Order Code RS22963
September 29, 2008
Financial Market Intervention
Edward V. Murphy
Analyst in Financial Economics
Government and Finance Division
Summary
Financial markets continue to experience significant disturbance and the banking
sector remains fragile. Efforts to restore confidence have been met with mixed success
thus far. After attempting to deal with troubled institutions on a case-by-case basis,
Treasury has proposed a plan to purchase mortgage-related assets to alleviate stress in
financial markets and in the banking system. This report provides answers to some
frequently asked questions concerning the financial disruptions of September 2008 and
the Troubled Asset Relief Program (TARP) in H.R. 3997.
Current Concerns
What, if anything, is wrong with the financial system? Banks and other
financial institutions have been reluctant to lend or otherwise engage with other
institutions for fear of exposure to the bad assets of troubled counterparties. That is, a
relatively healthy bank is afraid to sign a contract with other institutions because of the
fear that the other institution will not be able to fulfil its obligations. For similar reasons,
banks that need to raise capital have had trouble doing so because potential investors are
afraid that the full extent of damage to banks’ assets has not yet been revealed. Under
these conditions it is difficult for people who depend on regularly accessing credit markets
to get loans, which in turn can affect the broader economy. Often, this lack of confidence
in other financial institutions expresses itself in wide spreads between market interest
rates and the yield on Treasury securities. These spreads have been relatively wide for the
past year. They spiked following recent interventions intended to prevent disorderly
bankruptcies, an indication of significant loss of confidence.1
When did trouble in the financial markets start? Loss of market confidence
can be proxied by spreads in interest rates between Treasury securities and riskier assets
1 CRS Report RS22956, The Cost of Government Financial Interventions, Past and Present, by
Baird Webel, N. Eric Weiss, and Marc Labonte.

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of similar maturities. These spreads first spiked in August 2007.2 Although spreads
declined following policy responses by the Federal Reserve, the Treasury, and the passage
of the stimulus package, the spreads did not return to their pre-August 2007 level. The
persistence of historically wide spreads during 2007-2008 suggests that full confidence
has not been restored.
What caused financial market turmoil? Although there are several
contributing elements, most observers agree that rising defaults among residential
mortgage borrowers sparked the initial loss in financial market confidence.3 Various
observers place different emphasis on low interest rates that caused a housing bubble that
in this view was bound to eventually burst, insufficient regulation of subprime mortgage
lending practices, and insufficient monitoring of complex financial products and services,
especially rating agencies and derivatives markets.4
If 97% of borrowers are still current on their mortgage, why is the
financial turmoil so large? Several factors magnify the effects of loan defaults on the
financial system. First, banks are leveraged, which means that for a given dollar reduction
in the value of their assets they must either raise additional capital or reduce their lending
by a multiple of the loss.5 Second, banks have become less transparent because of
changes in accounting and risk management. This lack of transparency has made it more
difficult for banks to raise additional capital as an alternative to reducing lending or
selling assets. Third, the use of financial derivatives that should have reduced risk in the
banking system may have had the effect of increasing leverage and making it even harder
to identify sound counterparties.
Where are the problem loans located? Two of the problem loan categories,
subprime and Alt-A, are disproportionately located in areas that had previously
experienced rapid price appreciation. This includes Florida, California, Arizona, and
Nevada. In addition, subprime loans are disproportionately located in relatively low
income and minority neighborhoods across the country.6
Why did the financial shocks happen? Reasonable people will continue to
disagree as to the root cause of the turmoil. The following factors are not mutually
exclusive. Some believe that low interest rates and loose monetary policy caused a
housing bubble that was bound to burst when interest rates rose.7 Others place more
2 CRS Report RL34182, Financial Crisis? The Liquidity Crunch of August 2007, by Darryl E.
Getter, Edward V. Murphy, Marc Labonte, and Mark Jickling.
3 CRS Report RL33775, Alternative Mortgages: Causes and Policy Implications of Troubled
Mortgage Resets in the Subprime and Alt-A Markets, by Edward V. Murphy.
4 CRS Report RS22932, Credit Default Swaps: Frequently Asked Questions, by Edward V.
Murphy.
5 CRS Report RL34412, Averting Financial Crisis, by Mark Jickling.
6 CRS Report RL34232, Understanding Mortgage Foreclosure: Recent Events, the Process, and
Costs, by Darryl E. Getter.
7 CRS Report RL33666, Asset Bubbles: Economic Effects and Policy Options for the Federal
Reserve, by Marc Labonte.

