Financial Market Intervention

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Financial markets continue to experience significant disturbance and the banking sector remains
fragile. Efforts to restore confidence have been met with mixed success thus far. This report
provides answers to some frequently asked questions concerning ongoing financial disruptions
and the Troubled Asset Relief Program (TARP), enacted by Congress in the Emergency
Economic Stabilization Act of 2008 (EESA, Division A of H.R. 1424/P.L. 110-343). It also ^th
summarizes legislation in the 111 Congress such as H.R. 384, the TARP Reform and
Accountability Act of 2009.

Current Concerns.............................................................................................................................1
What, if anything, is wrong with the financial system?......................................................1
When did trouble in the financial markets start?................................................................1
What caused financial market turmoil?..............................................................................1
If 97% of mortgage borrowers are not in foreclosure, why is the financial turmoil
so large?...........................................................................................................................2
Where are the problem loans located?................................................................................2
Who is affected by the financial turmoil?...........................................................................2
How have policymakers responded to financial turmoil?...................................................2
Why have the Federal Reserve’s traditional tools not restored order in financial
market s? ....................................................................................................................... .... 4
What is contained in EESA, P.L. 110-343?........................................................................4
What has Treasury done under the EESA?.........................................................................5 ^th
What legislation is being considered in the 111 Congress?..............................................6
Author Contact Information............................................................................................................6

Banks and other financial institutions have been reluctant to lend or otherwise engage with other
institutions for fear of exposure to the bad assets of troubled counterparties. That is, a relatively
healthy bank is afraid to sign a contract with other institutions because of the fear that the other
institution will not be able to fulfil its obligations. For similar reasons, banks that need to raise
capital have had trouble doing so because potential investors are afraid that the full extent of
damage to banks’ assets has not yet been revealed. Furthermore, the possibility that a future
intervention by the government will dilute shareholder value might also deter private investors
from recapitalizing banks. Under these conditions it is difficult for people who depend on
regularly accessing credit markets to get loans, which in turn can affect the broader economy.
Often, this lack of confidence in other financial institutions expresses itself in wide spreads
between market interest rates and the yield on Treasury securities. These spreads have been
relatively wide for the past year. They spiked following recent interventions intended to prevent ¹
disorderly bankruptcies, an indication of significant loss of confidence.
Loss of market confidence can be proxied by spreads in interest rates between Treasury securities ²
and riskier assets of similar maturities. These spreads first spiked in August 2007. Although
spreads declined following policy responses by the Federal Reserve, the Treasury, and the
passage of the stimulus package, the spreads did not return to their pre-August 2007 level. The
persistence of historically wide spreads during 2007-2008 suggests that full confidence has not
been restored.
Most observers agree that rising defaults among residential mortgage borrowers sparked the ³
initial loss in financial market confidence. Reasonable people will continue to disagree as to the
initial cause of rising defaults and how these defaults were multiplied through the financial
system. Some believe that low interest rates and loose monetary policy caused a housing bubble ⁴
that was bound to burst when interest rates rose. Others place more emphasis on loose lending
standards that may have been fostered by a lack of regulation of non-bank lenders and a lack of ⁵
market discipline by mortgage-backed securities issuers who sold the loans to other investors.
Another group places the blame on the failure of officials to regulate relatively recent innovations

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in finance. Still others emphasize potentially irresponsible marketing practices or fraud by
subprime lenders. Some observers blame investors and borrowers who did not adequately
investigate the risks of their decisions.
Several factors magnify the effects of loan defaults on the financial system. First, banks are
leveraged, which means that for a given dollar reduction in the value of their assets they must ⁶
either raise additional capital or reduce their lending by a multiple of the loss. Second, banks
have become less transparent because of changes in accounting and risk management. This lack
of transparency has made it more difficult for banks to raise additional capital as an alternative to
reducing lending or selling assets. Third, the use of financial derivatives that should have reduced
risk in the banking system may have had the effect of increasing leverage and making it even
harder to identify sound counterparties.
Two of the problem loan categories, subprime and Alt-A, are disproportionately located in areas
that had previously experienced rapid price appreciation. This includes Florida, California,
Arizona, and Nevada. In addition, subprime loans are disproportionately located in relatively low ⁷
income and minority neighborhoods across the country.
The financial turmoil also affects anyone seeking credit, including troubled home owners who
wish to refinance out of a troubled mortgage. Restrictions in credit have contributed to a
downward spiral in home prices. The people most directly affected by financial market turmoil
are investment bankers and investors. These people may lose their jobs and livelihood. Business
firms are also affected because their cost of financing possible projects has risen, which in turn
can hurt the broader economy.
Policymakers have responded in several ways. The tools of standard macroeconomics have been
used to try to stimulate the broader economy. The tools of banking and financial regulators have
been used to try to restore order in financial markets. Congress has given Treasury and housing
finance regulators additional tools to stabilize mortgage markets and address troubled financial
assets.
Many modern macroeconomists believe that there are two basic policy responses to avoid an ⁸
economic slowdown. First, the Federal Reserve can provide expansionary monetary policy by

