The Subprime mortgage crisis solutions debate discusses various actions and proposals by economists, government officials, journalists, and business leaders to address the subprime mortgage crisis and broader 2008 financial crisis.
Overview The debate concerns both immediate responses to the ongoing subprime mortgage crisis, as well as long-term reforms to the global financial system. During 2008–2009, solutions focused on support for ailing financial institutions and economies. During 2010, debate continued regarding the nature of reform. Key points include: the split-up of large banks; whether depository banks and investment banks should be separated; whether banks should be able to make risky trades on their own accounts; how to wind-down large investment banks and other non-depository financial institutions without taxpayer impact; the extent of financial cushions that each institution should maintain (leverage restrictions); the creation of a consumer protection agency for financial products; and how to regulate derivatives.
Critics have argued that governments treated this crisis as one of investor confidence rather than deeply indebted institutions unable to lend, delaying the appropriate remedies. Others have argued that this crisis represents a reset of economic activity, rather than a recession or cyclical downturn.
In September 2008, major instability in world financial markets increased awareness and attention to the crisis. Various agencies and regulators, as well as political officials, began to take additional, more comprehensive steps to handle the crisis. To date, various government agencies have committed or spent trillions of dollars in loans, asset purchases, guarantees, and direct spending. For a summary of U.S. government financial commitments and investments related to the crisis, see CNN – Bailout Scorecard.
In the U.S. during late 2008 and early 2009, President Bush's $700 billion Troubled Asset Relief Program (TARP) was used to re-capitalize ailing banks through the investment of taxpayer funds. The U.S. response in 2009, orchestrated by U.S. Treasury Secretary Timothy Geithner and supported by President Barack Obama, focused on obtaining private sector money to recapitalize the banks, as opposed to bank nationalization or further taxpayer-funded capital injections. In an April 2010 interview, Geithner said: "The distinction in strategy that we adopted when we came in was to try and maximize the chance that capital needs could be met privately, not publicly." Geithner used "stress tests" or analysis of bank capital requirements to encourage private investors to re-capitalize the banks to the tune of $140 billion. Geithner has strenuously opposed actions that might interfere with private recapitalization, such as stringent pay caps, taxes on financial transactions, and the removal of key bank leaders. Geithner acknowledges this strategy is not popular with the public, which wants more draconian reforms and the punishment of bank leaders.
President Obama and key advisors introduced a series of longer-term regulatory proposals in June 2009. The proposals address consumer protection, executive pay, bank financial cushions or capital requirements, expanded regulation of the shadow banking system and derivatives, and enhanced authority for the Federal Reserve to safely wind-down systemically important institutions, among others.Washington Post – Geithner & Summers – A New Financial Foundation
Geithner testified before Congress on October 29, 2009. His testimony included five elements he stated as critical to effective reform: Expand the Federal Deposit Insurance Corporation (FDIC) bank resolution mechanism to include non-bank financial institutions; Ensure that a firm is allowed to fail in an orderly way and not be "rescued"; Ensure taxpayers are not on the hook for any losses, by applying losses to the firm's investors and creating a monetary pool funded by the largest financial institutions; Apply appropriate checks and balances to the FDIC and Federal Reserve in this resolution process; Require stronger capital and liquidity positions for financial firms and related regulatory authority.Secretary Geithner Testimony to House Financial Service Committee-October 29, 2009
The U.S. Senate passed a regulatory reform bill in May 2010, following the House, which passed a bill in December 2009. The New York Times has provided a comparative summary of the features of the two bills, which address to varying extent the principles enumerated by Secretary Geithner. The two bills were reconciled, and the Dodd–Frank Wall Street Reform and Consumer Protection Act was signed into law in July 2010.
Solutions may be organized in these categories: Investor confidence or liquidity: Central banks have expanded their lending and money supplies, to offset the decline in lending by private institutions and investors. Deeply indebted institutions or solvency: Some financial institutions are facing risks regarding their solvency, or ability to pay their obligations. Alternatives involve restructuring through bankruptcy, bondholder haircuts, or government bailouts (i.e., nationalization, receivership or asset purchases). Economic stimulus: Governments have increased spending or cut taxes to offset declines in consumer spending and business investment. Homeowner assistance: Banks are adjusting the terms of mortgage loans to avoid foreclosure, with the goal of maximizing cash payments. Governments are offering financial incentives for lenders to assist borrowers. Other alternatives include systematic refinancing of large numbers of mortgages and allowing mortgage debt to be "crammed down" (reduced) in homeowner bankruptcies. Regulatory: New or reinstated rules designed help stabilize the financial system over the long-run to mitigate or prevent future crises.
