A Secret Bailout

Two posts ago, I said this:

First it was only banks that got special protection. Then investment banks.
Then an insurance company. Now maybe the auto industry. The list will stop when
the government stops sending good money to chase after bad.

And today, we have evidence that the government has no intention of stopping. (You may have seen this link on Drudge but I'm giving it to you anyway.) Today it is being reported that in addition to the $700 billion that we already know about, the Fed has loaned some $2 trillion--that's $2,000,000,000,000--to troubled firms, and is refusing to disclose who is getting the money:

The Federal Reserve is refusing to identify the recipients of almost $2
trillion of emergency loans from American taxpayers or the troubled assets the
central bank is accepting as collateral.

Fed Chairman Ben S. Bernanke and Treasury Secretary Henry Paulson said in
September they would comply with congressional demands for transparency in a
$700 billion bailout of the banking system. Two months later, as the Fed lends
far more than that in separate rescue programs that didn't require approval by
Congress, Americans have no idea where their money is going or what securities
the banks are pledging in return.

Total Fed lending topped $2 trillion for the first time last week and has
risen by 140 percent, or $1.172 trillion, in the seven weeks since Fed governors
relaxed the collateral standards on Sept. 14. The difference includes a $788
billion increase in loans to banks through the Fed and $474 billion in other
lending, mostly through the central bank's purchase of Fannie Mae and Freddie
Mac bonds.

Before Sept. 14, the Fed accepted mostly top-rated government and
asset-backed securities as collateral. After that date, the central bank widened
standards to accept other kinds of securities, some with lower ratings. The Fed
collects interest on all its loans.

The news agency (Bloomberg) that published this story has filed a FOIA lawsuit to obtain the lending records, but it's appalling that the government requires a lawsuit to disclose spending $2 trillion. In lieu of working this week, I predict that I will be adrift in daydreams, pondering reforms to the Federal Reserve System, and wondering what might have been if I hadn't been tragically denied admission into the graduate economic program at the University of Maryland.

Financial Crisis: The Government Failed In Many Places

I've decided that it doesn't make much sense to attempt an all-encompassing post on the current economic conditions--partly because it would take too much time and effort, and mostly because it would clearly be presumptuous of me to claim to be able to explain it all. But, there are things that people are failing to understand. This is from a Capital (online) letter writer:

Many firms on Wall Street and around the world ran up debt-to-equity ratios
larger than 30 to 1. That means they borrowed $30 for every $1 they actually
had. They didn't get to that point on the strength of mortgages to poor people.
They were playing a leverage casino far beyond the subprime market.

When Lehman Brothers collapsed, its ratio was 45 to 1. That is what is
causing Wall Street to collapse in less than a month, at our great expense. Our
government, including both political parties, have failed us by ignoring the
abuses and failing to exercise proper oversight of the financial industry. Let's
give credit where credit is due.

The stance of many, notably the Obama campaign, is that the blame for our financial crisis lies mainly in the failure of government regulators. I tend to believe that the regulators knew what was going on, but were powerless to do anything because their interests were in conflict with a more momentous political prerogative. Let's discuss!

Leverage is a great way to make money, and a great way to lose it really quick. It's important to understand that leverage is tied to the assets being leveraged (borrowed against). In this case, artificially easy credit and artificially high demand for homes eventually dried up, rendering the writer's leverage complaint valid.

For most people, their homes are their chief investment. Taking that a step further, securities that are tied to mortgages make up a huge pool of investments, and a huge pool of profit for the companies mentioned in the above letter. The government, via Fannie and Freddy, distorted the market for mortgage-backed securities, and essentially forced such risky behavior. Acting on the assumption that every family deserves to own a home--a notion that is much younger than some might think--Fannie and Freddy created demand for sub prime loans by buying them from mortgage lenders. Banks felt the need to participate, lest they lose ground to the competition. Bottom line: the fault does not lie with unregulated capitalism, it lies with the government's forced limitation of free-market principles.

