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The financial crisis: an inside view.

ABSTRACT This paper reviews the policy response to the 2007-09
financial crisis from the perspective of a senior Treasury official at
the time. Government agencies faced severe constraints in addressing the
crisis: lack of legal authority for potentially helpful financial
stabilization measures, a Congress reluctant to grant such authority,
and the need to act quickly in the midst of a market panic. Treasury
officials recognized the dangers arising from mounting foreclosures and
worked to facilitate limited mortgage modifications, but going further
was politically unacceptable because public funds would have gone to
some irresponsible borrowers. The suddenness of Bear Stearns’
collapse in March 2008 made rescue necessary and led to preparation of
emergency options should conditions worsen. The Treasury saw Fannie Mae
and Freddie Mac’s rescue that summer as necessary to calm markets,
despite the moral hazard created. After Lehman Brothers failed in
September, the Treasury genuinely intended to buy illiquid securities
from troubled institutions but turned to capital injections as the
crisis deepened.


This paper reviews the events associated with the credit market
disruppaper on that began in August 2007 and developed into a full-blown
crisis in the fall of 2008. This is necessarily an incomplete history:
events continued to unfold as I was writing it, in the months
immediately after I left the Treasury, where I served as assistant
secretary for economic policy from December 2006 to the end of the
George W. Bush administration on January 20, 2009. It is also
necessarily a selective one: the focus is on key decisions made at the
Treasury with respect to housing and financial markets policies, and on
the constraints faced by decisionmakers at the Treasury and other
agencies over this period. I examine broad policy matters and economic
decisions but do not go into the financial details of specific
transactions, such as those involving the government-sponsored
enterprises (GSEs) and the rescue of the American International Group
(AIG) insurance company.

I first explain some constraints on the policy process–legal,
political, and otherwise–that were perhaps not readily apparent to
outsiders such as academic economists or financial market participants.
These constraints ruled out several policy approaches that might have
appeared attractive in principle, such as forcing lenders to troubled
firms to swap their bonds for equity. I then proceed with a
chronological discussion, starting with preparations taken at the
Treasury in 2006 and moving on to policy proposals considered in the
wake of the August 2007 lockup of the asset-backed commercial paper

The main development following the events of August was a new focus
on housing and in particular on foreclosure prevention, embodied in the
Hope Now Alliance. The Treasury sought to have mortgage servicers (the
firms that collect monthly payments on behalf of lenders) make economic
decisions with respect to loan modifications–to modify loans when this
was less costly than foreclosure. This approach involved no expenditure
of public money, and it focused on borrowers who could avoid foreclosure
through a moderate reduction in their monthly mortgage payment. People
whose mortgage balance far exceeded the value of their home–so-called
deeply underwater borrowers–would still have an incentive to walk away
and allow their lender to foreclose.

But political constraints bound tightly in addressing this
situation, since there was little appetite in Congress for a program
that would transparently reward “irresponsible” borrowers who
had purchased homes they could never have hoped to afford. Even after
the October 2008 enactment of the Emergency Economic Stabilization Act
of 2008 (EESA) gave the Treasury the resources and authority to put
public money into foreclosure avoidance, the need to husband limited
resources against worsening financial sector problems ruled out
undertaking a foreclosure avoidance program at the necessary scale until
after the change in administrations in January 2009. The foreclosure
avoidance initiative eventually implemented by the Obama administration
in March 2009, which took the form of an interest rate subsidy, was a
refinement of a proposal developed at the Treasury in October 2007.

Returning to events on Wall Street, the paper picks up the
chronology with the failure of Bear Steams in early 2008, the rescue of
the government-sponsored enterprises (GSEs) Fannie Mae and Freddie Mac
that summer, and the failures of the investment bank Lehman Brothers and
AIG the week of September 14, 2008. The run on money market mutual funds
in the wake of Lehman’s collapse led to a lockup of the commercial
paper market and spurred the Treasury to seek from Congress a $700
billion fund–the Troubled Assets Relief Program (TARP)–with which to
purchase illiquid assets from banks in order to alleviate uncertainty
about financial institutions’ viability and restore market
confidence. However, as market conditions continued to deteriorate even
after the early-October enactment of EESA, the Treasury shifted from
asset purchases to capital injections directly into banks, including the
surviving large investment banks that had either become bank holding
companies or merged with other banks. The capital injections, together
with a Federal Deposit Insurance Corporation (FDIC) program to guarantee
bank debt, eventually helped foster financial sector stability. Even in
late 2008, however, continued market doubts about the financial
condition of Citigroup and Bank of America led the Treasury and the Fed
to jointly provide additional capital and “ring fence”
insurance for some of the assets on these firms’ balance sheets. In
effect, providing insurance through nonrecourse financing from the Fed
meant that taxpayers owned much of the downside of these firms’
illiquid assets.

The paper concludes with a brief discussion of several key lessons
of the events of the fall of 2008. An essential insight regarding the
policies undertaken throughout the fall is that providing insurance
through nonrecourse financing is economically similar to buying
assets–indeed, underpricing insurance is akin to overpaying for assets.
But insurance is much less transparent than either asset purchases or
capital injections, and therefore politically preferable as a means of
providing subsidies to financial market participants. A second lesson is
that maintaining public support is essential to allowing these transfers
to take place. These two lessons appear to have informed the policies
put into place in the first part of 2009.

I. Constraints on the Policy Process

Legal constraints were omnipresent throughout the crisis, since the
Treasury and other government agencies such as the Fed necessarily
operate within existing legal authorities. Given these constraints, some
steps that are attractive in principle turn out to be impractical in
reality, two key examples being the notion of forcing investors to enter
into debt-for-equity swaps to address debt overhangs, and that of
forcing banks to accept government capital. These both run hard afoul of
the constraint that there is no legal mechanism to make them happen. A
lesson for academics is that any time they use the verb
“force” (as in “The policy should be to force banks to do
X or Y”), the next sentence should set forth the section of the
U.S. legal code that allows that course of action. Otherwise the policy
suggestion is of theoretical but not practical interest. Legal
constraints bound in other ways as well, including with respect to
modifications of loans.

New legal authorities can be obtained through legislative action,
but this runs hard into the political constraint: getting a bill through
Congress is much easier said than done. This difficulty was especially
salient in 2007 and 2008, the first two years after both chambers of
Congress switched from Republican to Democratic leadership. A
distrustful relationship between the congressional leadership and
President Bush and his White House staff made 2007 an unconstructive
year from the perspective of economic policy, although, ironically, it
had the effect of making possible the rapid enactment of the early-2008
stimulus: Democratic leaders by then appeared to be eager to demonstrate
that they could govern effectively. More legislative actions were taken
in 2008 as the credit crisis worsened and the economy slowed, but
political constraints remained a constant factor in the
administration’s deliberations.

Political constraints were an important factor in the reluctance at
the Treasury to put forward proposals to address the credit crisis early
in 2008. The options that later turned into the TARP were first written
down at the Treasury in March 2008: buy assets, insure them, inject
capital into financial institutions, or massively expand federally
guaranteed mortgage refinance programs to improve asset performance from
the bottom up. But we at the Treasury saw little prospect of getting
legislative approval for any of these steps, including a massive program
to avoid foreclosures. Legislative action would be possible only when
Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben
Bernanke could go to Congress and attest that the crisis was at the
doorstep, even though by then it could well be too late to head it off.

Political constraints also affected the types of legislative
authorities that could be requested in the first place, notably with
regard to the initial conception of the TARP. Secretary Paulson truly
meant to acquire troubled assets in order to stabilize the financial
system when he and Chairman Bernanke met with congressional leaders on
Thursday, September 18, 2008, to request a $700 billion fund for that
purpose. One criticism of the initial “Paulson plan” is that
it would have been better to inject capital into the system in the first
place, since the banking system was undercapitalized, and asset
purchases inject capital only to the extent that too high a price is
paid. But Congress would never have approved a proposal to inject
capital. House Republicans would have balked at voting to allow the
government to buy a large chunk of the banking system, and Democrats
would not have voted for such an unpopular bill without a reasonable
number of Republican votes to provide political cover.

A final constraint was simply time. Decisions had to be made
rapidly in the context of a continuous cascade of market events.
Certainly this was the case by the week of September 14, 2008, when
Lehman Brothers and AIG both failed; a major money market mutual fund,
the Reserve Fund, “broke the buck,” allowing its value per
share to fall below the $1 par level; a panicked flight from money
market mutual funds ensued; and then the commercial paper market locked
up, with major industrial companies that relied on commercial paper
issuance telling the Treasury that they faced imminent liquidity
problems. This was the situation in which the TARP was proposed, and the
decisions and actions surrounding its creation must be understood in the
context of the events of that week. Time constraints meant that
sometimes blunt actions were taken, notably the guarantees on the
liabilities of AIG, of money market mutual funds, and several weeks
later of banks’ qualified new senior debt issues. A blanket
guarantee is certainly not a preferred policy approach, but in the face
of broad runs on the financial system, guarantees were needed to deal
with the problems in real time.

Other impediments to decisionmaking were self-imposed hurdles
rather than external constraints. Notable among these was chronic
disorganization within the Treasury itself, a broadly haphazard policy
process within the administration, and sometimes strained relations
between the Treasury and White House staff that made it difficult to
harness the full energies of the administration in a common direction.
To many observers, the Treasury also lacked an appreciation that the
rationales behind its actions and decisions were not being explained in
sufficient detail; without understanding the motivation for each
decision, outside observers found it difficult to anticipate what
further steps would be taken as events unfolded. Part of the problem was
simply the difficulty of keeping up, of providing adequate explanation
in real time as decisions were being made rapidly, while another part
was a lack of trust in the Treasury and the administration. Many
journalists and other observers did not believe simple (and truthful)
explanations for actions. For example, the switch from asset purchases
to capital injections really was a response to market developments. It
was too easy–and wrong–to believe that Secretary Paulson was looking
out for the interests of Wall Street, or even of a particular firm,
rather than the interests of the nation as he saw them. Whatever the
reason, such communication gaps led to natural skepticism as the
Treasury’s approach to the crisis evolved in the fall. There were
valid reasons behind the initial plan to purchase assets (even if many
people found them inadequate), and valid reasons for the switch to
capital injections. But the insufficient explanations of these moves led
to skepticism and growing hostility in Congress and beyond to the rescue
plan as a whole.

Notwithstanding these criticisms with regard to the Treasury, a
paper such as this will inevitably be seen as defensive, if not outright
self-serving. Since this is unavoidable, I simply acknowledge it up
front. Other accounts of the credit crisis will come out in due course
and can be correlated with the discussion here.

II. On the Verge of Crisis

Secretary Paulson, on his arrival at the Treasury in summer 2006,
told Treasury staff that it was time to prepare for a financial system
challenge. As he put it, credit market conditions had been so easy for
so long that many market participants were not prepared for a financial
shock with systemic implications. His frame of reference was the market
dislocations of 1998 following the Russian debt default and the collapse
of the hedge fund Long Term Capital Management (LTCM). Starting that
summer, Treasury staff worked to identify potential financial market
challenges and policy responses, both in the near term and over the
horizon. The longer-range policy discussions eventually turned into the
March 2008 Treasury Blueprint for a Modernized Financial Regulatory
Structure. Possible near-term situations that were considered included
sudden exogenous crises such as terror attacks, natural disasters, or
massive power blackouts; market-driven events such as the failure of a
major financial institution, a large sovereign default, or huge losses
at hedge funds; as well as slower-moving macroeconomic developments such
as an energy price shock, a prolonged economic downturn that sparked
wholesale corporate bankruptcies, or a large and disorderly movement in
the exchange value of the dollar. These problems were not seen as
imminent in mid- to late 2006.

The focus at the Treasury was on risk mitigation beforehand and on
preparing broad outlines of appropriate responses in the event that a
crisis did develop, always recognizing that the details would vary with
the situation. To help ensure smooth teamwork in the event of a problem,
Secretary Paulson reinvigorated the President’s Working Group on
Financial Markets (PWG), which had been formed after the October 1987
stock market crash. The PWG brought together senior officials from the
Treasury, the Fed, the Securities and Exchange Commission (SEC), and the
Commodities Futures Trading Commission (CFTC) to discuss financial and
economic developments and potential problems. The heads of these
agencies met regularly to discuss market developments, and interaction
at the staff level was both frequent and routine. Secretary Paulson also
talked regularly in both public and private settings about the need for
financial institutions to prepare for an end to abnormally loose
financial conditions.

Treasury staff recognized that changes in financial markets since
1998 would affect the contours of any new financial crisis and the
policy response. These developments generally had positive impacts in
that they contributed to increased financial market efficiency, but they
often increased complexity as well. Such developments included

–Deeper international capital market integration. Tighter linkages
between financial markets in different countries lowered financing costs
for U.S. borrowers, given the low national saving rate and the need to
import capital to fund spending. But under some views of the
international financial architecture, capital market integration also
contributed to the housing bubble that helped precipitate the crisis.

–The rise of securitization. Financial assets of all types,
including credit card debt, auto loans, and residential and commercial
mortgages, were increasingly being packaged into ever more complex
securities. Securitization reduced finance costs and contributed to
stronger aggregate demand; it also allowed the risks of lending to be
diversified more widely across market participants than if the loans had
remained on bank balance sheets. These benefits, however, came with the
downsides of increased complexity and diminished transparency. When
problems with mortgage performance did emerge, the bundling of mortgages
into securities made it difficult to gauge the distribution and
magnitude of credit losses.

–The growth of private pools of capital. Hedge funds and private
equity firms were becoming increasingly important players. The rise of
these nontraditional asset managers should in general increase the
efficiency of financial markets: the presence in the market of asset
management approaches that include both long and short positions rather
than just long would be expected to improve liquidity and efficiency.
But these funds tend to be nontransparent; indeed, calls for increased
disclosure of their trading positions are at odds with the hedge fund
business model. Particularly in Europe, hedge funds were seen as the
source of the next financial markets crisis. In the event, many hedge
funds suffered massive losses in 2007 and 2008, and their deleveraging
certainly contributed to the downward spiral in asset markets. But hedge
funds do not appear to have been the fundamental source of the problem.

–The growth of financial derivatives. New financial instruments
such as credit default swaps increased financial market efficiency by
allowing market participants to better hedge the risks of underlying
assets such as commodities, bonds, equities, or currencies. But these
derivatives added complexity and reduced transparency and further
facilitated increased leverage. By September 2008, worsening performance
of securitized housing assets such as mortgage-backed securities (MBSs)
led to rapid and massive deterioration of the balance sheets of firms
such as AIG and Lehman. Derivatives also led to increased
interconnectedness of markets, as the over-the-counter nature of credit
default swaps and many repo (repurchase agreement) transactions meant
that difficulties at financial institutions such as Bear Stearns,
Lehman, and AIG could have broad impacts through their role as
counterparties to these transactions. These considerations were to play
important roles in decisions made throughout 2008 regarding the
deployment of public funds to “bail out” particular

Broadly speaking, these financial innovations were viewed at
Treasury as fundamentally a good thing in that they added to the
liquidity and efficiency of capital markets and made it easier for firms
and investors to lay off risk. Even so, the concern was that it was not
clear how the evolving financial system would perform under stress.
Under Secretary of the Treasury for Domestic Finance Robert Steel talked
to Treasury staff about the challenge of trying to figure out in advance
how correlations between asset classes would change in a crisis. He
pointed out that before the terror attacks of September I l, 2001, a
reasonable way to diversify a real estate portfolio would have been to
invest in high-rise office buildings in different cities, but that the
returns on these investments suddenly became correlated in the wake of
the attacks. The same would be likely to happen in a time of financial
crisis: financial structures that had worked before would break down in
unexpected ways.

Finally, Secretary Paulson and Under Secretary Steel tried hard in
the fall of 2006, but did not succeed, in getting a reform bill through
Congress that would give the GSEs’ regulator, the Office of Federal
Housing Enterprise Oversight (OFHEO), more power to limit the activities
of the two major GSEs, Fannie Mae and Freddie Mac. The push on this
issue came over opposition from some White House staff, who took the
reasonable position that no deal on GSEs was better than one that
appeared to strengthen these firms’ implicit government backing
without fully empowering their regulator.

My own introduction to the building credit bubble came at a talk I
gave early in 2007 to a group of financial industry participants in
commercial real estate–the firms that build, fund, and invest in office
buildings, factories, shopping centers, and apartments. Participants
told me that there was such incredible liquidity in the market that any
project that could be dreamed up could be financed. Although this talk
was alarming, economic indicators seemed to back it up: GDP growth had
slowed in the second half of 2006 but looked to be strong again in 2007
(as it proved to be in the middle two quarters of the year), and the
labor market upswing that had taken hold in mid-2003 remained in force.
Indeed, Secretary Paulson’s public message was that growth had been
unsustainably strong and that it would be no surprise to have a period
of slower growth as the economy settled into a more normal pattern.

By early 2007 we at the Treasury were well aware of the looming
problems in housing, especially among subprime borrowers as foreclosure
rates increased and subprime mortgage originators such as New Century
went out of business. Under Secretary Steel took the lead in organizing
a series of interagency meetings to discuss the situation. As part of
this, he asked for forward-looking analysis on housing prices, home
sales and starts, and foreclosure rates–how bad would it get and what
would be the economic implications? Economists at the Treasury and the
Fed separately did empirical work relating foreclosures to economic
conditions such as the unemployment rate, housing prices, and past
foreclosure rates. (The Fed work looked at a panel of pooled state data;
the Treasury’s approach was a time-series model, looking at the
nation as a whole and at key states with high or rising foreclosure
rates: the Midwest, the Gulf Coast, and bubble states such as California
and Florida.) At the Treasury, we then used Blue Chip forecasts for
future economic data and ran a dynamic forecast of future foreclosures.
The prediction we made at an interagency meeting in May 2007 was that
foreclosure starts would remain elevated and the inventory of foreclosed
homes would continue to build throughout 2007, but that the foreclosure
problem would subside after a peak in 2008.

What we at the Treasury missed was that our regressions did not use
information on the quality of the underwriting of subprime mortgages in
2005, 2006, and 2007. This was something pointed out by staff from the
FDIC, who had already (correctly) reported that the situation in housing
was bad and getting worse and would have important implications for the
banking system and the broader economy.

As shown in figure 1, which is from the Fed’s July 2008
Monetary Policy Report to the Congress, default rates on subprime
adjustable-rate mortgages (ARMs) originated in 2005, 2006, and early
2007 were substantially higher than in previous years, and the defaults
were coming quickly, within months of origination. The problems were
baked into the mortgage at origination in a way that they had not been
before 2005; they were not a function of the cooling economy, except in
the sense that the end of easy mortgage terms and the reversal of home
price gains removed the possibility of refinancing for subprime
borrowers. It is interesting to note as well that the default rates in
figure 1 do not have an inflection point upward at the 24-month mark,
when the interest rate typically adjusts upward in a “reset.”
There was, however, a marked propensity for borrowers to refinance at
the reset date. These facts further indicated that the problem in the
2005-07 loans was the initial underwriting, not the interest rate reset.
It was not that these borrowers could not afford the higher interest
rate after the reset–the rapid defaults suggested that borrowers could
not afford the initial home payment, or perhaps (rationally) did not
want to keep paying the monthly bill once the value of their home had
declined below their mortgage balance.


III. August 2007: The Vacation of the Blackberry

The initial moment for an urgent Treasury-wide response came in
August 2007, when asset-backed commercial paper markets seized up as
investors grew skeptical about the business model of banks’
off-balance-sheet structured investment vehicles (SIVs), which relied on
short-term funding to finance longer-term assets. Many Treasury
officials, including myself, were not in Washington when this crisis
broke. I was in Rehoboth Beach, Delaware, where up and down the
boardwalk one could see as many Blackberrys being toted around as tubes
of suntan lotion.

Many papers have since examined the economic and financial factors
that led to the crisis; Markus Brunnermeier (2009) provides a
discussion. Within the Treasury, the financial market disruption was
seen as the aftermath of twin credit and housing bubbles, with repricing
of risk across asset classes and consequent deleveraging across
financial institutions coming about as information on the poor
underwriting quality in the past several years became more widely
understood (this is discussed in detail by Gorton 2008), and as several
financial institutions announced dismal results reflecting losses from
subprime lending.

