RL34412
Containing Financial Crisis
November 24, 2008

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Summary

There is no precise definition of "financial crisis," but a common view is that disruptions in financial markets rise to the level of a crisis when the flow of credit to households and businesses is constrained and the real economy of goods and services is adversely affected. Since mid-2007, governments have tried with limited success to keep the downturn in U.S. subprime housing from developing into such a crisis. Subprime mortgage problems, and the financial shock they caused, were widely anticipated, but the spread of turmoil into many seemingly unrelated parts of the global financial system was not. Many of the losses occurring in diverse firms and markets -- often quite severe -- have common features: the use of complex, hard-to-value financial instruments; large speculative positions underwritten by borrowed funds, or leverage; and the use of off-the-books entities to remove risky trading activities from the balance sheets of major financial institutions. Because of the prevalence of innovative financial arrangements, the housing downturn appears to have triggered market dynamics that amplify the effects of financial shocks and generate self-reinforcing, downward financial and economic spirals. The Federal Reserve and foreign central banks have cut short-term interest rates dramatically and injected trillions of dollars into the banking system to keep credit flowing. The Fed and Treasury have engaged in a series of extraordinary interventions to shore up failing financial institutions. The Fed provided $29 billion to underwrite the rescue-through-acquisition of Bear Stearns, a leading investment bank, and loaned billions to AIG, a leading insurer. Fannie Mae and Freddie Mac have been placed in government conservatorship, with the Treasury pledging to stand behind 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 the commercial paper market and purchased tens of billions in short-term corporate debt. Simultaneously, trillions of dollars in private debt now carries government guarantees. The duration of the current instability is in marked contrast to financial shocks of recent decades, when the central bank was able to contain market problems quickly with little or no interruption of U.S. economic growth. Depending on how soon normal market conditions are restored, and on the severity of the economic slowdown, Congress may view the social costs of failed financial speculation as sufficient to warrant new restrictions to reduce the incidence of losses that have system-wide impacts or to put the markets and the economy in a better position to weather such shocks. The Treasury has already proposed a sweeping restructuring of financial regulation. This report supplements CRS Report RL34182, Financial Crisis? The Liquidity Crunch of August 2007, by Darryl Getter et al., which describes in greater detail the channels through which subprime problems cascaded through the financial system. This report focuses on the efforts of regulators to restore market stability and will be updated as developments warrant.

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