SHOULD GOVERNMENT BAIL OUT THE BIG FINANCIAL COMPANIES?
The 2008 financial crisis is thought by many to be the worst financial crisis since the Great Depression. The crisis was triggered by the burst of the housing bubble, a result of a complex interplay of government policies that encouraged home ownership and borrowing. Such government policies, in the absence of regulatory framework keeping up with new financial practices, led to irresponsible underwriting practices of both lenders and borrowers. These actions provided easier access to mortgages for subprime borrowers and contributed to the expansion of subprime lending.
The crisis started on March 10, 2008 when the Dow Jones Industrial Average plunged to its lowest level since October 2006, falling 20 percent from its peak just five months before. The downturn swept the whole of Wall Street. Bear Stearns, a global investment bank and securities trading and brokerage business, was among the worst affected. The company was interconnected with other banks up and down Wall Street. Fearing systemic risks that may affect the financial system as a whole, should Bear Stearns go bankrupt, Ben Bernanke, the Chairman of the Federal Reserve, determined the risks were too great to allow a Bear Stearns bankruptcy. The worry was also shared by Henry Paulson, the Secretary of the Treasury Department. In pondering whether to bail out Bear Stearns, Paulson posed the question of moral hazard: If you bail someone out of a problem caused by themselves, what incentive will they have to avoid making the same mistake in the future?
Anticipating the system risk, the Federal Reserve Bank of New York provided an emergency loan to Bear Stearns; however, it still could not avert the collapse of the company. Finally, the company was forced to be sold to JPMorgan Chase for a price far below its pre-crisis market value.
This was just the prelude of the crisis. Within six months of the federal takeover of Fannie Mae and Freddie Mac, as well as the selling of Merrill Lynch to Bank of America, Lehman Brothers started to collapse. This time, moral hazard trumped system risk. Bernanke and Paulson, under the pressure of exhausting bailout funds, decided not to intervene, in the hope that the risk of Lehman Brothers’ bankruptcy could be contained. Lehman Brothers’ bankruptcy, however, triggered a market avalanche. The stock market dropped by hundreds of points right after the opening bell. The company was far more interconnected than Bernanke and Paulson had thought. Systemic risk became a reality. Banks stopped lending in the fear that other banks would not be able to pay them back. The credit markets became frozen and commerce ground to a halt.
Meanwhile, the world’s largest insurance company, American International Group (AIG) was plunging to the rim of bankruptcy. AIG had invested tens of billions in risky investments that were tied to the housing market. The precipitous failure of such a big organization can be extremely disruptive. Fully aware of the potential risk, the Fed decided to lend AIG $85 billion and took the world’s largest insurance company under government control.
As one firm after another crumbled, systemic risk kicked in and a fear of losing control swept over Wall Street. Bernanke was afraid that the meltdown could no longer be handled on
a case-by-case basis and the Fed reached its limit. They had to get government involved in a broader rescue.
On September 18, Paulson and Bernanke met with key legislators to propose a $700 billion emergency bailout through the purchase of toxic assets. On October 3, 2008, President George W. Bush signed the Emergency Economic Stabilization Act and approved the $700 billion bailout bill.
Questions for Discussion and Analysis
1. Should government rescue these big financial companies? What are the implications of the bailout?
2. How would Adam Smith and Alexander Hamilton view the bailout?
3. How could we effectively prevent such a crisis from happening in the future?
Book: Building Business-Government Relations: A Skills Approach, 2016 Routledge
