments made on the underlying mortgages in the pool. For a variety of market and regulatory
reasons, these mortgage-backed securities (MBS) became widely held by most financial
institutions in the United States and by many institutions worldwide. In addition to the securities
directly backed by mortgages, financial institutions created numerous other complex securities
and derivatives based on the initial MBS. These secondary products, such as collateralized debt
obligations (CDO) and credit default swaps (CDS) were also very widely held by financial
institutions, although not by retail investors.
In 2006 and 2007, the rates of default and non-payment by mortgage holders increased
significantly. This, in turn, ultimately caused the securities and derivatives based on these
mortgages to lose value. In some cases, securities thought to be low risk were completely wiped
out. These losses have rippled through the financial system, causing problems for institutions in a
number of unexpected ways as well as stress to the general financial system. The failures of large
financial institutions, including Bear Stearns, IndyMac, Fannie Mae, Freddie Mac, Lehman ⁴
Brothers, and AIG, were part of this turmoil. Due largely to the uncertainty about what future
mortgage default rates will be, what institutions are exposed to mortgage-related assets, and
whether more institutions may fail unexpectedly, financial markets have nearly frozen at various
points in time since August 2007.
Difficulties for individual financial institutions, and for financial systems as a whole, can often ⁵
usefully be distinguished as problems of liquidity or of capital adequacy. A firm suffering from

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liquidity problems has assets whose values significantly outweigh liabilities, but is unable to
liquidate these assets fast enough to meet short-term obligations. A firm suffering from capital
adequacy problems has an inadequate buffer between its assets and its liabilities; if its asset
values fall or liability values rise unexpectedly, the firm may be unable to meet its liabilities even
if its assets can be liquidated quickly. Insolvency could result. The classical prescription for
addressing liquidity problems is for a lender of last resort (such as the Federal Reserve) to lend
freely, but at high enough interest rates so that institutions do not take too many risks. Capital
adequacy problems, particularly when widespread, can be more difficult to address. In past crises, ⁶
steps have included directly bolstering firms’ capital and sweeping insolvent, or near insolvent, ⁷
firms out of the system.

On September 19, 2008, the Secretary of the Treasury proposed a broad program of financial
intervention to stabilize markets. The Treasury plan called for government purchases of up to
$700 billion in mortgage-related securities, in the hope that, by partially purging the system of
these troubled assets, normal functioning of the financial markets could be restored.
The idea of broad asset purchases, as in the original Treasury plan, is only one of a number of
methods that could be used to address the uncertainties regarding mortgage-related assets. Among
the other concepts put forward have been
• a federal guarantee program to insure mortgage-related assets, thus eliminating
much of the uncertainty surrounding these securities;
• direct capital injections by the Treasury into financial institutions, thus shoring up
their capitalization; and
• direct support for homeowners, thus decreasing mortgage default rates and
increasing the value of mortgage-related securities.
After various legislative proposals and drafts were circulated and negotiations between Congress
and the administration were conducted, the Emergency Economic Stabilization Act of 2008
(EESA), was brought to a vote in the House as substitute amendment to H.R. 3997; this
amendment failed in the House on a vote of 205-228 on September 29, 2008. Another version of ⁸
EESA, which included the original EESA plus several other provisions not in the first bill, was

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offered on October 1 in the Senate as an amendment (S.Amdt. 5685) to an unrelated bill, H.R.
1424, which had previously passed the House. The amendment to H.R. 1424 was approved by a
Senate vote of 74-25; it was then taken up by the House and passed by a vote of 263-171 on
October 3, 2008. The President signed the amended version of H.R. 1424, now P.L. 110-343, the
same day as House passage.
Section 101 of EESA provides authority to the Secretary of the Treasury to purchase “troubled
assets” from any financial institution established and regulated under federal or state law, but
excluding any foreign governmental entity. These assets are defined by the statute as “residential
or commercial mortgages,” including securities “based on, or related to such mortgages.” In
addition to the mortgage-related assets that were the focus of the program, the Secretary is
authorized to purchase “any other financial instrument” that is “necessary to promote financial
market stability.” Congress must be notified of the Secretary’s determination to purchase non-
mortgage related assets, but the Secretary does not need Congress’ approval to do so. The
Secretary is to take steps to prevent “unjust enrichment” of financial institutions selling assets to
the government, in particular preventing the sale of troubled assets at a price higher than what the
seller initially paid for the asset. Section 113 directs the Secretary to use market mechanisms,
such as auctions, to purchase assets when possible.

Section 102 of EESA provides that, if the asset purchase program is created, the Secretary must
also create an insurance program providing federal guarantees for troubled assets. This insurance
program is to be funded by premiums paid by financial institutions for the federal guarantee, with
no specific provision for the TARP insurance fund to borrow from the U.S. Treasury. Under the
statute, the guarantees may be up to 100% of the value of the asset and the premiums may be risk-
based, but the Secretary is not required to implement either of these provisions.
Under Sections 115 and 102, the total size of the insurance and asset purchase program combined
is not to exceed $700 billion at any given time, which does allow the program to buy and sell
assets, then use the sales proceeds to purchase other assets. Authority to purchase or insure $250
billion is effective on the date of enactment, with an additional $100 billion in authority effective
upon submission of a Presidential certification. The final $350 billion in authority may be
exercised upon transmission of a written report by the President detailing the plan for the exercise

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of this authority. Congress has 15 calendar days to pass a joint resolution under “fast track” rules, ¹⁰
to deny the authority to use the final $350 billion.
Section 113 requires that, in return for federal purchase of troubled assets, financial institutions
must provide to the federal government either debt or equity considerations, such as preferred or
common stock in that institution. These considerations are to provide protection for the taxpayer
against losses on troubled asset sales and allow the taxpayers to benefit from future equity
appreciation of institutions participating in TARP.

The EESA creates a number of oversight mechanisms. Section 104 establishes a Financial
Stability Oversight Board to oversee the authorities in the act. Section 105 requires detailed
monthly reports by the Secretary to Congress on the operations of the program. Section 116 gives
the Comptroller General oversight and audit authority on TARP, including access to records and
office space within the Treasury for employees of the Government Accountability Office (GAO)
to exercise this oversight. Should GAO identify problems in the annual audit, TARP must either
take action to correct the problems, or certify to Congress that no action is necessary. Section 121
creates a Special Inspector General to oversee TARP, who shall report quarterly to Congress.
Section 125 creates a Congressional Oversight Panel made up of five congressional appointees.
One of the specific considerations Section 103 requires be taken into account in the general
operation of TARP is “to help families keep their homes.” EESA also includes specific measures
to that end. Section 109 directs the Secretary, as TARP acquires mortgages and mortgage-related ¹²
securities, to encourage servicers to take advantage of the HOPE for Homeowners Program. The
Secretary is also required to consent to reasonable requests for loan modifications from
homeowners whose loans are acquired by the government. Section 110 requires the Federal
Housing Finance Agency, the Federal Deposit Insurance Corporation, and the Federal Reserve
Board to implement a plan to “maximize assistance for homeowners,” including reduction of
interest rates or reduction of loan principal, for mortgages or mortgage backed securities owned
or managed by these institutions.
Section 303 extends an additional exception to the tax laws, first made available by the Mortgage ¹³
Forgiveness Debt Relief Act of 2007, relating to the cancellation of mortgage debt. The
additional exception allows for the exclusion of discharged qualified residential debt from gross
income. Qualified indebtedness is defined as debt, limited to $2 million ($1 million if married

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filing separately), incurred in acquiring, constructing, or substantially improving the taxpayer’s
principal residence that is secured by such residence. It also includes refinancing of this debt, to
the extent that the refinancing does not exceed the amount of refinanced indebtedness. The
taxpayer is required to reduce the basis in the principal residence by the amount of the excluded
income. The provision does not apply if the discharge was on account of services performed for
the lender or any other factor not directly related to a decline in the residence’s value or to the
taxpayer’s financial condition. The provision applies to debt discharges that are made on or after ¹⁴
January 1, 2007, and before January 1, 2013.

Sections 111 and 302 put limits on executive compensation for firms participating in TARP. For
institutions whose assets are bought directly, Section 111 requires that the Secretary publish
standards that will (1) limit incentives for executives to take excessive risks, (2) provide for
recovery of any bonus paid based on earnings statements that later prove to be inaccurate, and (3)
prohibit golden parachute payments to senior executives. These standards are to be in effect for
the duration of time that the government holds an equity or debt interest in the company. For
those institutions whose assets are bought at auction, only new employment contracts with
“golden parachutes” are prohibited.
Section 302 provides special tax rules pertaining to executive compensation for participants in
TARP. In particular, Section 162(m) of the Internal Revenue Code is amended to reduce the
limitation on deductible executive compensation from $1,000,000 to $500,000 and Section 280G
of the Internal Revenue Code is amended to expand the definition of a parachute payment for
covered employees of TARP participants.
Sections 132 and 133 address “mark-to-market” accounting rules required under Statement 157 of
the Financial Accounting Standards Board (FASB). The Securities and Exchange Commission
(SEC) is specifically given the authority to waive these accounting rules. In addition, the SEC
was directed to conduct an expansive study on mark-to-market accounting and what impact it
may have had on the current financial turmoil. The SEC released this study on December 30,
2008 finding that “investors generally believe fair value accounting increases financial reporting
transparency and facilitates better investment decision-making. The report also observes that fair
value accounting did not appear to play a meaningful role in the bank failures that occurred in
2008. Rather, the report indicated that bank failures in the U.S. appeared to be the result of
growing probable credit losses, concerns about asset quality, and in certain cases, eroding lender ¹⁶
and investor confidence.”

