In the days and weeks leading up to the $700 billion financial rescue plan, Treasury Secretary Henry M. Paulson underscored the seriousness of the problems panicking the financial system and the need for swift action to deal with the crisis. The markets tanked after the House voted down the proposal to give the Treasury funds to buy troubled assets from financial institutions, and then a spooked Congress quickly passed an amended version of the Paulson plan. Still, the markets remained volatile. The second week of October saw the Dow suffer the largest losses in its history, losing 22 percent, to rebound the next week with the biggest one-day rally since the 1930s, and then fade again.
With the bailout--including a $250 billion government recapitalization of U.S. banks--the past several months have changed the function of the U.S. financial system, with the federal government intervening in unprecedented ways and adopting eye-popping rescue packages that give the Treasury unparalleled powers. From the Bear Stearns bailout in March; the sale of Merrill Lynch in August; the government takeover of Fannie Mae, Freddie Mac, and AIG; the failure of Lehman Brothers and Washington Mutual; and the conversions of Goldman Sachs and Morgan Stanley to bank holding companies in September, AEI scholars have provided ideas to understand the crisis and have proposed what steps need to be taken to protect the financial system.
Peter J. Wallison has pointed out for a decade the dangers of the government-sponsored enterprise (GSE) model, saying that the "implicit" government backing of Fannie and Freddie would quickly become explicit--and costly to taxpayers--if the GSEs ever weakened or failed. Wallison coauthored or edited several prophetic AEI Press books on Fannie and Freddie, and he was proven correct in his predictions this year when the GSEs suffered massive losses from their risky loan portfolios and had to be saved by the government. He called the government rescue of the mortgage giants "a major disappointment," and in a September 2008 Financial Services Outlook, he and Charles W. Calomiris argued that policymakers must fight against the restoration of the GSE model to prevent a repeat of this financial disaster.
John H. Makin has repeatedly emphasized the connection between a weak housing sector and U.S. recessions, writing several Economic Outlooks about subprime lending losses and their impact on the economy. In his latest Outlook, he wrote that "the time had come for the Federal Reserve and the U.S. Treasury, together with other G7 central banks and treasuries, to move from a reactive, piecemeal approach in the face of a global financial crisis to a proactive, systemic approach." He warned that if lending institutions that make mortgage loans are not required to keep the loans on their balance sheets, we will continue to suffer future housing bubbles and busts.
It has not just been American markets and firms that have suffered the financial fallout from the crisis; international markets have tumbled, and foreign governments are devising their own bailout plans. Alex J. Pollock argued that the current situation requires direct equity capital injections into struggling U.S. banks, a plan adopted in Great Britain and then in the United States. This will make taxpayers explicit investors in the firms and should allow them to reap financial benefits when the firms return to profitability. Pollock wrote in a Forbes.com piece that "Congress and the Treasury should be putting a crisis equity investing operation, with any profits earmarked as dividends for the taxpayer-investors, in gear now."
For more information on the causes and consequences of the financial crisis and AEI scholars' predictions and responses, visit www.aei.org/FinancialCrisis/.
