Earvin ‘Magic’ Johnson with Nicole Garnier-Cosme (left) and Morris Reid of Westin Rinehart (right), at the launch of Magic Workforce Solutions on September 23, 2008 in NYC. Magic Workforce Solutions is a staffing service for companies committed to building a diverse workforce.

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By Douglas W. Diamond and Anil K. Kashyap

For most of the last 20 years we have been studying banks, monetary policy, and financial crises. So for us the events of the last year have been especially fascinating.

The last 10 days have been the most remarkable period of government intervention into the financial system since the Great Depression. In talking with reporters and our noneconomist friends, we have been besieged with questions about several aspects of these events. Here are a few of the most frequently asked questions with our best answers.

1) What has happened that is so remarkable?

This episode started when the Treasury nationalized Fannie Mae and Freddie Mac on September 8. Their combined assets are over $5 trillion. These firms help guarantee most of the mortgages in the United States. The Treasury only got authority from Congress to take this action in July, and in seeking the authority had insisted that no intervention would be needed.

The Treasury has replaced the management of both companies and will presumably oversee their operation. This decision marked an acknowledgment by the government that the mortgage market and the institutions to make it operate in the U.S. are broken.

On Monday, the largest bankruptcy filing in U.S. history was made by Lehman Brothers. Lehman had over $600 billion in assets and 25,000 employees. (The largest previous filing was WorldCom, whose assets just prior to bankruptcy were just over $100 billion.)

On Tuesday, the Federal Reserve made a bridge loan to A.I.G., the largest insurance company in the world; perhaps best known to most of the world as the shirt sponsor of Manchester United soccer club, A.I.G. has assets of over $1 trillion and over 100,000 employees worldwide. The Fed has the option to purchase up to 80 percent of the shares of A.I.G., is replacing A.I.G.’s management, and is nearly wiping out A.I.G.’s existing shareholders. A.I.G. is to be wound down by selling its assets over the next two years. (Don’t worry, Man U will be fine.) The Fed has never asserted its authority to intervene on this scale, in this form, or in a firm so far removed from its own supervisory authority.

2) Why did these things happen?

The common denominator in all three cases was the inability of the firms to retain financing. The reasons, though, differed in each case.

The Fannie and Freddie situation was a result of their unique roles in the economy. They had been set up to support the housing market. They helped guarantee mortgages (provided they met certain standards), and were able to fund these guarantees by issuing their own debt, which was in turn tacitly backed by the government. The government guarantees allowed Fannie and Freddie to take on far more debt than a normal company. In principle, they were also supposed to use the government guarantee to reduce the mortgage cost to the homeowners, but the Fed and others have argued that this hardly occurred. Instead, they appear to have used the funding advantage to rack up huge profits and squeeze the private sector out of the “conforming” mortgage market. Regardless, many firms and foreign governments considered the debt of Fannie and Freddie as a substitute for U.S. Treasury securities and snapped it up eagerly.

Fannie and Freddie were weakly supervised and strayed from the core mission. They began using their subsidized financing to buy mortgage-backed securities which were backed by pools of mortgages that did not meet their usual standards. Over the last year, it became clear that their thin capital was not enough to cover the losses on these subprime mortgages. The massive amount of diffusely held debt would have caused collapses everywhere if it was defaulted upon; so the Treasury announced that it would explicitly guarantee the debt.

But once the debt was guaranteed to be secure (and the government would wipe out shareholders if it carried through with the guarantee), no self-interested investor was willing to supply more equity to help buffer the losses. Hence, the Treasury ended up taking them over.

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Green Jobs Now is a National Day of Action that will empower everyday people to stage hundreds of grassroots events throughout the country. The events will have a special focus on low-income communities, communities of color and indigenous people. They hope to send a message to our leaders that, when it comes to creating green jobs for a more sustainable economy, PEOPLE ARE READY!

Right now, there are millions of people ready to work and countless jobs to be done that will strengthen our economy at home. There are thousands of buildings that need to be weatherized, solar panels to be installed, and wind turbines to be erected. There are communities that need local and sustainable food and people ready to farm the crops. There are public transit systems and smart electricity grids in need of engineers and electricians. Americans are ready to build the new economy. It’s time to invest in saving the planet and the people. It’s time for green jobs now!

~ Van Jones and the Green Jobs Now Team

Green Jobs Now is a project created by Green For All.

Green For All is a national organization dedicated to building an inclusive green economy strong enough to lift people out of poverty.

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President Bush, fourth from right, meets with congressional leaders, including the presidential nominees, in the Cabinet Room of the White House, Thursday, Sept. 25, 2008, in Washington to discuss the financial crisis. Seated from left to right are Bush Chief of Staff Joshua Bolten, Vice President Dick Cheney, Secretary of Treasury Henry Paulson, Rep. Barney Frank D-Mass., House Majority Leader Steny Hoyer, D-Md., Republican presidential candidate Sen. John McCain, R-Ariz., House Minority Leader Sen. John A. Boehner, R-Ohio, Speaker of the House Rep. Nancy Pelosi, D-Calif., Bush, Senate Majority Leader Sen. Harry Reid, D-Nev., Senate Minority Leader Mitch McConnell, R-Ky., and Democratic presidential candidate Sen. Barack Obama, D-Ill. (AP Photo/Pablo Martinez Monsivais)

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To the Speaker of the House of Representatives and the President Pro Tempore of the Senate:

As economists, we want to express to Congress our great concern for the plan proposed by Treasury Secretary Paulson to deal with the financial crisis. We are well aware of the difficulty of the current financial situation and we agree with the need for bold action to ensure that the financial system continues to function. We see three fatal pitfalls in the currently proposed plan:

1) Its fairness. The plan is a subsidy to investors at taxpayers’ expense. Investors who took risks to earn profits must also bear the losses.  Not every business failure carries systemic risk. The government can ensure a well-functioning financial industry, able to make new loans to creditworthy borrowers, without bailing out particular investors and institutions whose choices proved unwise.

2) Its ambiguity. Neither the mission of the new agency nor its oversight are clear. If taxpayers are to buy illiquid and opaque assets from troubled sellers, the terms, occasions, and methods of such purchases must be crystal clear ahead of time and carefully monitored afterwards.

3) Its long-term effects. If the plan is enacted, its effects will be with us for a generation. For all their recent troubles, America’s dynamic and innovative private capital markets have brought the nation unparalleled prosperity.  Fundamentally weakening those markets in order to calm short-run disruptions is desperately short-sighted.

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