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emphasis on loose lending standards that may have been fostered by a lack of regulation
of non-bank lenders and a lack of market discipline by mortgage-backed securities issuers
who sold the loans to other investors.8 Another group places the blame on the failure of
officials to regulate relatively recent innovations in finance. Still others emphasize
potentially irresponsible marketing practices or fraud by subprime lenders. Some
observers blame investors and borrowers who did not adequately investigate the risks of
their decisions.
Who is affected by the financial turmoil? The financial turmoil also affects
anyone seeking credit, including troubled home owners who wish to refinance out of a
troubled mortgage. Restrictions in credit have contributed to a downward spiral in home
prices. The people most directly affected by financial market turmoil are investment
bankers and investors. These people may lose their jobs and livelihood. Business firms
are also affected because their cost of financing possible projects has risen, which in turn
can hurt the broader economy.
How have policymakers responded to financial turmoil? Many modern
macroeconomists believe that there are two basic policy responses to avoid an economic
slowdown.9 First, the Federal Reserve can provide expansionary monetary policy by
lowering interest rates, as it did starting in the fall of 2007.10 Second, the government can
provide expansionary fiscal policy by spending more than it collects in taxes, as it did
with the stimulus package.11 In addition to pursuing both of these responses,
policymakers have also sought to prevent the financial sector from ceasing to function.
Liquidity was increased by expanding the range of collateral accepted at the Federal
Reserve’s discount window and by holding regular liquidity auctions.12 Policymakers at
the Federal Reserve and the Treasury have also tried to overcome collective action
problems among private investors to help arrange buyers of distressed firms, as it did for
Bear Stearns and Lehman Brothers (even though the government was unwilling to also
provide funding to facilitate a purchase of Lehman Brothers).13
Policymakers have also sought to help stabilize mortgage markets. In addition to
Treasury, the Department of Housing and Urban Development (HUD), and the Federal
Deposit Insurance Corporation (FDIC) efforts to help organize loan servicers through the
HOPE Now program, the Securities and Exchange Commission (SEC) and Internal
Revenue Service (IRS) have issued rules clarifying the ability of loan servicers to modify
8 CRS Report RS22722, Securitization and Federal Regulation of Mortgages for Safety and
Soundness, Edward V. Murphy.
9 CRS Report RL34349, Economic Slowdown: Issues and Policies, by Jane G. Gravelle, Thomas
L. Hungerford, Marc Labonte, N. Eric Weiss, and Julie M. Whittaker.
10 CRS Report RS22371, The Pattern of Interest Rates: Does It Signal an Impending Recession?
by Marc Labonte and Gail E. Makinen.
11 CRS Report RS22850, Tax Provisions of the Economic Stimulus Package, by Jane G. Gravelle.
12 CRS Report RL34427, Financial Turmoil: Federal Reserve Policy Responses, by Marc
Labonte.
13 CRS Report RL34420, Bear Stearns: Crisis and ‘Rescue’ for a Major Provider of
Mortgage-Related Products, by Gary Shorter.

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loans held in securitized trusts.14 The government also enacted (P.L. 110-289) a voluntary
plan to allow banks to write down the balance of existing loans so that borrowers can
refinance into FHA to avoid foreclosure.15 The act also provided some Community
Development Block Grant (CDBG) funds to allow local communities to acquire and
redevelop vacant and foreclosed properties.16 The act also created a new regulator for the
government-sponsored enterprises (GSEs), Fannie Mae, Freddie Mac, and the Federal
Home Loan Banks.17 The act gave Treasury the temporary authority to purchase debt and
equity securities of the GSEs.
September 2008 saw a series of financial market interventions. First, the newly
reorganized Federal Housing Finance Agency (FHFA) placed the GSEs in a
conservatorship with agreements by the Federal Reserve Bank of New York to assure
liquidity and by the Treasury to purchase enough preferred stock and securities to ensure
adequate capitalization.18 On a single weekend, policymakers helped broker a deal to sell
investment bank Merrill Lynch to Bank of America and failed to broker a similar deal for
Lehman Brothers, reportedly because the government declined to provide financial
support. Lehman Brothers subsequently declared bankruptcy. A policy of no financial
support did not survive the week, as insurer AIG was granted a bridge loan three days
later.19 The next day financial markets froze up and Treasury announced a proposal to
buy mortgage-related assets from financial institutions.
Why has the Federal Reserve not restored order in financial markets?
The Federal Reserve’s primary tools help provide liquidity but do not restore capital
levels. Liquidity generally refers to the ability to access markets, either as a firm issuing
bonds or as a person selling a good, without suffering “fire-sale” prices. An adequate
capital level is generally determined as a relation between assets and liabilities. All of a
firm’s assets can be completely liquid (cash) but the firm can remain undercapitalized if
small losses can reduce its capital to near insolvency. These concepts are related. Even
if a firm has liquid assets, it may have difficulty accessing credit markets to borrow more
funds because it is too close to insolvency to be perceived as a good credit risk.
Complexities of mortgage-related securities have made it difficult to ascertain their value,
thus those assets have become less liquid. Furthermore, investors know that some banks
have suffered loan losses that reduced their capital, but the complexities of the mortgage-
related assets have made it difficult to identify which banks are undercapitalized. As a
result, the liquidity of mortgage-related assets has been reduced, and the liquidity of
financial firms has been reduced. The Federal Reserve has taken steps to increase the
14 CRS Report RL34372, The HOPE NOW Alliance/American Securitization Forum (ASF) Plan
to Freeze Certain Mortgage Interest Rates, by David H. Carpenter and Edward V. Murphy.
15 CRS Report RL34623, Housing and Economic Recovery Act of 2008, by N. Eric Weiss, Darryl
E. Getter, Mark Jickling, Mark P. Keightley, Edward V. Murphy, and Bruce E. Foote.
16 CRS Report RS22919, Community Development Block Grants: Legislative Proposals to Assist
Communities Affected by Home Foreclosures, by Eugene Boyd and Oscar R. Gonzales.
17 CRS Report RL33940, Reforming the Regulation of Government-Sponsored Enterprises in the
110th Congress, by Mark Jickling, Edward V. Murphy, and N. Eric Weiss.
18 CRS Report RS22950, Fannie Mae and Freddie Mac in Conservatorship, by Mark Jickling.
19 CRS Report RS22956, The Cost of Government Financial Interventions, Past and Present
Baird Webel, N. Eric Weiss, and Marc Labonte.

