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The bank bailouts that began in 2008 were part of what some viewed then and continue to regard as the worst financial crisis since the Great Depression. The cracks in the U.S. economy infrastructure that led to the crisis and the bailouts started to show in 2006 and 2007, however. Specifically, until approximately 2006, the U.S. housing market experienced what some would call a "bubble." Driven by subprime lending--lending to borrowers who traditionally had been viewed as undesirable due to, for example, having little or no money available as a deposit--and facilitated by securitization and derivative financial products, housing prices escalated as housing borrowing and sales skyrocketed (Congressional Oversight Panel 2009, supra note 9, at 8). Housing prices increased at an average of 12 percent per year from 1999 to 2006 (Congressional Oversight Panel 2009, supra note 9, at 8).

In 2006, however, housing prices began a modest decline that spiraled into a double-digit percentage decline by 2008 (Congressional Oversight Panel 2009, supra note 9, at 8). This led to a rash of mortgage defaults by subprime borrowers and a spate of home foreclosure sales by banks, and banks found themselves unable to sell at a price high enough to recoup what they had lent. Foreclosure sales accelerated the decline of real estate prices, and a dismal financial free fall eclipsed the beginning of 2008. The carnage from this lending and housing implosion was magnified by widespread use of derivatives and securitization products by banks; therefore, even financial institutions that did not hold mortgages but held instead, for example, credit default swaps or other mortgage-related derivative products suffered from the market decline as well (Congressional Oversight Panel 2009, supra note 9, at 9).

The first major bank bailout in 2008 was that of Bear Stearns, the fifth largest U.S. investment bank and the leading trader of mortgage-backed bonds. In early 2008, Bear Stearns reported that it was highly exposed to the unstable subprime mortgage market. Alarmed, Bear Stearns clients withdrew their funds from Bear Stearns, and within three days in March 2008, Bear Stearns's available capital fell by 90 percent (Ritholtz 2009, 187). This prompted Federal Reserve and Treasury officials to try to arrange for a bailout of Bear Stearns. The bailout resulted in JPMorgan Chase buying Bear Stearns upon the agreement of the Federal Reserve Bank of New York to guarantee $29 million in Bear Stearns's riskiest assets, which led to reported losses of billions of dollars for the Federal Reserve Bank within months of participating in this bailout.

Shortly thereafter, Lehman Brothers, another banking behemoth, began to fail. While many clamored for a bailout for Lehman Brothers, it was instead allowed to fail completely and file for bankruptcy in September 2008, after the Federal Reserve and the Treasury made clear that they hoped never again to need to rescue a bank the way they rescued Bear Stearns (Ritholtz 2009, 190-192).

Lehman's failure spurred fears that other big banks and financial institutions would soon fail and the entire economy would be destabilized. Concern focused on American International Group (AIG), the world's largest insurer. AIG was deeply involved in the international derivatives market, and, in September 2008, as it became clear that many of AIG's investments were tied to failing mortgage-related assets, regulators decided that the world's largest insurer and a key participant in the international derivatives market must not be allowed to fail, because its failure could have far-reaching economic effects. The Federal Reserve and Treasury purchased a majority stake in AIG stock for $68 billion, thereby providing much-needed capital to AIG, and the government continued to make additional loans and purchases of stock so that, by March 2009, the government had infused roughly $175 billion into AIG (Ritholtz 2009, 208).

September 2008 also saw the government takeover and bailout of the Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Association (Freddie Mac). These two government-sponsored enterprises (GSEs) had been established by Congress to participate in the mortgage market and foster the accessibility of home loans. As the subprime mortgage market deteriorated, Fannie Mae and Freddie Mac became financially compromised, and Congress adopted legislation to provide for the government takeover of both GSEs in addition to the Federal Reserve infusing well over $100 billion into the GSEs.

Also in 2008, Citigroup, a Wall Street titan that had combined commercial banking with investment banking and a brokerage house, became a focus of concern. Citigroup held billions of dollars in mortgage-related securities whose value plummeted as the housing and mortgage markets crashed. The Treasury and Federal Reserve refused to risk a fatal blow to the already precarious banking system by allowing the largest financial institution on Wall Street to fail, so a complex deal valued at hundreds of billions of dollars to stabilize Citigroup was struck (Ritholtz 2009, 217).

The Citigroup bailout and later bailouts (including bailouts in the automotive industry) were a product of legislation--the Emergency Economic Stabilization Act (EESA)--hastily adopted on October 3, 2008, in the wake of the expanding financial crisis. EESA established the Troubled Assets Relief Program (TARP)--the bailout program. The program authorized the secretary of the Treasury, in consultation with the chairman of the Federal Reserve, to purchase up to $700 billion in "troubled assets," such as subprime mortgage-based securities, in order to promote financial market stability by removing toxic assets from the banks' balance sheets.

By the end of 2009, the Treasury had disbursed over $350 billion under TARP (General Accounting Office 2009). For example, pursuant to TARP, the FDIC, Treasury, and Federal Reserve entered into an agreement with Bank of America in January 2009 to purchase $20 billion in preferred stock from Bank of America and provide protection against loss for approximately $118 billion in assets. Banks that participated in TARP or received bailouts pursuant to TARP included some of the biggest and previously strongest banks, such as Citigroup, JPMorgan Chase, Wells Fargo, Bank of America, Goldman Sachs, and Morgan Stanley, and the top nine participants in TARP represent 55 percent of all U.S. bank assets.

References:

Congressional Oversight Panel, December Oversight Report: Taking Stock: What Has the Troubled Asset Relief Program Achieved? December 9, 2009. www. senate.gov/general/common/generic/COP_redirect.htm

Ritholtz, Barry, Bailout Nation: How Greed and Easy Money Corrupted Wall Street and Shook the World Economy. Hoboken, NJ: John Wiley, 2009.

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