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^Se^itz^ing^e^r.
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^Sta^nda^rds^,^”^a^v^a^ila^ble^a^t^http^://w^w^w^.s^ec^.g^ov^/new^s^/^pre^s^s^/^2008/²⁰^08-³⁰⁷^.htm^.

Section 135 provides for a temporary increase in the insurance on deposits in federally insured ¹⁷
banks and credit unions. From enactment until the end of 2009, this amount is increased from
$100,000 to $250,000. This temporary increase may not be taken into account when setting
premiums for deposit insurance.
Section 301 provides tax relief to financial institutions holding preferred stock in Fannie Mae or
Freddie Mac, which lost significant value after the government conservatorship announced in
September 2008. Capital gains or losses from the sale or exchange of preferred stock of Fannie
Mae and Freddie Mac will be treated as ordinary income or loss by applicable financial
institutions, which include banks, mutual savings banks, cooperative banks, and savings and loan
associations, among others. The basic rationale behind this tax relief is that it will reduce the need
of the bank “to obtain additional capital from the FDIC or investors. This should also prevent ¹⁸
some community banks from becoming insolvent.” Normally, in the case of corporations,
capital losses are allowed only to the extent of capital gains, although the losses may be carried
back three years or carried forward for five years. This provision allows these financial
institutions to use the losses incurred in the government takeover of Fannie Mae and Freddie Mac
to reduce their tax liability this year (a year with few capital gains), rather than carry the losses to ¹⁹
past tax years or forward to future tax years.
Section 120 authorizes TARP asset purchases until the end of 2009. Upon receipt of certification
and supporting information from the Secretary, this termination date may be extended until
October 3, 2010 (two years after the date of enactment).
Although the original discussion of the three-page draft Treasury plan focused on removing bad
assets from financial institution balance sheets, some policymakers urged, and P.L. 110-343
included, broad discretion for the use of TARP funds. The potential scope of the program can be
found in Part (B) of the definition of a troubled asset, which includes
^{... an}^y^oth^e^{r fin}^aⁿ^c^{ial i}ⁿ^s^t^r^u^m^eⁿ^t^th^{at t}^h^{e Secretar}^y^,^af^{ter con}^s^u^ltatioⁿ^wⁱ^th^t^h^{e C}^h^aⁱ^r^m^aⁿ^of
^t^h^{e Board of}^G^o^v^e^rn^ors^o^f^t^h^e^F^e^deral^R^e^s^e^rv^e^Sy^s^t^e^m^{, det}^e^rmⁱⁿ^es^t^h^{e pu}^rc^h^a^s^e^o^f^w^hⁱ^c^hⁱ^s

¹⁷^For^m^o^r^e^inf^o^r^m^a^{tion s}^e^e^C^R^S^R^e^por^{t R}^S²²⁹⁸^7,^N^a^ti^on^{al C}^r^e^d^it^Uⁿ^ion^S^har^e^Iⁿ^s^u^r^a^nc^e^Fun^d⁽^N^C^U^SI^F)^:^C^r^e^d^it
^Uⁿ^ion^D^e^pos^it^Iⁿ^s^u^r^anc^e^,^by^P^a^ul^ine^Sm^a^l^e^a^{nd C}^R^S^R^e^po^r^t^R^S²⁰⁷²⁴^,^Fe^de^r^a^{l D}^e^pos^it^a^nd^Sh^ar^e^Iⁿ^s^u^r^a^nc^e^:
^Pr^opos^als^f^o^r^C^h^an^ge^{, c}^o^or^di^na^te^{d by}^W^a^lte^r^W^.^Euba^nk^s
¹⁸^U^.^{S. Se}^na^te^{, C}^o^m^m^itte^e^{on Fi}^na^nc^e^,^“^T^a^x^P^r^ov^is^ionsⁱⁿ^Fⁱ^na^nc^ia^l^R^e^s^c^ue^P^l^aⁿ^P^r^o^t^e^c^t^H^o^m^e^o^w^ne^r^s^a^{nd C}^o^m^m^unity
^Ba^nk^s,”^Ne^w^s^Re^le^a^s^e^,^Se^pte^m^be^{r 28}^{, 2}⁰⁰⁸^{, a}^v^a^ila^ble^a^t^htt^p^://f^inaⁿ^c^e^.^se^na^te^.g^ov^/^p^re^ss/Bpre^ss/20⁰⁸^p^r^e^ss/
^pr^b⁰⁹²⁸^08.^pdf^.
¹⁹^F^o^{r m}^o^{re i}ⁿ^f^o^rm^atⁱ^oⁿ^on^t^h^{ese t}^a^{x i}^ssu^es,^coⁿ^t^act^CRS^S^p^eci^alⁱ^s^tⁱⁿ^P^u^b^lⁱ^c^Fⁱⁿ^aⁿ^{ce T}^h^o^m^{as Hu}ⁿ^g^erf^o^rd^,
^G^o^v^e^rⁿ^m^e^{nt a}^nd^Fina^nc^e^Dⁱ^vⁱ^sⁱ^oⁿ^.

ⁿ^eces^sar^y^to^p^r^o^m^o^t^e^fin^aⁿ^c^ial^m^a^rk^et^stab^ilit^y^,^b^u^{t o}ⁿ^l^y^u^p^oⁿ^traⁿ^s^m^itta^{l o}^f^s^u^c^h
^d^e^ter^mⁱⁿ^at^ioⁿ^,ⁱⁿ^w^r^itⁱⁿ^g^,^to^th^{e ap}^p^r^o^p^rⁱ^{ate co}^m^m^{ittees o}^f^C^oⁿ^g^r^es^s.
Shortly after passage, Treasury announced its plans to implement the program, which has been
coordinated by Neel Kashkari, the Interim Assistant Secretary for the Office of Financial
Stability. Mr. Kashkari created teams within Treasury to administer TARP, including hiring asset
managers to administer asset purchases, proposing rules for asset insurance, and injecting capital
into institutions through preferred stock purchases. Although Treasury has subsequently
announced that it will focus on capital purchases, the following section begins with the Treasury
actions relating to the troubled asset purchase and insurance programs specifically described in
the EESA and then moving to the various programs implemented by Treasury under the broader
definition described above.
Treasury must fulfill certain logistical and statutory conditions prior to fully implementing the
troubled asset purchase program in Section 101 of the EESA. The first definition of troubled
assets (Part A) eligible for the TARP program is any
^{... residen}^{tial or com}^m^ercial^mortg^a^g^e^{s a}ⁿ^{d any}^secu^ritie^{s, oblig}^atioⁿ^s^{, or oth}^e^{r in}^strum^eⁿ^t^s
^th^{at are bas}^e^{d on}^{or related to s}^u^ch^m^o^rtg^a^g^e^s^,^t^h^{at i}ⁿ^each^ca^s^e^w^a^s^origⁱⁿ^{ated or is}^s^u^{ed on}
^{or bef}^o^{re Ma}^rch^14,²⁰^{08, t}^h^e^pu^rch^a^s^e^of^w^hⁱ^c^h^t^h^e^S^e^c^r^e^t^a^r^y^d^e^t^e^rmⁱⁿ^e^s^p^r^o^m^o^t^es^fⁱⁿ^aⁿ^cⁱ^a^l
^m^a^r^k^{et stab}^ilit^y^.
To purchase these assets, Treasury must publish the mechanisms for purchasing assets, pricing
and valuation models, the process of choosing asset managers, and the method of identifying
troubled assets for purchase.
Some steps were completed for the purchase of complex mortgage-related securities. Treasury
selected Bank of New York-Mellon as the master custodian for the program. Treasury and the
Bank of New York sought to design the auction process and identify which assets to purchase.
Treasury chose PricewaterhouseCoopers LLP and Ernst & Young to provide accounting
assistance for the program. Treasury also began the process of hiring asset managers.
Should Treasury implement the troubled asset purchase program, institutions would have to
conform to program requirements in order to participate. Participating institutions must sell, or
commit to sell, to Treasury warrants for nonvoting common or preferred stock (or voting stock if
Treasury agrees not to vote). In addition to providing warrants, participating institutions must
agree to limits on executive compensation.
On November 12, the Secretary of the Treasury indicated that, in Treasury’s assessment, ²⁰
purchasing troubled assets was “not the most effective way to use TARP funds.” The Secretary
did indicate that the Treasury would be continuing to examine whether asset purchases might be
useful in the future. It is unclear to what degree the infrastructure discussed above to provide for
asset purchases will be retained or whether it would need to be reconstituted if a future decision
were made to purchase troubled assets.

²⁰^U^.^{S. D}^e^pa^r^t^m^e^{nt of}^T^r^e^a^s^ur^y^,^“^R^em^a^r^ks^by^Se^c^r^e^t^a^r^y^H^e^nr^y^{M. P}^a^uls^oⁿ^,^J^r^.^on^Fina^nc^ia^{l R}^e^s^c^ue^P^a^c^k^ag^e^a^nd
^Ec^onom^ic^U^pda^te^,”^pr^e^s^s^r^e^le^a^s^e^,^N^o^v^e^m^b^e^r^12,²⁰⁰⁸^{, a}^v^a^ila^ble^a^t^http:^//us^t^r^e^a^s^.g^ov^/pr^e^s^s^/^r^e^le^a^s^e^s^/^h^p12⁶⁵^.htm^.

