Financial Crisis: Bailout or Rescue?

October 8, 2008

Student readings explain some of the events leading up to the crisis as well as reactions to it from citizens and politicians. A DBQ asks students to consider and compare opinions on the issue.

If there was ever a teachable moment for student learning about the economy and financial affairs, this is it. The first student reading below juxtaposes the 17th century Dutch tulip craze with the 21st century American mortgage-backed securities craze. The second provides some detail on the events leading up to the mid-September crisis, an account of citizen and politician reaction to plans to deal with it and major provisions of the final product. Discussion questions follow.

The materials include a Document-Based Question exercise that might be used for individual student writing and/or as a basis for class discussion.

Additional available materials on the economic crisis include "Presidential Election 2008: Financial Crisis," "Presidential Election 2008: Inequality in America," and "Economic Anxiety," all available in the high school section of www.teachablemoment.org.

 


Student Reading 1:

Two manias

Time: 1554-1637

In 1554, an Austrian diplomat sent tulip bulbs from Constantinople (now Istanbul, Turkey) back home. The attractive flower won favor and spread throughout Europe. In time, rare species of tulips became the focus of a huge craze among the Dutch.

By 1636 the demand became so great in Holland "that regular marts for their sale were established on the Stock Exchange of Amsterdam, in Rotterdam and other towns. Symptoms of gambling now became, for the first time, apparent. At first, as in all these gambling mania, confidence was at its height, and everybody gained.

Many individuals grew suddenly rich.  Everyone imagined that the passion for tulips would last forever and that the wealthy from every part of the world would send to Holland, and pay whatever prices were asked for them.  Nobles, citizens, farmers, mechanics, seamen, footmen, maid-servants, even chimney sweeps and old clotheswomen, dabbled in tulips.  Foreigners became smitten with the same frenzy, and money poured into Holland from all directions." But then came 1637.

"At last, however, the more prudent began to see that this folly could not last forever. Rich people no longer bought the flowers prices fell and never rose again.  Substantial merchants were reduced almost to beggary, and many a representative of a noble line saw the fortunes of his house ruined beyond redemption."

(Charles Mackay, "The Tulipmania," Extraordinary Popular Delusions and the Madness of Crowds)

Time: April 28, 2004

Five members of the Securities and Exchange Commission (SEC) met to consider "an urgent plea by the big investment banks. They wanted an exemption from an old regulation that limited the amount of debt they could take on. The exemption would unshackle billions of dollars held in reserve as a cushion against losses on their investments. Those funds could then [enable them] to invest in the fast-growing but opaque world of mortgage-backed securities and other exotic instruments."

After a 55-minute discussion, a unanimous SEC vote granted the exemption. Its commissioners "also decided to rely on the firms' own computer models for determining the riskiness of investments, essentially outsourcing the job of monitoring risk to the banks themselves."

(Stephen Labaton, "Agency's '04 Rule Let Banks Pile Up Debt, and Risk," New York Times , 10/3/08)

Time: September 26, 2008

The SEC "formally ended the 2004 program acknowledging that it had failed to anticipate the problems at Bear Stearns [which had collapsed into bankruptcy] and the four other major investment banks."

(Stephen Labaton, "Agency's '04 Rule Let Banks Pile Up Debt, and Risk," New York Times , 10/3/08)

The mission of the SEC "is to protect investors, maintain fair, orderly, and efficient markets and facilitate capital formation." (www.sec.gov)

Then and Now

The SEC's 2004 decision came at a time when financiers and the Bush administration believed fervently that markets correct themselves and that the financial system works best when it polices itself. The SEC decision helped to unleash Housemania, a passion for houses and the money that could be made selling mortgages, mortgage-backed securities (packages of complex financial securities), and the houses themselves.

Just as in 17th century Holland, when the price of a special variety of tulip could command 5,000 florins—the equivalent of a house with a large garden—so in America a modest house, even with no garden, could command a price that people believed would rise and never fall.