Two main policy proposals aimed at calming the financial markets
emerged from the August episode: the so-called Master Liquidity
Enhancement Conduit (MLEC), or “Super SIV,” a common vehicle
in which banks would hold their illiquid assets, and a mortgage
information database that would provide individual loan-level
information on the quality of underwriting and subsequent performance of
mortgages, and thereby facilitate analysis of complex MBSs and their
derivatives. Neither of these efforts came to fruition, although the
American Securitization Forum (ASF) independently began to work on a
mortgage database under the rubric of their “Project Restart.”
A byproduct of the August credit meltdown that did come to fruition was
the formation of the Hope Now Alliance aimed at reducing foreclosures.
This is discussed further below.

The idea behind the mortgage information database was to directly
address the lack of transparency and information behind the August
lockup of the markets for asset-backed securities. A database could be
organized to provide market participants with loan-level information on
mortgage origination and ongoing performance. The data would be
anonymously tagged with an identification number akin to a CUSIP on a
security. This could be done on a forward-looking basis for new
mortgages as they were securitized into MBSs, or on a backward-looking
basis for existing MBSs. The latter would be much more difficult:
servicers were already overwhelmed by the volume of loan modification
requests and did not want to be diverted by a backward-looking project.
Investors could use the information in the database to analyze the
performance of MBSs and collateralized debt obligations (CDOs)
containing the mortgages, allowing analysis to pierce the complexity of
these arrangements (as I put it in a speech in February 2008).
Ultimately, the database would allow investors to assess the performance
of mortgages originated by particular firms or even particular loan
officers. This would create a “reputational tail” so that
originators would have a connection to the future performance of
mortgages even after they had been offloaded from their books through
securitization. This reputational tail could be a less intrusive
alternative to the suggestion that lenders be required to keep a piece
of any loans they originate–that they have “skin in the
game.” A database could also help overcome the informational
problem posed by second liens, which are often not visible to the
servicer of the first mortgage and pose an obstacle to loan
modification. What was surprising was that this database did not exist
already–that investors in MBSs had not demanded the information from
the beginning.

With the freeze of the asset-backed commercial paper market leaving
assets stuck in banks’ SIVs, officials in the Treasury’s
Office of Domestic Finance developed the MLEC plan as a temporary
“bridge” structure to give participating institutions time to
reprice and reassess risk. The idea was that the value of the complex
securities held by bank SIVs was not well understood and that it would
be useful for institutions to hold their illiquid assets in a common
pool until there was more clarity on performance. An orderly disposal of
the illiquid assets, it was thought, would avoid banks having to sell
off assets into a thin market at fire-sale prices. Under the MLEC
proposal, banks would have agreed on a multilateral pricing mechanism
for the illiquid assets and taken pro rata shares of a common pool,
which would have then turned into something close to a buy-and-hold
investment vehicle, with the intent being to unwind the portfolio as
markets stabilized. The MLEC concept implicitly rested on the assumption
that trading had ground to a halt because uncertainty about asset
performance gave rise to a liquidity premium. The metaphor of choice was
“mad cow disease”: investors could not tell which asset-backed
securities were toxic, so they chose not to touch any of them. MLEC
would have provided a breathing space under which conditions would
return to some new “normal” (not a new bubble), and bid-ask
spreads would have narrowed and trading naturally resumed. Of course,
such a pause is of little use if the problem is fundamentally one of
insufficient capital, not liquidity-as turned out to be the case.

Officials in the Office of Domestic Finance brought together market
participants at a Sunday meeting at the Treasury to discuss MLEC. The
meeting and the whole MLEC concept were something of a mystery to many
Treasury senior staff–including me. MLEC was seen within the Treasury
and portrayed to the world as a private sector solution. Some doubtful
banks, however, saw it as something being forced on them; indeed, a
number of economists at investment banks wondered if the supposed
utility of the idea in the first place rested upon a violation of the
Modigliani-Miller theorem (meaning that they did not see the utility).
MLEC never got off the ground; in the end, banks preferred to take the
SIV assets back onto their balance sheets–thus demonstrating the
tenuous nature of the off-balance-sheet treatment in the first place.
When the banks in the end chose to deal with the problem on their own,
the MLEC episode looked to the world, and to many within the Treasury,
like a basketball player going up in the air to pass without an open
teammate in mind–a rough and awkward situation. Ironically, the
Treasury bank rescue plan unveiled by the Obama administration in late
March 2009 had elements of MLEC in that institutions are supposed to
partner with the federal government to purchase pools of assets. That
version, however, has the (huge) advantage of being able to fund the
purchases through low-cost government financing, with taxpayers assuming
much of the downside risk.

IV. Housing Policy and Foreclosure Avoidance

Throughout 2007, staff at the Treasury and other government
agencies prepared numerous analyses and memos on the situation in
housing. There was a keen awareness of the serious problems facing
households with subprime mortgages, and a rising concern that households
with prime mortgages would soon exhibit a similar pattern of rising
delinquencies and foreclosures. It was also clear that there were two
types of housing problems. In some states in the Midwest and along the
Gulf Coast, high delinquency and foreclosure rates reflected weak
economies or the continued aftermath of the 2005 hurricanes. This was a
traditional problem, in which the causality ran from the economy to
housing. The other problem was found in states that were on the downside
of housing bubbles, notably Arizona, California, Florida, and Nevada. In
these areas, foreclosures reflected the steep declines in home prices
and limited availability of credit for marginal buyers, which together
put at risk subprime borrowers who had bought homes in 2004 to early
2007 in the expectation that rising home prices would give them equity
with which to refinance out of their subprime adjustable-rate mortgages
(ARMs). The end of the bubble had closed off this option and left
borrowers in danger.

Rising foreclosure rates among subprime borrowers led to
pressures-both political and economic–for the Treasury and the
administration to do something to assist families at risk of
foreclosure. The chairman of the FDIC, Sheila Bair, correctly identified
the rising foreclosure problem early on and pushed for the
administration to take action.

IV.A. Initial Measures

Housing policy was seen as involving two main dimensions: a
“forward-looking” one relating to measures that would boost
demand for housing, including through housing-specific policies such as
a tax credit for homebuyers (possibly first-time buyers only) or as part
of an economy-wide stimulus, and “backward-looking” policies
to help existing homeowners at risk of foreclosure. The
administration’s response to the housing crisis as of September
2007 included three main proposals, all requiring congressional action.
All three might have been worthwhile–indeed, all eventually were
enacted in one form or another–but they were dissatisfying in their
limited scope.

The first proposal was a set of changes to the legislation
governing the Federal Housing Authority (FHA) that would allow
additional low- and moderate-income homeowners to refinance into
FHA-guaranteed loans. (1) This was on top of a program known as
FHASecure, which allowed refinancing by borrowers who had become
delinquent because the interest rate on their ARM had increased. All
together, the proposals involving the FHA were seen as helping perhaps
500,000 families. The FHA had gained substantial market share as private
sector subprime lending disappeared in 2007, and there were concerns
that the agency was near its capacity, not least because Congress had
not approved funding requested by the administration to update its
computer systems.

The second proposal was a change to the tax code, eventually
enacted, that forgave the tax due from a borrower whose debt is canceled
by the lender, for example when a borrower walks away from a home
without paying off the mortgage. The existing tax law treated this
reduction in debt as income to the borrower. This change did not boost
housing demand or prevent foreclosures but was seen as avoiding an
unfair tax bill for people who had just lost their home.

The third proposal was the long-standing effort by the
administration to improve the regulation of Fannie Mae and Freddie Mac.
The idea was that a strong and independent regulator could better ensure
the safety and soundness of the two companies, thereby helping ensure
that they had the financial wherewithal to provide continued financing
to mortgage markets. GSE reform was finally enacted as part of the
summer 2008 housing bill, by which time it was too late to avert
insolvency at the two firms.

The initial focus of housing policy was on the difficulties faced
by homeowners in subprime ARMs who were facing an interest rate reset,
typically two years (but sometimes three years or more) after
origination. The concern by mid-2007 was that many families would not be
able to afford the resulting higher payments. (The term “payment
shock” was used, although this is a misnomer of sorts, since the
interest rate hike was not a surprise but instead the central feature of
the mortgage.) FDIC Chairman Bair, for example, argued that up to 1.75
million homeowners could benefit from keeping the interest rate on these
subprime mortgages unchanged rather than allowing the rate to reset.
Although we at the Treasury agreed that about 1.8 million subprime ARMs
would face resets in 2008 to 2010, our assessment was that the driver of
foreclosures was the original underwriting, not the reset. Too many
borrowers were in the wrong house, not the wrong mortgage. Moreover, as
the Fed cut interest rates in late 2007, the rates to which mortgage
resets were tied came down as well, reducing or even eliminating the
payment shock for many subprime borrowers. This meant that preventing
interest rate resets was not likely by itself to avert many

IV.B. Hope Now

To better identify avenues for effective solutions, the Treasury
convened meetings in the fall of 2007 with groups of housing industry
participants, including lenders, servicers, nonprofit housing
counselors, and organizations representing investors in MBSs. What
became apparent through this dialogue was that frictions and
communication gaps between housing industry participants meant that some
homeowners faced foreclosure unnecessarily. The Hope Now Alliance was
formed to address these issues.

The Hope Now Alliance was launched by the Department of Housing and
Urban Development (HUD) and the Treasury on October 10, 2007. As the
organization puts it on its website, Hope Now is an alliance among
HUD-approved counseling agents, mortgage companies, investors, and other
mortgage market participants that provides free foreclosure prevention
assistance. The Treasury saw an important part of the initial work done
through Hope Now as basic “blocking and tackling” (football
was a preferred source of metaphors in the Paulson Treasury) in getting
industry participants to work together and with borrowers more smoothly.
The first step in avoiding a foreclosure is for the servicer and
borrower to talk to one another, but this was not happening in a
surprisingly high proportion of instances: some estimates were that half
of foreclosures started without any contact between the borrower and the
lender or servicer. Failures of outreach were observed in all
directions: servicers were frustrated at the low response rate of
borrowers to their letters and phone calls, while many borrowers who did
reach out on their own found it difficult to get to the right person for
help at their servicer or lender. In some cases they could not get help
until they were already substantially delinquent, even if they had seen
the problem coming. Nonprofit housing counselors had a valuable role to
play, since they were often seen by borrowers as a neutral party, and
tended to report higher response rates from at-risk borrowers. But
counseling was something of a patchwork, with uncertain funding and
unclear relationships between counselors and lenders. Counselors would
tell the Treasury that they worked well with some lenders and servicers
but could not get in the door at others; servicers had similar issues
with uneven relationships in the other direction. For their part,
servicers were still hesitantly exploring the legal room they had to
modify loans, and they faced resource constraints in that their
contracts did not envision the need for large-scale modification efforts
to avoid foreclosures. (2)

Hope Now brought together the leading subprime servicers, national
counseling agencies (including the highly regarded NeighborWorks
organization), and industry and investor trade associations such as the
Mortgage Bankers Association, the Financial Services Roundtable, the
Securities Industry and Financial Markets Association, and the ASF. The
inclusion of industry associations was helpful, providing a channel
through which to bring together firms across the housing ecosystem.
Getting the servicers involved was essential, since they were the point
of contact between the industry and individual borrowers. From the
outset, servicers accounting for about half of subprime mortgages
participated in Hope Now; this grew to cover better than 90 percent of
subprime and 70 percent of all loans by mid-2008. (The potential
coverage is limited because some banks service their own mortgages.)
This effort was backstopped by intense involvement of Treasury staff
(particularly Neel Kashkari, then a senior adviser to Secretary Paulson
who had come up with the idea) and substantial personal involvement by
Paulson himself. Participants in Hope Now committed to creating a
unified plan to reach homeowners and help them avoid foreclosure.

Hope Now initially focused on outreach–the blocking and
tackling-with the goal of reaching troubled borrowers early enough so
that a loan modification could at least be contemplated. A national
foreclosure counseling hotline (888-995-HOPE) was set up, along with a
publicity campaign to advertise it, featuring public service
announcements and public events with government officials, including
President Bush. Hope Now arranged for servicers to provide funding for
the nonprofit counselors (who had previously relied on government and
foundation resources), standardized communication protocols between
counselors and servicers, and collected systematic data on the number of
people helped and the modifications made. Participants in Hope Now
agreed to provide subprime borrowers with information about their reset
four months in advance, and to send high-visibility letters to all
borrowers who became 60 days delinquent, urging them to call the Hope
Now hotline. This kind of outreach sounds basic, but it was
unprecedented for the industry. Hope Now reported that the call volume
on its hotline surged in late 2007 and into 2008.

The next step was to follow up these activities with a systematic
approach to help at-risk borrowers refinance or obtain a loan
modification that would avoid a foreclosure. The fundamental goal was to
“avoid preventable foreclosures.” As Secretary Paulson and
others were to say repeatedly, this meant that the Treasury was looking
for ways to help homeowners who were struggling with their mortgage
payments but both wanted to stay in their home and had the basic
financial wherewithal to do so. “Wanting to stay” meant that
the homeowner would not walk away from a home as long as he or she could
afford the monthly payment. “Basic financial wherewithal”
meant that the Treasury’s efforts were aimed at getting mortgage
servicers to modify loans for homeowners with subprime ARMs who could
afford their payments at the initial (pre-reset) interest rate, where
the cost to the beneficial owner of the mortgage of modifying the loan
was less than the loss that would be suffered in a foreclosure. Not
every foreclosure could be prevented through a modification–after all,
over 600,000 foreclosures occur in a “normal” year. But we at
the Treasury wanted to make sure that no borrowers got foreclosed on who
could afford to stay in their home under the set of circumstances above.
The loan modifications were part of the solution and would complement
other efforts to enable homeowners to refinance into fixed-rate loans,
whether through the FHA or through a private lender.

Through Hope Now, the Treasury pushed lenders and servicers to
undertake a calculation that balanced the cost (in net present value) of
a modification that would keep a family in their home against the loss
to the mortgage owner that would be suffered in a foreclosure–from
legal fees, possible damage to the home, the resale consequences for a
bank trying to sell a foreclosed home in a declining market, and the
fact that putting the house up for sale would further depress home
prices. When this net present value calculation indicated that it made
sense to modify the loan, the Treasury–and Secretary Paulson
personally–expected lenders to do so to avoid foreclosure. The Treasury
also pushed servicers to ensure that loan modifications were of a long
enough duration to give borrowers a chance for the income growth and
home price appreciation that would allow them to refinance permanently
into a conforming fixed-rate loan.

Although these modifications were in everyone’s best interest,
they did not appear to be taking place on the scale that would be
expected. The impact of second liens was one reason, since these make it
difficult for the servicer of the first lien to get agreement on a
modification–and in the case of piggyback second loans, it meant that
the borrower was in much worse financial shape than would be indicated
by the first lien alone and thus less likely to be able to sustain even
a modified first mortgage. Addressing the frictions in the modification
process turned out to be an ongoing project at the Treasury.

The goal, again, was a modification that would lower the monthly
payment to an amount that the borrower could afford. Some borrowers
might still walk away from their homes because they were deeply
underwater, while others would have such a severe mismatch between
mortgage and income that it made more sense from the point of view of
the mortgage owner to foreclose. Servicers would structure loan
modifications to lower an at-risk borrower’s monthly payment in the
way that imposed the least cost on the beneficial owner of the mortgage.
Given simple bond mathematics, this meant that servicers would first
reduce the monthly payment by extending the loan term out to 30 or 40
years; then, if necessary, lower the payment further by cutting the
interest rate; and only as a last resort lower the principal (and then
only if the contract governing the servicer allowed for a principal
reduction, which was not always the case).

If a homeowner could not sustain payments at the initial interest
rate, the view at the Treasury was that this person was probably in the
wrong home. The Treasury asked lenders to look at each situation, but we
recognized that, as Secretary Paulson put it, many such homeowners would
become renters.

The loan modification approach thus focused on people with payment
and income problems, not on underwater borrowers. Since mortgages in
many states do not allow the lender recourse to claim a borrower’s
assets beyond the home collateralizing the mortgage, this meant that
many underwater borrowers might walk away and allow foreclosure even if
they could afford their monthly payment. Not everyone would do so: a
household with a mortgage equal to 105 or 110 percent of their home
value might well stay if they could afford the monthly payment–they
might like their neighborhood or the local school, for example, or hope
to see prices rebound. But it was quite rational for a person who got
into a home with little or no equity and then suffered a 40 or 50
percent price decline to walk away. Being underwater thus made a
foreclosure more likely but was not a sufficient condition. The Treasury
did not expect banks to modify loans where borrowers could afford the
payment but were balking at paying because they were underwater–quite
the opposite: Secretary Paulson’s view was that a homeowner who
could afford the mortgage but chose to walk away was a speculator.

As a practical matter, servicers told us, reputational
considerations meant that they did not write down principal on a loan
when the borrower had the resources to pay–never. They would rather
take the loss in foreclosure when an underwater borrower walked away
than set a precedent for writing down principal, and then have to take
multiple losses when entire neighborhoods of homeowners asked for
similar writedowns.

We also realized that the prospect of assistance could lead
borrowers who were not in difficulty to stop making payments in order to
qualify for easier terms. Such moral hazard is unavoidable, but one can
choose the screens and hurdles that borrowers must pass to qualify for a
modification. The trade-off is that steps to limit moral hazard also
limit take-up.

IV.C The Debate over Subsidizing Foreclosure Avoidance

The Treasury expected lenders to go up to the line, making
modifications wherever the net present value calculation favored it. But
there was no public money on the table to get them to go further? Even
though we realized that there was no appetite in Washington for crossing
the line, Treasury economists in October 2007 developed plans for two
types of policies to put public resources into foreclosure prevention.

The first policy focused on underwater borrowers, with the federal
government in effect writing checks in cases where lenders were willing
to take a write-down. The lender had to take a loss on the principal,
after which the federal government would subsidize the cost of a
guarantee on the modified loan–this could in effect be a substantial
subsidy because these would be loans to borrowers who were still quite
risky. The borrower would be required to pay part of the annual premium
for the federal guarantee. This arrangement was broadly similar to the
Hope for Homeowners program later developed jointly by the Fed and
congressional staff, but with more realistic parameters for servicers
and without the pretense that no federal spending was involved. The plan
was known at the Treasury as the “GHA,” a reference both to
its operation through a dramatic expansion of the FHA in putting
guarantees on mortgages to risky borrowers, and to one of the main
authors of the idea, Deputy Assistant Secretary for Microeconomic
Analysis Ted Gayer, who was at the Treasury for a year on leave from
Georgetown University’s Public Policy Institute.

The second type of policy focused on affordability and involved a
matching federal subsidy to lenders willing to lower interest rates in
order to reduce the monthly payments for at-risk borrowers. (4) The
approach was based on the bond math above that the most cost-affordable
way to lower monthly payments, after extending the term, was to cut the
interest rate, and on the straightforward notion that the government
should pay lenders and servicers to do what it wanted them to do. In
this case the federal government wanted them to lower interest rates to
avoid foreclosures on at-risk borrowers, and therefore it would give
them a financial incentive to do so and no financial incentive to put
people into foreclosure. Lenders would have to fund the first 50 basis
points of the interest rate reduction, to give them an incentive to
screen out marginal cases where they should just modify the loan without
any subsidy, after which the federal government would pay half the cost
of lowering the interest rate up to a total of 450 basis points; thus,
the lender would fund a maximum of 250 basis points and the federal
government 200 basis points. Lenders could reduce interest rates further
on their own without an additional subsidy, but the presumption was that
a borrower who needed more than a 450-basis-point reduction was in the
wrong home. If a borrower defaulted after the modification, the federal
subsidy would end–the government would pay for success, not for
failure. The subsidy would end after five years, long enough of a
breathing space for borrowers to have income growth and home price
appreciation and thus be in a position to refinance into a fixed-rate
loan. The trade-off involved in setting this time limit is clear: a
longer subsidy than five years gives people more time to ensure that
they can afford the home after the subsidy ends, but it means a more
expensive modification for the lender and thus less uptake–fewer people
would get into the program, but more of those who did would be saved. We
saw five years as striking the right balance, and our analysis showed
that several million homeowners could avoid foreclosure with this
interest rate subsidy.