Treasury began the notice and comment rulemaking procedure for the insurance program on
October 14, 2008. Rather than providing a specific insurance plan, Treasury’s notice asked
questions to guide the creation of the troubled asset insurance program. Should the insurance
program include both whole loans and complex securities? Should the program differ by which
particular asset is troubled, and if so, how is that to be measured? How could Home Equity Lines
of Credit (HELOC) and other junior liens be addressed in an insurance program? Comments on
these and similar questions were due to Treasury by October 28, 2008. Given the focus on capital
purchase, discussed below, it was unclear how quickly the Treasury would act to create the
insurance program and how expansive the program would be. Section 102 of P.L. 110-343 clearly
requires that an insurance program be created, but sets no timelines on its operation, requiring
only that a report on the insurance program be filed within 90 days after enactment.
On December 31, 2008, Treasury released the congressionally mandated report on the insurance
program. This report indicated that it had established an “Asset Guarantee Program” as required
under the EESA and the program would provide “guarantees for assets held by systemically
significant financial institutions that face a high risk of losing market confidence due in large part
to a portfolio of distressed or illiquid assets.” The report continues that the “program will be
applied with extreme discretion in order to improve market confidence in the systemically
significant institution and in financial markets broadly. It is not anticipated that the program will ²¹
be made widely available.”
On January 16, 2009, part of the assistance to Citigroup was formally assigned to the Asset
Guarantee Program. Prior to the January 16, 2009 Citigroup assistance of $5 billion, there had
been no guarantees issued under the EESA insurance program. However, Treasury had indicated
in November 2008 that it might use this program for a $306 billion pool of assets that Treasury
guaranteed as part of its initial intervention into Citigroup (discussed further below).
Although many may not have anticipated the purchase of preferred shares to recapitalize the
banks, some policymakers had urged this approach from the beginning. Authority to purchase the
preferred shares of banks comes under Part B of the definition of troubled asset, which gives
Treasury broad discretion in consultation with the Federal Reserve.
On October 14, 2008, Treasury announced its ongoing focus would be to inject capital directly
into financial institutions through the purchase of preferred stock rather than purchasing the
troubled assets that had previously been the focus of the program. This announcement came after
European authorities announced that they were taking steps to inject capital into their banks.
Treasury also announced that nine large banks were participating in the initial preferred share
purchase, which amounted to $125 billion. Treasury indicated that an additional $125 billion was
being reserved for preferred share purchases from smaller banks. As of January 16, 2009, a total

²¹^Fr^om^the^U^.^{S. T}^r^e^a^s^ur^y^w^e^bs^ite^“^S^e^c^{tion 1}⁰²^C^o^ng^r^e^s^sⁱ^ona^{l R}^e^po^r^t^,”^a^v^a^ila^ble^a^t
^http:^//ustre^a^s^.g^ov^/init^ia^tiv^e^s^/e^e^s^a^/^c^ong^re^ssiona^lre^ports¹⁰^2.sh^tm^l.

of $194 billion of TARP funds has been disbursed for the capital purchase program, including ²²
funds for smaller banks such as Independence Bank of Rhode Island, which received $1 million.
Banks seeking capital use a single application form but submit it to their primary regulator
(Federal Reserve, the FDIC, the OCC or the OTS). Once a regulator has reviewed an application,
it will send the application and its recommendation to the Office of Financial Stability at the
Treasury Department. Treasury says that it will give considerable weight to the regulators’
recommendations and decide whether or not to make the capital purchase. The initial applications
for Treasury capital purchase were limited to publicly held corporations, which limited the ability
of many smaller institutions, such as private partnerships or mutual institutions, to apply. The
Treasury addressed also this concern on November 17, releasing a term sheet of additional
information for privately held institutions interested in applying.
The Treasury announced on November 10, 2008, that financial support under TARP would be
provided to AIG, which had previously received support exclusively from the Federal Reserve.
Originally listed under the capital purchase program, the Treasury subsequently announced the
Systemically Significant Failing Institutions Program (SSFIP) and included the AIG intervention
under this program. The TARP portion of the AIG restructuring consisted of the purchase of $40 ²³
billion in preferred shares, which will pay a 10% dividend.
While the SSFIP has only been used for AIG to this date, Treasury indicates that it may be used in
the future on a case-by-case basis. According to the Treasury, future designation of systemically ²⁴
significant failing institution status is to be determined based on the following criteria:
1. “The extent to which the failure of an institution could threaten the viability of its
creditors and counterparties because of their direct exposures to the institution;
2. The number and size of financial institutions that are seen by investors or
counterparties as similarly situated to the failing institution, or that would
otherwise be likely to experience indirect contagion effects from the failure of the
institution;
3. Whether the institution is sufficiently important to the nation’s financial and
economic system that a disorderly failure would, with a high probability, cause
major disruptions to credit markets or payments and settlement systems,
seriously destabilize key asset prices, significantly increase uncertainty or losses
of confidence thereby materially weakening overall economic performance; or

²²^Fig^u^r^e^s^ta^k^e^{n f}^r^om^the^T^r^e^a^s^ur^y^’^s^TA^R^P^T^r^aⁿ^s^a^c^tions^R^e^por^t^f^o^r^t^h^e^pe^rⁱ^o^d^eⁿ^ding^J^a^n.¹⁶^,²⁰^09,^a^v^a^ila^ble^a^t
^h^t^t^p^:^/^/^www^.^t^reas.^g^o^v^/^p^ress/^rel^eas^es^/r^e^por^ts^/0¹²²⁰^9c^ppta^b^le^ts⁰¹^.p^d^f
²³^A^dditio^na^{l a}^s^pe^c^t^{s of}^the^re^vⁱ^se^{d A}^I^G^inte^rv^eⁿ^{tion thr}^oug^h^the^Fe^d^e^ra^{l Re}^se^rve^inc^l^ude^d^a^$6⁰^billi^oⁿ^loaⁿ^f^r^om^the
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^http:^//ustre^a^s^.g^ov^/init^ia^tiv^e^s^/e^e^s^a^/^pr^og^r^a^m^-^de^s^c^rⁱ^ptions^/s^s^f^ip.s^htm^l^.

4. The extent and probability of the institution’s ability to access alternative sources
of capital and liquidity, whether from the private sector or other sources of
government funds.”
On November 23, 2008, the Treasury, Federal Reserve, and FDIC announced a joint intervention
in Citigroup, which had previously been a recipient of $25 billion in funding under TARP’s
general capital purchase program. This specific intervention consisted of an additional $20 billion
purchase of preferred shares under TARP and a government guarantee for a pool of $306 billion
in Citigroup assets. On January 2, 2009, the Treasury released guidelines for the “Targeted
Investment Program,” under which it indicated that the Citigroup preferred share purchase had
occurred. On January 16, 2009, Bank of America received $20 billion through the Targeted
Investment Program, in addition to the funds it received through the Capital Purchase Program. ²⁵
Future eligibility for this program would be determined based on the following criteria:
1. “The extent to which destabilization of the institution could threaten the viability
of creditors and counterparties exposed to the institution, whether directly or
indirectly;
2. The extent to which an institution is at risk of a loss of confidence and the degree
to which that stress is caused by a distressed or illiquid portfolio of assets;
3. The number and size of financial institutions that are similarly situated, or that
would be likely to be affected by destabilization of the institution being
considered for the program;
4. Whether the institution is sufficiently important to the nation’s financial and
economic system that a loss of confidence in the firm’s financial position could
potentially cause major disruptions to credit markets or payments and settlement
systems, destabilize asset prices, significantly increase uncertainty, or lead to
similar losses of confidence or financial market stability that could materially
weaken overall economic performance; and
5. The extent to which the institution has access to alternative sources of capital and
liquidity, whether from the private sector or from other sources of government
funds.”
In addition to the $20 billion in preferred share purchase, the Treasury, FDIC, and Federal
Reserve agreed to guarantee a $306 billion pool of Citigroup assets. The guarantee is in place for
10 years for residential assets and five years for non-residential assets. Should there be losses on
the pool, Citigroup will exclusively bear up to the first $29 billion. Any additional losses will be
split between Citigroup and the government, with Citigroup bearing 10% of the losses and the
government bearing 90%. The first $5 billion of government’s losses would be borne by the
Treasury using TARP funds; the next $10 billion would be borne by the FDIC; all further losses
would be borne by the Fed through a non-recourse loan. Citigroup will pay the federal
government a fee for the guarantee in the form of preferred stock. The assets will remain on
Citigroup’s balance sheet, and Citigroup will receive the income stream generated by the assets.
When announced, it was unclear through which program the Treasury portion of this guarantee

²⁵^From^the^{U.S. T}^r^e^a^s^ury^w^e^bsite^{, “}^T^a^r^g^e^te^{d Inv}^e^st^m^e^nt^P^r^og^ra^m^”^a^t^htt^p^://^ustre^a^s^.g^ov^/initia^tiv^e^s^/e^e^s^a^/^prog^ra^m^-
^de^sc^riptio^ns/ti^p.shtm^l.

