Why the Bank Bailouts Worked

In 2008, the government took historic measures to stabilize the financial industry by providing the Treasury unprecedented power to bail out the banks. Almost immediately after, the controversial move was despised by free-marketers everywhere. However, more pragmatic economic observers noted that they were unsavory, but unavoidable. 18 months later -- surprise! -- they actually appear to have worked pretty well. Andrew Ross Sorkin notes this revelation in his New York Times column today. Considering the underlying causes of the financial crisis, this should not be a shock.

Stabilizing the Market

The first important objective of the bailout was to stabilize the financial markets. That happened relatively quickly. It should have: when the U.S. government makes a choice to essentially prevent an industry from failing that goes a long way in calming markets. As soon as investors realized that the risk they feared would be covered by Uncle Sam, there was far less fear about banking. The credit crunch then began to lessen.

Several months later, the government decided to conduct a series of stress tests on the largest banks. That confirmed to the market that the Treasury would stand behind these firms. Again, investors were relieved and less worried about risk. The stress tests, thus, made it even less likely the bailouts would fail.

The Causes of the Crisis

Uncertainty drove the credit crunch. Investors and traders suddenly realized they didn't fully understand some of the securities they owned, many of which relied on a troubled housing market. They also didn't know how big the losses were that would hit banks that also held these bad assets.

But most banks had limited exposures to these toxic securities and the broader mortgage market. Home prices can only fall so far, so the losses slowed. When the credit crunch hit its climax, many of these assets had to be marked to prices that already reflected very serious loss levels. So some of the bank losses were unrealized at the time they were taken. That would provide banks some cushion going forward and even cause some institutions to see gains if losses turned out to be lower than anticipated.

So once investors got comfortable with the banks again, and the housing market's bleeding slowed from a hemorrhage to a drip, they got much better. There was no systematic problem in their business models; they just made some really poor assumptions about what would happen in the real estate market. Once that mistake was in their past, they could go back to business as usual.

Not All Bailouts Worked -- Yet

It should be noted, however, that not all of the bailouts worked, yet. The big banks that were given money have largely survived, because they didn't have flagrant business strategy flaws that would limit their future profitability. Firms that the U.S. may lose money on, including Fannie, Freddie and the auto companies, are a different story. There, problems were driven by their business models. Consequently, those bailouts could ultimately fail, unless reorganization strategies work extraordinarily well and these companies manage to pay back the government over an extended time period.

Just because the bank bailout worked doesn't mean bailouts, in general, are harmless. One statistic that's hard to track is the damage caused to smaller banks by the government's implicit guarantee of the bigger ones. Even though the bailout succeeded in stabilizing the economy, government support of private firms does have significant negative consequences. That's why reform is so important to minimize the need for such bailouts in the future.