In the past several years, many people of modest means were able to buy homes because brokers, bank presidents, managers of investment houses, and investors around the world were willing to finance them. The financiers were enabled by the SEC to use dollars held in reserve and to take on more debt. They didn't mind if the buyer didn't have the money to afford a house. They weren't bothered if the buyer was unable to make a down payment, or even had a poor credit history. Why? Because the financiers were certain that the house would increase in value. And so mortgages were packaged into securities and sold globally.

Then a day came when there were more houses on the market than there were buyers. Prices stalled. Soon, like Dutch tulips, homes began decreasing in value around the country. The 17th century merchants of Holland were stuck with crates of tulips. Twenty-first century banks, investment companies, mortgage brokers and investors around the world were stuck with mortgages that homeowners could not pay and empty houses that realtors could not sell.

Even during the centuries between the tulip bubble and the housing bubble, the financial world was not entirely sane. The British South Sea Bubble of 1721, the American Panic of 1873 and the Wall Street collapse of 1929 and Great Depression that followed—as well as similar episodes elsewhere in the world—tell us that humans are very susceptible to extraordinary delusions and that crowds are susceptible to madness.

"It is not at all unlikely that illnesses have their history, and each epoch has its own definite sickness which did not occur in such guise before and will never again return in the same form."
—-Troels-Lund, quoted in Zbigniew Herbert's "The Bitter Smell of Tulips," Still Life with a Bridle

For discussion

1. What questions do students have about the reading? How might they be answered?

2. What is a house worth? Who decides? How?

3. What similarities are there between the values of tulips and houses?

4. How did the SEC decision help to bring on the U.S. financial crisis?

 


Student Reading 2:

Collapses & credit crunches

Houses of cards

  • By early 2007, a growing epidemic of falling home prices and foreclosures was evident.
  • Gradually, the housing slump began affecting banks and mortgage institutions. A global insurance company holding paper assets saw the value of that paper plummet. As troubles deepened for these institutions, they failed. Some were sold to other banks at fire sale prices, some simply collapsed, others were bailed out by partial U.S. government purchase.
  • Dropping prices led banks and other institutions to reverse course when it came to offering credit. The loans that had once been so easy to get became very difficult, even impossible, to obtain. The over-confidence that made getting credit a cinch turned almost overnight across the financial world into a lack of confidence, anxiety, and fear.
  • Investors pulled their money out of stocks and ran for the security of short-term U.S. Treasury notes, which offer virtually no interest but do provide safety.
  • Credit tightened further and the stock market nose-dived.
  • Job losses mounted for nine straight months. By the end of September 2008, 760,000 U.S. workers had lost their jobs.
  • A bank in Iceland collapsed. Ireland and Germany had to bail out banks in Dublin and Berlin. Depositors of a bank in Hong Kong suddenly appeared at its doors demanding their money. The financial crisis, which had originated in the U.S. with the extraordinary popular delusion that home prices could only rise, now rippled across the globe.
  • By the second half of September 2008 panic was in the air.

Something had to be done. What?

The plan: "bailout" or "rescue"?

In meetings with congressional and other governmental leaders, U.S. Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke delivered a bleak message: financiers, investors and the American public faced disaster. The two men made public a complex plan: They proposed using $700 billion in taxpayer money to buy from failing financial institutions mortgage-backed securities that were now worth about what tulips in Holland were in 1637. In time, they said, as the financial markets steadied, these securities would rise in value and could be sold. Through their sale, taxpayers would recover some of the money, even possibly make a profit.

The plan was put before the House of Representatives. Its members were flooded with outraged phone calls and e-mails from citizens protesting that the plan was a bailout of the very people who were responsible for the crisis—a kind of socialism for the rich. The House members, all of whom were either up for reelection or retiring, responded to the outrage. In a vote that surprised Democratic and Republican leaders, the House turned the plan down by 12 votes. Among the objections citizens voiced to the plan:

  • It would bail out Wall Street financiers who had, in the words of Secretary Paulson himself, promoted "irresponsible borrowing and lending"
  • It violated the capitalist principle that government should stay out of the market and let the market correct itself.
  • At the same time it violated an opposing principle that a reasonable government must insist upon reasonable regulation of capital markets, since their failure affects everyone.
  • It failed to set limits on the huge pay packages of top executives at the firms seeking help.
  • It did not include any help for hundreds of thousands of homeowners facing foreclosures.
  • It permitted Secretary Paulson to act without any oversight in dispensing a phenomenal amount of taxpayer money.