would be provided. In the January 2009 report on the TARP insurance program, Treasury
indicated that it was considering using this program for the Citigroup guarantee.
On January 16, 2009, Treasury agreed to provide Bank of America $20 billion in guarantees,
liquidity access and capital. In addition to Treasury’s additional TARP funds, Bank of America
receives from the FDIC protection against the possibility of unusually large losses on an asset
pool of approximately $118 billion of loans, securities backed by residential and commercial real
estate loans, and other such assets that were part of the bank’s acquisition of Merrill Lynch. In
return for this additional assistance, Bank of America provides Treasury with preferred stock with
an 8% dividend.
On November 25, the Treasury announced that TARP funds would be used to purchase securities ²⁶
backed by non-mortgage debts. This asset-backed security (ABS) facility is designed to provide
support for consumer purchases and small business spending. Treasury argued that the
securitization of credit card receivables, auto loans, student loans, and similar consumer spending
shut down in October. Treasury is coordinating its ABS program with the Federal Reserve’s Term
Asset Backed Securities Loan Facility. Treasury will provide $20 billion of credit protection to
the $200 billion facility and announced that it could expand the program to include residential
and commercial mortgage securities.
Non-financial industries have also sought government support. Most notably, the U.S. automobile
industry has argued that disruptions in financial markets have made it even more difficult for
consumers to purchase cars. Initially, the Treasury did not provide TARP funds to manufacturers,
arguing that the program was intending to buy assets only from financial institutions. On
November 17, Senator Harry Reid introduced an amendment to EESA that would have directed
Treasury to use TARP funds to aid the automobile industry (S. 3688), but such legislation did not ^th
pass prior to the adjournment of the 110 Congress.
On December 20, 2008, the Treasury announced it was providing support through TARP to
General Motors and Chrysler. The package included up to $13.4 billion in a secured loan to GM
and $4 billion in a secured loan to Chrysler. In addition, up to $1 billion was lent to GM for its
participation in a rights offering by GMAC, GM’s former financing arm which is now becoming
a bank holding company. GMAC also received a $5 billion capital injection through preferred
share purchases. By December 31, 2008, the Treasury reported that $10.4 billion had been ²⁷
disbursed to GM, $5 billion to GMAC, and $4 billion to Chrysler. The secured loans to the
automakers are contingent on their producing plans for long-term profitability by March 31,
2009; at which point the loans can be called if these plans are judged unsatisfactory. Chrysler
received additional assistance of $1.5 billion on January 16, 2009. This assistance was through its
subsidiary Chrysler Financial Services America, LLC.

²⁶^“^S^e^c^r^e^t^a^r^y^P^a^ulson^Re^m^a^r^k^{s on}^Consum^e^r^A^B^S^L^e^nding^Fa^c^ility^,”^{U.S. De}^pa^rtm^e^{nt of}^T^r^e^a^sur^y^P^r^e^{ss Re}^le^a^s^e^HP^-
¹²⁹^{3, N}^o^v^e^m^b^e^r^{25, 2}⁰⁰⁸^.
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^http:^//ustre^a^s^.g^ov^/init^ia^tiv^e^s^/e^e^s^a^/^doc^s/0^01-^06-^09-C^PP-Re^por^t.p^d^f^.

One criticism leveled at TARP has been its focus on assisting financial institutions, providing
only indirect assistance to individual homeowners facing foreclosure. Critics point to Sections
103, 109 and 110 of the EESA embodying congressional intent that homeowners be aided under
TARP. The Chairman of the FDIC, in testimony before Congress, indicated that the FDIC saw ²⁸
“significant promise” in using authority in TARP to prevent foreclosures by providing loan
guarantees as an incentive to servicers to modify loans. The FDIC and the Treasury indicated they
were working on this approach to provide assistance to homeowners. Press reports provided ²⁹
details on a possible approach, but detailed information was not released by the Treasury on the
subject. President Bush’s press secretary indicated on October 30, 2008, that an announcement on ³⁰
a mortgage assistance plan was “not imminent.” The Secretary of the Treasury indicated in
questioning before the House Financial Services Committee on November 18, 2008, that he did
not expect to use TARP funding to directly prevent foreclosures.

On January 9, 2009, House Financial Services Chairman Barney Frank introduced H.R. 384. The
bill was referred to the Committees on Financial Services, Ways and Means, and the Judiciary.
The Financial Services Committee reported the bill on January 15, 2009, with three amendments.
The House passed the bill with four amendments on January 21, 2009, on a 260-144 vote.
H.R. 384 substantially amends the EESA to address several criticisms of the TARP since
enactment. The bill includes provisions to (1) increase reporting on the use of TARP funds; (2)
apply stricter executive compensation rules to institutions receiving TARP funds; (3) condition
the release of the second $350 billion on usage of at least $40 billion in foreclosure mitigation;
(4) confirm the authority to provide assistance to automobile manufactures and condition the
assistance on long-term restructuring; (5) clarify authority to provide support to consumer loans,
commercial real estate loans, and municipal securities; (6) amend the Hope for Homeowners
program to expand availability; (7) create a home buyer stimulus program through the purchase
of Fannie Mae and Freddie Mac issued securities, and (8) make permanent the increase in deposit
insurance included in the EESA.
Title I of H.R. 384 directs participating institutions to report their use of TARP funds at least
quarterly. The Treasury secretary is to consult with appropriate banking regulators in establishing

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benchmarks for the use of TARP funds, along with regular full-site examinations and appropriate
compliance procedures.
Section 101 limits the use of TARP funds for mergers and acquisitions. There are two conditions
that must be satisfied prior to a banking regulatory agency approving a merger or acquisition
involving a recipient of TARP funds. First, the Secretary and relevant banking agency must
determine that the merger or acquisition would reduce risk to the taxpayer. Second, they must
determine that the merger or acquisition could have been consummated without TARP funds.
The terms of agreements in Treasury’s capital purchase program had limited the ability of
recipients to withdraw from the program unless they had shown that they had raised replacement
capital. This limitation on withdrawal may have also limited the willingness of firms to
participate if there had been more stringent additional terms. Section 101 of H.R. 384 allows
assisted insured depository institutions to repay previous assistance even if the depository
institution has not raised replacement capital. The definition of insured depository institution is
the same as in the Federal Deposit Insurance Act. The definition of assisted institution includes
any institution that receives assistance or benefit from the program’s obligation, expenditure, loan
or investment of funds. The assistance can be either direct or indirect.
Section 102 amends executive compensation rules under TARP. The 25 most highly-compensated
employees shall not receive any bonuses or incentive compensations. Senior executive officers
shall not receive golden parachutes. Prior bonuses shall be recovered (clawed-back) if they were
based on criteria or statements that turn out to be materially inaccurate. Senior executive officers
shall not receive compensation based on incentives for “unnecessary and excessive risks.”
Recipients must divest themselves of private aircraft. These provisions shall be applied to prior
assistance. In order to enhance enforcement, the Treasury Secretary shall delegate a representative
to attend any board of director meetings of assisted institutions.
Assisted financial institutions are to report the amount of increase in new lending, or reduction in
lending, attributable to TARP. If assisted institutions have difficulty quantifying the effect of
TARP funds on new lending, they are directed to report their total new lending in the period.
Representative Frank introduced and the House passed H.Amdt. 9, which requires that Treasury
make these reports available online. Representative Hinchey introduced and the House passed
H.Amdt. 11, which requires that Treasury immediately conduct and analysis of participants’ use
of TARP funds.
Section 104 requires that assisted institutions provide warrants to the Treasury Secretary equal to

15% of the value of the assistance. The assistance can be in the form of nonvoting common stock

or preferred stock. The exercise price (sometimes called a strike price) on the warrant shall be the
15-day trailing average price as of 1 day prior to the date on any commitment to provide
assistance under the title. For mutual associations and other non-traded institutions, the exercise
price is to be the economic equivalent of the 15-day trailing average market price.
Section 105 directs the Treasury secretary to make TARP funds available to smaller community
institutions on comparable terms as larger institutions.
Section 106 changes the oversight board. There are three additional members, including the
chairperson of the FDIC and two presidential appointees. The presidential appointees require
consent of the Senate and must be individuals who are not officers or employees of the U.S.
government.
Title II commits both a minimum and maximum amount of TARP funds to a TARP foreclosure
mitigation plan. Section (B) establishes a plan with funding “ ... up to $100,000,000,000, but in
no case less than $40,000,000,000.” The Treasury Secretary must begin committing the funds no
later than April 1, 2009.
The TARP Foreclosure Mitigation Plan is to have several elements. It is limited to owner-
occupied residential properties. The plan must leverage private capital to prevent or mitigate
foreclosures. The secretary may consider the concentration of foreclosures in establishing the
plan.
Section 203 provides a number of program alternatives that may be used solely or in combination.
First, the program could assist the Hope for Homeowners Program established in July 2008. In
assisting Hope for Homeowners, the TARP plan could reduce fees, ensure affordable interest
rates, buy-down second liens, pay mortgage servicers who modify loans, or purchase whole loans
for the purpose of modification.
Section 204 establishes the systematic foreclosure prevention and loan modification plan. The
chairperson of the FDIC and the Secretary of HUD are to create a loan modification program that
compensates loan servicers for each loan modified and provides loss sharing or guarantees for
losses if modified loans re-default. However, loss sharing excludes early payment defaults,
meaning that borrowers must make a specified number of payments on the modified mortgage
before the debt-holder could benefit from loss sharing.
In modifying mortgages, servicers are to apply the net present value test. The secretary is to
establish standards for the net present value test that ensure consistent application. Servicers are
to maximize the net present value of the loan by comparing the expected loss in income that
would occur from modifying the existing loan to the expected loss that would occur through the
foreclosure process. Essentially, the net present value test directs servicers to pursue a least-loss
strategy. Participating lenders are to systematically review their loan portfolios to identify
candidates for modification as a condition for further participation in TARP. Modifications may

