The subprime mortgage crisis reached a critical stage during the first week of September 2008, characterized by severely contracted liquidity in the global credit marketsBanks in Miser Mode and insolvency threats to investment banks and other institutions.
US government takeover of home mortgage lenders
The United States director of the Federal Housing Finance Agency (FHFA), James B. Lockhart III, on September 7, 2008, announced his decision to place two United States government-sponsored enterprises (GSEs), Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation), into conservatorship run by FHFA. United States Treasury Secretary Henry Paulson, at the same press conference stated that placing the two GSEs into conservatorship was a decision he fully supported, and said that he advised "that conservatorship was the only form in which I would commit taxpayer money to the GSEs." He further said that "I attribute the need for today's action primarily to the inherent conflict and flawed business model embedded in the GSE structure, and to the ongoing housing correction." The same day, Federal Reserve Bank Chairman Ben Bernanke stated in support: "I strongly endorse both the decision by FHFA Director Lockhart to place Fannie Mae and Freddie Mac into conservatorship and the actions taken by Treasury Secretary Paulson to ensure the financial soundness of those two companies."
Developing global financial crisis
Beginning with bankruptcy of Lehman Brothers at midnight Monday, September 15, 2008, the financial crisis entered an acute phase marked by failures of prominent American and European banks and efforts by the American and European governments to rescue distressed financial institutions, in the United States by passage of the Emergency Economic Stabilization Act of 2008 and in European countries by infusion of capital into major banks. Afterwards, Iceland almost claimed to go bankrupt as the country's three largest banks, and in effect financial system, collapsed."Financial Crisis in Iceland: Affected Banks" Many financial institutions in Europe also faced the liquidity problem that they needed to raise their capital adequacy ratio. As the crisis developed, stock markets fell worldwide, and global financial regulators attempted to coordinate efforts to contain the crisis. The US government composed a $700 billion plan to purchase unperforming collaterals and assets. However, the plan failed to pass because some members of the US Congress rejected the idea of using taxpayers' money to bail out Wall Street investment bankers. After the stock market plunged, Congress amended the $700 billion bail out plan and passed the legislation. The market sentiment continued to deteriorate, however, and the global financial system almost collapsed. While the market turned extremely pessimistic, the British government launched a 500 billion pound bail out plan aimed at injecting capital into the financial system. The British government nationalized most of the financial institutions in trouble. Many European governments followed suit, as well as the US government. Stock markets appeared to have stabilized as October ended. In addition, the falling prices due to reduced demand for oil, coupled with projections of a global recession, brought the 2000s energy crisis to temporary resolution. In the Eastern European economies of Poland, Hungary, Romania, and Ukraine the economic crisis was characterized by difficulties with loans made in hard currencies such as the Swiss franc. As local currencies in those countries lost value, making payment on such loans became progressively more difficult."`Panic' Strikes East Europe Borrowers as Banks Cut Franc Loans" article by Ben Holland, Laura Cochrane and Balazs Penz; Bloomberg, October 31, 2008
As the financial panic developed during September and October 2008, there was a "flight-to-quality" as investors sought safety in U.S. Treasury bonds, gold, and currencies such as the US dollar (still widely perceived as the world's reserve currency) and the Yen (mainly through unwinding of carry trades). This currency crisis threatened to disrupt international trade and produced strong pressure on all world currencies. The International Monetary Fund had limited resources relative to the needs of the many nations with currency under pressure or near collapse.
A further shift towards assets that are perceived as tangible, sustainable, like gold or land (as opposed to "paper assets") was anticipated. However, as events progressed during early 2009, it was U.S. Treasury bonds which were the main refuge chosen. This inflow of money into the United States translated into an outflow from other countries restricting their ability to raise money for local rescue efforts.
Major US financial firms' crisis
On Sunday, September 14, it was announced that Lehman Brothers would file for bankruptcy after the Federal Reserve Bank declined to participate in creating a financial support facility for Lehman Brothers. The significance of the Lehman Brothers bankruptcy is disputed with some assigning it a pivotal role in the unfolding of subsequent events. The principals involved, Ben Bernanke and Henry Paulson, dispute this view, citing a volume of toxic assets at Lehman which made a rescue impossible. Immediately following the bankruptcy, JPMorgan Chase provided the broker dealer unit of Lehman Brothers with $138 billion to "settle securities transactions with customers of Lehman and its clearance parties" according to a statement made in a New York City Bankruptcy court filing.