Political and governmental leaders went back to the drawing board. The new plan required reframing—that is, the use of language to promote a more positive reaction from voters. It could not be called "a bailout," which sounded like giving away money. Instead, it would be "a rescue," which sounded more like help for passengers on a sinking ship. This time around, the Senate would get first crack at the legislation. And to encourage yea votes, senators would add sweeteners of political pork.

These changes were sufficient to win Senate approval for the plan. Then the plan returned to the House, where it passed. President Bush quickly signed the bill into law. Its official title: The Emergency Economic Stabilization Act of 2008.

Major provisions include:

  • The Treasury Secretary is authorized to immediately spend $250 billion in taxpayer money to buy bad debt, like mortgage-backed securities, from firms that are stuck with it. The worth of these securities will be determined by Secretary Paulson and his advisors. If we find, years from now, that the price Paulson paid was too high, taxpayers and the U.S. Treasury will suffer the loss.
  • The Treasury Secretary may receive additional installments of $100 billion upon presidential approval. Still later, he may receive $350 billion upon congressional approval.
  • The President must present a plan after five years to recoup any losses.
  • Two oversight committees will monitor how the money is spent.
  • There will be limits on the pay packages of top executives at firms seeking help.
  • Taxpayers will get a stake in firms receiving help and may earn a profit if their stocks rise.
  • Homeowners who are facing foreclosure and/or unmanageable mortgage payments will get a little help.
  • The government will temporarily increase federal insurance on bank deposits to promote confidence and avoid runs on banks. Instead of insuring only deposits of up to $100,000, the FDIC (Federal Deposit Insurance Corporation) will now insure deposits of up to $250,000.
  • A number of breaks for taxpayers, along with other add-ons, will increase the cost of the plan by more than $150 billion—in addition to the original $700 billion package. The bailout/rescue plan will increase U.S. debt to a $11.3 trillion.

Among the pork sweeteners added to the bill:

  • An excise tax exemption for Rose City Archery in Myrtle Point, Oregon, a company
    that makes an unusual cedar arrow shaft
  • Tax breaks for movie and TV companies
  • Help for employers who want to provide incentives for workers to commute on bicycles

Will the plan work? No one, including Secretary Paulson, can answer that question with certainty.

Will the American economy get worst before it gets better? Most people in the financial world say yes.

For discussion

1. What questions do students have about the reading? How might they be answered?

2. What seems to have been the major reason behind the financial panic?

3. Why were the effects felt internationally?

4. What was the chief provision in Paulson's original plan to halt the crisis? Why was it voted down in the House of Representatives? Why did many regard the plan as "socialism for the rich"?

5. How is the second plan different from the first?

6. What is political pork? Why was it included in the bill?

 


Document-Based Questions: The Financial Crisis

There are multiple ways to assess students' skills in thinking about controversial issues. "Document-based questions" is one employed by the New York State Regents Examination in social studies. The following exercise is modeled on that examination.

Read each paragraph, and then answer the question following it. After you have read all of the paragraphs, write an essay in response to item G.

A

Households across the nation are beginning to see the leading edge of the storm that is already roiling credit markets here and around the world. The sudden and dramatic drop in the value of retirement accounts after the House's initial refusal to agree to the package was just one symptom of what is to come. Even more important, however, is the continued deterioration of the credit system. Without action, ordinary Americans will face the effects of a dramatic economic contraction, including sharp increases in unemployment. Noxious though some of the [provisions in the law] are, taken together with the improvements they are not sufficient to risk the enormous economic damage that would ensue [without] the core features of the package.

—Stuart Butler and Edwin Meese III of the Heritage Foundation

Question: According to the writers, what is a reason for supporting the congressional action on the financial crisis even though that action includes some bad provisions?

B

This bill does not effectively address the issue of what the taxpayers of our country will actually own after they invest hundreds of billions of dollars in toxic assets. This bill does not effectively address the issue of oversight because the oversight board members have all been hand-picked by the Bush administration. This bill does not effectively deal with the issue of foreclosures which is impacting millions of low- and moderate-income Americans. This bill does not deal at all with how we got into this crisis in the first place and the need to undo the deregulatory fervor which created trillions of dollars in complicated and unregulated financial instruments.