include interest rate and fee reductions, extending the term of the maturity of the loan,
forgiveness of loan principal, and other similar provisions.
Servicers who modify loans receive a safe harbor (Section 205) from any lawsuits resulting from
an investment contract and a securitization vehicle as long as the modifications meet certain
criteria, including that the loans are owner-occupied, the modification meets the net present value
test, and default on the loan is reasonably foreseeable in the absence of modification. The bill was
amended on the House floor to delete language that would have required investors who sue to
block loan modifications, and lose, to pay the defendants’ legal costs.
The proposed changes to TARP include provisions for the automobile industry. The President is
to designate an executive branch official with industry experience to carry out the automobile
industry provisions (Section 402(a)). The amount of the bridge loans is to be consistent with the
plan submitted on December 2, 2009 (Section 402(b)). The automobile industry participants must
submit an agreement on a restructuring plan “ ... to achieve and sustain the long-term viability,
international competitiveness, and energy efficiency of an eligible automobile manufacturer, ... ”
(Section 405). The restructuring plan must include provisions for fuel efficiency, advanced
technology, net positive net present value taking into existing and future costs, proposals to
restructure existing debt including converting debt into equity, and product mix that reflects
competitiveness in the marketplace. Eligible automobile manufacturers must also provide
warrants to protect taxpayer financial interests up to a maximum of 20% of the issued and
outstanding common stock or its economic equivalent. The exercise price of the warrants will be
set as the 15-day trailing average on the date before a loan was provided. The automobile industry
participants shall not pay dividends.
Title IV clarifies the status of several categories of loans under TARP. Recall that the definition of
troubled asset to be purchased from a financial institution in the original TARP program includes
(1) mortgage-related assets and (2) other assets determined by the Treasury secretary and the
chairman of the Federal Reserve that could provide financial stability. Title IV specifies that
several categories are to be included in the second definition. The designated categories include
consumer loans, municipal securities, and commercial real estate loans.
Title V makes changes to the Hope for Homeowners Program established in July 2008 to try to
encourage additional participation in the program. It allows for reduction or termination of the
annual premiums charged for refinanced mortgages. It directs the Board to conform the
documents for refinanced mortgages to those for existing programs to reduce compliance burden.
It allows for payments to loan servicers for participation, similar to payments in the FDIC’s
existing IndyMac loan modification program. It allows for the use of TARP funds to reduce the
net costs of the existing Hope for Homeowners program.

The home buyer stimulus program in Title VI provides for the purchase of government-sponsored
enterprise (GSE) securities in order to reduce mortgage interest rates. Under this provision, the
GSEs, Fannie Mae and Freddie Mac, and any Federal Home Loan Bank, can issue securities in
order to fund new loans at affordable interest rates (Section (d)). Geographic concentration of
foreclosures may be used as one factor in consideration of the administration of the program.
Title VII addresses several Federal Deposit Insurance Corporation (FDIC) issues. First, it makes
permanent the increase in covered deposits from $100,000 to $250,000 per person per financial
institution. It amends the FDIC restoration plan period from five years to eight years. It increases
the FDIC’s borrowing authority from the Treasury for the deposit insurance fund from $30 billion
to $100 billion. It allows for an FDIC special assessment regarding assistance from the deposit
insurance fund for losses for systemic risk. For the purposes of the systemic risk assessment, bank
holding companies are to be treated as depository institutions.
In addition to the specific provisions discussed above, there have been more general amendments
to H.R. 384. Representative Matsui introduced and the House passed H.Amdt. 3, which provides
a sense of Congress that future recipients of TARP funds should halt foreclosure process on
residential mortgages until the systematic loan modification plan can be implemented.
Representative Myrick introduced and the House passed H.Amdt. 8, which prohibits participants
in TARP from outsourcing customer service jobs.

EESA authorized a flexible program to respond to financial instability. Treasury has announced
that it will implement TARP using a combination of the activities authorized by the act. As the
previous discussion has shown, TARP programs can help banks by removing bad assets or
injecting capital. TARP programs can also be used to insure bad assets or to directly assist
mortgage borrowers. The following section analyzes the TARP program by first discussing
potential sources of financial turmoil in general and then discussing some characteristics of the
recent turmoil that might be addressed by various TARP initiatives.
Financial markets serve as intermediaries between savers and borrowers. If they are running
effectively, funds from investors are allocated to borrowers according to their willingness and
ability to repay the loans, adjusted for risk. Over the course of a lifetime, most people will have
extended periods of being a borrower and of being a saver. Financial markets help young people
pay for college and buy their first home, and financial markets help when it comes time to retire.
However, if financial markets are disrupted then both savers and borrowers will be frustrated. At
times, market imperfections might cause financial markets to under-price risk, which might cause ³¹
assets to become overpriced (bubbles). At other times, market imperfections might also cause

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financial markets to over-price risk, which tends to restrict economic activity and possibly trigger
recessions. The difficulty for policymakers is to identify market practices that might tend to over-
price or under-price risk.
Financial markets are subject to a number of imperfections, some of which are described below.
In each case, private firms can attempt to address the problem through contract mechanisms, and
policymakers can attempt to address the problem through regulation or other tools. Because
private contract is such a flexible device, financial markets are constantly evolving. The evolution
of financial instruments and markets can make it difficult for policymakers to identify, monitor,
and neutralize potential weaknesses. Some important imperfections are detailed below.
Financial intermediaries often practice fractional reserve lending. That is, they keep some fraction
of their total assets available for contingencies and use the rest for lending. Because of this
fractional reserve system, financial intermediaries are often in a position in which they could not
immediately respond to all partners if everyone demanded their funds or other assets at the same
time. Even if the firm’s assets are much greater than liabilities (the firm is solvent) the firm might
not be able to exchange those assets to satisfy immediate costs (the firm is illiquid).
Unfortunately, prudence and risk move in opposite directions. The smaller the amount of reserves
the intermediary keeps on hand, the greater the potential for profit, but the greater the risk that the
firm will be caught without adequate funds if conditions change. Leverage, thus, works in both
directions.
To compensate for exposure to intermediaries with inadequate reserves, people may ask business
partners to post a bond. The required bond generally declines the more confident people are. As a
result, periods of investor confidence and investor pessimism can become self-fulfilling.
Confidence tends to expand available credit, which tends to bid up prices, which tends to make
the projects more likely to succeed, for a while. Lack of confidence tends to dry up credit, which
makes it harder for people to conduct economic activities, which makes it harder for projects to
succeed.
The vulnerability of the credit cycle to bouts of overconfidence or panic may be an inherent
market failure. One role of a regulator is to monitor reserve assets of financial intermediaries to
make sure the latter do not become overextended during times of confidence. In hindsight, it
appears that many financial firms became overextended during 2002-2005. Some have called for
trying to adjust reserve requirements, leverage, and similar characteristics to “lean against the
wind.” In this view, regulations should increase capital requirements during boom times and
lower them in periods of contraction.
In the current situation, which is discussed in more detail below, banks have experienced both
liquidity problems and capital adequacy (solvency) problems. The complexity of MBS has
contributed to the difficulty in exchanging these assets, which makes MBS less liquid for anyone
who holds them or who might buy them. In addition, default rates on mortgage loans have
increased significantly; higher than expected loan losses reduce bank capital. These effects are

^(...c^on^tin^ue^d)
^L^a^bonte^.

not mutually exclusive; undercapitalized banks find it more difficult to borrow funds, which
means they are less liquid. The asset purchase and asset insurance portions of TARP more directly ³²
address liquidity issues, whereas the preferred stock purchase plan more directly addresses
solvency issues.
It is often the case in financial contracts that one party has more information than another. It may
be the case that there is a group of assets, only some of which are defective. If the seller can
identify the defective assets but the buyer cannot, then there is said to be a “market for lemons”
and the value of all of the assets will be discounted by potential buyers. Private firms can try to
solve the problem through guarantees and similar contract terms. In addition, there may be a role
for government inspectors or mandatory disclosures. Regulation of ratings agencies could
arguably fall under this category. If a large pool of assets emerges where the assets are unrated
because some unknown portion of them are thought to be defective, it may minimize total costs to
have an institution with a long time horizon, such as government, acquire the assets and sort
quality assets from troubled assets at a later date.
For financial institutions, asymmetric information problems can also be a factor when designing
rescue plans. For example, if the originator of loans tends to keep some but sell others on the
secondary market then there may be an information problem. The originators may tend to keep
the good loans in their own portfolios and pass along the bad loans to others. Similarly, if
policymakers offer to acquire assets, firms may try to keep the good assets and sell the bad assets.
In the current situation, the complexity of MBS may have created a lemons problem. Some
policymakers are concerned that a program to buy assets from banks will allow banks to
“overcharge” the government for their assets. In this view, once the government establishes a
price for the assets, only firms who know that their assets are worth less than the price will
participate. To prevent the lemons problems, some have suggested an auction process to ensure ³³
that assets are priced correctly. If auctions correctly price assets, this program might help
remove illiquid assets from bank balance sheets. However, it could be argued that correctly
pricing troubled assets is not the only policy goal. Treasury may wish to use the lemons problem
with the express purpose of removing the most troubled assets from the bank balance sheets;
furthermore, paying more than the current assessed price might also address the policy goal of
recapitalizing banks.
Another information problem is what is known as the “winner’s curse.” In a winner’s curse some
of the potential bidders have more information than others. Unsophisticated bidders try to free
ride on the information provided by the more sophisticated. People watch the “smart” people bid
and copy them. The problem in this is that the “smart” people will know when to stop bidding.
Unfortunately, the “winners” will continue bidding for a while, unaware that the sophisticated
have stopped participating. As a result, assets become overpriced and could become subject to
crashes. Some believe that the process of creating MBS (securitization) was subject to a winner’s