The initial reaction to the proposed interest rate subsidy among
Fed staff responsible for analysis of housing policy in October 2007 was
disinterest, because the plan did not address the problem of underwater
borrowers on which they were focused (as shown by the Hope for
Homeowners approach the Fed helped to develop). We agreed that the
subsidy would not be enough of an incentive to dissuade a deeply
underwater borrower-say, one with a loan of 150 percent of home
value–from walking away. But our view was that there was a government
budget constraint (even if many outside critics charged that the Bush
administration did not act like it), and it was not a wise use of public
resources to write huge checks to people who could afford their homes
but might then choose not to stay in them. This view, unlike the
secretary’s assertion that a person who would walk away was a
speculator, was based on practical, not moral, grounds: it would be
better at the margin to use taxpayer dollars to hire more preschool
teachers, say, than to subsidize deeply underwater borrowers.

While the Fed staff was focused on underwater borrowers, within the
administration–among White House staff in particular, but also within
the Treasury–many were unwilling to put public money on the line to
prevent additional foreclosures, because any such program would
inevitably involve a bailout of some “irresponsible”
homeowners. Put more cynically, spending public money on foreclosure
avoidance would be asking responsible taxpayers to subsidize people
living in McMansions they could not afford, with flat-screen televisions
paid for out of their home equity line of credit. The policy rationale
to spend public money is clear in that there is a negative externality
from foreclosures to home inventories and thus prices. But the public
opposition to such bailouts appeared to be intense-ironically, many
people were already angry at the Treasury for supposedly bailing out
irresponsible homeowners through Hope Now, even though this did not
involve explicit public spending.

Congress appeared to heed this opposition as well: there were
constant calls for the Treasury and the administration to do more on
foreclosure prevention, but this was just rhetoric. Until the FDIC came
out with a proposal late in 2008, there was no legislative support to
spend public money to actually prevent foreclosures–the congressional
proposal discussed below ostensibly did not use public funds. And as
discussed below in relation to the TARP, even in the fall of 2008,
Congress’ desire was for the Treasury to spend TARP money for
foreclosure avoidance. Members of Congress did not want to have to vote
specifically to spend money on this, suggesting that they understood the
poor optics of having the government write checks when some would find
their way into the hands of “irresponsible homeowners.”

In 2007 and through the middle of 2008, the focus of legislative
energies was on the so-called Frank-Dodd legislation, which became law
on July 30, 2008, as part of the Housing and Economic Recovery Act of
2008 (which included provisions to reform the GSEs). This proposal,
named for its main sponsors Congressman Barney Frank (D-MA) and Senator
Christopher Dodd (D-CT), involved FHA-guaranteed refinances of mortgages
for which lenders were willing to write down the loan principal to 87
percent of the current market value. This was a great deal for the
homeowner, who would face lower payments and gain substantial equity
(while having to share some of these gains with the federal government
on a future sale), but a huge write-down for the lender, actually
exceeding 13 percent in instances where home prices had declined since
origination. And there was ostensibly no government money involved, as
the legislation required the GSEs to cover any costs–again
demonstrating the reluctance of policymakers to be seen as writing
checks to irresponsible homeowners. The Congressional Budget Office
(CBO) estimated that the Frank-Dodd approach would help some 400,000
homeowners. Having heard directly from lenders about their reluctance to
reduce loan principals, we saw the CBO estimate as optimistic by
400,000. Because the bill included legislation to strengthen the
regulation of the GSEs, however, President Bush signed it into law.
Staff from the FHA, HUD, the Fed, the Treasury, and the FDIC made an
immense effort to implement the new Hope for Homeowners program-and then
unfortunately the Treasury’s estimate of participation turned out
to be correct, with few loans refinanced through the middle of 2009.

As before, avoiding more foreclosures required someone–either the
government or lenders–to write a check. The attraction of the so-called
bankruptcy cramdown proposal, under which bankruptcy courts could
retroactively change mortgage contracts by reducing the loan principal,
was that it appeared to be “free”–which it was to the
government–but only because the cramdown would be a forced transfer
from lenders to homeowners. The Treasury opposed the cramdown proposal
out of concern that abrogating contracts in this way would have
undesirable consequences for the future availability of credit,
especially to low-income borrowers. Some current borrowers would benefit
from having their mortgage balance reduced, but future borrowers would
find it more difficult to obtain a loan.

IV.D. The ASF FastTrack Framework

With subsidies still off the table, what was done with respect to
foreclosure avoidance in late 2007 and into 2008 was that the Treasury
and Hope Now worked with the ASF to make modifications happen faster and
more frequently. This turned into the Streamlined Foreclosure and Loss
Avoidance Framework announced on December 6, 2007. This initiative
focused on approximately 1.8 million subprime ARMs with initial teaser
rates set to reset in 2008 and 2009. Servicers agreed to carry out a
fast-track process to help borrowers refinance into a fixed-rate loan
(the first choice for borrowers with adequate income and credit
history), or, failing this, to provide a five-year extension of the
initial rate for borrowers who could afford their monthly payment at
that rate. This would give borrowers time to experience income gains and
home appreciation that would put them in a position to refinance into a
fixed-rate loan in the future. A longer modification than five years
would be more costly to a lender, and thus fewer modifications would
pass the cost test. And even a five-year horizon would be a change from
industry practice, which was geared to “repayment
plans”–short-term modifications appropriate for a borrower with a
temporary income problem of a few months. Industry participants
estimated that about one-third of the 1.8 million potential borrowers in
the program could not afford their starter rate, and another one-third
could clearly receive either a refinancing or a rate freeze. The aim was
to save as many as possible of the remaining 600,000, so as to come
close to helping 1.2 million homeowners. The ASF fast-track framework
provided servicers with a set of best practices to implement

The streamlined framework was formally launched in early 2008, but
some servicers began to use it in late 2007. Hope Now reported a
dramatic increase in the number of homeowners receiving help in the form
of a refinancing or a loan modification, from about 300,000 per quarter
in the first half of 2007 to over 500,000 per quarter in mid-2008 and
nearly 700,000 in the last three months of 2008. The increase was
especially noticeable for subprime borrowers, where the number of
long-term modifications rose from fewer than 50,000 per quarter in the
first nine months of 2007 to over 200,000 in the last quarter of 2008
alone. By the end of 2008, nearly half of homeowners receiving help got
long-term modifications rather than short-term repayment plans, compared
with fewer than 20 percent previously. Hope Now was not solving the
foreclosure problem, but it was performing as designed. Moreover, other
homeowners refinanced without the involvement of Hope Now.

The Treasury and Hope Now nonetheless faced continuing criticism
that these efforts were inadequate and that servicers were not doing
enough loan modifications. The Center for Responsible Lending (CRL), for
example, put out a widely cited report on January 30, 2008, claiming
that the “Paulson plan” for voluntary loan modifications would
help only 3 percent of at-risk homes. What was not reported, however,
was that the 3 percent figure was calculated using several unusual
assumptions. First, the denominator, the number of at-risk homes,
included not just owner-occupied homes but also investor properties,
even though the ostensible goal was to save homeowners, not investors.
Second, the numerator–the measure of success–included the loan
modifications but not the refinancings into fixed-rate mortgages, which
were usually better than a modification. Treasury economists who redid
the analysis correcting these questionable assumptions calculated that
at least 30 percent, and possibly more than half, of eligible homeowners
would be helped by the Hope Now framework. The CRL did not correct their
analysis when we quietly pointed out to them the flaws (which their
researchers acknowledged), but neither did the Treasury go out
proactively to the media to dispel the misconception.

As criticisms continued that not enough was being done to prevent
foreclosures, the focus at Treasury turned to coming up with additional
actions through Hope Now that would show that more was being done. Out
of this came the February 12 announcement of “Project
Lifeline,” under which severely delinquent borrowers would be
granted a 30-day pause on foreclosure proceedings, as a last-ditch
breathing space to allow borrowers to work with their lender or servicer
to find a modification that made sense for both sides.

Some hurdles to modifications were difficult to address. Servicers
had varying abilities to deal with the large number of modification
requests. Also, as already noted, the presence of a second lien, such as
a home equity line of credit or a piggyback mortgage, could present a
challenge to a modification on the primary mortgage, since owners of
second liens had an incentive to hold up the process unless they
received a payoff–this even though a second lien on a troubled borrower
was worth only pennies on the dollar, since the primary mortgage holder
would have the first right to the proceeds of a foreclosure sale.

Legal and accounting issues constituted two further hurdles to loan
modifications. Servicers were unclear as to their legal ability to
modify loans within securitization trusts, and they worried that
undertaking too many modifications would lead to an adverse change in
the accounting treatment of the MBSs containing the loans. Financial
Accounting Standards Board statement number 140 provides guidance on
whether a transfer of assets to a securitization trust can receive
off-balance-sheet treatment. The concern was that if too many loans were
modified, this would make the trust no longer a passive structure and
therefore ineligible for off-balance-sheet treatment. SEC Chairman
Christopher Cox indicated that having loans in an MBS trust receive the
five-year rate freeze did not preclude continued off-balance-sheet
treatment so long as it was “reasonably foreseeable” that the
loans being modified were otherwise headed for default. Treasury
economists worked with FDIC staff to analyze loan-level data on subprime
mortgages. The results showed that for subprime borrowers in the years
covered by the Hope Now streamlined approach, it was sadly
straightforward to conclude that a default was reasonably foreseeable.
These results went into a letter from the Treasury to the SEC that was
meant to provide backing for Chairman Cox. The view at the Treasury was
then that servicers had the legal authority they needed to modify loans,
and that there was no need for congressional proposals to enact a
“safe harbor” that would explicitly provide such cover.
Although we realized that the safe harbor provision might have avoided
some lawsuits against servicers who modified loans, our concern was that
it was a retroactive change to contracts–not as obviously harmful as
the mortgage cramdown proposal, but harmful nonetheless in suggesting to
lenders that they should henceforth worry about retroactive changes to

It turned out that the original motivation for the Hope Now
streamlined modification protocol was incorrect, in that interest rate
resets by themselves were not the fundamental driver of rising
foreclosures–a point documented by Mark Schweitzer and Guhan Venkatu
(2009). This can be inferred from figure 1, since the foreclosure rate
does not have an upward kink at the typical reset point at month 24.
Many subprime ARMs started at an initial rate of 8 to 9 percent for two
years and then were scheduled to reset to 600 basis points above the
six-month LIBOR (the London interbank offered rate). By early 2008,
however, LIBOR had fallen to 3 percent or less, so that the step-up in
the interest rates and thus the payment shock were fairly modest. We
nonetheless saw the ASF streamlined modification framework as useful,
since it would be ready in case interest rates rose in the future, and
it was driving modifications for loans even before resets.

IV.E. Housing Policy in 2008

Treasury housing policy by early 2008 had four goals:

–avoiding preventable foreclosures as discussed above;

–ensuring the continued flow of capital into housing markets, both
through efforts to enact reform of the GSEs and by resisting proposals,
such as the bankruptcy cramdown, that would have reduced the
availability of capital for housing finance;

–enabling the necessary housing correction to proceed, which meant
warding off proposals for long-lasting foreclosure moratoriums, which we
saw as simply prolonging the difficulty without providing lasting help
for at-risk homeowners; and

–supporting the broad economy, such as through the January 2008

With little desire on anyone’s part to put public money on the
table, housing policy was to remain largely focused around the debate
over modifications achieved through Hope Now, and over the Frank-Dodd

A recurring theme of policy proposals from outside the Treasury was
that the Treasury should promote shared-appreciation mortgages, in which
homeowners would get a loan modification or financing concessions in
exchange for giving up part of the home’s future appreciation to
the lender. We studied this proposal, which amounted to a
debt-for-equity swap, but concluded that this type of mortgage was not
already common because there was little demand for it.

The one truly new proposal we heard in early 2008 was that of
Martin Feldstein, who in a March 7 op-ed in the Wall Street Journal
(“How to Stop the Mortgage Crisis,” p. A15) and in subsequent
writings proposed stabilizing the housing market by offering all
homeowners a government loan that would be used to reduce the principal
on first-lien mortgages. Such a loan would make it less likely that
homeowners would have negative mortgage equity and thereby reduce future
defaults in the face of continued home price declines. Participating
homeowners would not be able to walk away from the government loan,
because it would be a tax lien that could not be escaped in bankruptcy.
The Feldstein proposal would not help borrowers already facing
foreclosure, but that was not the point–it was meant to arrest the
impact of future potential underwater borrowers walking away from their
homes and adding to inventories, thus intensifying the downward momentum
of home prices. Intrigued, we analyzed the potential impacts, including
looking at the Internal Revenue Service’s record in collecting on
tax liens to get a sense of the budget cost. In the end, however, with
little political support for spending money on risky homeowners, there
was even less prospect of a massive housing program aimed at the
better-off homeowners who were not in imminent danger.

Housing policy was to stay essentially static until later in 2008,
when the $700 billion TARP fund became available and calls grew to spend
part of it on foreclosure prevention. In the fall of 2008, the FDIC
developed two initiatives aimed at foreclosure avoidance. The first was
a roadmap for servicers to follow in modifying loans–a “rood in a
box” as they called it–detailing the calculations needed to
implement the net present value calculation comparing the costs of
foreclosure with those of loan modification. This was based on the
FDIC’s experience with IndyMac, the Los Angeles-area savings and
loan that the agency had taken over on July 11. The IndyMac protocol
involved steps to bring a borrower’s monthly payment on his or her
first mortgage down to 38 percent of pre-tax income (a figure that the
FDIC changed to 31 percent when it found that many borrowers could not
stay current at the 38 percent level). The steps were familiar from the
bond math above: there was no principal writedown but instead a term
extension, interest rate cuts, and principal forbearance, all aimed at
lowering monthly payments. The FDIC approach looked only at the monthly
payment as a share of the first mortgage–the so-called front end
ratio–and not at total loan payments (the so-called back-end ratio)
including a second lien, if present, and any auto loans and credit card
bills. This focus on the front end was done for speed; the idea was to
allow for rapid modification of loans, accepting that some might well go
bad, since a borrower with loaded-up credit cards might ultimately still
default even if the interest rate on the home loan was reduced. This
approach to modifications was a natural extension of the streamlined
protocol developed in late 2007 through the auspices of Hope Now,
although the media did not make this connection and the Treasury did not
press it (that is, the Treasury did not pro-actively note that the Hope
Now activities that so many people had criticized had provided the
groundwork for the widely acclaimed FDIC approach). The GSEs later
adopted much of the approach of the IndyMac protocol in putting out
their own streamlined approach to modifications on November 11, 2008.

The second FDIC proposal for foreclosure avoidance was a
loss-sharing insurance plan, under which the federal government would
make good on half of the loss suffered by a lender that modified a loan
according to the IndyMac protocol but later saw the loan go into default
and foreclosure. This was an innovative margin on which to push: there
was a great deal of anecdotal evidence, later confirmed by statistical
evidence from the Office of the Comptroller of the Currency, that many
loans were going bad even after they had been modified to reduce the
payment. The FDIC plan provided some comfort to a lender for making the
modification, since the lender would be reimbursed for half of the loss
if the borrower eventually defaulted. Housing activist groups such as
the Center for Responsible Lending endorsed the FDIC plan, as did
Elizabeth Warren, the Harvard law professor appointed by Congress to
chair an oversight panel for the TARP. The proposal received a good deal
of coverage in the press, some of which confused the loss-sharing
insurance proposal with the IndyMac protocol, even though the latter
involved no government resources.

At the Treasury, we noted that the FDIC plan gave rise to new forms
of both adverse selection and moral hazard in ways that made it mainly a
windfall for the beneficial owners of mortgages rather than a benefit
for homeowners. In other words, American taxpayers would be providing a
subsidy to banks, hedge funds, and other owners of MBSs (including
foreign banks and foreign hedge funds) rather than to American families.
Under the FDIC proposal, if a servicer modified a loan and the borrower
was able to stay in the home as a result, the owner of the mortgage got
nothing from the government. (5) If, however, a loan was modified
according to the FDIC’s protocol and it went bad, the government
would write a large check to the mortgage owner. Moreover, there was no
deductible on this loss-sharing insurance coverage, so in the case of an
underwater borrower, the government would have in effect been providing
fire insurance on an entire house when several of the rooms were already
engulfed in flames. At the Treasury, we viewed the loss-sharing
insurance proposal as a nontransparent way to funnel money to
institutions that had made bad lending decisions and to investors who
had bought the loans–a hidden bailout. Ironically, however, the New
York Times on November 1, 2008, published an article by columnist Joe
Nocera asserting that the Treasury opposed the FDIC proposal because
“aid is going to homeowners, not giant financial
institutions.” (6)

The confusion in the New York Times column might have reflected a
common difficulty in understanding the impacts of insurance proposals,
since the costs are implicit at the start whereas the payouts are yet to
be realized, and thus the subsidy is somewhat obscured. In this case,
big checks would get written to banks and hedge funds, but only six
months or more down the road as the modified loans defaulted. In
contrast, the interest rate subsidy puts the government resources to
avoid foreclosure in clear daylight–it looks exactly like what it is,
which is writing checks to people who are in homes they cannot afford.
The cost per incremental foreclosure avoided, however, is much less with
the interest rate subsidy. In short, this proposal is more efficient but
suffers from its transparency.

In evaluating the FDIC proposal, Treasury economists suggested that
a way to remove some of the unwanted windfall for lenders was to have
the insurance payout reflect any decline in the area home price index
after the loan modification, rather than the lender’s loss from
foreclosure. Setting the payout in this way would cover the valid
concern that declining home prices gave servicers an incentive to
foreclose sooner rather than give a risky borrower another chance.
Although the FDIC declined to incorporate this suggestion, the Obama
administration eventually made it part of its February 2009 foreclosure
avoidance proposal. A related proposal by Treasury economist Steven
Sharpe (a Fed staffer who came to Treasury for several months to help
with capital markets and housing proposals) was for the federal
government to sell insurance against price declines to home purchasers.
At closing, buyers could pay a fee and receive insurance that
compensated them five years later for any decline in overall home prices
in their area–homeowners would receive the payout, if any, without
having to sell their home. The idea was to boost housing demand going
forward by removing the fear among potential homebuyers of
“catching a falling knife”–that is, buying a home that would
continue to lose value and leave them underwater.

The adverse selection in the FDIC loss-sharing proposal came about
because lenders would naturally want to put into the program those loans
that were most likely to default, so that the government would cover
half of any loss. At the suggestion of the Fed, the FDIC included a
six-month waiting period, which meant that the lender would have to bear
the cost of modifying the loan for six months. The moral hazard came
about because the lender would have a financial incentive to foreclose
immediately after the six-month waiting period. Under the FDIC proposal,
lenders would qualify for this loss-sharing insurance coverage only if
they agreed to apply the IndyMac modification protocol to all loans in
their portfolio–lenders could not choose to include, for example, only
the loans of borrowers that they knew had huge credit card debts. But
this did not change the fundamental incentives; it just meant that
lenders would participate in the program only if the expected value of
the insurance windfall they received to cover losses exceeded the total
cost of the modifications they would be required to fund.

Both the interest rate subsidy developed at the Treasury and the
FDIC’s loss-sharing insurance proposal focused on affordability
rather than on underwater borrowers; we saw this as entirely appropriate
from the point of view of the allocation of government resources. But
the incentive effects of the two proposals were clearly different, since
the interest rate subsidy would be paid only when foreclosure was
avoided, whereas the loss-sharing insurance by its nature would pay out
when foreclosure occurred. Even Elizabeth Warren conceded to Treasury
staff that she understood that banks rather than homeowners would
benefit more from the FDIC plan. She was evidently supporting the FDIC
proposal in public because she thought something had to be done about
foreclosures, and the FDIC plan seemed to be the only one on the table.
The American Bankers Association endorsed the FDIC plan as well;
presumably this reflected their understanding of its impact.

