Is politics the enemy of problem solving?
Evidence from the Emergency Economic Stabilization Act of 2008
October 24, 2011
PUBP 502
Introduction
The Emergency Economic Stabilization Act of 2008 (EESA) was a bipartisan bill signed into law on October 3, 2008, during the peak of the financial crisis. The bill was introduced by Rep. Patrick Kennedy (D-RI) and passed the Senate by a vote of 75-24. The final House vote was 263-171 (U.S. Senate 2008) . The focus of the bill was 700 billion dollars authorized to Treasury for the purchase of distressed assets, otherwise known as the Troubled Asset Relief Program (TARP) and the financial bailout bill (Library of Congress 2008) .
Politics played a significant role in the passage of the EESA in October 2008. The defeat of the bill on Monday, September 29, led to a simultaneous drop in the stock market greater than 700 points (Rosenbloom 2011) . The Bailout plan was an example of how policymakers and Congress reacted to changes in market conditions to prevent massive bank failures in a time of crisis. Public opinion was one obstacle that was overcome to do what was best to stabilize the economy.
Political costs of the bank bailout were extremely high. Voting on a controversial issue was difficult for incumbent candidates given the upcoming elections. Siding with President Bush was certain disaster with his approval ratings reaching 25% (Jones 2008) . Systemically important institutions that were deemed ‘too big to fail’ created a moral hazard (Sorkin 2010) . Positive effects of the bank bailout included restoring confidence, providing institutions access to cheap capital, preventing bank failures, and receiving a positive return on invested capital.
The first section will discuss important events of the financial crisis leading up to EESA. The second section describes how the bill came to the floor of the house. The third section describes the vote and breakdown by party. The fourth section goes over provisions of the plan. The fifth section discusses political consequences, followed by negative effects and positive effects of the EESA. Finally, the paper will end with a discussion of public opinion and the conclusion.
Financial Crisis Events
Events leading up to October 2008 played an important role in the passage of EESA. March 2008 saw the takeover of Bear Stearns by JP Morgan Chase. In June of 2008, the Federal Reserve approved Bank of America’s takeover of Countrywide Financial. Indymac, F.S.B. went bankrupt in July of 2008. Also in July, President Bush signed the Housing and Economic Recovery Act of 2008, authorizing the takeover of Freddie Mac and Fannie Mae (Federal Reserve Bank of St. Louis n.d.) .
In September 2008, the Federal Reserve and policymakers took dramatic action to prevent the collapse of the financial system. The conservatorship of the Government Sponsored Enterprises (GSEs) was announced on September 7. Shortly after, on September 15, Merrill Lynch agreed to a merger with Bank of America while Lehman Brothers filed for Chapter 11 bankruptcy. The next day, AIG was rescued as a result of exposure to credit default swaps (CDS). Morgan Stanly and Goldman Sachs were transformed from investment banks to bank holding companies on September 21 (Federal Reserve Bank of St. Louis n.d.) .
The external shocks throughout 2007 and 2008 took a heavy toll on regulatory capital and the health of financial institutions. Shareholder equity was depleted. Banks held illiquid asset backed securities (ABS) in off-balance sheet companies to avoid holding capital. High leverage ratios and deregulation led to vulnerabilities within the financial system. Faltering confidence and runs on liquidity plagued the banking system of what little core capital was left (Lewis 2011) . The London Interbank Offer Rate (LIBOR) spiked, indicating severe credit and liquidity constraints (Kwan 2009) . The political stakes of passing a rescue plan were high. The Federal Reserve used every tool available as an independent agency. The stock market was anxiously waiting for legislative action to restore confidence in the system. The Bush administration and Treasury Secretary Paulson were desperate to prevent the system from collapsing further.
The Paulson Plan
The Paulson Plan
The idea of financial rescue was put forth by Treasury Secretary Henry Paulson on September 19, 2008, and nicknamed the Paulson Plan. The Paulson Plan was short in length and broad on power. The plan authorized the purchase of 700 billion dollars in illiquid mortgage-related assets. Paulson provided few details in the process for appropriating the money through lending facilities. Additionally, the plan explicitly granted the Treasury department the ability to avoid judicial review (Shah 2009) .
