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Scott Petty

Professor Wilson
Econ 2020
12/5/15
U.S. Financial System Bail-Out
My final paper for class will be on the financial system bail-out that was
intended to improve the economy that was suffering due to toxic assets held by
investment bankers. I will describe the history of the great recession after the dot
com bust, the issue created by investment banks with mortgage-backed
securities, and the bail-out that was intended to fix the problem that the banks
and home owners were having and to get the economy rolling again.
Traditionally, investors in the US would buy treasury bills because the
security of the investment. The investors did this because treasury bills were sold
below par so they would make good money at maturity. In 2001 real GDP was
increasing very slowly and after the September 11th attack and the stock market
bust the economy fell into a decline (recession) and many people lost their
fortunes and businesses. In an effort to counter what was going on, Alan
Greenspan (chairman of the Federal Reserve) decided to lower the interest
dramatically on the bills all the way from 6.5% to 1%. ( FRB: Monetary Policy

Report to the Congress, February 27, 2002) This did two important things, it
made it so investors stopped buying the bills, and it made it so banks bought
huge amounts of them. The reason that was is because investors would only get
a small return, and banks would only have a small interest fee, at maturity. Due

to this cheap credit, banks were able to use a lot of leverage in deals to enhance
their profit.
Since banks then had a lot of money and were making great deals, the
investors wanted to be involved somehow because the treasury bills wouldnt
have returned enough. What happened is a mortgage broker would make a
transactional commission by connecting hopeful home buyers with a lender, who
then gave them a mortgage for a house. An investment banker would then buy
huge amounts of mortgages and turn those into a collateralized debt obligation
(CDO), which is a security backed by an asset; in this case the assets are the
homes that could default. The aforementioned investors would then buy the AAA
rated (senior) derivative of the CDO and they would have a nice return on it
because of the interest from the mortgage. An issue happened when investors
wanted more securities, but there werent enough people who qualified for AAA
status, creating more demand than there was supply. As a result, lenders
lowered the qualifications to obtain mortgages knowing that even if it was
defaulted on the asset of the home would still be a profitable asset to posses.
This led to many people obtaining a mortgage that had more risk for the lender
(sub-prime mortgages); there wasnt much concern because of the moral hazard
involved in the chain. But then people started foreclosing in huge numbers and
the mortgages turned into property owned by the investment banks, and due to
the increasingly lower value of homes, the banks couldnt sell them to investors
anymore, they became stuck with worthless property because there became
more supply than demand for them. So the investment bankers had toxic assets

and they borrowed massive amounts to obtain them, the mortgage lenders were
out of work, the investors still had bad investments on their hands and the actual
home owners investments in the houses were also worthless; this is when the
government stepped in with the financial system bail-out.
In 2008 George W. Bush signed the emergency economic stabilization act
in an attempt to free up the stagnant credit market. TARP (troubled asset relief
program) was formed and its purpose was to buy up the troubled assets from
financial institutions. With TARP the treasury department would be granted
potentially as much as 700 billion to buy up the troubled mortgages and
mortgage-backed securities from struggling institutions in hopes to un-freeze the
flow of credit and get people borrowing and lending again. The idea was to
protect Main Street from Wall Street, and letting the banks fail would be too
damaging to the American public. The term too big to fail was used to describe
the importance of keeping the connected companies healthy because of the
disastrous outcome for the economy if they werent. The government needed to
step in and fix the bankers and investors mistakes essentially, because even
though the investment bankers made some bad choices they were still very
important, and the American public needed them. With cyclical unemployment
increasing (Databases, Tables & Calculators by Subject) and disillusionment
about Wall Street in the American public, the auto industry having a breakdown
and the banks not giving out loans, the government needed to act fast and get it
right.

AIG was a huge focus regarding the events that took place; they offer a
good glimpse as to why the American public was upset with what took place
during the time and the greed and controversy that surrounded it. AIG is the
biggest insurance company in the world and during the time of these suspect
bank dealings AIG was doing a thing called a credit default swap (CDS) with the
banks; it was basically a loophole around the Basel 2 (how much banks had to
keep in reserve). So what this did was allow banks to lend their reserves as well
and AIG would pay them should a default on credit occur. This worked great for
banks and for AIG because banks were able to maximize profits and AIG was
able to sell the default swap derivatives without having incurred a capital cost on
them. AIG used expected revenue rather than revenue earned for their books,
which goes against the GAAP revenue recognition principle; they also mixed
revenue with other periods going against the matching principle, essentially
committing fraud.
When foreclosures began occurring and it came time for AIG to pay up,
they didnt have the money to because they were banking on the deal working
out. AIG was in an awful predicament financially and was doomed to fail, and
they likely would have had the government not bailed them out; they were too
big to fail because major banks connected may have failed as well. In 2008 the
government purchased 79.9% capital in AIG for an 85 billion dollar loan,
(KARNITSCHNIG, MATTHEW) with the idea of breaking it up and selling it off
to replay the loan. However the stock market turmoil at the time made it
impossible to find buyers and there were still billions in CDSs to deal with so the

Fed purchased mortgage-backed securities of $52.5 billion and the Treasury


Dept. purchased preferred shares of $40 billion. That kept AIG from going
bankrupt and it allowed the government to save its investment. ( Amadeo,

Kimberly) In 2009 AIG reported a huge loss which in turn caused the stock
market to dip even lower than in 2002, but AIG still gave around $165 million to
employees in bonuses. This outraged the American public but the logic was that
these employees were the only ones who knew the fine details of the time
sensitive credit default swaps, so their retention in the company was paramount.
AIG CEO Edward Liddy eventually implemented strategies to reduce the CDSs;
this protected huge amounts of tax payers portfolios (many money markets and
mutual funds had invested in AIG default swaps).
Hundreds of billions of more dollars were pumped into the economy to
save banks and auto makers from going bankrupt; (Bailout Recipients) this,
along with saving AIG and the conservatorship of Fannie Mae and Freddie Mac,
the financial system began to gradually improve. While the economy has been
dealing with the effects long since they happened, unemployment rates are
becoming relatively low and we are certainly not in as bad of shape as we once
were; there are many lessons to be learned from the financial crisis and the bailout, we can only hope lenders and investors will be more careful in the future.

Works Cited

Amadeo, Kimberly. "AIG Bailout: Cost, Timeline, Bonuses, Causes,


Effects."About News. About.com, 2015. Web. 05 Dec. 2015.
<http://useconomy.about.com/od/criticalssues/tp/AIG_Bailout.htm>.
"Bailout Recipients." Pro Publica. Pro Publica Inc., 2015. Web. 06 Dec.
2015. <https://projects.propublica.org/bailout/list>.
"Databases, Tables & Calculators by Subject." Bureau of Labor Statistics
Data. U.S. Bureau of Labor Statistics, 2015. Web. 07 Dec. 2015.
<http://data.bls.gov/timeseries/LNS14000000>.
"FRB: Monetary Policy Report to the Congress, February 27, 2002." FRB:
Monetary Policy Report to the Congress, February 27, 2002. N.p.,
2002. Web. 07 Dec. 2015.
<http://www.federalreserve.gov/boarddocs/hh/2002/February/Report
Section2.htm>.
KARNITSCHNIG, MATTHEW, DEBORAH SOLOMON, LIAM PLEVEN, and
JON E. HILSENRATH. "U.S. to Take Over AIG in $85 Billion Bailout;
Central Banks Inject Cash as Credit Dries Up." WSJ. Dow Jones &

Company, Inc, 2015. Web. 07 Dec. 2015.


<http://www.wsj.com/articles/SB122156561931242905?mg=id-wsj>.