Perhaps more alarming is the preferred method of bailing these companies out. In the late 1990's, a hedge fund named Long Term Capital Management was on the brink of bankruptcy. To put it in perspective, they were leveraged at least 30:1, and probably more--they were very secretive and nobody really knew where their money was or how much was at risk. A failure of LTCM was thought to have far-reaching effects, as many banks had significant stakes. After a bailout offer from Warren Buffet was rejected, the Fed was brought in. BUT, rather than bail the fund out themselves, the Fed merely acted as a mediator--orchestrating a $525 billion bailout from the fund's creditors, and not the taxpayers.

The contemporary method to bail out companies is direct investment or securitization from the government. Unlike the creditors or investors of a company, the government has significantly less expertise in monitoring the company, and significantly less incentive to recover its money (because the government doesn't have its own money, it has our money). And whereas investors only deal with their investments, the government has no clearly defined restraints. First it was only banks that got special protection. Then investment banks. Then an insurance company. Now maybe the auto industry. The list will stop when the government stops sending good money to chase after bad.

"Too Important To Fail" Is The New Argument For Socialism

Using strict statistical methods, I have calculated that my productivity has dropped by a record 8% in the last 48 hours while I try and sort through the financial nightmare that is terrorizing some major money moguls as we speak. The latest victim is AIG, which just ceded an 80% stake to The Federal Reserve (yikes) for a barely fathomable $85 billion.

Historically, the government has identified industries that are too big or too important to fail. Amtrak and the airlines both have enjoyed government favoritism to some extent. But the financial industry is in a class by itself. The Federal Reserve came in 1913, and the FDIC came in 1933, creating a foundation for a system that now allows firms to make stupid decisions and people to obtain stupid loans.

In case you didn't realize this by now, with public goods being the notable exception, when the government gets involved in industry it screws everything up, and necessarily produces a result inferior to that of the private market. What incentive do banks have to make responsible loans if the government is going to bail them out?

As an economics student, I learned the virtues of the Fed. After all, countries need central banks. But, the Fed's purposes have evolved. Originally meant to control bank panics, it became a regulatory agency for banks, a monetary policy instrument, and a lender of last resort to banks. There has been some history of the Fed serving as a mediator and broker for emergency rescues of too-big-to-fail financial institutions, with Long Term Capital Management being perhaps the most noteworthy. But in the last 6 months, the Fed has pushed even that boundary and has acted a lender of last resort to investment banks (not regular banks), and now, today, has apparently nationalized the nation's largest insurer! Not only are we taxpayers on the hook for the first $85 billion, but I'm quite sure AIG is about to shell out infinity billion dollars to rebuild Texas from Hurricane Ike--are we going to have to pay for that too?!!!!

If that weren't scary enough, consider this: at some point, the Democrat Congress is going to realize that they now have an 80% stake in an insurance company. Democrats want national health insurance. Get the picture?

I hope to research a mega-post on this, but in case I don't, here's what I'm thinking. Most of this is the fault of Democrats, not of the free market or capitalism. Democrats created Fannie Mae and Freddy Mac, and Democrats ran those agencies into the ground while cooking the books and pocketing tens of millions of dollars. When President Bush tried to reform those agencies in 2003 (I think), Democrats blocked it. Fannie and Freddie gave millions of lobbying dollars to Democrats (Obama, Hillary, and Biden were all in the top 5 I think...McCain was #342)--which essentially means the government was lobbying the Democrat part of itself--and we can now see why.

Even so, I am not happy with the Bush administration. That itwould allow such an overt breach of free-market principles is horrible. If the Fed did this unilaterally using its independence, then we need to find limits to the Fed's powers outside of monetary policy. To borrow terminology from Warren Buffet, we the taxpayers are throwing good money after bad money, and we didn't have an ounce of say about it. Earlier in the post I announced that the latest victim was AIG, but the true victim is us.