The Senate passed the $700 billion bank bailout bill on October 3 2008. The guts of the bill was the same as the three-page document submitted on September 21 2008, by Treasury Secretary Henry Paulson. Paulson had asked Congress to approve a $700 billion bailout to buy mortgage-backed securities that were in danger of defaulting. By doing so, Paulson wanted to take these debts off the books of the banks, hedge funds and pension funds that held them. The goal was to instill confidence in the functioning of the global banking system, which had narrowly avoided collapse.
The bill established the Troubled Assets Recovery Program (TARP). It originally gave troubled banks the right to submit a bid price to sell their assets to TARP as part of a reverse auction. Each auction was to be for a certain asset class. TARP administrators would select the lowest price for each asset class, which was to help assure that the government didn't pay too much for distressed assets. However, it took too long to develop the auction program, so instead Treasury lent $115 billion to banks by purchasing preferred stock. (Source: WSJ, Historic Bailout Passes as Economy Slips Further, October 4, 2008)
The Bailout Bill Helped More Than Just Banks
Congress attached other much-needed oversights. As a result, the bill included help for homeowners facing foreclosure by requiring Treasury to both guarantee their loans and assist them in adjusting mortgage terms through HOPE NOW. It increased FDIC insurance for bank deposits to $250,000, and allowed the agency to tap as much federal funds as needed through 2009, allaying any fears that the FDIC itself might go bankrupt.
The bill allowed the SEC to suspend the mark-to-market rule. This law forced banks to continually write down the value of their mortgages to present-day levels. This meant that bad loans, which could not be resold in the current panic-stricken climate, had to be valued at less than their probable true worth. (Source: Bloomberg, Bank-Rescue Plan Wins Approval as House Reverses Vote, October 3, 2008)
The bill contained an additional $150 billion in tax breaks to be phased in over 10 years. These included an extension of the AMT patch, tax credits for research and development, and relief for hurricane survivors. For more of the tax breaks, see WSJ, Senate Vote Gives Bailout Plan New Life, October 1, 2008.
Exactly How Was the Bailout Bill Passed?
By October 3, the Senate had re-introduced the proposal by attaching it to a bill that was already under consideration. This side-stepped the House of Representatives, which usually must introduce any funding bills. The Senate's tactic resulted in successful passage of the bill by the House, and President Bush signed it into law.
It also kept many of the provisions added by the House:
- An oversight committee to review Treasury's purchase and sale of mortgages. The committee is comprised of Federal Reserve Chair Ben Bernanke, and the leaders of the SEC, the Federal Home Finance Agency and HUD.
- Bailout installments, starting with $250 billion.
- The ability for Treasury to negotiate a government equity stake in companies that received bailout assistance.
- Limits on executive compensation of rescued firms. Specifically, companies can't deduct the expense of executive compensation above $500,000.
- Government-sponsored insurance of assets in troubled firms.
- A requirement that the President propose legislation to recoup losses from the financial industry if any still existed after five years. (Source: Senate Banking Committee, Bailout Bill Summary pdf; CNNMoney, Rescue Bill Released, September 28, 2008.)
The Senate was forced to bypass the House, which had initially defeated the proposal that amounted to a taxpayer bailout of bad banking decisions. However, this caused the Dow to drop 770 points, and global markets to plummet. Therefore, the Senate created an amendment to an existing bill, and the House finally approved that version on October 3, 2008. (For more, read Bank Bailout Bill Implodes)
Why Was the Bailout Bill Necessary?
The bailout was triggered by a record $140 billion being pulled out of money-market accounts, usually considered the safest of investments. That's because investors were moving the funds to U.S. Treasuries, causing yields to drop to zero. To stem the panic, the Treasury agreed to insure these funds for a year. In addition the SEC banned short-selling of financial stocks until October 2 to reduce volatility in the stock market. (For more, see What Triggered the Bank Bailout Bill?)
The U.S. government bought these bad mortgages because banks were afraid to lend to each other. This fear caused LIBOR rates to be unnaturally higher than the Fed funds rate and stock prices to plummet. Financial firms were unable to sell their debt. Without the ability to raise capital, these firms were in danger of going bankrupt, just as Lehman Brothers did, and AIG and Bear Stearns would have without Federal intervention.
As it should, Congress debated the pros and cons of such a massive intervention. Political leaders wanted to protect the taxpayer and not let businesses off the hook for making bad decisions. Most in Congress recognized the need to act swiftly to avoid a further financial meltdown. It became a case of fear feeding on fear, with banks afraid to disclose their bad debt, which would lead to a downgrade in their debt rating, which would lead to a decline in their stock price, which would lead to their inability to raise capital, which would lead to bankruptcy. This fear of disclosure led to an overall panic, fed by rumor, which locked up the credit markets.
Was the taxpayer really out $700 billion? No, since Congress only authorized $350 billion to be lent out in 2008. The other $350 billion was saved for the new President when he took office in 2009. Obama never used the TARP funds to further bail out banks. Instead, he launched the $787 billion Economic Stimulus package. Second, the government bought bank stocks when the prices were depressed and sold later, when prices were higher. By 2012, banks had repaid $292 billion of TARP funds, leaving only $120 billion still outstanding. These funds were used for the HARP program, to help homeowners facing foreclosure. Third, the bill required the President to develop a plan to recoup losses from the financial industry if needed.
For an explanation of the events that led to the crisis, read Financial Crisis Timeline, Could the Mortgage Crisis and Bailout Have Been Prevented?, and What Was the Global Financial Crisis of 2008?