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curse. It might be a role for regulators to limit the right to bid in some circumstances to
sophisticated parties or require participants to conduct a minimum of due diligence.
Moral hazard occurs when someone has the incentive to take fewer risks prior to an agreement,
but the agreement itself creates an incentive for them to take more risks, against the interests of
their contracting party. For example, insurance often causes moral hazard so insurance companies
often insist that people pay deductibles, install smoke alarms, do not live in a flood plain, and the
like. If policymakers rescue some firms then the perception of a safety net may encourage other
firms to take on more risk. Similarly, if firms approach insolvency with only a low probability of
survival, they might take extremely large risks.
In the current situation, some are concerned that the TARP program could cause moral hazard.
Once financial institutions know that the government will spend large sums to remove bad assets
or inject additional capital, they may be willing to take additional risks. EESA attempts to deal
with moral hazard in part by limiting the compensation that the executives of participating
financial institutions can receive. One of the limits specifically prohibits executive compensation
that is linked to excessive risk taking during the period that Treasury holds a debt or equity
interest in the financial institution (Section 11(B)(2)(a)).
In some instances, firms can compete in one arena but be network partners in another. For
example, sports teams compete on the field and for players and coaches but a sports team must
have other sports teams in order to have a marketable entertainment product. Similarly, financial
institutions compete in many areas but also must cooperate to clear checks, exchange securities,
and manage risk. A trading exchange cannot operate without multiple parties. Furthermore, the
greater the number of people that participate, the more liquid the market will be, which in turn
increases the value of participating in the exchange. These network externalities can cause
coordination problems when the interests of participants conflict. One role for policymakers may
be to help resolve network externalities. In the present circumstances, the coordination of trading
complex derivatives is arguably one concern of policymakers when considering financial market
intervention. TARP may help address this problem by allowing Treasury to consider removing
complex derivatives that may pose systemic risks.
Resolving the aforementioned vulnerabilities in financial markets may be in the interests of all
financial firms. But it may not be in the interest of any single firm or group of firms to pay all the
costs of resolving problems. In these instances, it may be the role of policymakers to help
coordinate solutions to collective action problems. The role may be as simple as making
information available or gathering parties to facilitate negotiations, or the role may be to provide
investment in the infrastructure of the markets themselves. In the present circumstances, both the
Federal Reserve and Treasury have been active in attempting to find acquisition partners for
troubled financial institutions believed to pose systemic risks. This coordination role may have

been helpful in finding a way to unwind the assets of Bear Stearns, but was not successful in ³⁴
similar action for Lehman Brothers.

Although the prior section addressed financial market problems in general terms, this section
discusses problems specific to the current episode of financial turmoil. The initial spark for the
financial turmoil is generally agreed to be the increase in defaults among subprime mortgage
borrowers and the loss of liquidity of securities backed by mortgage loans. Since August 2007,
financial firms have suffered repeated problems in disposing of “toxic” assets, rolling over their
own debt, identifying the relative financial health of potential trading partners, and recapitalizing ³⁵
their balance sheets. The primary tools of the Federal Reserve address liquidity, but financial
firms are also experiencing capital adequacy problems. For Fannie Mae and Freddie Mac, the
Federal Housing Finance Agency (FHFA, formerly OFHEO) and Treasury helped with both ³⁶
liquidity and capital adequacy for institutions the government deems essential. Some argue that
the apparent inconsistency between aid for Bear Stearns, no aid for Lehman Brothers, and then
the subsequent rescue of AIG increased rather than decreased uncertainty. At any rate, credit
markets suffered a near collapse in the days after the Lehman Brothers and AIG episodes.
If investors expect high default rates by borrowers then prices might adjust to compensate for
increased losses; therefore, high default rates by themselves do not necessarily lead to financial
market turmoil as long as prices reflect the elevated risk. The rapid rate of increase in defaults on
subprime mortgages, however, was unexpected by many investors in global mortgage-backed ³⁷
securities markets. During the early stages of the mortgage market turmoil, some believed that it ³⁸
was largely a subprime problem caused by predatory practices of unregulated lenders. Others
argued that there were more general problems in mortgage markets, both prime and subprime,
that had encouraged the use of nontraditional mortgage products to speculate on house price ³⁹
appreciation. If the only problem was wrong estimates of default rates then financial markets
might be expected to restore stability once higher risk levels are incorporated in prices.
Unfortunately, this has not as yet occurred, perhaps in part because there are characteristics of
housing markets that tend to reinforce downward price pressures, which also tend to increase ⁴⁰
default rates.

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Evidence of default rates by type of mortgage is consistent with the view that unexpectedly high
default rates were not confined to the subprime market. First, defaults are concentrated in
formerly rapidly appreciating regions. Second, the default rate on prime adjustable-rate
mortgages (ARMs) has increased more rapidly than the default rate on subprime ARMs. At the
same time, subprime fixed-rate mortgages are performing better than they had before the housing
boom, suggesting that there are issues related to ARMs. Figure 1 constructs an index (base equals
2001) of the default rates on ARMs, for fixed-rate mortgages, subprime mortgages, and FHA
mortgages. Market participants who might have expected default rates to continue would have
missed by a greater margin on prime ARMs than on subprime ARMs. Note that the absolute level
of default rates is much higher on subprime loans than on prime loans; however, because higher
interest rates for riskier loans compensate partially for default risk, the relative change in a given
default rate compared to its history is arguably more important to an investor than the absolute
default rate. If so, then Figure 1 and Figure 2 show that investors in MBS did not just experience
a subprime problem, they experienced an ARM problem.
Figure 1. Index of ARM Foreclosure Rates, 2001=100
Prime ARMs Have Unexpectedly High Foreclosure Rates
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Figure 2. Index of FRM Foreclosure Rates, 2001=100 Fixed-Rate
Subprime Loans Have Unexpectedly Low Foreclosure Rates
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²⁰⁰^2_²⁰^3_²⁰^4_²¹^_²^2_²⁰³^_²^4_²¹^_²^2_²⁰³^_²^4_²⁰¹^_²^2_²⁰³^_²^4_²⁰¹^_²^2_²⁰³^_²^4_²⁰^1_²^2_²⁰³^_²^4_²⁰^1_²²^_²⁰³^_²^4_²⁰
^Q¹^_^Q^Q^Q^Q^Q^Q^Q^Q^Q^Q^Q^Q^Q^Q^Q^Q^Q^Q^Q^Q^Q^Q^Q^Q^Q^Q^Q
^Prⁱ^m^{e FRM}^Su^bp^rⁱ^m^e^FRM^FH^{A F}^R^M
^Source:^{Mortgage Ba}^{nkers As}^{sociation National Del}^inquen^{cy Sur}^vey.
Prices for MBS have been affected by changing views of housing markets. Early in the turmoil,
many observers believed that problem loans were largely a subprime phenomenon. However,
falling house prices in California, Florida, and several other formerly booming states have
exacerbated default rates among all categories of borrowers in those regions. One contributing
factor is that mortgage debts exceed the market value of some borrowers homes; therefore, some
of these borrowers are increasingly tempted to walk away from their mortgages. As a result, some
investors consider a wider class of MBS tainted and these assets are harder to sell at any price.
When mortgage problems were considered only a subprime problem, few thought that Fannie ⁴¹
Mae or Freddie Mac had a great deal of exposure to problem loans. Subsequently, problems in
the broader market have shown that Fannie Mae and Freddie Mac had more problem loans than
originally thought. Because housing markets and financial markets are linked, many have
expressed skepticism that financial markets will recover before housing markets stabilize.

⁴¹^Se^e^f^o^r^e^x^am^ple^,^A^lle^{n Fis}^hbeⁱⁿ^,^Dⁱ^r^e^c^t^or^of^H^ousⁱⁿ^g^a^{nd C}^r^e^d^it^Polic^y^,^C^ons^um^e^r^Fe^de^r^a^{tion of}^A^m^e^r^ic^a^,
^“^T^es^ti^m^ony^B^e^f^o^r^e^the^H^ous^e^Fin^a^nc^ia^{l Se}^r^v^ic^e^s^C^o^m^m^itte^e^,^”^Ma^r^c^{h 15}^{, 2}⁰⁰⁷^,^pp^{. 6-}^{7, s}^u^g^g^e^s^ting^tha^t^the^G^S^Es^be
^eⁿ^c^our^a^g^e^d^to^le^a^d^the^m^a^r^k^e^t^am^ong^rⁱ^s^k^ie^r^bor^r^o^w^e^r^g^r^oups^{, i}ⁿ^c^l^udi^ng^low^e^r^-ⁱ^nc^om^e^,^fⁱ^r^s^t-^tim^e^ho^m^e^buy^e^r^s^,^a^nd
^mⁱ^noritie^s.

Loss of liquidity has been one of several problems in financial markets since the beginning of
what originally became known as the subprime crisis. Liquidity refers to the ability to sell an
asset quickly without suffering a significant price reduction—cash is typically the most liquid
asset. A firm is liquid if it has a significant portion of its assets in liquid form or can easily access
debt markets to acquire liquid assets as needed. A firm is solvent if the value of its assets is
greater than the value of its liabilities. An insolvent firm can be in trouble even if all of its assets
are perfectly liquid, such as in cash. When mortgage-related securities held by investment banks
and other financial firms suffered higher than expected default rates, the MBS lost their liquidity
in part because potential buyers were uncertain as to which securities contained the loans that
were unlikely to perform. Complex accounting rules which allowed certain assets to be held off-
balance sheet made the uncertainty worse, and many mortgage-related securities became illiquid.
Policymakers attempted to restore liquidity to MBS markets over the past year. The Federal
Reserve increased liquidity to markets in general by lowering interest rates. It provided liquidity
to targeted financial firms by expanding the list of institutions that could directly access the ⁴²
discount window and by providing regular liquidity auctions. The Federal Reserve also
attempted to increase the liquidity of mortgage-related assets by adding them to the list of
collateral that it would accept for loans. The government tried to increase the liquidity of
mortgages by increasing the conforming loan limit (the maximum size loan that the GSEs may
purchase). Despite these efforts, financial markets continue to experience significant turmoil.
Efforts to restore liquidity do not necessarily address capital adequacy or solvency problems. A
relatively small drop in the market value of a firm’s assets can cause significant capital reduction
if the firm is highly leveraged. Leverage refers to the ratio of a firm’s equity capital to its other
assets. The greater this ratio the more vulnerable the firm is to falling asset prices. If a firm is
leveraged 10:1 and it has $100 in assets then it has $10 in equity capital and $90 in liabilities. In
this case, a 5% drop in the value of the firm’s assets would reduce assets to $95 (results from a $5
loss). Because assets equal liabilities plus owners equity, and liabilities have not changed, the $5
loss comes out of equity capital. The firms equity would drop from $10 to $5, still solvent in this
example. If the firm had been leveraged 25:1 instead of 10:1, then the firm would start with $100
in assets, $96 in liabilities, and $4 in owner’s equity. The same 5% drop in asset values would
completely wipe out owner’s equity and cause the firm to be insolvent (-$1 equity). A key
principle of financial markets is that highly leveraged firms can become insolvent for relatively
small decreases in asset values; therefore, the damage to the financial system from nonperforming ⁴³
loans can be several times the increase in default rates.
Policymakers have encouraged the financial sector to attempt to rebuild equity capital. Early in
the financial crisis, hedge funds and sovereign wealth funds invested in some troubled U.S.
financial firms. Investment banks may prove more difficult to recapitalize than commercial
banks. Regulation does not specify minimum capital standards for investment banks. Their
leverage ratio is largely limited by the confidence, or lack thereof, that financial markets have in

