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This chapter reports the results of an experimental test of alternative auction designs suitable for pricing and removing troubled assets from banks' balance sheets as part of the financial rescue planned by the U.S. Department of Treasury in the fall of 2008. All auction mechanisms tested here are structured so that many individual securities or pools of securities are auctioned simultaneously. Securities that are widely held are purchased in auctions for individual securities; securities with concentrated ownership are purchased as pools of related securities. Each experimental subject represents a bank which has private information about its liquidity need and the true common value of each security. The chapter studies bidding behavior and performance of sealed-bid uniform-price auctions and dynamic clock auctions. The clock and sealed-bid auctions resulted in similar prices. However, the clock auctions resulted in substantially higher bank payoffs, since the dynamic auction enabled the banks to better manage their liquidity needs. The clock auctions also reduced bidder error. The experiments demonstrated the feasibility of quickly implementing simple and effective auction designs to help resolve the crisis.

The Fed’s rescue of Bear Stearns and the Treasury Department’s nationalization of Fannie Mae and Freddie Mac in 2008 provoked widespread criticism. Consequently, the Fed and Treasury were very reluctant to approve further bailouts, and they allowed Lehman Brothers to fail in September 2008. Lehman’s collapse triggered a global panic and a meltdown of financial markets around the world. The Fed and Treasury quickly arranged a bailout of AIG, and Congress approved a $700 billion financial rescue bill. Treasury established the Troubled Asset Relief Program, which injected capital into large universal banks, while the Fed provided trillions of dollars of emergency loans and the FDIC established new guarantee programs for bank debts and deposits. In February 2009, federal regulators pledged to provide any further capital that the nineteen largest U.S. banks needed to survive, thereby cementing the “too big to fail” status of U.S. megabanks. The U.K. and other European nations arranged similar bailouts for their universal banks. Meanwhile, thousands of small banks and small businesses failed, millions of people lost their jobs, and millions of families lost their homes during the Great Recession.

In this chapter, Chester Spatt argues that policymakers should rely on economic principles to formulate and evaluate policy and discusses how adherence to these principles could have improved regulators’ responses to the crisis. He emphasizes the role of clear and predictable rules and cautions that discretion creates uncertainty and risk for capital market participants. He notes that moral hazard is often ignored by policymakers during times of crisis, but observes that this is when moral hazard is most important. Professor Spatt concludes the chapter by raising questions about how to improve our regulatory system.

This chapter discusses the reforms for the banking sector in the United States. In 2008, the Troubled Asset Relief Program (TARP) was initiated to advance a cash buffer to affected banks. But before banks could seek out profitable lending opportunities, the Federal Reserve devised a stress test for major banks in order to examine the assets in their balance sheets and measure their potential losses over a two-year period under the worst-case scenario of a severe recession. Despite having doubts on the outcome, the results indicated that the banking industry was in better shape than anticipated, with few glitches according to an independent assessment. The stress tests and TARP were premised on the expectation that banks would restructure their assets and devise forecasting regulations for similar financial downturn in the future. The chapter also considers the banking sector in the EU.

With the onset of the financial crisis, the Troubled Asset Relief Program (TARP) was established by the Emergency Economic Stabilization Act of 2008 (EESA) to stabilize the US financial system. The core of the recapitalization plan under TARP was the Capital Purchase Program (CPP), under which “healthy, viable” financial institutions would receive capital injections from Treasury. This chapter examines the CPP and other TARP support programs. The CPP was open to all qualified financial institutions approved by their respective banking regulators, whether large or small. The government wanted the healthy as well as less healthy major banks to take government assistance to avoid publicly identifying any banks as insolvent. While it is clear that politics favored giving support to small as well as large banks, the failure of small banks would not have endangered the system. The remainder of the chapter discusses the expiration and wind-down of TARP and TARP housing programs.