Liquidity All major corporations, even highly profitable ones, borrow money to finance their operations. In theory, the lower interest rate paid to the lender is offset by the higher return obtained from the investments made using the borrowed funds. Corporations regularly borrow for a period of time and periodically "rollover" or pay back the borrowed amounts and obtain new loans in the credit markets, a generic term for places where investors can provide funds through financial institutions to these corporations. The term liquidity refers to this ability to borrow funds in the credit markets or pay immediate obligations with available cash. Prior to the crisis, many companies borrowed short-term in liquid markets to purchase long-term, illiquid assets like mortgage-backed securities (MBSs), profiting on the difference between lower short-term rates and higher long-term rates. Some have been unable to "rollover" this short-term debt due to disruptions in the credit markets, forcing them to sell long-term, illiquid assets at fire-sale prices and suffering huge losses.
The central bank of the USA, the Federal Reserve or Fed, in partnership with central banks around the world, has taken several steps to increase liquidity, essentially stepping in to provide short-term funding to various institutional borrowers through various programs such as the Term Asset-Backed Securities Loan Facility (TALF). Fed Chairman Ben Bernanke stated in early 2008: "Broadly, the Federal Reserve's response has followed two tracks: efforts to support market liquidity and functioning and the pursuit of our macroeconomic objectives through monetary policy." The Fed, a quasi-public institution, has a mandate to support liquidity as the "lender of last resort" but not solvency, which resides with government regulators and bankruptcy courts.
Lower interest rates
Arguments for lower interest rates Lower interest rates stimulate the economy by making borrowing less expensive. The Fed lowered the target for the Federal funds rate from 5.25% to a target range of 0-0.25% since 18 September 2007. Central banks around the world have also lowered interest rates.
Lower interest rates may also help banks "earn their way out" of financial difficulties, because banks can borrow at very low interest rates from depositors and lend at higher rates for mortgages or credit cards. In other words, the "spread" between bank borrowing costs and revenues from lending increases. For example, a large U.S. bank reported in February 2009 that its average cost to borrow from depositors was 0.91%, with a net interest margin (spread) of 4.83%. Profits help banks build back equity or capital lost during the crisis.
Arguments against lower interest rates Other things being equal, economic theory suggests that lowering interest rates relative to other countries weakens the domestic currency. This is because capital flows to nations with higher interest rates (after subtracting inflation and the political risk premium), causing the domestic currency to be sold in favor of foreign currencies, a variation of which is called the carry trade. Further, there is risk that the stimulus provided by lower interest rates can lead to demand-driven inflation once the economy is growing again. Maintaining interest rates at a low level also discourages saving, while encouraging spending.
Monetary policy and "credit easing" Expanding the money supply is a means of encouraging banks to lend, thereby stimulating the economy. The Fed can expand the money supply by purchasing Treasury securities through a process called open market operations which provides cash to member banks for lending. The Fed can also provide loans against various types of collateral to enhance liquidity in markets, a process called credit easing. This is also called "expanding the Fed's balance sheet" as additional assets and liabilities represented by these loans appear there. A helpful overview of credit easing is available at: Cleveland Federal Reserve Bank-Credit Easing
The Fed has been active in its role as "lender of last resort" to offset declines in lending by both depository banks and the shadow banking system. The Fed has implemented a variety of programs to expand the types of collateral against which it is willing to lend. The programs have various names such as the Term auction facility and Term Asset-Backed Securities Loan Facility. A total of $1.6 (~$ in ) trillion in loans to banks were made for various types of collateral by November 2008. In March 2009, the Federal Open Market Committee (FOMC) decided to increase the size of the Federal Reserve’s balance sheet further by purchasing up to an additional $750 billion of agency (Government-sponsored enterprise) mortgage-backed securities, bringing its total purchases of these securities to up to $1.25 trillion this year, and to increase its purchases of agency debt this year by up to $100 billion to a total of up to $200 billion. Moreover, to help improve conditions in private credit markets, the Committee decided to purchase up to $300 billion (~$ in ) of longer-term Treasury securities during 2009. The Fed also announced that it was expanding the scope of the TALF program to allow loans against additional types of collateral.
Arguments for credit easing According to Ben Bernanke, expansion of the Fed balance sheet means the Fed is electronically creating money, necessary "... because our economy is very weak and inflation is very low. When the economy begins to recover, that will be the time that we need to unwind those programs, raise interest rates, reduce the money supply, and make sure that we have a recovery that does not involve inflation."
Arguments against credit easing