Massive Government Intervention in the Private Markets: TARP, Dodd-Frank, and Beyond

After nearly eight years of favoring the deregulation of the financial industry, President George W. Bush's administration aggressively interceded in the private markets in the fall of 2008 to quell the panic and stabilize the leading financial institutions in the United States. This dramatic change in regulatory policy began in earnest when the venerable investment bank Bear Stearns, badly damaged by the subprime mortgage crisis, sold itself to JPMorgan Chase in a fire sale in March 2008. (The subprime mortgage crisis of 2007-2008 is discussed further in the "Inside Story" in Chapter 18.) The U.S. government paid more than $150 billion to bail out and recapitalize Fannie Mae and Freddie Mac, the government-sponsored home mortgage giants devastated by the subprime mortgage crisis.

The government paid another $150 billion to keep insurance behemoth American International Group (AIG) from collapsing. AIG had issued $440 billion in credit-default swaps ensuring the repayment of mortgage-backed securities and other debt. Originally procured by investors to guarantee the repayment of bonds in case the issuer defaulted, credit- default swaps became a popular vehicle for hedge funds and other traders betting on how close a firm was to insolvency. In a controversial decision, the U.S. Treasury Department paid AIG's counterparties 100 cents on the dollar.

The value of a swap or other financial derivative contract depends in part on the counterparty's solvency and its ability to honor its obligations. Brooksley Born, then chair of the Commodity Futures Trading Commission (CFTC), had warned in 1998 that the explosion of the financial derivatives market allowed traders "to take positions that may threaten our regulatory markets or, indeed, our economy, without the knowledge of any federal regulatory authority." Her colleagues on the Working Group on Financial MarketsAlan Greenspan, chair of the Federal Reserve, SEC chair Arthur Levitt Jr., and

U.S. Treasury Secretary Robert Rubinvoiced "grave concerns" about her proposal to regulate the financial derivatives market. Deputy Treasury Secretary Lawrence Summers criticized her for "casting a shadow of regulatory uncertainty over an otherwise thriving market," and Congress passed a law in 2000 that exempted swaps from oversight by the CFTC and the SEC. The massive but unregulated swaps markets only aggravated the downward pressure on financial institutions already burdened by subprime mortgage-backed securities. On September 26, 2008, SEC Chair Christopher Cox admitted that "the last six months have made it abundantly clear that voluntary regulation does not work."

Investment bank Lehman Brothers declared bankruptcy on September 15, 2008. Soon thereafter, Goldman Sachs and Morgan Stanley, the last two major independent investment banks in the United States, became a commercial bank holding companies subject to permanent on-site regulation by the Federal Reserve.

The Federal Reserve immediately extended credit to the firms' broker-dealer subsidiaries and sent the message that it would not allow these powerhouses to go under. The Senate passed what became the Emergency Economic Stabilization Act on October 1, 2008, by a vote of 74 to 25. On Friday, October 3, the House passed the bill by a vote of 263 to 171. President George W. Bush signed it into law a few hours later.

The statute authorized the U.S. Treasury to "immediately provide authority and facilities that the Secretary of the Treasury can use to restore liquidity and stability to the financial system of the United States" and granted the secretary the power to "purchase . . . troubled assets from any financial

institution, on such terms and conditions as determined by the Secretary." Congress initially appropriated $700 billion for this Troubled Asset Relief Program (TARP).

In his testimony before the U.S. Senate, Treasury Secretary Henry Paulson claimed that the bill would stabilize the economy, improve liquidity in the credit market, and stimulate investor confidence.80 In fact, the act failed to spark the hoped-for rebound in the stock market. On Monday, October 6, 2008, the Dow Jones Average dropped more than 700 points and fell below 10,000 for the first time in four years.

In early October 2008, the Federal Reserve announced its intention to start lending directly to nonfinancial firms by buying up short-term corporate debt (commercial paper) for the first time since the Great Depression. On October 14, President Bush announced that the Treasury Department would spend up to $250 billion of the $700 billion authorized by the bailout law to buy nonvoting senior preferred shares in the nation's commercial banks. Secretary Paulson had summoned the CEOs of the nine largest U.S. banks to the Treasury Department on October 13 and told them in no uncertain terms that they had no choice but to accept $125 billion in government funds in exchange for preferred stock "for their own good and that of the country."

A number of members of Congress reported significant resistance to the bailouts from their constituents, who were outraged that the measure appeared to unfairly enrich the same executives who may have caused the financial crisis in the first place. Bloomberg News reported that the top five Wall Street investment banks paid their senior executives more than $5 billion in the five years before Lehman Brothers filed for bankruptcy.

Public indignation sparked again in 2009 when a number of banks that had received TARP funds, AIG, and other Wall Street firms announced that they were paying almost $20 billion in bonuses to their traders and executives. AIG alone awarded $165 million in bonuses for the year ended December 31, 2008. Limits on executive compensation imposed by TARP were strengthened in February 2009 after President Obama called the bonuses "shameful."

In June and July of 2010, the House (by a vote of 237-192) and the Senate (by a vote of 60-39) passed the Dodd-Frank Wall Street Reform and Consumer Protection Actthe most sweeping reform of the U.S. financial markets since the Great Depression. As discussed in the "Inside Story" in Chapter 6, the act created the Consumer Financial Protection Bureau and imposed new regulations on the $55 trillion credit-default swap market and other derivatives trading. Efforts to create electronic swaps trading platforms were predicated on the premise that greater transparency around the pricing of derivatives would bring structure and stability to this heretofore "dark market."

When President Obama signed the bill, he stated that the reforms in the Dodd-Frank Act "represent the strongest consumer financial protections in history." U.S. Treasury Secretary Timothy Geithner explained: "It was designed to lay a stronger foundation for innovation, economic growth and job creation with robust protections for consumers and investors and tough constraints on risk-taking."

Only six Republican senators voted in favor of the bill. Former Speaker of the House and 2012 Republican presidential candidate Newt Gingrich charged that Dodd-Frank was "making it harder to make loans for housing, and . . . crippling small business borrowing," partly by "crushing independent banks." In one presidential debate, he stated: "If they would repeal [Dodd-Frank] tomorrow morning, you would have a better housing market the next day."

Dodd-Frank reduced the amount of TARP funding from $700 billion to $475 billion. Of the nearly $457 billion committed under TARP, approximately $423 billion had been disbursed by March 31, 2014. The net cost of TARP to the U.S. taxpayers as of that date was roughly $41 billion.

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