This chapter discusses five general criticisms of government bailout efforts. First, taxpayers can suffer losses. While bailouts may, in the end, not be costly for taxpayers, one does not know this in advance of the expenditure. Second, bailouts may not work or may be prolonged. Bailouts may be the beginning and not the end of financial recovery. Third, bailouts create moral hazard. Both individual firms and the market may have perverse incentives if they know the government will come to the rescue. The consequence of this moral hazard is that firms will take on more risk than would otherwise be optimal because risk taking becomes a one-sided bet. Fourth, government decisions over bailout may be political and ad hoc. Some have claimed that the use of Troubled Asset Relief Program (TARP) funds was determined based on political rather than actual systemic risk grounds. Public confidence in the bailout effort can be seriously damaged if it is perceived by the public that the government did not follow any clearly articulated goals and principles in making important decisions. Fifth, bailouts may fail to boost lending activities.

This chapter considers the major criticisms of the Troubled Asset Relief Program (TARP). The first criticism is too favorable terms for Capital Purchase Program (CPP) recipients. The Treasury designed the terms for the CPP to be favorable for the banks to increase their capital base, to rescue the financial system, not to make money. Excessively demanding terms might have undermined the banks' ability to participate in the program, thereby making it difficult to achieve the objective of stabilizing the financial sector. The second criticism is too much or too little interference in recipient operations. As most of the largest banks exited CPP within a year of its implementation, discussions about potential excessive government interference in the day-to-day management of rescued firms concentrated on a few institutions such as Citigroup and AIG, in which the government held its position for a longer period. The third criticism is lack of enforcement of the terms of support. While the vast majority of CPP recipient institutions have exited the program, those that remain illustrate this problem. Majority of the remaining CPP institutions are smaller banks that were on the FDIC's “problem bank list” as of December 31, 2014.

This chapter analyses how the global financial crisis was governed as a problem of so-called ‘toxic assets’ and ‘toxic waste’ poisoning capital markets during 2008. It covers the key interventions of the Federal Reserve and US Treasury that purchased the toxic assets of Bear Stearns and American International Group (AIG), and which proposed the $700 billion Troubled Assets Relief Program (TARP) as a more comprehensive solution. It shows how the crisis was rendered as a problem of toxicity through the relational arrangement of orthodox economics and a metaphorical discourse that figured the crisis as a contagious infection of the economic body, and explains how the creation of so-called ‘bad banks’ by way of a solution entailed a mix of sovereign and market techniques, including the reverse auction process of the TARP which proved to be unworkable.

This chapter describes a more obscure chapter in the history of market design: the attempt on the part of certain market designers to supposedly “fix” the economic meltdown of 2008 by proposing to construct markets that would sell “toxic assets” at their true prices. This reveals the hubris of market designers, but also the disdain in which they were eventually held by the Treasury officials responsible for the TARP. The chapter reveals some of the drawbacks of the belief that market failures can be remedied by more markets retailed by economists.

This chapter details events in 2008 as the subprime crisis unfolded. These include the placement of Fannie Mae and Freddie Mac into conservatorship; the collapse of Lehman Brothers, which sent worldwide markets into a panic; enactment of the Emergency Economic Stabilization Act of 2008 (EESA), which included the $700 billion Troubled Asset Relief Program (TARP) that allowed Treasury to buy toxic assets from banks; and efforts of world leaders to gird the world economy.

Chapter 3 traces the sources of the 2008–2009 and 2020 financial and economic implosions and the winners and losers of the Fed’s massive responses. Across two distinct crises, the Fed’s policies followed a similar pattern of favoring large financial institutions and big business while neglecting or altogether ignoring homeowners, small- and medium-sized businesses, and state and local governments. This conclusion is based on tracking detailed institutional features: the assertion of emergency power; the redefinition of the Fed’s boundaries to aid financial and corporate firms that previously lacked direct contacts with the Bank; the generous stretching of loan duration; and the considerable weakening of collateral requirements.