We left off at the point of the collapse of the housing market. Its implosion was already afoot in 2007, but none of the decision-makers foresaw the devastation it was about to cause in the economy. Bernanke, the chairman of the FED, expressed his belief in a testimony before Congress that the damage will be contained.
What Bernanke didn't count with was the subsequent panic that spread to the healthy part of the financial world as well, up to a point where policymakers realized that if they let the market sort the mess out itself - as libertarian-leaning purists proposed - there will be carnage. After the French investment bank BNP Paribas froze three of its investment funds in the US in August 2007, and thereby caused a liquidity crunch, intervention seemed necessary.
The first move the FED made to alleviate the situation was the classic one from the central bankers' book. It stepped up as the lender of last resort by opening a so-called discount window where banks in trouble could borrow, albeit at penalty rates. Although this infused some welcome liquidity into the system, it didn't turn out to be a great success. The transactions were confidential, but many banks feared that they would look weak if the market got wind about them. Therefore many of even those who urgently needed liquidity declined the opportunity. Despite the underwhelming results, the fears of inflation rose. Later the FED changed its strategy and organized loan auctions which were much more popular than the discount window.
Although the common narrative holds that the FED bailed out all the irresponsible actors, it silently declined such requests until much later. The first major victim of this intentional inactivity was Countrywide Financial, a $200 billion firm that financed 20% of all mortgages in the US. In January 2008, it was forced to sell itself to Bank of America for a fraction of its value in 2006.
The time for the next major player to buckle came in March 2008. Bear Sterns, one of the five stand-alone investment banks in the US, was twice the size of Countrywide and too interconnected not to wreak havoc if it collapsed. Although they changed their mind by this time, neither the FED nor the Treasury had the authority to help it directly. Bear Stearns was a nonbank, therefore the FED had even fewer tools at its disposal to intervene on its behalf. For a time it looked like Bear will file for bankruptcy, but almost at the last minute, Bernanke and Paulson could convince JP Morgan to buy up Bear Sterns with the help of the FED and the Treasury. Which doesn't mean Bear Sterns was bailed out. It ceased to exist and its assets were taken over by JP Morgan.
The next major event, in September 2008, was the nationalization of Fannie Mae and Freddy Mac, the strange, government-sponsored private enterprises, that underwrote half of the US residential mortgages. This was the biggest financial act since the depression. Republicans cried socialism, the liberals cried crony capitalism.
Bernanke and Paulson hoped that nationalizing Fannie Mae and Freddy Mac will send the soothing signal to the markets that the government is willing to do whatever it takes to contain the situation. But the message had the opposite effect. The markets suddenly realized how big the problem really is.
Then just a week later came the infamous collapse of Lehman Brothers. Lehman was much smaller than Fannie Mae or Freddy Mac, but somehow in the public consciousness, it became the symbol of the start of the Recession. Both the FED and the Treasury wanted to prevent its collapse, but their toolset was limited. Contrary to common belief, the authorities of both institutions were severely constrained. The FED was allowed to lend only against solid collateral and the Treasury could do little without congressional approval. No one in the private sector was willing to step up to buy it as JP Morgan did with Bear Sterns.
Lehman fell. Its demise sent shockwaves through the whole economy. Still, opinion writers of the FT and the WSJ praised the FED and the government for finally manning up and refusing to bail out irresponsible bankers. Some others, fearing the consequences of Lehman's fall, called Bernanke and Paulson idiots. Both types of reactions showed how much the pundits usually know of the things they write about.
Some saw the inactivity as a calculated political act to frighten the congress into action. It definitely played at the hand of Bernanke, because actually seeing what Lehman's fall entailed, Congress swiftly voted for expanding the powers of the FED and the Treasury and passed the TARP - Troubled Assets Program to authorize the expenditure of $700 billion to purchase toxic assets.
The next one on the verge of collapse was AIG, the insurance giant. It was deemed too big to fail and was bailed out just two days after Lehman's fall.
By then, the troubles of the financial sphere spread to the real economy. GE had problems.
The government's and the central bank's actions weren't popular, to say the least. The public was still against the bailouts. Republicans were against the prospect of runaway inflation. Professionals were against the moral hazard the saving of irresponsible market players might introduce.
There still were some negative new records in the system. The fall of 2008 saw the two largest bank failures in U.S. history: Washington Mutual and Wachovia bit the dust.
In October 2008, The FED organized the first-ever coordinated interest rate cut by major central banks around the world. At home, it organized stress testing of every bank to reassure the markets through transparency.
In November 2008, it started an aggressive monetary stimulus experiment, known as Quantitative Easing to pump even more money into the economy. The first round was followed by the second in November 2010, then by the third in September 2012.
Tapering down some of the FED's QE policies started only in 2013, by which time the Great Recession was a thing of the past.
In the end, the authors admit that their course of action was constant improvisation. The Great Recession was something no one was prepared for. Instead of following some pre-written emergency plan, their method was constant experimenting, changing tools and minds along the way. But in the end, the problem was contained. There was a real possibility of disaster. Among the "could have been" outcomes were Zimbabwe-style hyperinflation, Japanese zombie-banks, even the end of free-market capitalism. To evaluate how successful the crisis management was, we can put the events in historical perspective. The Great Depression sank the US GDP by almost 30%, which was accompanied by an unemployment rate of 20%. The Great Recession caused a GDP fall of less than 5% while the unemployment peaked at 10%.
Contrary to popular belief, the taxpayers' money didn't fall victim to saving the irresponsible Wall Street types. The FED never lost a dollar on its loans and the government, so ultimately the taxpayers, earned a substantial return on their investment in US banks. Which of course doesn't console those who lost their homes, jobs, or savings. And while the public resented the government for saving bankers instead of jailing them, the ones who were bailed out were not happy about the specifics of their rescue either. AIG actually sued the government for what they perceived as an unfairly harsh treatment.
And what about the next crisis? The authors are sure that it will come one day but less sure about how well America is prepared for that. Some things have changed for the better. Regulations have become stricter. Banks have higher capital requirements and some restrictions apply to nonbanks as well. But the emergency powers of the FED and the Treasury have been weakened.
And, very briefly and very simply, that was the story.
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