V. The Stimulus of 2008

By October 2007 there were increasing signs that the economy would
remain weak into 2008 and that there was considerable downside risk from
the housing and financial markets. Work began in earnest on fiscal
policy options to support growth. The idea that such action might be
needed was buttressed by public calls for it by prominent economists,
notably Lawrence Summers and Martin Feldstein. Throughout November and
December, the administration’s economic team–the Treasury, the
Council of Economic Advisers (CEA), the Office of Management and Budget,
and the National Economic Council–considered various approaches,
focusing on tax cuts for households and businesses. In the end, the
Economic Stimulus Act of 2008 contained mainly tax cuts, along with an
extension of unemployment insurance benefits. The form of the tax cuts
was remarkably similar to what CEA Chairman Edward Lazear had sketched
out as an initial proposal: rebate checks implemented as a reduction of
the lowest individual income tax rate, and thus mainly an infra-marginal
tax cut, along with additional expensing and bonus depreciation for
businesses. Sending a one-time check to households was not the
administration’s first choice–the view was that a longer-lasting
policy would have more impact. But there was no political prospect of a
permanent tax cut or extending the administration’s 2001 and 2003
tax cuts. This was about tactics–supporting the broad economy while
housing and credit markets continued to adjust–not a strategic approach
to increasing long-term growth.

The stimulus was proposed in early January and signed into law in
mid-February, speeded by the administration’s stipulation that it
would not fight for “Bush-style” tax policy and what seemed to
be a determination by the congressional leadership to get this done
quickly after an initial year in power with only modest accomplishments.
The details of the tax provisions were agreed with the House leadership
late one evening, when only that very morning the Treasury legislative
affairs staff had reported that it could be weeks before a compromise
was reached.

The Internal Revenue Service and the Financial Management Service
within the Treasury worked wonders to push out nearly $100 billion in
rebate checks and electronic payments, with most of the cash going out
the door from April 28 to July 11, 2008. We at the Treasury, at least,
expected the main impact of the stimulus to come from the rebate checks
rather than the expensing provision; with the economy weakening, it was
hard to see much stimulus to business investment from a tax incentive
that amounted to the time value of money. Our expectation was that about
30 percent would be spent in the second and third quarters, rising to 40
percent by the end of 2008. Assuming a modest second-round multiplier,
we tallied up a boost of $50 billion to aggregate demand. With each job
created or preserved corresponding to about $100,000 of income in the
national accounts, a back-of-the-envelope calculation suggested a boost
of 500,000 jobs. Simulations using the private sector Macroeconomic
Advisers model suggested roughly the same impact on employment.

In retrospect, the stimulus appears to have been the right thing
for the wrong reason in that the rebate checks effectively served to
offset the drag from higher energy prices. Looking back in January 2009,
we calculated that higher energy prices in mid-2008 had meant an
unexpected hit to U.S. consumers of about $40 billion–close to the
additional spending we had expected from the stimulus. Others have
disagreed, claiming that the stimulus was simply ineffective. This
remains an important topic for future research. The higher energy prices
hit at precisely the wrong time, causing a downdraft to spending just as
the labor market was finally feeling the impact of slower-than-potential
GDP growth in the latter part of 2007.

VI. Bear Stearns and Plans to Break the Glass

The collapse of Bear Stearns over the weekend of March 14, 2008,
was a watershed event for the Treasury. Until that point the Treasury
had urged financial institutions to raise capital to provide a buffer
against possible losses but had not contemplated fiscal actions aimed
directly at the financial sector. Instead, the main policy levers were
seen as being the purview of the Fed, which had cut interest rates and
developed new lending facilities in the face of events. From the
Treasury side, the deliberations of that weekend were handled directly
by Secretary Paulson working the phones from his home; meanwhile the Fed
provided J. P. Morgan with financing to purchase Bear Stearns. Moral
hazard was a huge concern, but the feeling at the Treasury was that even
when the Bear Stearns transaction was renegotiated up from $2 per share
to $10, the loss of wealth was still large enough to give pause to
market participants and thus mitigate the moral hazard. Of course, moral
hazard derived more broadly from the fact that Bear Stearns’
bondholders and counterparties avoided a loss. But the Treasury and the
Fed saw little alternative to rescuing the firm at that time (or at
least cushioning its fall), simply because the speed of its collapse
left markets unprepared.

A number of lessons of that weekend have received extensive
discussion in the financial press and in the academic literature,
including the role of liquidity (as discussed by Allen and Carletti
2008), the fragilities arising from counterparty risks embedded in the
three-party repo system and the over-the-counter derivative markets, and
the need for a resolution mechanism for troubled nonbank financial
institutions. At the Treasury, two additional lessons were learned:
first, we had better get to work on contingency plans in case things got
worse, and second, many in Washington did not understand the
implications of nonrecourse lending from the Fed. The second lesson was
somewhat fortuitous, in that it took some time before the political
class realized that the Fed had not just lent J. P. Morgan money to buy
Bear Stearns, but in effect now owned the downside of a portfolio of $29
billion of possibly dodgy assets. This discovery of the lack of
transparency of nonrecourse lending by the Fed was to figure prominently
in later financial rescue plans.

The Fed’s March 17 announcement that it would provide loans to
broker-dealers through the new Primary Dealer Credit Facility seemed to
us and many Wall Street economists to remove the risk of another large
financial institution suffering a sudden and catastrophic collapse as a
result of a liquidity crisis. This provided some time to plan for
further events.

Part of the planning was for the long term. On March 31, 2008, the
Treasury released its Blueprint for a Modernized Financial Regulatory
Structure, with a vision for a long-term reshaping of financial sector
regulation. This plan had long been in the works; indeed, Treasury had
requested public comments on the topic in October 2007. However, the
timing of the Blueprint’s release led to press reports that this
was the Treasury’s “response” to the crisis.

More near term in vision was work being done on so-called
break-the-glass options–what to do in case of another major emergency.
This work evolved from a recurring theme of input from market
participants, which was that the solution to the financial crisis was
for the Treasury to buy up the toxic assets on bank balance sheets.
Eventually Neel Kashkari and I wrote a memo listing options for dealing
with a financial sector crisis arising from an undercapitalized system.
The memo went through more than a dozen iterations in discussions around
the Treasury and with Fed headquarters and the New York Federal Reserve
Bank between March and April.

The options were fourfold: buy the toxic assets, turn the Treasury
into a monoline insurer and insure the assets, directly buy stakes in
banks to inject capital, or refinance risky mortgages into
government-guaranteed loans and thus improve asset performance and
firms’ capital positions from the bottom up. With estimates such as
that of David Greenlaw and others (2008) in mind that U.S. financial
institutions would suffer $250 billion of losses from mortgage
securities, we envisioned a government fund of $500 billion. A mix of
asset purchases, capital injections, and additional private capital
raising by banks would allow this amount to roughly offset the expected

These options would move the focus of financial markets policy back
from the Fed to the Treasury, which would be appropriate in that the
problem reflected inadequate capital rather than insufficient liquidity.
But these actions all required congressional action, and there was no
prospect of getting approval for any of this. With economic growth
positive and the stimulus rebates only just beginning to go out in late
April, it was unimaginable that Congress would give the Treasury
secretary such a fund. And it was doubly unimaginable that the fund
could be enacted without immediately being put to use. Such a massive
intervention in financial markets could be proposed only if Secretary
Paulson and Chairman Bernanke went to Congress and announced that the
financial system and the economy were on the verge of collapse. By then
it could well be too late.

For several months in the second quarter of 2008, things seemed to
be improving. The housing adjustment appeared to be proceeding. Prices
continued to fall and construction and sales were still in decline, but
the rate of descent appeared to be slowing, and our view was that by the
end of 2008 housing would no longer be subtracting from GDP. The second
half of 2008 looked to be difficult, but we expected the rebate checks
to support consumption until the drags from housing and the credit
disruption eased and growth rebounded in 2009.

VII. Rescuing the GSEs

The relative quiet was to hold until early summer, when the effects
of the housing collapse manifested themselves in the collapse of IndyMac
and severe pressures on the GSEs, in the form of declining stock prices
and widening spreads on Fannie and Freddie securities, and thus on
mortgage interest rates for potential homebuyers. The FDIC took over
IndyMac and turned the firm into a laboratory for its foreclosure
prevention ideas, but the problems of the GSEs fell squarely in the
Treasury’s court. The Treasury was in a difficult position. GSE
debt and MBSs with GSE guarantees were held throughout the financial
system, and a failure of the firms would have meant chaos in financial
markets. As commentators such as Peter Wallison of the American
Enterprise Institute had long warned, (see, for example, Wallison,
Stanton, and Ely 2004), the GSEs were holding the financial system and
taxpayers hostage–and in mid-July 2008 it seemed they would win the

The options were all unpleasant, and all required congressional
action: to provide the GSEs with more liquidity by raising their line of
credit with the Treasury from $2.25 billion each to something much
larger; to inject capital; or to ask Congress to put the two firms into
conservatorship, with the government running the companies on behalf of
their shareholders (which would eventually be mainly the government).
This last option could be done under existing legislative authority but
still required congressional approval, and the GSEs could have fought
this and might well have won, since their regulator had said as recently
as July that the two firms were adequately capitalized. (This statement
referred to statutory definitions of capital, which included tax assets
that could only be monetized in the future when the firms became
profitable again, but it nonetheless carried weight.) Moreover, even
putting the GSEs into conservatorship raised questions about whether
their $5 trillion in liabilities would be added to the public balance
sheet. This did not seem to Treasury economists to be a meaningful
issue, since the liabilities had always been implicitly on the balance
sheet–and in any case were matched by about the same amount of assets.
But the prospect that rating agencies might respond by downgrading U.S.
sovereign debt was unappealing. A fourth option, receivership, would
involve liquidating the companies and was deemed off the table because
it would have required winding down the GSE portfolios. These portfolios
were the source of the systemic risk arising from the GSEs’
activities, but the GSEs’ purchases of MBSs were important for
ensuring the availability of financing to potential homebuyers.
Addressing the portfolios would have to wait for a longer-term reform.

In the end, Secretary Paulson went to the steps of the Treasury
building on Sunday, July 13, and proposed “all of the above”:
the power to give the GSEs both liquidity and capital in amounts that
would make clear to market participants that the U.S. government stood
behind the obligations of these companies. He asked Congress to raise
the GSEs’ lines of credit; to authorize unlimited (subject to the
statutory debt ceiling) direct Treasury purchases of GSE securities,
including both their MBSs and their common stock, through the end of
2009, to ensure that the firms could fulfill their missions with respect
to housing markets; and to give their regulator, OFHEO, the power of
conservatorship and other authorities that the administration had long
sought. The Treasury would insist on terms and conditions to protect the
taxpayer if public money were ever put into the firms. These powers were
requested with the idea that the firms’ liquidity crunch reflected
a lack of market confidence that a show of Treasury support could
assuage–that standing behind the firms would calm market fears and
avoid the need for a bailout. (The secretary’s unfortunate
phrasing, at a July 15 congressional hearing, about having a
“bazooka” in terms of the financial ability to stand behind
the firms was to be repeated constantly in the media in the months to

The Fed authorized bridge lending to Fannie and Freddie while
Congress worked on the legislation, which was enacted on July 30, 2008
(and which included the Hope for Homeowners program). Some market
participants complained that the rescue did not distinguish between
senior and subordinated debt but instead made both of them whole,
whereas many participants had expected the subordinated debt not to be
included within the rubric of a guarantee. However, the view at the
Treasury was that simplicity and clarity were paramount (although, of
course, clarity is sometimes in the eye of the beholder).

This effective hardening of the heretofore-implicit guarantee of
the GSEs left mixed feelings among Treasury staff. A crisis had been
forestalled with a flurry of weekend activity (soon to become a regular
part of the Treasury workweek), but the outcome seemed to cement in
place the awkward status of the GSEs and their ability to privatize
gains and socialize risk by borrowing at advantageous terms under the
shelter of a now-explicit government guarantee. Past Treasury
departments across administrations had sought to remove the implicit
guarantee, not to harden it. At a dinner in Cambridge, Massachusetts, on
Thursday, July 24, 2008, to honor Martin Feldstein, outgoing president
of the National Bureau of Economic Research, many people expressed to me
directly their misgivings about what looked like a bailout, in which GSE
bondholders and shareholders won and taxpayers lost. It was hard to

It turned out that Secretary Paulson had the same misgivings. The
following Monday, July 28, he instructed Treasury staff to analyze the
capital situations of the GSEs. To protect taxpayers in the case that an
actual investment was needed in the future, he wanted to know first if
these firms were solvent. The Treasury’s Office of Domestic Finance
engaged a topnotch team from Morgan Stanley to dig into Fannie and
Freddie’s books and assess their financial condition. While this
was happening, it became apparent that the July 13 announcement and
subsequent legislation had left markets uncertain about the status of
the enterprises. The GSEs had access to private sector debt funding,
although with increased costs, as the spreads on five-year Fannie
benchmark agency debt above Treasuries rose from about 65 basis points
in early June to 94 basis points on September 5, just before the firms
were put into conservatorship. But the common stocks of the two firms
continued to decline. Market participants were in effect saying that
they (mostly) believed that the government stood behind the debt and
guarantees on the MBSs, but were not confident that the firms were
solvent. This was not Secretary Paulson’s intent–he did not
deliberately set up the GSEs to fail and get them into conservatorship.
The weeks in July and August were tense ones within the Treasury, as
markets deteriorated while waiting for more clarity on Fannie and
Freddie. It looked to market participants as if there was no guidance,
but this was because we were busy working–and Secretary Paulson was
willing to suffer for a few weeks in order to have his next step come
out right.

The Morgan Stanley team came back several weeks later in August
with a bleak analysis: both Fannie and Freddie looked to be deeply
insolvent, with Freddie the worse of the two. In light of the
firms’ well-publicized accounting irregularities of previous years,
Treasury staff were especially amazed that the GSEs appeared to have
made accounting decisions that obscured their problems. With
receivership still an undesirable outcome because it would imply
prematurely winding down the retained portfolio, the Treasury worked
with the GSEs’ regulator (formerly OFHEO, the July legislation
having merged it with the Federal Housing Finance Board to create the
Federal Housing Finance Agency, or FHFA) to set out an airtight case of
insolvency that warranted putting the firms into conservatorship. The
July legislation allowed to do this without consulting Congress,
although no one had contemplated actually using that power so rapidly.
Even though the analysis from Morgan Stanley was clear, it took some
time to bring the FHFA examiners on board–it seemed difficult for them
to acknowledge that the firms they had long overseen had gone so wrong,
and it would have been awkward for the head of FHFA to decide on the
conservatorship over the objection of his senior career staff. It was
also necessary to convince the management of Fannie and Freddie to
acquiesce without a legal fight. There was no expectation of a problem
with Freddie’s management–the CEO had publicly expressed his
fatigue with the whole situation–but Fannie appeared then to be in
somewhat better financial shape and might reasonably have expected to be
treated differently than Freddie. Ultimately, Secretary Paulson had a
trump card: he could say in public that he could not in good conscience
invest taxpayer money in these firms, and that would doubtless spark
their demise. But in the end he did not have to play this card. In
well-publicized meetings with Secretary Paulson, Chairman Bernanke, and
FHFA Director James Lockhart, both firms acceded to conservatorship,
which was announced on Sunday, September 7, 2008.

The Treasury announced three measures jointly with the
conservatorship decision: so-called keepwells, under which the Treasury
committed to inject up to $100 billion of capital each into Fannie and
Freddie as needed to ensure their positive net worth; a Treasury lending
facility if needed; and a program under which the Treasury would
purchase the GSEs’ MBSs in the open market. This last program was
mainly symbolic–a demonstration by the Treasury that the obligations of
the GSEs were “good enough for us” and should be seen as
secure by the rest of the world. The U.S. government ended up as 79.9
percent owner of the GSEs, receiving preferred stock on terms that
essentially crushed the existing shareholders. (The precise level of
ownership was chosen in light of accounting rules that would have
brought GSE assets and liabilities onto the government balance sheet at
80 percent ownership.)

The real action here was the two $100 billion keepwells, which were
meant to effectuate the now-explicit guarantee of GSE debt and MBS
coverage–they would provide just-in-time capital injections as losses
were realized and ensure that Fannie and Freddie had the financial
ability to service their debt and insurance obligations. The Treasury
could not by law make GSE debts full-faith-and-credit obligations of the
U.S. government–this could only happen through an act of Congress that
changed the GSE charters. Unfortunately, the keepwells were not well
explained by the Treasury, and it took some time for market participants
to understand that they were the explicit guarantee–and even then, some
observers questioned whether $100 billion was enough to cover possible
losses at either firm. As with many decisions made quickly at the
Treasury in this period, the figure of $100 billion did not receive
considered discussion across the building and was eventually revised
upward by the Obama administration.

The conservatorship arrangement left unanswered the question of the
long-term status of Fannie and Freddie. This was by necessity, since any
such decision required congressional action to amend the firms’
charters. An unfortunate consequence, however, was that borrowing costs
for the GSEs remained above those for Treasury debt. Even though the
public balance sheet was effectively behind the firms, this could change
in the future, and the spread over Treasuries seemed to reflect this
uncertainty. The confusion over what the Treasury could and could not do
was evident in the writings of outside observers. In his blog on
November 25, 2008, for example, New York Times columnist Paul Krugman
wrote, “the Bush administration, weirdly, has refused to declare
that GSE debt is backed by the full faith and credit of the US
government.” Krugman wondered whether this reflected politics. No
politics were involved: the Treasury did not do this because it was not
legal. Although the criticism of the Bush administration was off target,
the Treasury had not explained the situation clearly.

The long-term status of the GSEs remains at this writing to be
decided by Congress. Each of the GSEs before conservatorship could be
thought of as two related entities under one roof: a securitizer and
monoline insurer that packaged and guaranteed mortgages with relatively
good underwriting standards, and a hedge fund that leveraged the funding
advantage from its implicit guarantee. Their retained portfolios were
the embodiment of this positive carry and the source of the systemic
risk, since scaling up the balance sheet with MBS purchases had driven
the GSEs’ massive borrowing. It was clear that the desired
long-term outcome for the GSEs was to wind down the portfolios. Indeed,
the agreements struck at the time of the conservatorship explicitly
committed the firms to do so over time, starting in 2010. In the
meantime, however, the portfolios were a tool with which to support the
housing market, and the Treasury wanted there to be upward room for more
MBS purchases so that homebuyers would not face higher interest rates.
As a result, Treasury officials, including the secretary, did not talk
directly about winding down the portfolios, out of fear that this would
fluster markets and cause a spike in interest rates paid by the GSEs.
This tension was not resolved until later in the year, with the November
25, 2008, announcement by the Fed that it would fund the GSEs directly
by purchasing their debt and MBSs.

Treasury staff did draw up sketches of long-run plans for the GSEs,
and Secretary Paulson spoke publicly on this topic in early January
2009. He favored turning the GSEs into a utility-like company, with
private shareholders but government regulation. This preference seemed
to be driven by a view that there would be substantial waste from the
duplication involved with multiple GSEs, which was an approach favored
by some at the Fed. A possible alternative would combine the two, with
one or two GSEs running the automated networks by which banks
originating mortgages sold conforming loans to the GSEs, and then a
multitude of financial institutions competing with each other to
securitize those loans into MBSs that would receive a government-backed
guarantee. Such a restructuring would be along the lines of the present
credit card market, which consists of a few large networks such as Visa
and MasterCard but many credit card issuers in fierce competition.

The agreements struck with the GSEs took one small step in the
direction of fostering future competition, in that the companies would
have to pay a fee to the government for the explicit backing of the
securities they issued starting in 2009. The details remain to be
determined, but one could imagine over time allowing banks to pay such a
tee and receive government backing on their securitizations of
conforming loans. This would allow entry, which, one hopes, would drive
innovation for the benefit of American homebuyers. Eventually the GSEs
could become boutique financial firms rather than behemoths, or they
might even one day acquire banks and become normal financial services
firms. All of this, however, is for the future.