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lowering interest rates, as it did starting in the fall of 2007.⁹ Second, the government can provide
expansionary fiscal policy by spending more than it collects in taxes, as it did with the stimulus ¹⁰
package. These expansionary macroeconomic policies have not prevented further financial
turmoil.
In addition to pursuing both of these responses, financial regulators have tried to restore order in
the financial sector using existing authority. Liquidity was increased by expanding the range of
collateral accepted at the Federal Reserve’s discount window and by holding regular liquidity ¹¹
auctions. The Federal Reserve and Treasury have also tried to help arrange buyers of distressed
firms, as it did for Bear Stearns and Lehman Brothers (even though the government was
unwilling to also provide funding to facilitate a purchase of Lehman Brothers). Similarly, the
Federal Deposit Insurance Corporation (FDIC) has sought buyers for distressed banks. In
addition, the FDIC and the Department of Housing and Urban Development (HUD) have tried to
help organize loan servicers through the HOPE Now program. The Securities and Exchange
Commission (SEC) and Internal Revenue Service (IRS) have issued rules clarifying the ability of ¹²
loan servicers to modify loans held in securitized trusts.
Congress gave HUD and the newly created Federal Housing Finance Agency (FHFA) additional
authority to address mortgage markets. The Housing and Economic Recovery Act (HERA) (P.L.

110-289) contains a voluntary plan to allow banks to write down the balance of existing loans so ¹³

that borrowers can refinance into FHA to avoid foreclosure. The act also provided some
Community Development Block Grant (CDBG) funds to allow local communities to acquire and ¹⁴
redevelop vacant and foreclosed properties. The act also created a new regulator for the
government-sponsored enterprises (GSEs), Fannie Mae, Freddie Mac, and the Federal Home ¹⁵
Loan Banks. The act gave Treasury the temporary authority to purchase debt and equity
securities of the GSEs.
Fall 2008 saw a series of financial market interventions. First, the FHFA placed the GSEs in a
conservatorship with agreements by the Federal Reserve Bank of New York to assure liquidity
and by the Treasury to purchase enough preferred stock and securities to ensure adequate ¹⁶
capitalization. On a single weekend, policymakers helped broker a deal to sell investment bank
Merrill Lynch to Bank of America and failed to broker a similar deal for Lehman Brothers,
reportedly because the government declined to provide financial support. Lehman Brothers
subsequently declared bankruptcy. A policy of no financial support did not survive the week, as
insurer AIG was granted a Federal Reserve loan three days later. The next day financial markets

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froze up and Treasury announced a proposal to buy mortgage-related assets from financial
institutions.
Congress also gave Treasury additional tools to address financial market instability. The
Emergency Economic Stabilization Act of 2008 (EESA, Division A of P.L. 110-343) created a
Troubled Asset Relief Program (TARP) that allows Treasury to purchase up to $700 billion of
assets from financial institutions. Although the plan was originally discussed in terms of
purchasing assets from financial institutions similar to the Resolution Trust Corporation (RTC),
some policymakers argued that it would be preferable to purchase stock in banks similar to the
Reconstruction Finance Corporation (RFC). The definition of troubled asset is broad enough to
encompass both approaches. The troubled assets purchase proposal has been used primarily to
inject capital into banks.

