But investors are forward looking. With the high leverage in our financial system and the large and necessary housing correction, investors quickly realized that the financial system had insufficient capital to withstand the expected losses. But the opacity of mortgage-backed securities and the difficulty in valuing mortgage assets meant it was hard for investors to determine exactly which institutions were at greatest risk.
Not wanting to be exposed to a failing institution, but also being unable to determine for certain which institutions were at risk, investors pulled back wherever they could.
A capital problem for some institutions led to a liquidity problem for all institutions. That liquidity problem created a serious risk that our financial system as a whole, both in the U.S. and abroad, could fail.
Secretary Paulson and Chairman Bernanke recognized early that there might come a time when the private markets would become unwilling to provide the necessary capital to our financial system to deal with the large losses from the housing correction. In such a scenario, only the Federal government would be in a position to support the financial system -- to step in to provide the needed capital to prevent a collapse. Although government leaders have numerous tools to combat financial market crises, there was no existing tool to provide capital to the financial system. Government intervention was not our first choice, as it often has unintended, far-reaching consequences. But it was a necessary choice. We began contingency planning in early 2008.
The crisis deeply intensified in the spring of 2008 and our major financial institutions came under severe pressure from deteriorating market conditions and the loss of confidence. In a short period of time several of our largest financial institutions failed. In March 2008 - Bear Stearns. In July - IndyMac. In September, we witnessed the conservatorship of Fannie Mae and Freddie Mac, the bankruptcy of Lehman Brothers, the rescue of AIG, the distressed sale of Wachovia, and the failure of Washington Mutual. Eight major U.S. financial institutions effectively failed in 6 months -- six of them in September alone.
As a result, credit markets froze. The commercial paper market shut down, 3-month Treasuries dipped below zero, and a money market mutual fund "broke the buck" for only the second time in history. The savings of millions of Americans and the ability of businesses and consumers to access affordable credit were put at serious risk.
The need for government action
Recognizing the threat to every American family, we knew the time had come to provide government support for the U.S. financial system. On September 18, we went to the Congress to ask for unprecedented authority to prevent a financial collapse. Congress also recognized this threat and just two weeks later the Congress passed and President Bush signed into law the Emergency Economic Stabilization Act of 2008. We worked hard with the Congress to build tremendous flexibility into the legislation because the one constant throughout the credit crisis has been its unpredictability.
The stress in the financial system I've been describing is reflected in something we track called the LIBOR-OIS spread, which is a key measure of risk in the financial system. Typically, 5 - 10 basis points, on September 1, 2008 the one month spread was 47 basis points. By the 18th, when we first went to Congress, the spread had climbed to 135 basis points. By the time the bill passed, just two week later on October 3, the spread had nearly doubled to 263 basis points. Credit markets continued to deteriorate and, just one week later, the spread had spiked to 338 basis points -- almost 50 times normal levels. Our Nation was faced with the potential imminent collapse of our financial system.
What if the financial system had collapsed? Businesses of all sizes might not have been able to access funds to pay their employees, who then wouldn't have money to pay their bills. Families might not have been able to access their savings. Basic financial services could have been disrupted. The severe economic contraction and large job losses we are now experiencing were triggered by the credit crisis. However, had the financial system collapsed, this recession, including terrible job losses and numerous foreclosures, could have been far, far more severe.
As conditions deteriorated rapidly, it became clear to us that we needed to use the authority granted by Congress as aggressively as possible to quickly attempt to stabilize the system. A program as large and complex as the TARP would normally take many months or years to establish. But, we didn't have months or years. We had to move as fast as possible. We designed a Capital Purchase Program, to invest up to $250 billion in banks. It would be the fastest and most direct way to inject much-needed capital into the system and restore confidence. But a big question remained: Would banks participate? Banks traditionally resist government assistance because they fear it could make them look weak -- and undermine the market's confidence in them that is so vital to their business. If they didn't participate, our plan would not work.
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