The continuing foreclosure crisis: new institutions and risks

The Federal Reserve (Fed) and the U.S. Treasury have taken unprecedented steps to stem the financial crisis that began in August 2007 as part of the extended foreclosure crisis. In the most recent episode in September 2008, seven financial institutions either failed or were merged with stronger firms, sparking public concerns for their assets and for their own financial institutions. This has led to several new institutional arrangements of questionable value, foremost among them, the Bush Administration’s $700 billion bailout fund for illiquid mortgage-related assets on the books of financial institutions. All of these events had been anticipated for months, but the surprise was the bunching of these failures over such a short interval. The other noteworthy feature of these developments is the speed and completeness with which the private sector moved in to acquire the assets and operations of these companies with little or no regulatory or taxpayer cost. There are exceptions, but even in those cases, the costs were minimized and the firms involved hardly missed a beat, except for their new owners. This paper reviews arguments that the failure of Lehman precipitated recent developments and also whether financial deregulation was responsible. A Lehman-related development was the run on money market mutual funds and policy responses to it by both the Fed and Treasury. These are critically reviewed here as well. Finally, it reviews how rapidly and effectively the Fed responded to the September issues, something that Treasury bailouts cannot do, and that represents a major turning point in the Fed response to the foreclosure/financial crisis.