The Federal Reserve’s primary tools help provide liquidity but do not restore capital levels.
Liquidity generally refers to the ability to access markets, either as a firm issuing bonds or as a
person selling a good, without suffering “fire-sale” prices. An adequate capital level is generally
determined as a relation between assets and liabilities. All of a firm’s assets can be completely
liquid (cash) but the firm can remain undercapitalized if small losses can reduce its capital to near
insolvency. These concepts are related. Even if a firm has liquid assets, it may have difficulty
accessing credit markets to borrow more funds because it is too close to insolvency to be
perceived as a good credit risk. Complexities of mortgage-related securities have made it difficult
to ascertain their value, thus those assets have become less liquid. Furthermore, investors know
that some banks have suffered loan losses that reduced their capital, but the complexities of the
mortgage-related assets have made it difficult to identify which banks are undercapitalized. As a
result, the liquidity of mortgage-related assets has been reduced, and the liquidity of financial
firms has been reduced. The Federal Reserve has taken steps to increase the liquidity of particular
assets, for example, by expanding the categories of assets that it will accept as collateral for loans,
but the Federal Reserve has not restored bank capital.

The expressed purpose of EESA (Division A of P.L. 110-343) is to “ ... provide authority and
facilities that the Secretary of the Treasury can use to restore liquidity and stability to the financial
system.” This measure addressed some of the concerns that some policymakers may have had
regarding the original three-page Treasury plan. A short description of some of the provisions of
the Troubled Asset Relief Program (TARP) follows.
• It has two definitions of troubled assets. The first definition specifies mortgages
and mortgage-related assets. The second definition is more general, and includes
any asset that the Treasury, in consultation with the Federal Reserve, believes the

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purchase of which from financial institutions would help restore financial
stability.
• It includes an asset insurance program as an alternative to, or in addition to,
purchasing troubled assets.
• It excludes foreign central banks from the definition of eligible financial
institutions but includes institutions in U.S. territories, such as Guam and the
Virgin Islands.
• It includes a variety of oversight mechanisms including a Financial Stability
Oversight Board of executive branch officers to review the exercise of authority
under the program; ongoing oversight by the Comptroller General; a
Congressional Oversight board; and a special inspector to be appointed by the ¹⁹
President and confirmed by the Senate.
• The Treasury will manage the acquisition and sale of assets with any proceeds
accruing to the general fund for reduction of the public debt.
• The measure instructs the Secretary of Treasury to implement a plan to maximize
assistance for homeowners and to encourage loan servicers to participate in the
Hope for Homeowners program. Assistance to homeowners includes consent to
reasonable loan modification requests.
• The measure puts limits on executive compensation of institutions that
participate. Under certain circumstances, these include limits on incentive
compensation for risk-taking during the period that the program has an equity or
debt position in the firm, recovery of incentive bonuses paid to senior executives
based on financial statements that are later shown to be false, and a prohibition of
golden parachutes.
• The debt limit is raised to $11.3 trillion.
• The SEC is given the authority to suspend mark-to-market accounting rules.
• The limit on FDIC insurance for accounts at depository institutions is raised from
$100,000 to $250,000 per individual until the end of TARP (December 31, 2009).
While the initial Treasury focus was on purchasing troubled mortgage-related assets, this portion
of TARP has not been implemented. Instead, Treasury has focused on direct capital injections
though preferred stock purchases. On October 14, 2008, Treasury announced the Capital Purchase
Plan (CPP). Under the initial CPP announcement, nine large banks received $125 billion in
capital with another $125 billion intended for the rest of the banking system. Approximately
$62.5 billion of the second $125 billion had been disbursed as of December 31, 2008. In addition
to the general capital purchase plan, there have been several other case-by-case interventions
since the passage of the EESA. AIG received $40 billion in preferred share purchases as part of a
revamp of an earlier rescue package. Citigroup received an additional $20 billion in preferred

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share purchases after an initial $25 billion from the CPP, along with a package of federal
guarantees to cover losses on a $306 billion pool of assets, with $5 billion in losses covered under
TARP. The U.S. automakers also received financial assistance through TARP, with a $5 billion
preferred share purchase from GMAC, up to $14.4 billion in loans to GM and $4 billion in loans
to Chrysler. Treasury also committed up to $20 billion in TARP funds to absorb 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. In total, over $350 billion in funds have been
committed through TARP, although less than this has actually been disbursed.

On January 9, 2009, House Financial Services Chairman Barney Frank introduced H.R. 384, the
TARP Reform and Accountability Act of 2009, which is scheduled for floor action during the
week of January 12, 2009. 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 conditions 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) make permanent the
increase in deposit insurance included in the EESA.
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