VIII. “Free Market Day”: Lehman Brothers and AIG

The way Congressman Barney Frank put it at a hearing at which I
testified on Wednesday, September 17, was that we should celebrate the
previous Monday, September 15, as “Free Market Day,” because
on that day Lehman Brothers was allowed to fail and the free market to
work. On the 16th, however, AIG had been bailed out, so, Chairman Frank
continued, “the national commitment to the free market lasted one
day,” but we should celebrate that day. (7)

The decision not to save Lehman Brothers is perhaps the most hotly
debated decision of the entire crisis. Secretary Paulson and Chairman
Bernanke have made the point that with the firm evidently insolvent,
they had no authority to save it: the Treasury had no such authority
whatsoever, whereas the Fed could provide liquidity but not capital. The
Fed can, however, lend against collateral to its satisfaction, and so in
principle it could have lent against Lehman’s unencumbered
assets–essentially what it did with AIG. This would not have saved
Lehman–indeed, it would have concentrated losses on the rest of the
firm–but it might have provided time for a more orderly dissolution.
Indeed, there are estimates that the disorderly bankruptcy reduced the
recovery value of the firm by billions of dollars. The view at Treasury,
however, was that Lehman’s management had been given abundant time
to resolve their situation by raising additional capital or selling off
the firm, and market participants were aware of this and had time to
prepare. In the end there was no one prepared to buy Lehman with any
realistic amount of government assistance as had been the case with Bear

On Monday, September 15, it did not look like the outcome of
Lehman’s bankruptcy would be the start of the third and most
difficult phase of the crisis (the first being from August 2007 to the
collapse of Bear Stearns). What we did not realize would occur next were
two things: the breaking of the buck by the Reserve Fund, and the
reaction of foreign investors to the failure of Lehman. It is hard to
see how the Treasury could have anticipated that the Reserve Fund money
market mutual fund would incur such heavy losses from Lehman commercial
paper and medium-term notes that it would break the buck, with its net
asset value slipping below par. We might have better anticipated,
however, that foreign investors were not prepared for Lehman to
collapse–after all, there is an evident gulf in the understanding of
policy actions even in moving from Washington to New York or Boston;
this deficit of clarity grows only more severe across borders and
oceans. Together these events led to a run on money market mutual funds,
which in turn caused commercial paper markets to freeze up. If left
unstopped, this would have led issuers of commercial paper to turn to
their backup lines of credit–meaning that banks would have needed to
massively fund these lines simultaneously under circumstances they had
never contemplated, and then hoard capital against those lines. As
discussed by Victoria Ivashina and David Scharfstein (2008), banks in
the fall of 2008 did fund these lines as companies drew on them as a
precautionary measure, but this played out over time rather than all at

From the Treasury’s perspective, all this looked like a broad
run on the financial system. The panic in the money market mutual funds
led investors to pull out roughly $200 billion net from these vehicles
from September 5 to 19–more than 7 percent of assets in the funds. In
the face of these large-scale redemptions, money market mutual fund
companies began to hoard cash rather than invest in wholesale funding
instruments such as commercial paper, repo agreements, and certificates
of deposit. As the wholesale funding market dried up, broker-dealers
began cutting their credit lines to clients such as hedge funds and
other counterparties. This in turn threatened to lead to fire sales of
assets and a disorderly deleveraging, with potentially catastrophic
consequences across the entire financial system.

The focus at the Treasury and the Fed was on the commercial paper
market. As the three-month Treasury rate fell nearly to zero, the rate
on overnight asset-backed commercial paper jumped from 2.4 percent on
Friday, September 12, to 5.7 percent on Wednesday, September 17. Firms
were reporting to the Treasury, however, that they could not obtain
funds at all. It is hard to know how to evaluate this; economists
instinctively believe that there is some interest rate at which lenders
will lend, on a highly secured basis, to blue chip industrial companies,
provided the latter are willing to pay. Other companies said they could
issue commercial paper only at very short maturities: issuance of term
commercial paper (80+ days), for example, fell from $13.7 billion on
Friday, September 12, to $2.4 billion on Friday, September 19, and over
70 percent of commercial paper issued by financial institutions was at
one- to four-day maturities, compared with only about 50 percent
previously. One possibility is that there are transition costs in asset
allocation decisions: once the money market mutual funds stopped buying
commercial paper, there was simply no ready buyer to take their
place–it would take time for other potential investors to observe
rising yields, evaluate particular assets, and then buy. In the
meantime, companies calling the Treasury worried about whether they
would have the liquidity to make payroll.

Meanwhile in this chaotic week, AIG failed on Tuesday, September
16, and was kept afloat by emergency lending from the Fed. Treasury
staff were sent to the New York Fed for weeks to negotiate the terms of
the support package for AIG that was eventually announced on October 8.

If Monday, September 15, felt like a good day at the Treasury in
that the market was allowed to work (and it was too soon to know the
full adverse ramifications), Tuesday, September 16, when AIG was not
allowed to fail, felt much the opposite. Saving AIG was not what anyone
wanted, but at the time it seemed the only possible course of action.
The belief at the Treasury and the Fed was that bankruptcy at AIG would
have far-reaching and disruptive effects on the financial system and on
American families, as failure of the parent firm disrupted the operating
companies that provide insurance in the United States and around the
world. AIG had $ l trillion in assets at the time of its crisis; the
firm was one of the world’s largest insurance companies, the
largest property and casualty insurer in the United States, and a
leading provider of insurance and annuity products and retirement
services. Individual 401(k) retirement plans would have been at risk,
because AIG insured the returns of large mutual funds. Nonfinancial
businesses would also have come under pressure because AIG provided
credit guarantees to bank loans, and thus its failure would have forced
banks to raise capital. Moreover, money markets bad even more exposure
to AIG than to Lehman. In sum, AIG was larger, more interconnected, and
more “consumer facing” than Lehman. There was little time to
prepare for anything but pumping in money–and at the time only the Fed
had the ability to do so for AIG. Eventually the AIG deal was
restructured, with TARP funds replacing Fed lending, to give AIG a more
sustainable capital structure and avoid a rating downgrade that would
have triggered collateral calls. As time went on, it became clear that
AIG was a black hole for taxpayer money, and perhaps a retrospective
analysis will demonstrate that the cost-benefit analysis of the action
to save AIG came out on the other side. But this was not apparent at the

IX. Launching the TARP

With markets in disarray, Secretary Paulson on Wednesday, September
17, set out three principles for Treasury staff in how to deal with the

1. Simplicity. Any policies adopted should be readily understood by

2. Actions should be decisive and overwhelming. This was a lesson
from the experience with the GSEs, where the initial July announcement
left the situation unresolved.

3. Actions must have the explicit endorsement of Congress. The
secretary made clear that a large-scale intervention would be undertaken
as fiscal policy; he would not ask or expect the Fed to take on a
massive bank rescue, and he would not look for a statutory loophole
through which to commit massive amounts of public funds (for example, by
reinterpreting the July housing bill to tap into the $300 billion that
had been authorized but not used for the Hope for Homeowners program
since the program was not yet in operation).

Treasury staff had worked late into the night on Wednesday,
September 17, on a series of calls with staff from Fed headquarters and
the New York Fed, to come up with options that included ways to add
liquidity to the particular markets under stress and approaches to shore
up the financial system broadly. That day already, the Treasury had
announced the Supplementary Financing Program under which the Treasury
would borrow, through special bill issues, to soak up cash on behalf of
the Fed (a program that became redundant once the Fed was given the
authority to pay interest on deposits), and the SEC had put into effect
an emergency ban on short selling of stock of financial companies.
Opinions about this latter action at the Treasury and other government
agencies differed sharply: economists were skeptical that reducing
liquidity in markets would be helpful, whereas those with market
backgrounds thought it was important to short-circuit
“predatory” behavior in the markets.

Liquidity options focused on money market mutual funds and the
commercial paper market. After rapid consultations with industry
participants, the Treasury announced on Friday morning, September 19, in
a pre-market conference call, a temporary guarantee program for money
market mutual funds to directly stem the panicked withdrawals. At the
same time the Fed announced its Asset-Backed Commercial Paper Money
Market Mutual Fund Liquidity Facility, to provide money market funds
with liquidity so that they could avoid fire sales of their assets in
the face of redemption pressures. Fund managers were quite positive
about the Treasury guarantee until they realized they would have to pay
for it; most funds eventually participated, but not happily (and with no
subsequent failures, the guarantee will be a moneymaker for taxpayers).
There was incoming fire at the same time from banks, who (reasonably)
complained that the guarantee put them at a competitive disadvantage
against the money market funds. This became a familiar story: nearly
every Treasury action had some side effect or consequence that we had
not expected or had foreseen only imperfectly.

Other options included action by the SEC to reinstate the so-called
uptick rule, which prohibits short selling of a stock when the price has
just declined from one trade to the next, or to require disclosure on
short positions, having the Fed allow investment banks to convert
rapidly into bank holding companies (which Goldman Sachs and Morgan
Stanley did the next weekend), or changes in accounting or tax rules to
foster bank consolidation. Guidance on a related tax issue–the
so-called section 382 rule on the use of tax credits from net operating
losses of acquisitions–was released by the Treasury to some controversy
later in September. The controversy arose because of reports that this
action played a role in the acquisition of Wachovia by Wells Fargo; the
guidance was repealed in the February 2009 stimulus bill. Everyone was
aware that this was not the time to propose fundamental changes in the
regulatory structure of the financial system, but it was important to
ensure that any steps taken not conflict directly with long-term goals
such as had been set out in the Blueprint.

The actions taken with respect to money market mutual funds and
commercial paper seemed useful but incremental–it was a sign of the
times that so drastic a step as using the Treasury’s main source of
emergency funding to put a blanket guarantee on heretofore-unguaranteed
assets seemed incremental. What was still needed was action to get ahead
of the downward market dynamic and broadly stabilize the financial
system. The options were familiar from the “break the glass”
work back in March and April: buy stakes in banks directly, buy the
toxic assets, or dramatically expand the FHA and Hope for Homeowners
programs to refinance loans and improve asset performance from the
bottom up. Buying stakes in banks would constitute a “high
powered” capital injection, whereas buying assets would add
liquidity but also inject a wedge of capital to the extent that the
price paid after the announcement of the program was higher than the
price ex ante (because simply announcing an asset purchase program would
boost asset prices).

Secretary Paulson and Chairman Bernanke went to Capitol Hill
Thursday night, September 18, to tell congressional leaders that the
problems in financial markets posed a severe threat to the economy, and
that they wanted authority to buy the illiquid assets that were creating
uncertainty about the viability of firms at the core of the financial
system. Equity markets had rallied strongly that day even before the
meeting, evidently sparked by afternoon comments from Senator Charles
Schumer (D-NY) that the Treasury and the Fed were working on a
“comprehensive solution” to the financial market difficulties.
Senator Schumer had it exactly right–but no one at the Treasury could
figure out what he actually knew when he spoke.

On Saturday, September 20, the Treasury sent Congress a
“Legislative Proposal for Treasury Authority to Purchase
Mortgage-Related Assets”–a three-page request for a $700 billion
fund to be used over the following two years. The proposal sought
maximum flexibility, allowing the secretary to determine the terms and
conditions for purchases of “mortgage-related assets from any
financial institution having its headquarters in the United
States.” In doing so, section 3 of the proposal instructed the
secretary to “take into consideration means for (1) providing
stability or preventing disruption to the financial markets or banking
system; and (2) protecting the taxpayer,” while section 4 required
reports to Congress. Section 8 was to raise immense controversy, with
its assertion that “Decisions by the Secretary pursuant to the
authority of this Act are nonreviewable and committed to agency
discretion, and may not be reviewed by any court of law or any
administrative agency.” The legislation eventually enacted–the
Emergency Economic Stabilization Act of 2008–showed if anything that
there had been a counterreaction, as it provided abundant layers of
oversight, including by the Government Accountability Office, a new
inspector general specially for the TARP, and a congressional oversight
panel. Treasury staff were soon to venture that there would be more
people working on TARP oversight than on the TARP itself. The initial
proposal was meant purely as a starting point, not as a demand. In
retrospect, however, the sparseness of those three pages was a
communications mistake that foreshadowed later recriminations.

Eventually the lengthier EESA was negotiated with Congress, but the
core was the same: the Treasury would have broad authority to purchase
$700 billion of assets through the TARP, with the money split into two
equal tranches (technically the Treasury had access to only an initial
$250 billion, but an additional $100 billion could be obtained without a
further role for Congress). Most of the negotiation was over issues
relating to executive compensation and warrants. Members of Congress
eventually settled for fairly modest restrictions on compensation (their
main focus), but congressional staff insisted that the government should
receive warrants in the firm selling assets to the government rather
than warrants relating to the future performance of the specific assets
purchased. Congressional staff also insisted on a provision to guard
against “unjust enrichment,” which was defined as the Treasury
buying an MBS for more than the seller had paid for it. This effectively
made it impossible for, say, a hedge fund to buy assets from a bank
before the TARP got up and running and later sell those assets to the
Treasury. This was counterproductive; it ran precisely counter to the
goal of using the TARP to get illiquid MBSs off bank balance sheets. But
this obvious point fell on deaf ears on the Hill.

The TARP proposal was voted down in the House of Representatives on
September 29, and an amended bill was then enacted on October 3.
President Bush signed the bill on arrival and then came over to the
Treasury to give a pep talk to staff assembled in the department’s
Diplomatic Reception Room. Always gracious, the president had warm words
for the Treasury team, including recognition of the Treasury dining room
staff, who had become part of the weekend efforts.

While Congress debated the legislation, markets got worse–the
S&P 500 index fell almost 9 percent the day the House rejected the
bill–and conditions continued to deteriorate after EESA was enacted.
One-month and three-month LIBOR rates rose another 100 basis points
after EESA was approved, and stock market volatility as measured by the
VIX went up from about 30 percent on September 19 to 45 percent on
October 3 and 70 percent on October 10. After EESA was approved, the
amount of outstanding commercial paper fell by another $160 billion, or
nearly 10 percent, and financial institutions were issuing nearly 90
percent of their commercial paper on a one- to four-day basis. The Dow
Jones Industrial Average fell 18 percent, or almost 1,900 points, the
week after EESA was approved.

It is hard to remember from the vantage point of mid-2009, when the
United States and other nations are in the midst of a severe economic
downturn, but in late September and early October of 2008 it was a
challenge to explain to people that what was happening in credit markets
mattered for the broad economy–that it would affect the proverbial Main
Street, not just lower Manhattan. By mid-October, however, everyone
understood that the crisis was real. Families stopped spending, while
firms stopped hiring and put investment projects on hold. The economy
had been deteriorating since July after having been in a sideways grind
for the first half of 2008. Activity pitched slightly downward by some
economic measures, but GDP growth remained positive in the first and
second quarters, even though growth was not strong enough to maintain
positive job growth or prevent rising unemployment.

In October and beyond, everyone got the message to pull back on
spending all at once–and the economy plunged. For some time within the
Treasury, we had been analyzing statistical relationships between
financial markets and the real economy. Back in February we had
predicted in internal analysis that the unemployment rate, which had
been only 4.9 percent in January, would reach 5.5 to 6 percent by
year’s end as the economy slowed, but would hit 6.5 percent or more
if the problems in financial markets became worse than expected. That
was the limit of the ability of our (linear) models to predict the
worst, although we acknowledged and explained this limitation in the
prose of the accompanying memos. In fact, the unemployment rate reached
7.2 percent in December 2008, en route to 8.1 percent by February 2009,
with yet-higher rates to come.

Many factors were at work to dampen consumer and business spending,
including the weak and deteriorating job market and huge wealth losses
in both housing and equity markets. Yet the way in which the TARP was
proposed and eventually enacted must have contributed to the lockup in
spending. Having long known that the Treasury could not obtain the
authorities to act until both Secretary Paulson and Chairman Bernanke
could honestly state that the economic and financial world seemed to be
ending, they went up and said just that, first in a private meeting with
congressional leaders and then several days later in testimony to
Congress on September 23 and 24. Americans might not have understood the
precise channels by which credit markets would affect the real economy,
but they finally realized that it was happening. And whether or not they
agreed with the proposed response of buying assets with the TARP, they
could plainly see that the U.S. political system appeared insufficient
to the task of a considered response to the crisis. Surely these
circumstances contributed to the economic downturn, although the extent
to which they did remains for future study. A counterfactual to consider
is that the Treasury and the Fed could have acted incrementally, with
backstops and a flood of liquidity focused on money markets and
commercial paper, but without the TARP. With financial institutions
beyond Lehman weakening as asset performance deteriorated, it seems
likely that the lockup would have taken place anyway, and perhaps sooner
than it did.

The proposal to buy assets was met with substantial criticism from
academic economists, with a leading source of skepticism being faculty
at the University of Chicago’s Booth School of Business (where,
ironically, I taught a course on money and banking to MBA candidates in
the spring of 2009 after leaving the Treasury). There was little public
defense of the proposal–instead, the Treasury’s efforts were aimed
mainly at the 535 members of Congress whose votes were needed. These
were difficult issues to explain to the vast majority of Americans who
had not yet felt the direct impact of the credit market disruption in
their daily lives, yet it strikes me as a fair criticism that the
Treasury did not try hard enough.

So far as I know, I provided the only detailed public defense of
the Paulson plan at the time that addressed criticisms from both
academic economists and market participants. In a September 25, 2008,
posting on Harvard economics professor Gregory Mankiw’s blog, I
addressed three common concerns about the Treasury’s proposal to
buy assets. (8)

The first criticism was that the only way the Treasury plan could
work was if the Treasury intentionally overpaid for assets. Implicit in
this criticism was either that the Treasury would not overpay, and thus
the plan would not work, or that the Treasury intended to bail out
financial institutions (starting, the cynics inevitably said, with the
secretary’s former firm, Goldman Sachs). This is simply wrong in
both directions. At the Treasury, we were already working hard to set up
reverse auctions with which to buy structured financial products such as
MBSs, focusing on mechanisms to elicit market prices. On this we
received a huge amount of help from auction experts in academia–an
outpouring of support that to us represented the economics profession at
its finest. There was no plan to overpay. The announcement of the
proposal (or rather, Senator Schumer’s announcement) had lifted
asset prices by itself. If the Treasury got the asset prices exactly
right in the reverse auctions, those prices would be higher than the
prices that would have obtained before the program was announced. That
difference means that by paying the correct price, Treasury would be
injecting capital relative to the situation ex ante. And the taxpayer
could still see gains–say, if the announcement and enactment of the
TARP removed some uncertainty about the economy and asset performance,
but not all. Then prices could rise further over time. But the main
point is that it is not necessary to overpay to add capital.

The second criticism of the plan to buy assets was that in order to
safeguard the taxpayer’s interests, the warrants in the plan needed
to give the government additional protection (that is, it should pay a
lower price ex post) if the assets being purchased turned out to perform
markedly worse than was contemplated at the time of the transaction.
This would have been a valid point had the warrants in question been
specific to the assets being purchased. But this was not the case–as
already noted, congressional staff had insisted instead that the
warrants be on the firms selling the assets, not on the assets
themselves. Thus, the point being made by academic and other critics was
a non sequitur. Instead, warrants proved to be a huge hassle for the
auctions in that they diluted the price signal and thereby confused the

This was a straightforward application of the Modigliani-Miller
theorem. Rather than bid to sell assets such as MBSs at a particular
price to the Treasury, firms would have to bid to jointly sell both MBSs
and stakes in the selling firm. If the warrants and assets were
identical across sellers, the price of the assets would simply adjust to
net out the value of the warrants. Modigliani-Miller implies that the
price of the asset (assuming the auction gets it right) will adjust to
offset the value of any warrants the Treasury receives. In this case of
a reverse auction, imagine that the price of an asset is set at $10. If
the Treasury instead demands warrants for future gains of some sort,
then the price will rise by the expected value of the warrants. If that
value is, say, $2, the Treasury will pay $12 total for the asset and the

Working with academic experts, we came up with a reverse auction
mechanism that would go a long way to make for apples-to-apples
comparisons across different MBSs. The auction would not be perfect–we
knew that it was possible only to minimize adverse selection, not to
eliminate it. Firm-specific warrants confounded this, since even if the
MBSs being offered by seller A were identical to those offered by seller
B, the warrants on firms A and B would not be identical. (We considered
using penny warrants–essentially common stock–to get around the
problem but concluded that this was contrary to congressional intent.)
All of this resulted from the insistence in Congress on this type of
warrant. Ironically, critics of the September blog posting asserted that
the Treasury did not understand the Modigliani-Miller theorem, when in
fact it was the critics who did not understand the nature of the
warrants specified by Congress.

