Containing Financial Crisis
Summary
There is no precise definition of “financial crisis,” but a common view is thatdisruptions in financial markets rise to the level of a crisis when the flow of credit tohouseholds and businesses is constrained and the real economy of goods and servicesis adversely affected. Since mid-2007, governments have tried with limited successto keep the downturn in U.S. subprime housing from developing into such a crisis.Subprime mortgage problems, and the financial shock they caused, were widelyanticipated, but the spread of turmoil into many seemingly unrelated parts of theglobal financial system was not. Many of the losses occurring in diverse firms andmarkets — often quite severe — have common features: the use of complex,hard-to-value financial instruments; large speculative positions underwritten byborrowed funds, or leverage; and the use of off-the-books entities to remove riskytrading activities from the balance sheets of major financial institutions. Because of the prevalence of innovative financial arrangements, the housing downturn appearsto have triggered market dynamics that amplify the effects of financial shocks andgenerate self-reinforcing, downward financial and economic spirals.The Federal Reserve and foreign central banks have cut short-term interest ratesdramatically and injected trillions of dollars into the banking system to keep creditflowing. The Fed and Treasury have engaged in a series of extraordinaryinterventions to shore up failing financial institutions. The Fed provided $29 billionto underwrite the rescue-through-acquisition of Bear Stearns, a leading investmentbank, and loaned billions to AIG, a leading insurer. Fannie Mae and Freddie Machave been placed in government conservatorship, with the Treasury pledging to standbehind the $5 trillion in bonds the two firms sold or guaranteed. In September 2008,as market conditions appeared to worsen, Congress passed a $700 billion rescue plan(P.L. 110-343), authorizing the Treasury to purchase securities to shore up bank balance sheets. In October, as conditions appeared to worsen, the Fed entered thecommercial paper market and purchased tens of billions in short-term corporate debt.Simultaneously, trillions of dollars in private debt now carries governmentguarantees. The duration of the current instability is in marked contrast to financialshocks of recent decades, when the central bank was able to contain market problemsquickly with little or no interruption of U.S. economic growth.Depending on how soon normal market conditions are restored, and on theseverity of the economic slowdown, Congress may view the social costs of failedfinancial speculation as sufficient to warrant new restrictions to reduce the incidenceof losses that have system-wide impacts or to put the markets and the economy in abetter position to weather such shocks. The Treasury has already proposed asweeping restructuring of financial regulation.This report supplements CRS Report RL34182,
Financial Crisis? The LiquidityCrunch of August 2007
, by Darryl Getter et al., which describes in greater detail thechannels through which subprime problems cascaded through the financial system.This report focuses on the efforts of regulators to restore market stability and will beupdated as developments warrant.
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