Before the bill was voted on, both political parties made compromises. Republicans included an insurance fund to guarantee mortgage related assets. Democrats attached an oversight panel and limitations for executive compensation. These concessions were necessary to bring the bill out of committee for an official vote. The concessions made by Democrat and Republican parties forced a moderate approach to policy making and allowed the EESA bill to move forward quickly. The Bush administration argued that congressional action was a key to restoring confidence in the economy (Shah 2009) .
Presidential Candidates Weigh-in
Presidential Candidates Weigh-in
The upcoming presidential election complicated the process further. The financial crisis provided many opportunities for the two senators to challenge one another on issues. Senator McCain questioned Obama’s leadership abilities and Obama noted McCain’s voting record was very much in favor of deregulation. Shortly after the Paulson Plan was announced, both Senators spoke out in a September 21st in a New York Times article. McCain spoke in favor of adding oversight while Obama wanted more focus geared towards homeowners (Harwood and Cooper 2008) . Senator McCain and Obama voted in favor of the EESA (U.S. Senate 2008) .
The Vote
After one week of negotiating, H.R. 3997 was debated for three hours on the House floor before a vote took place. The measure failed by a margin of 205-228, leading to a 778 point drop in the Dow Jones Industrial Average (Associated Press 2008) . Approximately two-thirds of Republicans voted against the bill along with forty-percent of Democrats (Associated Press 2008) .
President Bush and Secretary Paulson urged opponents to put politics aside to do what was best for the economy. Despite the desperate circumstances, House Republicans voted the bill down. The political costs of voting in favor of the bailout bill supported by House Speaker Nancy Pelosi and President Bush were too high, with elections only five weeks away. However, the market and investor opinion was swift and decisive. The stock market’s strong response to the defeat of H.R. 3997 was the driving force that led to the success of the EESA days later (Shah 2009) .
The failed House version of the bill was taken over by the Senate. To avoid starting at ground zero, the Senate attached the Paulson Plan as an amendment to the Paul Wellstone Mental Health Parity and Addiction Equity Act of 2008 (Shah 2009) . The Senate version made minor adjustments. They added a clause raising the limit on deposit insurance from $100,000 to $250,000 to convince some House members to change their vote. The financial bailout (H.R. 1424) passed by a vote of 75-24. Among those opposing the Senate version of the bill, fifteen were Republicans (U.S. Senate 2008) .
The House vote to accept the Senate version of the bill was taken on October 3, 2008. The vote passed by a measure of 268-171 (U.S. House of Representatives October) . President Bush used the support of Democrats in Congress to push the bill through Congress. Among the 171 members who voted against the EESA, 60% were Republicans. Republican incumbents who supported TARP would become a target for the political backlash.
Provisions
Provisions
The Treasury Department was authorized to spend $700 billion for the purchase of asset backed securities from financial institutions in exchange for a stake in equity. The government also raised the ceiling on deposits insured by the FDIC to $250,000; allowed an increase in interest payments on bank deposits held at the Federal Reserve; formed an oversight council to monitor activities of the TARP; Treasury activities related to EESA were subject to judicial review (over-turning one of Paulson’s original powers); restrictions were placed on executive compensation of banks accepting TARP money (Library of Congress 2008) ; The healthcare related portion of EESA prohibited insurance companies from denying coverage for mental health, addiction, and substance abuse prevention (Shah 2009) .
Political Consequences
Congressional representatives were concerned with upcoming elections and the political consequences of voting against the opinion of their constituents. The bill failed the first time for this very reason. Two year terms for members of the House of Representatives exacerbate this effect because they are constantly raising money, running for reelection and defending their voting record.
Politicians were well aware of the consequences of voting in favor of EESA. Eleven candidates who voted for the TARP lost in 2008 elections. In 2010 elections, twenty-five candidates who voted for TARP lost reelection or the primary bid (Holeywell 2010) .