The third criticism of the original plan to purchase assets was
that it would be better to inject capital into banks–to buy parts of
institutions instead of the assets they held. Capital injections were
allowed even in the initial three-page proposal, under which Treasury
could purchase any mortgage-related assets, including shares of
companies that originate mortgages. The problem with this criticism is
that Secretary Paulson never would have gotten legislative authority if
he had proposed from the start to inject capital into banks. The
secretary truly intended to buy assets–this was absolutely the plan;
the TARP focused on asset purchases and was not a bait-and-switch
maneuver to inject capital. But Secretary Paulson would have gotten zero
votes from Republican members of the House of Representatives for a
proposal that would have been portrayed as nationalizing the banking
system. And Democratic House members would not have voted for the
proposal without the bipartisan cover of votes from Republicans. This
was simply a political reality–and a binding constraint on the
Treasury. The calls from academics to inject capital were helpful,
however, in lending support for the eventual switch to capital
injections (even though at times the vitriolic criticism was frustrating
in that it was so politically oblivious).

A similar calculus applies to suggestions that holders of bank debt
should have been compelled to accept a debt-for-equity swap. As Luigi
Zingales (2008, p. 4) notes, debt-for-equity swaps could
“immediately make banks solid, by providing a large equity
buffer.” All that would be required, according to Zingales, was a
change in the bankruptcy code. A major change to the bankruptcy law had
previously been enacted (for better or for worse, depending on
one’s point of view) with the Bankruptcy Abuse Prevention and
Consumer Protection Act of 2005, but this was the culmination of years
of legislative debate. Thus, the idea of a further instantaneous change
in the bankruptcy code was unrealistic. Indeed, efforts to make such
changes in the middle of the crisis would have reopened the debate over
the 2005 act, along with controversial provisions such as the mortgage
cramdown. The simple truth is that it was not feasible to force a
debt-for-equity swap or to rapidly enact the laws necessary to make this
feasible. To academics who made this suggestion to me directly, my
response was to gently suggest that they spend more time in Washington.

X. From Asset Purchases to Capital Injections

Secretary Paulson’s intent to use the TARP to purchase assets
reflected a philosophical concern with having the government buy equity
stakes in banks: he saw it as fundamentally a bad idea to have the
government involved in bank ownership. From the vantage point of early
September, it still looked like buying $700 billion of assets would be
enough to settle the markets: there were about $1 trillion each of whole
loans and structured products such as MBSs and CDOs on U.S. firms’
balance sheets, so that $700 billion would have been sufficient to add
liquidity, improve price discovery by closing bid-ask spreads, and
inject some measure of capital relative to the situation ex ante.

As markets continued to deteriorate after the enactment of EESA,
however, Secretary Paulson switched gears and came to favor injecting
capital, since he well understood that directly adding capital to the
banking system provided greater leverage in terms of providing a buffer
to ensure the viability of banks against further losses from their
rapidly souring assets. Confidence in the banking system continued to
deteriorate, with the one-month LIBOR-OIS spread (the difference between
LIBOR and the overnight index swap rate), for example, rising from
around 250 basis points when EESA was enacted to nearly 350 basis points
in the first full week of October, just before the three-day Columbus
Day weekend (figure 2). With confidence rapidly ebbing in the banking
system, the secretary, in consultation with the Fed chairman and New
York Fed President Timothy Geithner, instructed the “deal
team” at the Treasury to prepare term sheets that spelled out the
financial arrangements under which capital would be injected into banks.

Discussions began as well with the FDIC around the middle of the
week of October 5 about guarantees on bank debt–an idea that we were
hearing about from Wall Street economists and which had some support at
both the Treasury and the Fed. As Pietro Veronesi and Zingales (2009)
have shown, these guarantees involved a huge benefit for market
participants–most of the “gift” calculated by Veronesi and
Zingales arises from the guarantees. No one at the Treasury or the Fed
was happy about the prospect of giving blanket guarantees, but in the
midst of what appeared to be a renewed run on the banking system, this
blunt instrument was seen as essential to stopping the run. This
highlights the constraint that the policymaking process must be done in
real time even while the rush of events continues.


Treasury staff had been working on plans for capital injections for
some time, focusing on matching programs under which the Treasury would
invest on terms similar to what private investors received in exchange
for equal investments in banks. In early October, however, banks were
neither able nor willing to raise private capital on the terms available
from private investors–if any were to be found. Warren Buffett had
extracted a premium for investing in Goldman Sachs, but other firms did
not have even that possibility available to them. In the face of these
circumstances, the Treasury instead worked with bank regulators and
outside counsel to develop term sheets for a stand-alone investment by
the Treasury; this work went from not far past the starting line to
completion in just four days, from Thursday, October 9, to Monday,
October 13. It was on that Monday that the CEOs of the nine largest
American banks came to the Treasury to meet with Secretary Paulson,
Chairman Bernanke, SEC Chairman Christopher Cox, and others to be told
about and ultimately accept capital injections from the TARP in the form
of preferred stock purchases. This was called the Capital Purchase
Program, or CPP.

An important consideration with regard to the terms of the capital
injections was that the U.S. executive branch has no authority to force
a private institution to accept government capital. This is a hard legal
constraint. The government can take over a failing institution, but this
is done on a one-by-one basis, not en masse, and is not the same as
injecting capital into an institution that is healthy in order to guard
against future asset problems. Therefore, to ensure that the capital
injection was widely and rapidly accepted, the terms had to be
attractive, not punitive. In a sense, this had to be the opposite of the
“Sopranos” or the “Godfather”–not an attempt to
intimidate banks, but instead a deal so attractive that banks would be
unwise to refuse it. The terms of the capital injections were later to
lead to reports that the Treasury had “overpaid” for its
stakes in banks, which is true relative to the terms received by Warren
Buffett. But this was for a policy purpose: to ensure broad and rapid

The terms of the CPP–the TARP’s program to put capital into
“good banks”–allowed banks to sell preferred stock to the
Treasury in an amount equal to up to 3 percent of their risk-weighted
assets. The annual interest rate on the preferred shares was 5 percent
for five years and then increased to 9 percent, meaning that banks would
have a substantial incentive to pay back the money at that point. This
made the funds more of a five-year bridge loan than high-quality
capital. EESA was about distressed assets, which might have seemed at
odds with the notion of the CPP as a “good bank” program, but
the idea was that the low level of confidence among banks, as indicated
by the soaring LIBOR-OIS spread, meant that the whole financial system
was under stress. Capital injections would foster stability in banks in
particular, and thus in the financial system as a whole, initially by
ensuring that banks had the capacity to lend against a sufficient
capital buffer and would not have to hunker down and hoard capital. The
ultimate goal was to improve confidence in the system so that over time
private capital would again invest in the banking system.

Other terms were similarly aimed at ensuring broad uptake: the
Treasury wanted no part of running banks, so the preferred shares would
be nonvoting except when an issue affected an entire class of investors
in a way that would adversely affect the taxpayer’s interest. The
Treasury received warrants with a 10-year maturity that could be
exercised at any time, with an aggregate market value equal to 15
percent of the amount of the preferred stock; the strike price on the
warrants equaled the previous-20-day-average stock price for each
institution on the day of preliminary approval of the investment.
Warrants in this context made sense in that they allowed the taxpayer to
participate in any upside from increased stability in the financial
system. Banks were allowed to continue to pay dividends (but not to
increase them); this provision in particular drew criticism, but it,
too, was aimed at ensuring broad take-up of the capital.

The capital injections included rules meant to address not just the
letter but also the spirit of EESA, which required participating
financial institutions to meet “appropriate standards for executive
compensation and corporate governance,” while avoiding such
burdensome restrictions that banks would not participate or would find
it difficult to attract and retain key personnel. It is worth spelling
out these restrictions in some detail to make clear that the TARP from
the start had reasonable provisions in place to protect taxpayers–this
might not have seemed the case to someone landing in Washington in March
2009 and observing the president of the United States competing with
members of Congress over who could most angrily denounce the
compensation agreements at AIG (which, it should be noted, were outside
the CPP).

Each bank’s compensation committee would be required to review
incentive compensation features each year with the CEO, the CFO, and the
three highest-paid executives to ensure that contracts did not encourage
unnecessary and excessive risk, and to certify annually that this had
been done. Incentive payments for senior executives could be taken back
after the fact if it was found that they had been made on the basis of
materially inaccurate statements of earnings or gains or performance
criteria. These rules applied to more executives than section 304 of the
Sarbanes-Oxley Act (the provision that required executives to return
bonuses in the event of an accounting error) and would not be limited to
financial restatements. Banks could not provide senior executive
officers with golden parachute payments; severance payments were capped
at three times base salary, calculated as a moving average of each
officer’s taxable compensation over the previous five years. And
recipients of TARP capital would have to agree to limit the income tax
deduction of compensation paid to each senior executive to $500,000
instead of $1 million for as long as the Treasury held a capital stake
in the bank. This was not a tax rule but instead a bilateral contract
between the Treasury and the firm. In sum, the TARP did not involve the
Treasury in the details of setting pay, nor did it outright ban bonuses
or severance pay, but it did include a number of provisions aimed at
ensuring that taxpayer investments were not squandered through excessive
executive compensation.

As has been widely reported, most (but not all) of the nine CEOs
needed little persuasion to accept the capital investments on Monday,
October 13. Nearly 8,500 banks were eligible to receive TARP funds
through the CPP, but these nine alone accounted for close to half of
both the more than $8 trillion of deposits and the more than $13
trillion of assets in the U.S. banking system. In contrast, the bottom
70 percent of banks all together accounted for only about 5 percent of
both total assets and total deposits. It would take time for the
Treasury to inject capital into these thousands of banks. The combined
actions of that Monday–the FDIC guarantee and the injections into the
top nine banks–stabilized the financial sector, as demonstrated by the
LIBOR-OIS spread falling back to 100 basis points (figure 2). Although
this seemed like progress, it was still twice the spread that had
prevailed before Lehman’s failure, suggesting that market
participants were still not reassured about the soundness of financial
institutions. Subsequent events were to prove their doubts correct.

EESA had created a new Office of Financial Stability within the
Treasury, which Neel Kashkari was appointed to head as interim assistant
secretary (he had been confirmed by the Senate earlier in 2008 to be an
assistant secretary for international affairs). The office borrowed
personnel from across the government and brought in experts from the
private sector to help get the CPP up and running. The details of the
process are beyond the scope of this paper, but suffice it to say that
TARP staff, working in concert with the federal bank regulators, worked
diligently and effectively: a January 27 press release from the Treasury
noted that the CPP team had made capital injections of $194.2 billion in
317 institutions in 43 states and Puerto Rico since Columbus Day.
President Obama was to tell Congress on February 24, 2009, that he was
“infuriated by the mismanagement and the results” of the
assistance for struggling banks. His actions, however, belied the words
on the teleprompter–the Office of Financial Stability was kept
essentially whole through the presidential transition and beyond.

XI. The Decision to Call Off Asset Purchases

Of the first $350 billion of the TARP, $250 billion was allocated
to the CPP, which was enough for all banks that might potentially apply
to get capital equal to up to 3 percent of their risk-weighted assets.
It was already clear that part of the TARP would be needed to
restructure the federal rescue of AIG, since the company needed capital
rather than liquidity, and this implied that with the TARP now
available, the Treasury should take this operation over from the Fed
(which was done on November 10, 2008).

Financial market conditions had improved since the launch of the
CPP and the announcement of other actions including additional Fed
facilities aimed at money markets and commercial paper issuance. But
credit markets were still disrupted–and the implosion of business and
household demand as output fell and the labor market sagged would make
things worse.

Treasury staff turned to the task of figuring out how to allocate
the remainder of the TARP, a process that ultimately led Secretary
Paulson to announce, on November 12, 2008, that he would not use the
TARP for its original purpose of purchasing assets. This decision
ultimately came down to the fact that the TARP’ s $700 billion
looked insufficient to buy assets on a scale large enough to make a
difference while at the same time holding in reserve enough resources
for additional capital programs that might be needed. What we did not
fully see in late October and early November was that the Federal
Reserve’s balance sheet could be used to extend the TARP. This was
done in late 2008 and early 2009, with ring fence insurance applied to
assets held by Citigroup and Bank of America, and then on a larger scale
with the Term Asset-Backed Securities Loan Facility (TALF) announced in
late 2008 and the Public-Private Investment Funds announced in 2009.

We had reverse auctions to buy MBSs essentially ready to go by late
October 2008–including a pricing mechanism–but faced a decision as to
whether we had the resources left in the TARP to implement them. We
figured that at least $200 billion was needed for the program to make a
difference. With credit markets still in worse shape than before the
TARP had been proposed, it seemed more important to reserve TARP
resources for future capital injections, including the wherewithal to
act in the face of further AIG-like situations. Secretary Paulson
therefore decided to cancel the auctions. Another factor in this
decision was simply time: the first reverse auction to buy MBSs might
have taken place in early December but would have been small–perhaps a
few hundred million dollars–while we became comfortable with the
systems. The auctions would have ramped up in size but still would
likely have remained at $5 billion or $10 billion a month, meaning that
it could have taken two or more years to deploy the TARP resources in
this way.

A concern of many at the Treasury was that the reverse auctions
would indicate prices for MBSs so low as to make other companies appear
to be insolvent if their balance sheets were revalued to the auction
results. (9) This could easily be handled within the reverse auction
framework, however: many of the individual securities are owned by only
a small number of entities, so Treasury would not have purchased all of
the outstanding issues of any security such as an MBS. The fraction to
be purchased thus represented a demand shift–we could experiment with
the share of each security to bid on; the more we purchased, the higher,
presumably, would be the price that resulted. But this was yet another
reason why the auctions would take time–and why to some at the Treasury
the whole auction setup looked like a big science project. Further
delaying the auctions was a procurement process that left us with an
outside vendor that was supposed to run the auctions but whose staff did
not seem to understand that the form of the auction mattered crucially,
given the complexity of the MBSs and the ultimate goal of protecting the
taxpayer (although, to be fair, the vendor was receiving mixed signals
from within the Treasury as well). Warrants and executive compensation
restrictions played havoc with setting up the auctions. For executive
compensation, the administrative systems had to be able to detect, for
each of the many firms (which often had many subsidiaries), when the
total securities purchased crossed the congressionally determined dollar
amounts at which the restrictions kicked in. And finally, the
firm-specific warrants complicated the auctions, since as noted above,
they confounded the effort made in the reverse auctions to ensure a
level playing field across assets being offered for sale by different

Despite all this, by the last weekend of October, the auction team
returned from a day of meetings in New York on Sunday, October 26,
feeling that the asset purchases could be done, first for MBSs and then
later for whole loans (for which the idea was to create “artificial
MBSs” out of a random selection of the whole loans offered by
banks). We would have tried two auction approaches, one static and one
dynamic–the latter approach is discussed by Lawrence Ausubel and Peter
Cramton (2008), who were among the academic experts providing enormous
help to the Treasury in developing the reverse auctions.

Meeting at the Treasury on Sunday evening, October 26, Treasury
senior staff and the secretary focused on the key question of whether to
proceed with asset purchases or instead to put that work on hold and
focus on additional programs to inject capital and on the nascent
securitization project that would use TARP money to boost key credit
markets directly (and which eventually turned into the TALF). At another
meeting the following Sunday, November 2, senior staff and the secretary
went through the options about the uses of the remaining money in the
first part of the TARP and the $350 billion in the second tranche.

By the time of this second meeting, the economy had deteriorated
and the tide of public opinion had begun to turn against the TARP, so
much so that there were real doubts as to whether Congress would release
the second stage of TARP funds. We knew that to have a chance, there had
to be a well-developed set of programs to account for the money. The
Treasury had to be able to explain what it was doing and how the
programs fit together–never our strength. There could not be another
instance of asking for money to do one thing and then using it for
another as had happened with the first part of the TARP.

The objectives that the TARP needed to accomplish were, in broad
strokes, to continue to stabilize the financial system and avoid
systemic meltdown; to improve credit markets and facilitate stronger
demand by consumers and businesses; to protect taxpayers; and to help
homeowners. To meet these objectives, there were several possible uses
of TARP funds in late October and early November:

–More capital for banks and nonbanks, including one-time
situations such as systemically significant failing institutions and
nonfailing financial firms other than banks. With regard to nonbanks,
proposals were on the table to inject capital into the broader financial
sector, including life insurers, municipal bond insurers, and private
mortgage insurers. Resources for further capital would also constitute
“dry powder” in case of unforeseen situations.

–Asset purchases to buy illiquid MBSs and whole loans.

–Foreclosure prevention or forward-looking actions to lower
mortgage rates and thereby boost housing demand. This category included
ideas such as directly funding the GSEs to buy down interest rates for
homebuyers, something that the Fed eventually put into effect with its
purchases of GSE debt and MBSs.

–Direct assistance to unplug securitization channels, which had
been locked up since August 2007 but had previously provided financing
for auto loans, credit cards, student loans, commercial real estate, and
jumbo mortgages. This nascent “securitization project”
eventually grew into the TALF–a centerpiece of the programs in effect
in 2009.

The TARP was looking undersized against these competing
alternatives, particularly as the slowing economy began to have a
noticeable second-round impact on the financial system. Internal
estimates by the New York Fed of bank losses and capital raised
suggested that banks faced a capital hole above and beyond the initial
$250 billion CPP of perhaps as much as $100 billion in the case of a
moderate recession and perhaps another $250 billion or more in a severe
recession. These would be in addition to hundreds of billions of dollars
in losses among U.S. nonbank financial firms such as hedge funds and
insurance companies.

The decision to cancel the asset purchases was made on October 26
with this in mind. Instead, the focus was to be on developing the
securitization project and a second capital program with a private
match. There were some continued discussions of possible whole loan
purchase programs. At even a modest scale, this activity would have
allowed the secretary to say that he was fulfilling his initial promise
to buy toxic assets–the bad mortgages–directly and then to address
foreclosures by modifying the loans. Again, however, the decision was
made that it was more important to husband the resources.

With the work on asset purchases set aside, Treasury staff worked
intensely during the week between October 26 and November 2 to flesh out
proposals for the remaining uses of the TARP: more capital, assistance
for securitization, and foreclosure prevention. To unlock the second
$350 billion of the TARP, we realized that $50 billion of it would have
to be used for a foreclosure prevention effort. Helping homeowners had
been part of the TARP’s original mandate. Section 109(a) of EESA
specified that:

   To the extent that the Secretary acquires mortgages, mortgage
   backed securities, and other assets secured by residential real
   estate ... the Secretary shall implement a plan that seeks to
   maximize assistance for homeowners and use the authority of the
   Secretary to encourage the servicers of the underlying mortgages,
   considering net present value to the taxpayer, to take advantage of
   the HOPE for Homeowners Program under section 257 of the National
   Housing Act or other available programs to minimize foreclosures.
   In addition, the Secretary may use loan guarantees and credit
   enhancements to facilitate loan modifications to prevent avoidable

This language made sense in the context of buying whole loans and
MBSs: the Treasury could modify the whole loans it purchased or
encourage servicers to modify loans for mortgages in securitizations
where the Treasury owned a large share of the MBS structure. But the
EESA language never contemplated direct spending to subsidize
modifications such as were occurring under the FDIC insurance
loss-sharing proposal and the interest rate subsidy. Under EESA, the
TARP was to be used to purchase or guarantee troubled assets.
Implementing a foreclosure avoidance plan under the law would require
the Treasury to intentionally purchase a loss-making asset, where the
loss was then structured, using financial engineering, to turn into the
subsidies to the parties for taking the desired actions to avoid
foreclosure (as either insurance payouts or interest rate subsidies).
This was hugely ironic, since at the same time that the Treasury was
being pushed to use TARP resources for foreclosure avoidance, we were
being criticized for having overpaid for the preferred shares in banks.

From the secretary’s point of view, it was essential to
husband the TARP resources to use to shore up the financial sector. By
this time he was less adamant against crossing the line and using public
money for foreclosure avoidance, but he did not want it to be done with
TARP money. As discussed previously, however, Congress did not appear
eager to record a vote that transparently spent money on foreclosure
avoidance: members wanted the outcome but not any potential blame for a
bailout of “irresponsible” homeowners (a reasonable concern in
light of the political backlash that ensued when the Obama
administration announced that it would implement the interest rate
subsidy proposal).