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liquidity of particular assets, for example, by expanding the categories of assets that it will
accept as collateral for loans, but the Federal Reserve has not restored bank capital.
What does Treasury propose to do? The Department of the Treasury
proposed replacing the case-by-case approach to interventions in the financial markets
that had prevailed from summer 2007 through summer 2008 with a systemic program.20
Some believe that intervening on behalf of some ailing financial institutions but not others
contributes to investor uncertainty. Treasury proposed a program similar to the
Resolution Trust Corporation (RTC) that could acquire $700 billion of mortgage-related
assets from the banking system. The original proposal gave the Secretary of the Treasury
broad discretion to determine the terms of asset acquisition and the operations of the
program. Some policymakers have suggested that any program provide greater
management oversight, limits on the executive pay of participating financial institutions,
and other conditions to monitor the use of taxpayer funds. Some policymakers have also
suggested that bankruptcy judges be granted the authority to modify loans of troubled
borrowers under some circumstances. Another possibility is providing a government
guarantee of payment on the assets rather than government acquisition.
What were some of the additions and deletions to the proposal offered
in H.R. 3997? The expressed purpose of the Emergency Economic Stabilization Act
of 2008, H.R. 3997, was to “...provide authority and facilities that the Secretary of the
Treasury can use to restore liquidity and stability to the financial system.”21 This measure,
voted down on September 29, 2008, addressed some of the concerns that some
policymakers may have had regarding the three-page Treasury plan. A short description
of some of the provisions of the Troubled Asset Relief Program (TARP) follows.
! It excludes foreign central banks from the definition of eligible financial
institutions but includes institutions in U.S. territories, such as Guam and
the Virgin Islands.
! It provides for insurance of some troubled assets as an alternative to, or
in addition to, purchasing troubled assets.
! It creates a Financial Stability Oversight Board to review the exercise of
authority under the program. The board will be made up of the Chairman
of the Federal Reserve, the Secretary of the Treasury, the Secretary of the
Department of Housing and Urban Development, the Director of the
Federal Housing Finance Agency, and the Chairman of the Securities and
Exchange Commission.
! The Treasury will manage the acquisition and sale of assets with any
proceeds accruing to the general fund for reduction of the public debt.
! The measure instructs the Secretary of Treasury to implement a plan to
maximize assistance for homeowners and to encourage loan servicers to
participate in the Hope for Homeowners program. Assistance to
homeowners includes consent to reasonable loan modification requests.
20 CRS Report RS22957, Proposal to Allow Treasury to Buy Mortgage-Related Assets to Address
Financial Instability, by Edward V. Murphy and Baird Webel.
21 H.R. 3997 was originally introduced as a tax relief measure to assist service members. The
present discussion is based on a draft (as of 9:10 p.m., Sep. 28, 2008) offered by the House in the
nature of a substitute.

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! The measure puts limits on executive compensation of institutions that
participate. Under certain circumstances, these limits include limits on
incentive compensation for risk-taking during the period that the program
has an equity or debt position in the firm, recovery of incentive bonuses
paid to senior executives based on financial statements that are later
shown to be false, and a prohibition of golden parachutes.
! The Comptroller General has ongoing oversight of TARP management
and activities.
! There is to be a study of excessive leverage in financial institutions.
! The President will appoint a special inspector for TARP, with Senate
confirmation.
! The debt limit is raised to $11.3 trillion.
! A Congressional Oversight Panel is created in the legislative branch to
monitor financial markets and make regular reports to Congress, and to
provide a report on financial market regulatory reform by January 20,
2009.
! There is no provision for allowing bankruptcy judges to reduce mortgage
debt.

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