⁴²^C^R^S^R^e^por^{t R}^L³⁴⁴²⁷^,^Fi^na^nc^ial^Tur^m^oil^:^Fe^de^r^a^l^Re^s^e^r^v^e^Polic^y^Re^s^pons^e^s^,^by^Ma^r^c^La^bonte^.
⁴³^C^R^S^R^e^por^{t R}^L³⁴⁴¹²^,^C^o^nt^ainiⁿ^g^Fi^na^nc^{ial C}^r^is^is^,^by^Ma^r^k^Jⁱ^c^k^li^ng^.

them. When market confidence drops for financials, these firms risk their liquidity drying up. If,
at the same time that they lose liquidity, they happen to be undercapitalized or near insolvent,
then they may not survive.
A number of factors contributed to the increase in leverage in recent years, and the process of
reducing leverage may be difficult. One factor that contributed to the increase in leverage during

2002-2005 was low interest rates across the globe, which made it very easy to use short-term debt ⁴⁴

to finance risky activities. Another factor was the increased use of structured finance
(securitization), which allowed banks and other loan originators to move assets off of their
balance sheets even though they were still exposed to some risk if the loans failed to perform as ⁴⁵
expected. A third factor contributing to leverage was the use of complex financial derivatives,
which had the potential to reduce financial risks but also had the potential to increase financial
risk.
Complex financial derivatives have been characterized by some observers as financial weapons of
mass destruction. A financial derivative is a contract in which two (or more) parties agree to a
payment if a referenced financial instrument changes price or otherwise satisfies conditions set in ⁴⁶
the contract. Examples of financial derivatives include interest rate swaps and foreign exchange
swaps that help firms that are exposed to interest rate risk or exchange rate risk hedge against
unexpected market events. The contracts are typically tradable, which has benefits for the market
as a whole as well as for the two firms entering into the contract. The ability to trade the
derivatives grants the two parties a more liquid asset. The ability to trade the derivatives also
provides information to the market as a whole because the observed price of the contracts is a
clue to market expectations about the future movements of interest rates, exchange rates, etc. A
cost to this increased liquidity is that linkages among firms through the derivative contracts can
become very complex and it may become difficult for parties to assess whether their ⁴⁷
counterparties can actually honor all of their derivative contracts.
The complexity of derivatives contracts has made policymakers uncertain as to the repercussions
of allowing a major participant in financial derivatives markets to fail. One worry is that there
would be a long period of uncertainty during the unwinding of the derivatives contracts that could
potentially freeze global financial markets. In two previous episodes, policymakers chose to
facilitate the unwinding of the derivatives contracts. During the Russian debt crisis, the Federal
Reserve facilitated the unwinding of Long Term Capital Management (LTCM), although the ⁴⁸
Federal Reserve did not directly provide funding. For Bear Stearns, the Federal Reserve helped
arrange an acquisition by J.P. Morgan, and the Federal Reserve also helped provide the ⁴⁹
financing. One interpretation of the current market is that policymakers treated AIG as too

⁴⁴^C^R^S^R^e^por^{t R}^L³⁴¹⁸²^,^Fⁱⁿ^aⁿ^cⁱ^a^{l C}^rⁱ^sⁱ^s^?^Th^{e L}ⁱ^qu^idⁱ^t^y^C^r^un^ch^o^f^A^u^gu^st²⁰⁰⁷^,^by^D^a^rr^y^l^{E. G}^e^tte^{r e}^t^a^l^.
⁴⁵^C^R^S^R^e^por^{t R}^S²²⁷²^2,^Se^c^u^ritiza^tion^a^{nd Fe}^de^{ral Re}^gul^atioⁿ^{of M}^o^rtga^ge^{s for}^Sa^fe^ty^an^d^So^un^dne^s^s^{, by}^Edw^a^{rd V}^.
^Murp^hy^.
⁴⁶^C^R^S^R^e^por^{t R}^S²²⁹¹^8,^P^rⁱ^m^{er on}^Eⁿ^erg^y^Deri^va^tⁱ^{ves an}^{d T}^h^ei^r^R^e^g^u^l^atⁱ^oⁿ^,^by^Ma^rk^Jⁱ^c^k^ling^.
⁴⁷^C^R^S^R^e^por^{t R}^L³⁴⁴²⁰^,^Be^ar^Ste^a^rⁿ^s^:^C^r^is^is^an^{d “}^R^e^s^c^u^e^”^for^{a M}^a^jor^Pr^ov^ide^r^of^M^o^r^t^g^age^-^R^e^l^ate^d^Pr^o^duc^ts^{, by}
^G^a^r^y^Shor^te^r^.
⁴⁸^C^R^S^R^e^por^{t R}^L³³⁷⁴⁶^,^H^e^d^g^e^Fu^{nd F}^a^il^ur^e^s^{, by}^Ma^rk^Jⁱ^c^k^ling^.
⁴⁹^C^R^S^R^e^por^{t R}^L³⁴⁴²⁷^,^Fi^na^nc^ial^Tur^m^oil^:^Fe^de^r^a^l^Re^s^e^r^v^e^Polic^y^Re^s^pons^e^s^,^by^Ma^r^c^La^bonte^.

complex to fail because of the potential difficulty in unwinding their derivatives.⁵⁰ AIG is a major
participant in credit default swaps, which are derivatives tied to credit losses.

Troubles in financial markets do not always spill over into other economic sectors, such as
industrial production, agriculture, services, or other parts of the broader economy. Because the
current turmoil has lasted more than a year while national unemployment had remained relatively
low by historical standards (although rising) and economic growth remained positive (although
low) for much of that time, some have questioned whether there is evidence that the current
financial turmoil has had significant real effects. Third quarter 2008 growth has been
preliminarily assessed by the Commerce Department as negative. Although the fall in house
prices could directly reduce consumer spending by making home owners feel poorer (a so-called
wealth effect), most economists consider the primary way that financial market turmoil affects the
broader economy to be by making it more difficult to get loans, which restricts business
investment and consumer purchases of durable goods. The evidence of such effects is thought to
be largely in financial market spreads, the difference between the interest rate on less risky debt
such as U.S. Treasuries, and the rates paid by banks, firms, and consumers. Interest rate spreads
remained elevated after August 2007, even in the inter-bank market where banks lend to each
other. Treasury’s initial draft for the TARP program was developed the weekend following the
large spike in interest rate spreads on September 14, 2008.
Interest rates can be an indicator of financial market spillovers. The rates at which market
participants borrow is typically above the rate that the U.S. government borrows (although not all
governments enjoy low borrowing costs). The difference between market rates and the U.S.
government rate for a debt of similar maturity, called a spread, can be an indicator of the degree
of confidence that market participants have in each other (among other factors). A wide spread
can be an indicator of a lack of confidence whereas narrow spreads can be an indicator that
markets do not demand a high risk premium. Figure 3 shows the spread between commercial
paper, one form of short-term private loan used mostly by large, high-quality corporations, and
short-term Treasury securities. In Figure 3, the spread remains relatively narrow from September
2003 until August 2007, which is considered the beginning of the liquidity crunch. The spread on
commercial paper spiked in August 2007, remained volatile during the next year, and then spiked
again in September 2008. The financial market interventions between August 2007 and
September 2008 apparently failed to restore market confidence; as a result, private borrowers
continued to pay high interest rates even as interest rates on U.S. Treasury debt declined. The
spike in September of 2008 occurred during the week of the interventions for Lehman Brothers
and AIG.

⁵⁰^C^R^S^R^e^por^{t R}^S²²⁹³^{2, C}^r^e^dⁱ^t^D^e^f^a^{ult Sw}^a^p^s^:^Fr^e^que^ntly^A^s^ke^{d Q}^u^e^s^tions^,^by^Edw^a^r^d^V.^Mur^phy^.

Figure 3. Spread Between Commercial Paper and
One-Month Treasuries
^Source:^{The Federal Reserve.}
A wealth effect refers to the tendency of people to spend in the current period at least part of any
increase in wealth that they receive. When asset prices rise, such as houses, stocks and bonds in
retirement accounts, collectible art, or similar savings instruments, people may feel wealthier.