By early November it was becoming increasingly clear that what we
were saving the “dry powder” for would include addressing the
crisis at the automobile companies. A group of Treasury staff had worked
with the Commerce Department on auto industry issues from Columbus Day
on. Indeed, I went over to the Commerce Department building that Monday
with a group from Treasury to meet with General Motors management.
Walking out the south side of the Treasury building around noon, we
strode past the television cameras that had assembled to get shots of
the nine bank CEOs, whose pending arrival at Treasury had by then become
known to the press.

At a November 12 speech to the assembled press, Secretary Paulson
formally announced that he would not be using the TARP to buy assets.
The secretary fully understood that canceling the auctions would make it
seem as if he was switching course yet again–first in changing from
asset purchases to capital injections, and then in canceling the asset
purchases altogether. He was willing to take the criticism, however, as
he viewed it as essential to keep the resources available for more
capital injections. The problem was that the capital program that was
slated to form the core of the second wave of TARP programs was never
developed. Instead, events again overtook the Treasury as problems at
Citigroup and the U.S. auto companies demanded attention.

XII. Ring Fence Insurance Schemes

Two weeks later, on November 23, 2008, the Treasury, the Fed, and
the FDIC jointly announced that Citigroup was being given another $20
billion of TARP capital (on less generous terms than the CPP but not as
onerous as those faced by AIG before the TARP was available), and that
the three federal agencies would provide guarantees against losses on a
$306 billion pool of Citi assets. The Treasury put up a modest amount of
TARP money as a second loss position, the FDIC took the next set of
losses, and the Fed then took the rest of the downside. This position of
the Treasury reflected the language of section 102 of EESA, which
counted each dollar of gross assets insured by the TARP as a dollar
against the $700 billion allotment. This meant that it was most
efficient from a TARP perspective for the Treasury to take an early loss
position and provide coverage of a narrow band in the asset structure
with a high probability of loss. The Fed could then use its balance
sheet to take on the rest of the risk.

The crucial new development in this use of TARP resources was the
use of the Fed’s balance sheet to effectively extend the TARP
beyond $700 billion; the Fed decided that having the Treasury ahead of
it in a sufficient loss position provided the credit enhancement for it
to take further downside risk. As had been the case with the Bear
Stearns transaction, it took some time for the arrangement to be
understood in Washington. The transaction, it turned out, did not appear
to stabilize Citigroup. This could have reflected a number of reasons,
including that the pool of covered assets was still modest compared with
a balance sheet of nearly $2 trillion, that the Treasury did not provide
details of the assets within the ring fence, and perhaps that many
market participants saw the firm as deeply insolvent.

A key insight, however, is that underpricing insurance coverage is
economically similar to overpaying for assets–but turns out to be far
less transparent. This insight underpins both the TALF and the bank
rescue programs announced by the Obama administration in March 2009. The
federal government is effectively providing potential buyers of assets
in either program with a two-part subsidy of both low-cost financing and
low-cost insurance. This federal contribution then helps to close the
bid-ask spread and restore functioning in illiquid markets.

From the perspective of the Treasury in November 2008, the second
Citi transaction meant that we had fallen behind the market and were
back into reactive mode. Moreover, the downside insurance appeared to
give rise to moral hazard, as Citi announced its support for the
mortgage cramdown proposal. Many within the Treasury viewed this as an
artifact of the transfer of risk to the public balance sheet inherent in
the nonrecourse financing behind the ring fence insurance–Citi could
make this politically popular offer because taxpayers ultimately were on
the hook for the losses. A feeling of resignation likewise marked the
work by Treasury staff on a similar ring fence insurance scheme and
additional TARP capital promised to Bank of America late in 2008.
Treasury staff nonetheless worked intensely until the transaction was
formalized on January 16, 2009, the last business day of the Bush

In contrast, the use of the TARP to support the auto companies was
straightforwardly political: Congress did not appear to want to take on
the burden of writing these checks, and President Bush did not want his
administration to end with the firms’ bankruptcies. A concern in
the administration was that the rapid collapse of the automakers would
have severe adverse consequences for an economy that was already
staggering. With the incoming administration refusing to coordinate
policy with regard to automakers, TARP funds were used to provide the
firms with enough breathing space to give the next team a chance to
address the situation.

Using TARP to support unsustainable firms is akin to burning public
money while industry stakeholders arrive at a sustainable long-term
arrangement. This appears to be the American approach to systemically
significant “zombie” firms–to use public resources to cushion
their dissolution and restructuring.

XIII. Evaluation and Conclusion

There is something of a playbook (to again use a football metaphor)
for dealing with a banking crisis. The steps are familiar from previous
crises, such as the Swedish bank crisis in the early 1990s:

–Winnow the banking system by putting insolvent institutions out
of business (including through nationalization where a buyer is not at
hand). The key is to avoid supporting zombie firms that squander
resources and clog credit channels. This was done to a modest degree
with the decisions made by the federal bank regulators and the Treasury
regarding which institutions would receive money from the TARP under the
CPP. The denial of funds to National City Bank and its acquisition by
PNC Bank, however, set off a firestorm of criticism that banks were
using their TARP funds for mergers rather than to support lending. This
criticism is misguided; it is fundamentally good for everyone when a
strong bank that is in a position to boost lending and serve its
community takes over a weak one that is not in that position. But this
point was lost in October and onward. In any case, the furor revealed
that there was no prospect of putting out of business a large number of

–Recapitalize the surviving banks to ensure that they have a
buffer against further losses. The TARP was able to do this in a broad
and rapid way. Notwithstanding President Obama’s assertion to the
contrary, the CPP appears as of this writing to be a salient success of
the TARP.

–Resolve uncertainty about the viability of surviving banks by
either taking away or “disinfecting” their toxic assets, for
example through ring fence insurance. The near-term goal is to avoid
having banks hunker down and ride out the uncertainty, but instead to
give them the confidence to put capital to work. Over time, the goal is
to bring about conditions under which private capital flows back into
the banking system.

I would add a fourth play, which is to ensure continued public
support for the difficult decisions involved in plays one to three. An
honest appraisal is that the Treasury in 2007 and 2008 took important
and difficult steps to stabilize the financial system but did not
succeed in explaining them to a skeptical public. An alternative
approach to this challenging necessity is to use populist rhetoric and
symbolic actions to create the political space within which the implicit
subsidies involved in resolving the uncertainty of legacy assets can be
undertaken. It remains to be seen whether this approach will be
successful in 2009.

ACKNOWLEDGMENTS I am grateful to Ted Gayer of Georgetown University
for helpful comments. The opinions expressed in this paper are solely
those of the author and should not be ascribed to anyone else.


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Georgetown University

(1.) The FHA package included lowering required down payments,
raising loan limits, and allowing for risk-based pricing of insurance
premiums so that the FHA could insure loans to yet riskier borrowers by
charging them higher premiums. Such risk-based pricing was a political
red line for many in Congress, who saw it as unfair to charge more to
the people in the worst financial condition and thus in the greatest
need of assistance.

(2.) Cordell and others (2008) discuss issues regarding servicers
in detail.

(3.) A possible exception was that FHA-guaranteed loans involved a
public subsidy to the extent that the FHA unintentionally underpriced
its insurance, as one might expect from a government insurer.

(4.) Credit for this idea goes to Ted Gayer and John Worth,
director of the Office of Microeconomic Analysis. Their idea was adopted
by the Obama administration in 2009.

(5.) The proposal would have paid a flat $1,000 for modifying a
loan, but this went to the servicer, not to the owner of the loan; this
payment could have put the servicer at odds with its fiduciary
obligation to make modifications that were only for the benefit of the
owners of the mortgage.

(6.) Joe Nocera, “A Rescue Hindered by Politics,” New
York Times, November 1, 2008, p. B1.

(7.) As quoted by the Wall Street Journal on

(8.) “A Defense of the Paulson Plan,” Greg Mankiw’s
Blog, September 25, 2008. greg

(9.) In contrast to the TALF, and to the Public-Private Investment
Program announced in March 2009, the reverse auctions involved did not
provide financial institutions with low-cost financing or downside risk
protection, both of which effectively constitute a subsidy.

Comments and Discussion


RENE M. STULZ This paper by Phillip Swagel is an extremely useful
one. The author deserves credit for providing an explanation of what the
Treasury was up to from the start of the credit crisis to the end of
2008 and why. As a result of this paper, generations of future
economists will have a better understanding of the thinking behind
various actions by the Treasury. No doubt this is also a very brave
paper, because it would be surprising if future generations thought that
2008 was a time during which the Treasury addressed the financial market
crisis with sufficient wisdom, skill, and foresight.

In this discussion I will not question a key theme of the Swagel
paper, namely, that many actions that the Treasury might have wanted to
undertake were simply not feasible politically, because Congress would
not have approved them. I have no expertise on this issue. I am also
willing to give Swagel and the Treasury much of the benefit of the doubt
when it comes to actions taken in the midst of the market panic after
Lehman Brothers’ bankruptcy. Had I been in the position of Treasury
officials at that time, I would have tried to do my best in very
difficult circumstances to help the financial markets. But it would be
presumptuous to argue that I would have done better than they did. I do
not question that these officials were trying to do their best at that

Where these officials should not receive the benefit of the doubt
is for what happened before the fall of Lehman. One could argue that the
difficulties at mortgage banks early in 2007, as well as the sharp
decline of various ABX indices at that time, should have been a wake-up
call for regulators and the Treasury that there were problems in the
housing market. The next wake-up call was one that could not possibly
have escaped them. It was what John Taylor and John Williams (2008) call
the “black swan” in the money markets in early August 2007.
From then on it was clear that the financial markets and financial
institutions were in unknown territory. In short order this black swan
was followed by massive downgrades of collateralized debt obligations
and securitization tranches, by a dramatic reduction in asset-backed
commercial paper outstanding, and by a freeze in the markets for
asset-backed securities. In the language of Frank Knight, investors
seemed to go from the world of risk, where probabilities can be assigned
to foreseeable outcomes, to the world of uncertainty, where they thought
they had little clue about what the possible outcomes were and how to
assign probabilities to them. From then until the fall of Lehman, there
was ample time for regulators and the Treasury to have taken action.

The road to Lehman’s bankruptcy was marked with still more
wake-up calls. The fall of Bear Stearns in the spring of 2008 made it
transparently clear that runs on investment banks could take place,
because these banks were funded with large amounts of overnight repos.
After Bear Steams’ failure, one had to know that investment banks
were fragile and that what to do if a run took place was a key question
that had to be addressed. Yet even today a resolution mechanism for such
situations is lacking. Although Swagel focuses on poor underwriting and
fraud in the subprime market as a serious issue, by the time of Bear
Stearns’ failure there was not much more to learn on that issue, if
there ever was. The Treasury had been receiving reports on mortgage
fraud all along (the so-called SAR reports received by Treasury have a
mortgage fraud component) and had seen that it was increasing before the
move in the ABX indices in February 2007 (Pendley, Costello, and Kelsch
2007). The fundamental fact about subprime mortgages was always that
they were much less risky as long as home prices were rising.

An observer transported from the summer of 2007 to today would find
it hard to believe that the crisis could have caused as much damage as
it did. Many have called it a subprime crisis. At the end of the second
quarter of that year, subprime securitized debt amounted to $1.3
trillion. (l) At least another $300 billion of subprime loans was held
on banks’ books (International Monetary Fund 2008, p. 51). An
extreme scenario at that time would have been that half of all subprime
mortgages would go into default, generating losses of 50 percent: losses
expected by Moody’s were well below this level in 2007
(Moody’s Investor Service 2008a). In such a scenario, one would
have expected a loss of $400 billion on subprime mortgages due to
default–less than half of what was lost during the stock market crash
of 1987, which did not lead to a massive recession. Moreover, this loss
in the subprime market would not have happened all at once, but rather
would have been spread over time.

Why then did the problems in the subprime market lead to such
serious difficulties for the financial system? The consensus explanation
is that banks and broker-dealers had large positions in securities
backed by these mortgages. Only a fraction, perhaps one-third, of the
securitized subprime mortgages were held by banks. Had these mortgages
been held as individual loans on banks’ books, the losses from
their default would have been recognized slowly over time, as borrowers
stopped paying interest and principal. Banks would have been adversely
affected earlier through required increases in loan provisions. Much of
this impact could have been absorbed by the banks out of their current
income. Instead, however, banks held interests in these mortgages
through securities that had to be marked to market. Marking to market
meant that the increase in the probability of default of these subprime
mortgages affected banks’ regulatory capital immediately. This
impact was made worse by the increase in liquidity premiums charged by
investors, which would not have affected mortgages kept on the
banks’ books as individual loans rather than as securities. By
reducing the value of the securities through marking to market, the
increase in liquidity premiums adversely affected banks’ regulatory
capital. Marking to market therefore dramatically accelerated the impact
of the worsening prospects of subprime mortgages. As the Bank of England
(2008, pp. 18-20) has pointed out, the drop in the dollar value of
triple-A tranches from subprime securitizations was extremely large.
However, most of that drop appears to have been caused by an increase in
liquidity premiums. In fact, to this day a default on a tranche rated
triple-A at issuance of a subprime securitization has yet to occur. (2)

Banks were suffering mark-to-market losses in plain sight in the
fall of 2007. It was also clear then that banks would have to take back
on their books securities held by off-balance-sheet vehicles, lowering
their regulatory capital ratio even more. By then any market participant
could tell that the market for many securities with subprime collateral
was not functioning properly and that, as a result, banks would have to
suffer costs from marking to market that had not been anticipated when
the accounting roles were put in place.

In the fall of 2008, counterparty risks were a major factor in the
freezing up of financial markets. It was difficult to know which
financial institutions were solvent and which were not. Whereas before
Lehman’s failure the markets thought that default by a major
counterparty was highly unlikely, they could no longer believe that in
the immediate aftermath of that debacle. The freeze of money markets
that occurred at the same time heightened concerns about fire sales of
assets even further. Yet counterparty risk was already a concern much
earlier. In fact, regulators were well aware of it. A report by senior
supervisors of the most financially developed countries, published in
April 2008, reported discussions with banks in which they raised
concerns about counterparty risk to guarantors. The report then added,
“Subsequent to our meetings, these concerns have become more
widespread and pronounced across the industry, with many firms’
exposures continuing to grow through year-end 2007” (Senior
Supervisors Group 2008, p. 19) Thus, the counterparty risk problem did
not come out of nowhere in September 2008. There was ample warning of

For the markets and for most observers, August 2007 was an
unexpected lightning strike. Even those who at times get credit for
having forecast the crisis did not predict the events of that month. The
dramatic move in LIBOR that occurred then had never before been seen,
nor had many of the other events that transpired. To be sure, many of
the regulators of financial institutions had gone on a long vacation.
The Treasury appeared focused on reducing regulation. A commission of
academics, aptly named for the secretary of the Treasury and with his
apparent blessing, was pushing for deregulation in the financial
industry. Even after the start of the crisis, the focus of the Treasury
was still on deregulation. But in August 2007 the regulatory vacation
should have been over. The focus should have been on making sure that
worst-case scenarios could be handled effectively and that contingency
plans were in place. It is quite clear that there was much concern about
moral hazard in 2008. Yet not much can be done about moral hazard in the
midst of a crisis. If the objective of letting Lehman go under was to
reduce moral hazard in the future, by showing that the Treasury was
willing to let large financial institutions go bankrupt, this was a
complete failure. Instead, letting Lehman fail put moral hazard on
steroids, and it is not clear how moral hazard will ever be restored to
where it was before Lehman’s demise. Controlling moral hazard is
critical when the taxpayers are the insurers of banks. It cannot be done
without regulation and robust enforcement. However, the regulators also
have to be provided with the right incentives to do their job. They did
not have these incentives when the Treasury was focused on deregulation.
Instead, the regulatory regime was at times too intrusive and at other
times nonexistent. Unfortunately, trying to install regulation
“lite” may have had the unintended effect of creating a world
in which much more intrusive regulation, which may hurt economic growth
in the United States, is likely.

There has been much criticism of banks’ risk management
practices. However, the official sector has a clear risk management
task: to avoid, plan for, and resolve systemic events. No bank has
failed at risk management as badly as the official sector has. Banks are
not responsible for systemic risk. They face complicated trade-offs
between risk and return. The task for the Treasury and the rest of the
official sector was to focus on events that could endanger the financial
system and be ready for them. At this they failed.


Bank of England. 2008. Financial Stability Report, no. 23. London
(April). International Monetary Fund. 2008. Global Financial Stability
Report: Containing Systemic Risks and Restoring Financial Soundness.
Washington (April).

Moody’s Investors Service. 2008a. “RMBS Investor
Briefing.” New York (May 13). –. 2008b. “Default and Loss
Rates of Structured Finance Securities: 19932007.” New York (July).

Pendley, M. Diane, Glenn Costello, and Mary Kelsch. 2007. “The
Impact of Poor Underwriting Practices and Fraud in Subprime RMBS
Performance.” New York: Fitch Ratings (November 28).

Senior Supervisors Group. 2008. “Observations on Risk
Management Practices during the Recent Market Turbulence.” New York
(March 6).

Taylor, John B., and John C. Williams. 2008. “A Black Swan in
the Money Market.” American Economic Journal: Macroeconomics 1, no.
1: 58-83.

(1.) Steve Schifferes. “Carnage on Wall Street as Loans Go
Bad,” BBC News, November 13, 2007.

(2.) Moody’s Investors Service (2008b) shows no impairments
for triple–A tranches of subprime securitizations in 2007.
Collateralized debt obligations with an initial triple–A rating backed
by subprime asset-backed securities have, however, defaulted.


LUIGI ZINGALES The end of an administration is no time to have a
financial crisis, and the end of the George W. Bush administration was
an especially inopportune time. With its senior staff substantially
reduced and the remaining political appointees potentially distracted by
concerns about their next job, the most powerful Treasury in the world
found itself in late 2007 and 2008 without the human capital needed to
plan for and deal with the worst financial crisis in three generations.
Worse still, by that time the administration had lost the trust of
Congress over the alleged weapons of mass destruction in Iraq, and the
unpopular president was all but missing from the scene. This paper by
Phillip Swagel provides some 60 pages of detailed description of the
events of this period, yet President Bush appears only once, thanking
the Treasury’s cafeteria staff as well as the policy team for their

In this context, Swagel should be thrice commended. First, he
should be commended for serving his country with passion and dedication
until the end of his appointment. Although I disagree with many of the
choices made, I have complete faith that Swagel worked with only with
the interest of the country at heart. Second, he should be commended for
consenting to serve as the public voice and face of an unpopular
administration. Last but not least, he should be commended for the
candor with which he has written this account of his extraordinary time
at the Treasury. I think historians will long use his chronicle as the
best description of what was going on at those critical moments.

It is precisely this candor that makes my role as a discussant
easy, perhaps unfairly so. Although I write without the full benefit of
hindsight-the crisis has yet to run its course, making it too early to
draw final lessons–I certainly benefit from more information and more
time to process it than Swagel and the other key players had at the
time. Most important, criticizing other people’s choices is much
easier than improving upon them.

With all these caveats, however, my role as discussant is to point
out the contradictions and limitations in Swagel’s account. Only by
reviewing and criticizing the decisions made in this crisis can the
economic policy community train itself and prepare for the next one.
Just as the analysis of the policy mistakes at the onset of the Great
Depression proved useful in informing the decisions made at the onset of
the current crisis, so, too, one may hope, analysis of the mistakes made
at the onset of this crisis will help tomorrow’s policymakers cope
with or even avoid the next one.

