Guarantees and Capital Infusions in Response to Financial Crises A: Haircuts and Resolutions

Abstract

After the mortgage market meltdown in mid-2007 and during the financial crisis in 2008, major financial institutions around the world were on the verge of collapsing one after another. Faced with these troubles, the government had to respond quickly to contain the crisis as efficiently as possible. It was, however, limited in resources, time and experience. To make matters worse, the complexity and opaqueness of the financial market and these institutions greatly affected the governments’ ability to design an efficient and consistent method to contain the crisis. Shortly after Lehman Brothers filed for bankruptcy on September 15, 2008, American International Group (AIG) was also in deep trouble and close to failure when the Federal Reserve decided to bailout the institution. Washington Mutual (WaMu) and Wachovia were also facing collapse due to their exposure in risky mortgage products around the same time. WaMu closed and the Federal Deposit Insurance Corporation (FDIC), appointed as a receiver. When the FDIC was appointed, the FDIC was able to arrange a transaction that protected all depositors in the bank and transferred all ongoing operations to JP Morgan Chase without any cost to the FDIC Deposit Insurance Fund. In contrast to WaMu, in the case of Wachovia the FDIC Board of Directors initially approved a sale of Wachovia through a closed bank resolution to Citigroup under the FDIC’s systemic risk authority. However, Wachovia’s Board of Directors subsequently decided to approve a sale – with no FDIC assistance – to Wells Fargo. This case provides details on the background and government response for each troubled financial institution during the financial crisis, and the rationale behind the design of each response.