Subprime Mortgage Crisis Solutions Debate - Overview

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.

Geithner testified before Congress on October 29, 2009. His testimony included five elements he stated as critical to effective reform:

  1. Expand the Federal Deposit Insurance Corporation (FDIC) bank resolution mechanism to include non-bank financial institutions;
  2. Ensure that a firm is allowed to fail in an orderly way and not be "rescued";
  3. 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;
  4. Apply appropriate checks and balances to the FDIC and Federal Reserve in this resolution process;
  5. Require stronger capital and liquidity positions for financial firms and related regulatory authority.

The U.S. Senate passed a regulatory reform bill in May 2010, following the House which passed a bill in December 2009. These bills must now be reconciled. 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 Dodd–Frank Wall Street Reform and Consumer Protection Act was signed into law in July 2010.

Solutions may be organized in these categories:

  1. Investor confidence or liquidity: Central banks have expanded their lending and money supplies, to offset the decline in lending by private institutions and investors.
  2. 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).
  3. Economic stimulus: Governments have increased spending or cut taxes to offset declines in consumer spending and business investment.
  4. 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.
  5. Regulatory: New or reinstated rules designed help stabilize the financial system over the long-run to mitigate or prevent future crises.

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