Let me first point out the elements of Swagel’s narrative most
likely to suffer from the naturally “self-serving” bias he
honestly admits to. The first regards the role played by the lack of
legal authority, which, according to Swagel, prevented the Treasury from
taking all the actions it deemed appropriate to deal with the crisis.
Obviously, the United States is a country of law, and an administration
cannot intervene in financial markets without legal authority. But this
limitation is not so clear cut as Swagel makes it out to be. In March
2008 the Federal Reserve had dubious legal authority to lend to Bear
Stearns, yet it found a mechanism (lending to J.P. Morgan to purchase
Bear Stearns) by which to do so. It had no legal authority to buy toxic
assets from Bear Stearns, yet, as Swagel describes, it found a trick to
make it happen. The Treasury had no authority to force the major banks
to take TARP money, but by exercising moral suasion it was able to bring
them on board. Indeed, so strong is the power of moral suasion wielded
by U.S. bank regulators that bankers often joke that when the regulators
tell them to jump, they can only ask, “How high?” When one
considers these various capacities in their totality–the Fed’s
control over whom to lend to, the FDIC’s authority to take over
bank subsidiaries (but not bank holding companies) that pose a systemic
risk, the Treasury’s ability to exercise moral suasion–it is clear
there was some power to intervene, had there been the political will.
For example, the Fed could have mandated a very large bank
recapitalization, with the Treasury offering to provide the capital in
case the market was unwilling to do so.

Thus, the real problem was the lack of political will, and the real
question is why it was lacking. Was it because the Treasury experts
really thought that buying toxic assets was the right solution, or
because the lobbying pressure to do so was overwhelming? Unfortunately,
it is here that Swagel’s account is uncharacteristically lacking in
detail: the paper contains no mention of any lobbying pressure from the
financial industry. Is it possible that an industry that in 2008 spent
$422 million in lobbying expenses played no role in shaping a policy so
crucial for its survival? Why is the paper silent about these pressures?

The second potentially self-serving bias in Swagel’s account
is the emphasis on the limits imposed by Congress, which the paper amply
blames as the source of all the administration’s woes. Much of the
paper suggests or implies that if only Treasury officials could have
made Congress do what they wanted, the world today would be a better
place. To be sure, Congress has imposed and still imposes limits on what
an administration can do. But this is not necessarily a bad thing; in
fact, this country was founded on the premise that there should be no
taxation without representation and that each branch of government
should exercise a check over the others. Decisions that impose a fiscal
burden on U.S. taxpayers are and should be subject to the approval of
their elected representatives. Of course, Congress does not always
perform this job perfectly, and often individual representatives in
powerful positions pursue their own agendas rather than the interest of
the American people. But that does not justify the implicit call, which
percolates through Swagel’s account, for freeing the administration
from congressional oversight. In fact, more useful than a blunt attack
on Congress as a body would have been a detailed account of the
self-serving constraints that individual members may have put on the
path to a superior solution. Yet the only constraints that Swagel
outlines in some detail appear to have been imposed not by self-serving
minority interests, but by the lack of political (and popular) consensus
on the proposed policies-which in a democracy should be a constraint.

Beyond that, Congress’ unwillingness to appear to be rewarding
people who overextended themselves financially to buy a house was not
only a legitimate democratic constraint, but also good economic policy.
And with the right amount of ingenuity, the negative home equity problem
could have been (and still could be) resolved without violating this
constraint (see, for example, Zingales 2008a and Posner and Zingales
2009). Similarly, when Congress balked at the prospect of handing out
billions of dollars to the banks through the TARP, that was not a
manifestation of congressional myopia, but rather an indictment of a
Treasury secretary more used to strong-arming corporate boards than to
eliciting popular consensus. The September 29, 2008, House vote against
the TARP, far from being the short-sighted response of a hopelessly
politicized Congress, was in fact a high point of American democracy.
Undaunted by the dramatic headlines and the catastrophic forecasts
issued by Secretary Paulson and Fed Chairman Bernanke, Congress realized
the dangers involved in issuing a $700 billion blank check–and voted
no. In fact, if there are grounds for criticizing Congress’s
performance in this episode, it is for later reversing its vote under
the enticement of a heavy dose of pork-barrel add-ons.

This view of Congress as an obstacle to the Treasury’s
enlightened leadership, rather than as an equal player exercising proper
constitutional balance, is what leads Swagel to congratulate the
Treasury and the Fed for engaging in various financial engineering
maneuvers aimed at imposing a fiscal burden on taxpayers without
Congress’ approval. One example is the nonrecourse loans offered by
the Fed to Bear Stearns. Another is the guarantees offered to Citigroup
and Bank of America. It is sad to learn that Swagel regrets that the
Paulson Treasury took too long to fully appreciate the power of these
tricks, leaving to the Obama administration the rare privilege of
actually implementing the most deceptive ones. Having written against
the use of these interventions by Paulson’s successor, Tim Geithner
(Veronesi and Zingales 2009), I believe I can criticize their creation
by the Paulson team without fear of being accused of bias. It is
precisely these types of tricks that feed the mistrust that Congress and
the American people have toward the administration. As Swagel aptly
describes, congressional mistrust toward the Treasury had very negative
consequences during the crisis. But Swagel’s own account provides
the justification for that mistrust.

We know from microeconomics that any choice can be represented as
the optimal one, depending on how one characterizes the constraints that
apply. Swagel’s description of the Bush Treasury’s political
constraints seems calculated in exactly this manner, as a means of
relieving the administration of any responsibility for making the wrong
decision: if the chosen strategy was the only feasible one, it must also
have been the optimal one. Ironically, Swagel persists in maintaining
this fiction of an absence of alternatives even after the
Treasury’s policy changed course dramatically in a matter of weeks.
Whence the change in policy? The constraints had changed!

This Manichean view of an enlightened elite fighting against the
neutering constraints imposed by Congress prevents Swagel from
discussing the other feasible options in greater detail. Since the
approval of the TARP, academics have produced detailed analyses of the
costs and benefits of several such alternatives: from asset purchases to
debt guarantees, from equity infusions to long-term put options to a
spinoff of toxic assets into a “bad bank” (Philippon and
Schnabl 2009; Caballero and Kurlat 2009; Landier and Ueda 2009; Veronesi
and Zingales 2008; Zingales 2009). Similar discussions should have taken
place inside the Treasury and the Fed before any decision was made. Yet
Swagel’s account provides no evidence that the costs and benefits
were seriously debated. As he correctly points out, the turning point
was the Bear Stearns crisis. Up to that point the administration could
cultivate the illusion that the crisis would remain contained; afterward
there was no excuse. Indeed, as Swagel recounts, it was after Bear
Stearns that the Treasury started thinking about what he calls the
“break the glass” policy–what to do in the event of a
systemwide collapse. From the Bear Stearns rescue to the Lehman
collapse, six months went by. What was the Treasury able to produce in
that time? By Swagel’s own admission, only the three pages of draft
legislation that Paulson presented to Congress on September 20 and that
led to the TARP. There is no mention of any intellectual discussion, no
mention of any internal disagreement, no mention of any assessment of
costs and benefits. This deafening silence in Swagel’s account does
nothing to dispel the pervasive (and, one hopes, wrong) view that the
TARP was just a welfare plan for needy bankers pushed by Wall Street
upon their friends in the government.

Even if the TARP had been the right break-the-glass plan–which it
was not, as I wrote at the time (Zingales 2008b) and as Paulson himself
later admitted–the fact that the plan required two full months to
become implementable (as Swagel clearly details) validates the
accusation of incompetence raised against the Paulson Treasury. What
would one say about a hurricane emergency plan that took two months
after the calamity to start working? Why were the details of a plan that
had been conceived by at least March not fully worked out by September?
If lack of staff is the reason, then the Obama administration is right
to make the creation of a more permanent research department at the
Treasury a priority.

Swagel’s account is extremely interesting not only for what it
says, but also for what it does not say. There is no mention of any
economic principles guiding the Paulson Treasury. All its actions seem
to have been guided entirely by legal and political constraints, without
any overarching aim. Even if one accepts the idea that these constraints
were rigidly binding, a well-justified strategy would have been helpful
not only in selling the plan to Congress and the country, but also in
avoiding confusion in the markets. After all, the government’s
actions during the course of the crisis were all over the map–from
bailing out creditors but not shareholders in Bear Stearns, Fannie Mae,
and Freddie Mac, to wiping out both in Lehman Brothers and Washington
Mutual, to bailing out both in AIG, Citigroup, and since. In the words
of the legendary Yale endowment manager David Swensen,
“they’ve [acted] with an extraordinary degree of
inconsistency. You almost have to be trying to do things in an
incoherent and inconsistent way to have ended up with the huge range of
ways that they have come up with to address these problems.” (1)
Nor has this inconsistency escaped the notice of ordinary Americans. In
a representative survey of more than 1,000 American households conducted
in December 2008, 80 percent declared that they felt less confident
about investing in financial markets as a result of the type of
government intervention undertaken in the last three months of 2008
(Sapienza and Zingales 2009b). This outcome did not stem from an
ideological bias against government involvement; on the contrary, a
majority of respondents expressed the belief that the government must
regulate financial markets. What they objected to was the specifics. It
is hard to estimate the real damage created by this inconsistency. What
is known is that it had major negative effects on the level of trust
that Americans have in the stock market (Sapienza and Zingales 2009a),
leading them to shun investing in equities (Guiso, Sapienza, and
Zingales 2008).

In his conclusion, Swagel nicely summarizes the four key dimensions
along which a rescue plan should be evaluated: shutting down the zombie
banks, adequately recapitalizing the solvent ones, eliminating
uncertainty about the surviving institutions, and maintaining consensus
on all these actions. Swagel admits failure on the first and last
counts–the Paulson Treasury was unable to be selective in the
allocation of TARP money and unable to maintain political consensus–but
he claims victory on the other two. A final judgment is certainly

In 1998, after its first bank recapitalization, the Japanese
government declared victory only to discover later that it would have to
go through four more recapitalizations (Hoshi and Kashyap 2008). But
even at this early date, Swagel’s claim of victory seems hollow. As
the recent bank stress tests have shown, the capital injections under
the CPP program were insufficient to make troubled institutions fully
viable, but sufficient to allow insolvent ones to keep limping along.
The very fact that additional interventions had to be undertaken to
support Citigroup and Bank of America after the first CPP injection
suggests that the second and third goals had not been reached. Although
Swagel is right in pointing out that after the CPP program the tension
in financial markets subsided, it is unclear whether most of the credit
goes to the capital injection or to the FDIC debt guarantee. And even if
the Treasury is given full credit for stopping the panic in October
2008, one cannot ignore the fact that the Treasury shares much of the
blame for creating that panic to begin with.


Caballero, Ricardo J., and Pablo Kurlat. 2009. “Public-Private
Partnerships for Liquidity Provision.” Massachusetts Institute of
Technology (March 4).

Guiso, Luigi, Paola Sapienza, and Luigi Zingales. 2008.
“Trusting the Stock Market.” Journal of Finance 63, no. 6:

Hoshi, Takeo, and Anil Kashyap. 2008. “Will the U.S. Bank
Recapitaliztion Succeed? Lessons from Japan.” Working Paper 14401.
Cambridge, Mass.: National Bureau of Economic Research (December).

Landier, Augustin, and Kenichi Ueda. 2009. “The Economics of
Bank Restructuring: Understanding the Options.” Staff Position Note
2009/12. Washington: International Monetary Fund.

Philippon, Thomas, and Philipp Schnabl. 2009. “Cost-Efficient
Mechanisms against Debt Overhang.” Working paper. New York

Posner, Eric A., and Luigi Zingales. 2009. “The Housing Crisis
and Bankruptcy Reform: The Prepackaged Chapter 13 Approach.”
Working paper. London: Centre for Economic Policy Research.

Sapienza, Paola, and Luigi Zingales. 2009a. “Anti-Trust
America: A Trust Deficit Is Driving Our Economy Down.” City
Journal, February 27 (

–. 2009b. “The Results: Wave 1.” Chicago Booth/Kellogg

Veronesi, Pietro, and Luigi Zingales. 2008. “Paulson’s
Gift.” Paper presented at the Annual Meeting of the American
Economic Association, San Francisco, January 5.

–. 2009. “Geithner’s AIG Strategy.” City Journal,
February 18 (

Zingales, Luigi. 2008a. “‘Plan B.” The
Economists’ Voice 5, no. 6, article 4.

–. 2008b. “Why Paulson Is Wrong.” The Economists’
Voice 5, no. 5, article 2.

–. 2009. “Yes We Can, Secretary Geithner.” The
Economists’ Voice 6, no. 2, article 3.

(1.) FOXBusiness, “Yale’s Swensen: Pols Missing the
Point,” January 6, 2009

GENERAL DISCUSSION Several panelists praised Swagel for sharing his
insider perspective and for his frank description and assessment of the
events he had witnessed. Alan Blinder summarized the paper’s main
point as follows: critics, particularly academics, pay too little
attention to the legal and political constraints faced by the Treasury.
And there are times when Treasury officials would like to take certain
actions but refrain from seeking the authority because they are
convinced Congress will not grant it. Blinder framed the rest of his
comment by citing the motto of Montagu Norman, former head of the Bank
of England: “Never explain, never apologize.” Although the
Paulson Treasury never enunciated it, in Blinder’s view it operated
under this motto. That said, Blinder did not believe the Paulson
Treasury should be excused for its actions or its inactions. There are
two ways to get around a legal constraint: either go to Congress to have
the constraint relaxed, as the Paulson Treasury attempted with Fannie
Mae and Freddie Mac, or get clever and find ways to get around the
constraint within the law, as was done with the nationalization of AIG.
Blinder disputed Swagel’s point that, in the law-based society of
the United States, banks cannot be forced to accept capital. He noted
that Paulson did force some banks to take capital against their will,
under the pretext of preventing stigmatization of other banks, and those
banks made it very clear to the press that they did not want the money.
Blinder also pointed out that although the TARP legislation mentioned
foreclosure avoidance 12 to 15 times, no TARP dollars were used for that
purpose during the Bush administration.

Daron Acemoglu noted that thinking about constraints is important,
but that it is also important to consider the process, in particular its
gradual nature. He described the Bush administration’s approach as
taking whatever action sufficed to keep an institution alive and then
waiting to see what happened next. This strategy is correct, he argued,
in a single-player decision problem, but when dealing with markets,
gradual action may be counterproductive because there is a specter of
something bad, like bankruptcy, nationalization, or other types of asset
sales, happening at the end. This uncertainty breeds inaction and might
make the problem much worse. Instead, Acemoglu suggested a different way
of thinking about these situations, one in which making mistakes is
acceptable, and making a decision and sticking to it is better than
letting events unfold gradually.

Robert Hall brought to the Panel’s attention a factor that had
been underdiscussed but was, in his view, responsible for some of the
economic distress in the commercial paper market following the Lehman
Brothers bankruptcy, namely, the failure of money market mutual funds to
behave like true mutual funds. One problem is that the “penny
rounding rule” of the Securities and Exchange Commission allows
money market funds to pay a withdrawal as if the fund’s net asset
value per share were $1 as long as the actual net asset value is between
$0.995 to $1.005. This rule by itself provides a strong incentive for
investors to withdraw when net asset value drops below $1. In addition,
it appears that some funds did not write down their net asset value by
enough when Lehman went bankrupt, further increasing the incentive for a
run. Hall claimed that these two factors effectively turned money market
funds into depository institutions and made them susceptible to runs.
The Lehman bankruptcy might have gone more smoothly, he asserted, had
the Reserve Fund, a large money market fund, immediately lowered its net
asset value to a realistic level, so that early withdrawals did not have
an advantage over later withdrawals. The run on money market funds
caused the commercial paper market to fall apart, because these funds
were among the main buyers. Hall argued that the central problem was
that money market mutual funds wanted to be banks and not mutual funds,
and that the SEC had failed to insist that they behave like mutual

Justin Wolfers complimented Swagel on a compelling paper, from
which he and others had learned a great deal about the political and
legal constraints on policymakers. He was distressed that economists as
a group know so little about how policy is really made, and he faulted
the White House and the Treasury for not better communicating those
constraints, as well as the economics profession for not taking those
constraints seriously. He took issue with the veneration of political
naivete expressed in Luigi Zingales’s comment, arguing instead that
to take public positions on important policy issues without knowledge of
the political process is a big mistake.

Zingales countered that economists should say what they think are
the proper actions to take, regardless of the political constraints.
Constraints are endogenous, and economists can help bring pressure to
bear to modify those constraints. Paulson himself, for example, changed
his ideas on capital injection as a result of pressure from the
economics profession. Zingales did concede that although economists need
not internalize the political constraints on policymakers, they should
not criticize policymakers when constraints prevent them from taking
recommended actions.

Caroline Hoxby questioned the asymmetry in the Treasury’s use
of TARP funds. People were concerned initially about the exact value of
the assets to be bought and argued over whether it was, say, 76 or 81
cents on the dollar. In contrast, no such calculations were made for the
multitude of other ways the stimulus money was spent. She wondered why
the Treasury did not say up front that it might inadvertently buy assets
at the wrong price, thus ending up throwing money away, but that even if
they bought at 76 cents something that later proved to be worth 38
cents, the amount of money thrown away was at least eventually known.
She observed that today money is being thrown away in many directions,
whereas the earlier troubled assets likely would have recovered their
value. It concerned her that the Treasury was too worried about getting
the prices right, which ended up making matters worse.

Frederic Mishkin expressed concern about the Treasury’s
capital injections into banks, particularly the absence of conditions
placed on taking the money in order to get all the banks to take it and
avoid stigma. He noted that in MBA ethics courses, students are taught
to maximize shareholder value. Under this principle, capital given to a
business with a lot of debt should be used to pay the shareholders and
other stakeholders, and potentially to give bonuses to management. He
agreed that “getting clever,” as Blinder put it, is important
in tough times, and he acknowledged that the Federal Reserve had
reasonably acted at the limits of its legal authority. Mishkin raised
the issue of the importance of the AIG bankruptcy in comparison to
Lehman Brothers. He felt that Lehman’s downturn had been expected
and therefore did not shake up the markets as badly as the surprising
collapse of AIG, which revealed the rot in the entire financial system,
causing a systemwide blowup.

David Romer asked why, if the Treasury had been working on the
break-the-glass plan since March 2008, the bill that emerged in
September 2008 was so minimal. He also wondered whether Swagel agreed
with the claims of Paul Krugman and others that regulators interact so
much with the financial markets that it causes them to give greater
weight to the interests of Wall Street than to the general public

John Campbell noted that during the boom years credit ratings had
been extended to new types of instruments carrying systemic risk, and
that this had allowed investors to buy assets within a credit rating
constraint yet still load up on systemic risk. The credit rating
agencies had moved outside their sphere of competence, and the
information in their ratings had become corrupted. He wondered at what
point the Treasury had become aware of this problem and whether anything
could have been done early on to mitigate its effects.

Benjamin Friedman expressed reservations about the use of the
central bank to conduct what amounts to a shadow fiscal policy, which it
does when it assumes credit risk. He noted that there is a reason why
fiscal actions should go through Congress, namely, that such actions use
taxpayer money, and he expressed concern that the end result, should the
Federal Reserve take losses on the amounts it has advanced in private
credit during this episode, would be to compromise central bank
independence. He also underlined a distinction, which he felt had been
overlooked, between two types of losses. The first involves a genuine
loss to the economy, as in the case of a decline in the price of a home.
Someone bears the loss, whether it be the homeowner, the lender, an
investor who bought the securitized loan, or the taxpayer if the
Treasury steps in to bail out the investor. The second involves a
zero-sum loss, in which one party gains exactly what the other loses.
Although the distinction might not matter to an individual institution
that loses money, for the system as a whole, which is the ultimate
concern of public policy, the two types of losses are very different.

Charles Schultze interpreted Rene Stulz’s comment to say that
underwriting standards were not an important factor in causing the
financial crisis. But, he pointed out, between mid-September 2008 and
mid-March 2009, the ABX price index for the second-half 2005 vintage of
PENAAA subprime mortgage-backed securities fell from 96 to 83, whereas
for the first-half 2007 vintage, the index declined from 57 to 26.
Schultze argued that the large erosion of underwriting standards,
combined with market uncertainty about how it had affected the quality
of the portfolios of individual financial institutions, accounted for
this pattern. He also thought worth mentioning, even though of little
relevance to the paper, the role that annual bonuses had played in the
decline of underwriting standards. In response, Stulz explained that he
did not mean to say that underwriting was unimportant, but that there
had been no visible change in standards consistent with the facts
mentioned in the paper. He noted that fraud was very important at the
end of the timeframe discussed, but he did not view it as a driving