At the height of the recession, President George W. Bush and the congress authorized a bail-out of banks and investment companies headed for failure.

In a similar plan to bail out Fannie Mae and Freddie Mac, the government authorized the Treasury moved forward with the plan to stabilize the financial industry, and to an extent the economy. The Treasury purchased $225 billion in mortgage-backed securities insured by Fannie Mae and Freddie Mac.

These securities were considered toxic because investors believed that the underlying mortgages were risky, and the price on the open market did not reflect that risk. When investment banks couldn’t get rid of these bad products on the open market, the Treasury stepped in and paid a discount to acquire the assets. This helped the investment banks pad their balance sheet with more cash, improving their financial conditions, avoiding bankruptcy or failure, alleviating to some degree panic in the market that could have led to a more damaging recession or economic depression.

One year ago, the Treasury began selling these mortgage-backed securities, and as of today, the government no longer has any of the assets purchased under this bailout plan. Not only that, but the Treasury earned $25 billion on its $225 billion investment. That works out to a total return of about 11 percent over about three and a half years (the purchases began in October 2008), though that doesn’t take into account the timing of the buying and selling transactions. The good news is that the Treasury did not lose money on toxic assets, a legitimate concern at the time.

The concern is not over, however. The quality of the underlying mortgages is still in question. The investments could still fail.

… [I]f the mortgages behind those securities fail, taxpayers will still be on the hook, since federal housing giants guarantee the loans and taxpayers have been propping up Fannie Mae and Freddie Mac.

The $25 billion earned through the bail-out of Fannie Mae and Freddie Mac will go to paying down government debt.

Photo: cliff1066
CNN

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After the recession, the Federal Reserve developed a stress test for banks and financial firms too big too fail. The stress test looks at the financial condition of these corporations and simulates a new recession. Under the simulation, based on a worst-case scenario, not an actual economic forecast, banks pass the test if the companies have sufficient capital to continue lending; if not, they fail.

Here’s the doomsday recession scenario or assumptions applied to the banks’ financial condition:

• An unemployment rate of 13 percent.
• A 50 percent drop in the stock market.
• A 21 percent drop in the real estate market.

This scenario, which isn’t a prediction for the future, is non far-fetched. The recession in 2008 produced similar or worse results in the stock market and housing prices.

Overall, the banks fared better with this year’s test than with last year’s same analysis. The improvement is due to increased capital at the corporations. The companies lowered dividends to keep more money on hand for emergencies.

While fifteen of the nineteen banks were found to have sufficient capital to withstand the recession without assistance, four bank holding companies or financial institutions in the test failed to meet the capital requirements: Ally Financial, Citigroup, SunTrust, and MetLife.

Officials from the banks quickly responded to the Federal Reserve’s results.

Citigroup said it remains among the best capitalized large banks in the world. However, it said it would not be able to raise its dividend as it hoped, and would submit a revised capital plan to the Fed. Ally said it supported the idea of stress tests, but it disagreed with a number of the assumptions the Fed made, including overstating the bank’s potential mortgage losses. SunTrust could not be reached for comment. Metlife said it was unfair to apply the same tests to insurers as it did to banks.

These companies’ failures isn’t too concerning for customers. Customers shouldn’t be worried that their savings accounts aren’t safe or their insurance policies are in danger. No one has ever lost money in an FDIC-insured bank account. If these corporations don’t improve their financial situation by raising more capital or paying less to shareholders, a recession might result in more government intervention in the companies’ continued operation. The lack of sufficient capital in these financial institutions might lead to another bail-out scenario.

While not concerning from a personal perspective, there is reason to be somewhat concerned with the Federal Reserve’s findings. Financial institutions haven’t adequately planned for systemic risk. When banks fail or need a government bail-out, capital infusion, or partial nationalization, all taxpayers are affected. Shareholders need to be concerned. Will the recent bail-outs still fresh in people’s minds, the public and policymakers have likely lost its appetite for using taxpayer money for assisting banks that are “too big to fail,” and might rather see a firm like Citi go bankrupt rather than submit to a government takeover.

ᔥ Federal Reserve
↬ Fortune

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