The economic circumstances of the crisis forced a very unpopular political decision five weeks before the election. On one hand, the economy and stock market would have deteriorated significantly if the EESA did not pass the second time around. This was evident from the market reaction after the first vote. On the other hand, a vote in favor of the TARP gave ammunition to political opponents and resulted in the loss of support from their constituents.
Negative Effects
One major negative effect of EESA was the creation of banks that were deemed ‘too big to fail’. Too big to fail refers to a moral hazard where systemically important financial institutions were not allowed to fail during the economic crisis. Bank of America and Citigroup were two examples of banks that were dangerously close to failing based on the price of common equity shares. Generally, these institutions held deposits, commercial loans, mortgage loans and other forms of credit necessary for businesses and consumers to function. The moral hazard was created by offering a government backstop in the event that the institution took on too much risk, thus encouraging more risk taking. ‘Too big to fail’ is a policy concern today for lawmakers when referring to systemically important financial institutions (Sorkin 2010) .
The government taking equity stakes in commercial banks was viewed as a form of socialism (Bigg 2008) . According to a September 30, 2008 Reuters article, conservative talk radio hosts viewed the stock market crash as a price worth paying to avoid endangering the capitalist system with a “socialist bill”. The public did not recognize the effect that the stock market had on the broader economy and job creation.
Another negative effect of TARP was the interdependence of government and financial institutions. The government took an enormous amount of risk by receiving equity warrants in the banking sector. If the banks had failed, the taxpayer was on the hook for the losses. This form of political capitalism caused a backlash against ‘the establishment’.
Positive effects
Positive effects of the EESA include lower borrowing costs for banks, restored confidence in the market, and a positive return on capital for the money invested by the Treasury. According to a March 30, 2011 New York Times article, the Treasury estimated profits from the bailout at $24 billion (Dash 2011) .
Raising private capital during the peak of the financial crisis was not an option. Government money came with a lower borrowing cost because the capital markets viewed the Treasury as the risk free rate. Other positive effects of EESA were not obvious and difficult to measure. Confidence and capital ratios were restored at the largest financial institutions. The stock market gradually gained confidence, but did not bottom out until March of 2009.
Public Opinion
According to a Gallup survey, President Bush’s approval rating during the October crisis was 25% (Jones 2008) . Because of Bush’s lack of popularity, Republicans tried to distant themselves from his policies in the 2008 election cycle. This made the EESA very difficult to pass.
A study conducted by Pew Research showed a shift in Republican views after the EESA was passed. On the September 27-29 version of the survey, Republicans supported the measure 49% versus 38%. The October 3-5 survey, just after the EESA was passed, the Republicans voted not in favor, 45% to 41% (Pew Reserach Center Publications 2008) .
Even with the success of the EESA, the public viewed the political action as a failure for government and banks. Backlash against ‘the establishment’ has helped spark political movements such as the Tea Party and recently, ‘Occupy Wall Street’.
Conclusion
Conclusion
Politics affected the EESA in positive and negative ways. Term limits enabled President Bush to make a tough political decision without the added distraction of an upcoming election. House Republicans were (justifiably) concerned with the broad reach of government into the capital markets along with backlash from their constituency. The majority of Democrats supported the EESA to help stabilize the economy. The initial vote in the House on September 29, 2008 led to the largest decline in the stock market on a single day. The immediate decline in stock prices forced Congress to pass the EESA just days after it failed.
The long run effects of EESA were mostly positive, despite public perception. The banking system is much healthier today than it was in October of 2008. Moreover, the rescue plan helped restore confidence and stabilize the U.S. economy with the use of political capitalism. The EESA reinforced broad measures taken by the Federal Reserve during the financial crisis. It is difficult to measure the effects on the economy had the EESA not passed. The primary negative consequence of the EESA was identifying financial institutions that were ‘too big to fail’. The EESA was viewed as a form of socialism by the conservative right-wing establishment. Ultimately, the EESA provided proof that the government will step in during a time of crisis as ‘lender of last resort’ (Ferguson 2008) .
Appendix
Figure 1: Stock market collapses on September 29, 2008.
Source: <http://www.tradingauthority.com/article/debt-ceiling-and-market-crash-2008>.
Figure 2: Gallup survey.
Figure 2: Gallup survey.
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