When house prices were booming, consumer spending was supplemented by mortgage equity
withdrawal to access households’ perceived increase in wealth. Now that house prices have
stopped rising nationally, and are falling significantly in some areas, mortgage equity withdrawal
has no longer been contributing much to consumer spending. In some cases, lenders have been
seeking to cancel or reduce lines of credit they had extended on homes. Although falling house
prices could possibly have a negative wealth effect, few people fully tapped their home equity so
the reduction in the lines of credit is not widely expected to have a large effect. Furthermore,
according to the Mortgage Bankers Association National Delinquency Survey, 97% of home
owners are not in the foreclosure process, and aggregate consumer spending levels did not decline
for the first year of financial turmoil (although consumer spending growth was below trend).
Whether due to rising unemployment, a wealth effect from falling house prices, the stock market
declines in the Fall of 2008, or other factors, third quarter consumer spending is estimated to have
declined.
Rather than working directly through consumer spending, financial market turmoil is generally
considered to affect the broader economy by reducing the availability of credit to firms and
consumers. Rising default rates and falling asset prices reduce the value of the assets on bank
balance sheets. As discussed above, banks are leveraged so that a fall in the value of their assets
can significantly damage their capital. Falling house prices have the potential to cause mortgage
lenders both liquidity and solvency problems. In response, banks may become hesitant to part
with cash and may therefore choose to tighten their lending standards. Low risk borrowers may
be able to qualify for loans, possibly even at low interest rates, but many higher risk loans might
not be granted at any interest rate. It is possible to observe low interest rates in these
circumstances with relatively little actual lending taking place.
The evidence in the current market is consistent with tightening lending standards and reduced
credit availability. The survey of bank lending managers showed tightening lending standards
since the beginning of the financial market turmoil. Reductions in the Federal Reserve’s policy
interest rate have not, as yet, been followed by loosening lending standards. Spreads between
Treasury rates and consumer loans, such as mortgage rates, initially remained elevated so that the
reduction in the Fed’s rate provided little relief to borrowers facing an increase in their mortgage
rate.
The TARP program can strengthen bank balance sheets in several ways. Under TARP, Treasury
can directly inject capital into the bank balance sheet though the preferred share stock purchase
program. This creates a larger cushion between a bank’s current standing and insolvency. TARP
also enables the Treasury to remove troubled assets from bank balance sheets, This increases the
institution’s liquidity, but does less for bank solvency. TARP can also allow financial institutions
to insure their troubled assets, which would make those assets more liquid, but may also do little
for bank solvency. TARP permits direct assistance to homeowners, which would presumably be
aimed at reducing default rates. Reducing default rates by fully paying loans could in theory
simultaneously remove the stigma of mortgage-related assets, increase their price and their
liquidity, and restore some bank capital.

Tight lending standards tend to reinforce delinquencies and foreclosures. Some borrowers may
have taken out large mortgages when credit was easy and rates were low, with the intent of
refinancing their loans before maturity. Tightening lending standards reduce their ability to
refinance on favorable terms and make it less likely that they can keep their house. Not only do
tight lending markets reduce the ability of current residents to pay their loans, but strict lending
standards also make it less likely that a third party can be found to purchase the house. As a
result, foreclosures can add to the unsold inventory of homes, which tends to drive down prices
and further depress bank balance sheets. Some fear that this process can become self-reinforcing
because rising delinquencies might also result in tight lending conditions.
There are also other assets besides housing for which demand depends on the ability of buyers to
find financing. Some municipalities had depended on the ability to roll over short term debt in the
form of auction-rate securities. When financial markets froze, some auctions failed to attract
enough bidders to continue rolling over the debt. As a result, the interest rates paid increased
significantly. Complaints by some municipalities that the risks of these investment instruments
were not fully disclosed has led several investment banks to agree to take back the securities on to ⁵¹
their own balance sheets (which may already be under significant stress). The automobile
market has also suffered as automakers canceled some leasing programs. Student loans have also
become harder to get, although some believe that this is be due at least in part, to a change in the ⁵²
federal funding formula.

The EESA authorizes Treasury to spend up to $700 billion to restore financial stability. In
general, there are at least five policy responses to a banking disruption: (1) removing bad assets
from bank balance sheets, (2) injecting capital into the banking system, (3) insuring “toxic”
assets, (4) directing support of delinquent borrowers to reduce default rates, and (5) allowing the
free market time to liquidate troubled assets and process insolvent institutions. The breadth of the
definition of a troubled asset under the TARP statute grants Treasury the discretion to implement
any of these options individually or in combination. Although Treasury’s original proposal
focused on option 1 (removing bad assets), the majority of TARP funding to date has been more
consistent with option 2 (injecting capital). Using the majority of TARP funds for capital injection
matches the approach taken by several European nations in response to their banking turmoil.

⁵¹^C^R^S^R^e^por^{t R}^L³⁴⁶⁷²^,^A^u^ctⁱ^oⁿ^-^R^a^t^e^S^ecu^ri^tⁱ^es^{, by}^D^.^A^ndre^w^A^u^s^tin.
⁵²^C^R^S^R^e^por^{t R}^L³⁴⁴⁵²^,^T^h^e^Ens^u^rⁱ^{ng C}^ont^inue^{d Ac}^c^e^s^s^to^Stu^d^eⁿ^t^Loaⁿ^s^Ac^t^of²⁰⁰⁸^,^by^D^a^vⁱ^{d P}^.^S^m^ole^,^a^{nd C}^R^S
^R^e^por^{t R}^L³⁴⁵⁷^8,^Ec^on^om^ic^s^{of G}^uar^aⁿ^te^e^d^Stu^d^eⁿ^t^Lo^ans^,^by^D^.^A^ndre^w^A^u^s^tin.

Adverse Selection—When a party having greater information about the quality of a pool of assets
offers to sell the inferior ones to the less knowledgeable party.
AIG—American International Group, Inc.
ARM—Adjustable Rate Mortgage.
Bank holding companies—Companies that own one or more banks.
Bubble—Self-reinforcing process in which the price of an asset exceeds its fundamental value for
a sustained period. Often followed by a rapid price decline.
Conservatorship—When an insolvent financial institution is reorganized by a regulator with the
intent to restoring it to an ongoing business.
CDO, Collateralized Debt Obligation—Securities deriving their income from other fixed income
assets, including but not limited to, mortgage-related assets.
CDS, Credit Default Swap—A tradeable contract in which one party agrees to pay another if a
third party experiences a credit event, such as bankruptcy or credit downgrade.
Credit Event—In a credit default swap, an event specified in the contract that triggers the
payment between the parties. Is often a bankruptcy or credit downgrade.
Credit Risk—The risk that a borrower will fail to repay a loan in full.
EESA—Emergency Economic Stabilization Act, P.L. 110-343.
FASB—Financial Accounting Standards Board.
FAS 157—An accounting standard issued by FASB that covers the reporting of the fair value of
financial assets. Determines if financial assets must be marked-to-market.
FDIC—Federal Deposit Insurance Corporation.
FHA—Federal Housing Administration.
FHFA—Federal Housing Finance Agency.
Financial Derivatives—Investment products that derive their payments from previously issued
securities.
FRM—Fixed Rate Mortgage.
Hedge Funds—Unregulated mutual funds that buy and sell investment assets.

HELOC—Home Equity Line of Credit.
Insolvent—When a firm’s liabilities are greater than assets.
LTCM—Long Term Capital Management.
Leverage Ratio—Ratio of a firm’s capital to its assets.
Liquidity—The ability to trade an asset quickly without significantly reducing its price, or the
ability of a person or firm to access credit markets.
Mark-to-Market—The accounting requirement to report assets held for sale at current market
prices. Related to FAS 157.
MBS, Mortgage Backed Security—A security which derives its payments from a pool of
mortgage obligations.
Moral Hazard—The tendency of people to take more risks once another party has agreed to
provide protection.
Notional Principal—In a swap contract, the amount on which the interest is being paid (for
interest rate swaps) or the protection payment is calculated (for credit default swaps).
OCC—Office of the Comptroller of the Currency.
OFHEO—Office of Federal Housing Enterprise Oversight.
OTC, Over-the-Counter Market—Unregulated market in which dealers at different locations
stand ready to trade securities with anyone willing to accept the prices.
OTS—Office of Thrift Supervision.
Preferred Stock—Receives a fixed dividend and must be paid before common stock but typically
does not have voting rights.
Prime Borrowers—Borrowers with high credit scores, sufficient down payments, documented
income, and other indicators of low credit risk.
Protection Buyer—In a credit default swap, the party that receives payment if a credit event
occurs.
Protection Seller—In a credit default swap, the party that makes payment if a credit event occurs.
Receivership—When an insolvent financial institution is taken over with the intent to liquidate its
assets.
Risk-Based Capital—An amount of capital a lending institution must keep in reserve based on the
riskiness of its assets.
Securitization—The process of transforming a flow of funds, typically from a debt, into a new
marketable security.

SEC—Securities and Exchange Commission.
Spreads—The difference between two rates, typically bond yields or interest rates of the same
maturity. Wide spreads often indicate lack of market confidence.
Subprime Borrowers—Borrowers with low credit scores and/or other indicators of higher credit
risk.
TARP—Troubled Asset Relief Program, created by P.L. 110-343.
^Bai^r^{d We}^bel ^Ed^w^a^{rd V. Mu}^rphy
^Aⁿ^a^l^ystⁱⁿ^Fi^na^ncⁱ^a^l^E^c^oⁿ^o^mⁱ^c^s^Sp^{ecialist i}ⁿ^Fiⁿ^aⁿ^c^{ial Eco}ⁿ^o^m^ics
^b^w^ebel^@^c^r^s^.l^oc.g^ov^{, 7-}⁰⁶⁵²^t^m^u^r^phy^@^c^rs^.l^oc.g^o^v^{, 7-}⁶²⁰¹