—Senator Bernie Sanders, Independent, Vermont

Question: What bothers Senator Sanders about allowing the Bush administration to choose oversight board members?

C

As disturbing as the volatility and turmoil on Wall Street are, the prospect of transferring trillions of dollars of risk and losses to taxpayers is appalling. How can any America look their neighbor in the eye and suggest that they should bear the losses for the mistakes and greed of America's wealthiest financial firms. Accountability is a pillar of our free market economic system. The market rewards good business decisions and punishes bad ones. Losses on Wall Street should be first and foremost the responsibility of the investors and creditors who engaged in these business transactions.

—Congressman Darrell Issa, Republican, California

Question: According to the congressman, who should take responsibility for Wall Street losses?

D

We were very very close to a system that was totally dysfunctional and would have not only gummed up the financial markets, but gummed up the economy in a way that would take us years and years to repair. I'm not saying the Paulson plan eliminates those problems. But it was absolutely, and is absolutely necessary, in my view, to really avoid going over the precipice. No plan is going to be perfect, but thank heavens that Paulson had the imagination to step up with something that is of the scope that can really do something about it.

—Warren Buffett, CEO, Berkshire Hathaway, in a CNBC interview

Question: What is one reason that Warren Buffett favors the Paulson plan?

E

As it did in 1929, the free market has failed beyond tolerance. Overwhelming popular sentiment...may, sooner or later, bring not only a full recognition of just how wrong-headed the country has been for how long, but how much in need it is of fresh institutions. New forms of public authority, closely overseen by the mechanisms of democracy rather than turned over to some autocrat on leave from his day job as an investment banker, might have a chance of doing what was once unthinkable: desanctifying private property and compelling it to perform in the general interest when its private misuse has placed us all in peril. The New Deal [under the administration of President Franklin Roosevelt] ventured in that direction. We need to venture further.

—Steve Fraser, "The Specter of Wall Street," www.tomdispatch.com

Question: In what direction, according to the writer, do we need to venture?

F

During the housing bubble, people borrowed heavily not only to buy houses but also to compensate for the weakest job and income growth of any expansion since the end of World War II. Between 2001 and 2007, homeowners withdrew almost $5 trillion in cash from their houses, either by borrowing against their equity or pocketing the proceeds of sales. That extra life disguised the labor market's underlying weakness. it looked like Wall Street had entered a utopia: an eternal bull market. Regulators stopped regulating and auditors looked the other way as financial practices lost all traces of prudence. 
Although we're hearing a lot now about how the era of big government is back, an expanded government isn't likely to do much more than rescue a failing financial system. Nothing more humane will be pursued without a far more energized populace than we have.

—Doug Henwood, a contributing editor of The Nation

Question: According to the writer, why do we need to do much more than rescue a failing financial system?

G

Treasury Secretary Paulson proposed—and Congress and the president ultimately ratified—a plan to use taxpayer money to buy mortgage-backed securities and other bad debt from distressed banks and other financial firms. Paulson argues that this will enable the firms to obtain the credit they need to resume their normal business activities. Specifically, Paulson argues, these firms will once again be able to make loans on reasonable terms for small businesses and individuals so they can buy furniture, cars, and houses. This will get the economy going again.

Using information from the documents and your knowledge of the financial crisis, write a well-organized essay that includes an introduction, several paragraphs and a conclusion in which you:

1) compare and contrast different viewpoints on the financial plan approved by Congress
and

2) discuss your own viewpoint and the reasons for it.
 


A discussion procedure

1. Have students read each item in the DBQ, then answer the question in writing in a sentence of two. Discuss responses with class.

2. Organize small groups of students to discuss differing viewpoints, including their own, about the merits of the financial plan passed by Congress. Assign one student in each group to summarize the discussion for the class.

3. After the groups present the summaries, invite class discussion.

 

This lesson was written for TeachableMoment.Org, a project of Morningside Center for Teaching Social Responsibility. We welcome your comments. Please email them to: lmcclure@morningsidecenter.org