The same day, the sale of Merrill Lynch to Bank of America was announced."Lehman Files for Bankruptcy; Merrill Is Sold" article by Andrew Ross Sorkin in The New York Times September 14, 2008 The beginning of the week was marked by extreme instability in global stock markets, with dramatic drops in market values on Monday, September 15, and Wednesday, September 17. On September 16, the large insurer American International Group (AIG), a significant participant in the credit default swaps markets, suffered a liquidity crisis following the downgrade of its credit rating. The Federal Reserve, at AIG's request, and after AIG had shown that it could not find lenders willing to save it from insolvency, created a credit facility for up to US$85 billion in exchange for a 79.9% equity interest, and the right to suspend dividends to previously issued common and preferred stock.See American International Group for details and citations.
Money market funds insurance and short sales prohibitions On September 16, the Reserve Primary Fund, a large money market mutual fund, lowered its share price below $1 because of exposure to Lehman debt securities. This resulted in demands from investors to return their funds as the financial crisis mounted."Money Market Funds Enter a World of Risk" article by Tara Siegel Bernard in The New York Times September 17, 2008 By the morning of September 18, money market sell orders from institutional investors totalled $0.5 trillion, out of a total market capitalization of $4 trillion, but a $105 billion liquidity injection from the Federal Reserve averted an immediate collapse.Gray, Michael. "Almost Armageddon: Markets Were 500 Trades from a Meltdown (September 21, 2008 ) New York PostHouse Representative Kanjorski about the $550 Billion "run on the banks" in two hours during September, 2008 On September 19 the U.S. Treasury offered temporary insurance (akin to Federal Deposit Insurance Corporation insurance of bank accounts) to money market funds."Treasury Announces Guaranty Program for Money Market Funds" (September 19, 2008) Press Release. United States Department of the Treasury. Toward the end of the week, short selling of financial stocks was suspended by the Financial Services Authority in the United Kingdom and by the Securities and Exchange Commission in the United States."S.E.C. Issues Temporary Ban on Short-Selling" article by Vikas Bajaj and Jonathan D. Glater in The New York Times September 19, 2008 Similar measures were taken by authorities in other countries. Some restoration of market confidence occurred with the publicity surrounding efforts of the Treasury and the Securities Exchange Commission"Stocks Surge as U.S. Acts to Shore Up Money Funds and Limits Short Selling" article by Graham Bowley in The New York Times September 19, 2008"Congressional Leaders Were Stunned by Warnings" article by David M. Herszenhorn in The New York Times September 19, 2008
US Troubled Asset Relief Program
On September 19, 2008, a plan intended to ameliorate the difficulties caused by the subprime mortgage crisis was proposed by the Secretary of the Treasury, Henry Paulson. He proposed a Troubled Assets Relief Program (TARP), later incorporated into the Emergency Economic Stabilization Act, which would permit the United States government to purchase illiquid assets, informally termed toxic assets, from financial institutions."Vast Bailout by U.S. Proposed in Bid to Stem Financial Crisis" article by Edmund L. Andrews in The New York Times September 18, 2008"Paulson Argues for Need to Buy Mortgages" article by David Stout in The New York Times September 19, 2008 The value of the securities is extremely difficult to determine."Plan's Mystery: What's All This Stuff Worth?" article by Vikas Bajaj in The New York Times September 24, 2008
Consultations between the Secretary of the Treasury, the Chairman of the Federal Reserve, and the Chairman of the U.S. Securities and Exchange Commission, Congressional leaders and the President of the United States moved forward plans to advance a comprehensive solution to the problems created by illiquid mortgage-backed securities. Of this time the President later said: "... I was told by [my] chief economic advisors that the situation we were facing could be worse than the Great Depression."Greater than the great depressionBush Press Conference
At the close of the week the Secretary of the Treasury and President Bush announced a proposal for the federal government to buy up to US$700 billion of illiquid mortgage-backed securities with the intent to increase the liquidity of the secondary mortgage markets and reduce potential losses encountered by financial institutions owning the securities. The draft proposal of the plan was received favorably by investors in the stock market. Details of the bailout remained to be acted upon by Congress."Bush Officials Urge Swift Action on Rescue Powers" article by Edmund L. Andrews in The New York Times September 19, 2008 Draft Proposal for Bailout Plan (September 21, 2008). New York Times"Rescue Plan Seeks $700 Billion to Buy Bad Mortgages" article by The Associated Press in The New York Times September 20, 2008"$700 Billion Is Sought for Wall Street in Vast Bailout" article by David M. Herszenhorn in The New York Times September 20, 2008
Week of September 21 On Sunday, September 21, the two remaining US investment banks, Goldman Sachs and Morgan Stanley, with the approval of the Federal Reserve, converted to bank holding companies, a status subject to more regulation, but with readier access to capital."Shift for Goldman and Morgan Marks the End of an Era" article by Andrew Ross Sorkin and Vikas Bajaj in The New York Times September 21, 2008 On September 21, Treasury Secretary Henry Paulson announced that the original proposal, which would have excluded foreign banks, had been widened to include foreign financial institutions with a presence in the US. The US administration was pressuring other countries to set up similar bailout plans.