Page 2 of 2 A risk-free
revolution By Julian
Delasantellis
screens that would have
authorized another funding rollover. Bear Stearns
was going down.
In the overnight of March
13-14, the Federal Reserve, in the person of New
York Federal Reserve Bank chairman Timothy
Geithner, arranged a loan of undetermined size to
Bear, with JP Morgan essentially acting as
middleman.
Wait a minute. Bear Stearns was
not a commercial bank - it was an investment bank,
not normally regulated by the Fed. Since the Fed
had no regulatory oversight role with institutions
like investment banks, it had no way to determine
if it was operating under sound and prudent
banking principles. (Guess what - it
wasn’t!). Simply put, Bear
Stearns was not supposed to be eligible for
assistance from the Federal Reserve.
Probably deep down in the bowels of the
Fed’s law library, some eager young law clerk
found and dusted off Section 11(r)(3)(ii)(I) of
the Federal Reserve Act of 1932, which allowed
lending to non-regulated financial institutions if
"unusual and exigent circumstances exist and the
borrower is unable to secure adequate credit
accommodations from other sources".
This
provision had been rarely (some say never) used
since the 1930’s, but, like Lenin picking up and
seizing power laying unused in the gutter,
Bernanke assumed the new power to rescue Bear
Stearns. The weekend of March 15-16 saw a still
existent Bear Stearns (although its stock had
dropped to $30 from $170 last year.)
But
as that weekend waxed and waned, and as the
opening of Asian trading beckoned late Sunday
afternoon New York time, it became obvious that
the Fed’s unprecedented late week moves were not
going to be enough to save poor Bear Stearns.
Bernanke’s revolutionaries took to the street
again.
As the bank that daily acted to net
out the credits and debits, to "clear" in finance
lingo, of Bear, JP Morgan already had a
significant pre-existing relationship with Bear
Stearns. The New York Fed asked Morgan if it
wanted to buy the investment bank.
"Sure,"
Morgan replied. It agreed to the purchase, in the
form of a stock swap that essentially valued Bear
at $2 a share - thus that
Romanov-in-the-root-cellar feeling among Bear’s
shareholders.
But there was one catch.
Like a prospective suitor telling his
bride-to-be’s father that he would marry his
daughter only if Dad paid to have his daughter
made a bit more appealing, like maybe undergoing
breast augmentation surgery to turn her A cups
into GGs, JP Morgan wanted, and got, $29 billion
of Bear Stearns’ worst, most unlikely to be repaid
loans taken out of the deal. Those would go into
the portfolio of the Federal Reserve itself.
"But what about moral hazard?" I
remembered my young Beijing interviewer asking.
What about it? If this wasn’t an example
of moral hazard being rewarded, what would be? The
Fed’s supporters, of course, came out with the
standard defense that a Bear Stearns bankruptcy
would have caused significant turmoil and
disruption to the system as a whole, that Bear
was, to use the cliche, too big to fail. Maybe
that was true, maybe not, but by saving an
institution that it had no role in overseeing, in
exercising a regulatory stewardship that opened
the wallets of the taxpayers for the benefit of
the financiers, a new addendum was added to the
cliche. Not only was Bear too big too fail, it was
also too addled by incompetent overweening greed
and hubris to succeed, and it was the Federal
Reserve that forevermore would sort out this sort
of contradiction.
True, Bear’s
shareholders lost $168 off last year’s $170 stock.
But in the old days, Bear’s owners would have been
required to pay back out of personal funds all of
the loans that the bank was defaulting on. With
the company so leveraged up in order to produce
the go-go returns of the early and middle years of
this decade, (it probably was using each dollar of
its owners capital to make about $25 of investment
loans), such a requirement would have been
devastating to Bear’s principals. We would not be
talking about a hit to their individual retirement
accounts (and if they were well diversified, it
would have been a modest hit) - we would be
talking about confiscation of all of their assets,
eviction from their mansions, settling down into
the soft cushions of a chaise lounge by the pool
at the Hamptons country club never again.
Thus, as March ends, we see the United
States financial system, previously thought to be
exemplified by rough and ready individualists and
free marketers, who previously said that all they
wanted from the government was that it stopped
making them pay back Social Security taxes on
their household help, gleefully accepting the
greatest government intervention in the financial
markets in at least 70 years. As if this was an
episode of the NBC network reality game show "Deal
or No Deal", the financial markets were offered a
choice between their principles and their
portfolios, not surprisingly, they went straight
for the cash.
For, at first, the markets
loved their new Big Brother. The feeling that the
Fed was at last well-ahead of the subprime curve
tempted lots of buying back into the stock market.
From the opening of trading on March 17 to the end
of the week the Dow Jones Industrial Average
gained 6.8%; the S&P’s BIX Banking and
Financial stock index tacked on over 13%.
Naturally, for the nation’s free market
economic conservatives, the success of the Federal
Reserve/Government intervention, indeed, the
entire subprime crisis itself, presents an
irritating paradox.
It is patently obvious
that the free marketers usual solution for
everything - from the crisis in Darfur to local
soccer league schedules - less government
intervention - failed in this circumstance. For
most of this decade, free marketers have been
firmly ensconced at the seats of power of all
three branches of American government; even in the
90s, under Bill Clinton, his third-way
middle-ground politics and personal troubles meant
that the free marketers were also then getting
just about everything they wanted out of
Washington. The 1933 Glass-Steagall Act, the
centerpiece of Franklin D Roosevelt’s New Deal
financial regulation legislation, was repealed not
by Bush 41 or 43, but by Clinton 42, in 1999.
If lesser government was the path to
happiness, by the time the Democrats retook the
Congress in 2007 America’s quantities of joy then
should have made the Elysian Fields look like Love
Canal, the chemically polluted Buffalo, New York,
neighborhood that in the 1970s came to symbolize
the cavalier corporate attitude towards the
environment.
If the free marketers have a
problem with laissez-faire not working, some have
an even greater problem when government
intervention actually is working. These are the
people that endlessly delight in repeating Ronald
Reagan’s old joke that the nine most dangerous
words in the English language are "I'm from the
government and I'm here to help." The Fed’s
interventions clearly do seem to have helped - how
can the truth be reconciled with ideology?
The famous German philosopher Friedrich
Hegel, according to legend, once replied to a
student’s query along the lines that "Herr Doktor
Professor, your theories are inconsistent with the
facts"; with "Well, so much the worse for the
facts." In this spirit, the free marketers are
essentially ignoring the trials and tribulations
of March, and all that led up to them. They still
say that the best way to prosperity is sharply
limited government intervention.
Senator
John McCain, the Republican Party’s presumptive
nominee for this November’s presidential election,
much in contrast to Senators Clinton and Obama’s
(and perhaps Ben Bernanke’s) system-wide approach
to solving the problem, huffed and puffed for the
standards and customs of the old days in a March
25 speech, just like you would expect a
conservative 72-year-old to do. In his, and in
many other conservative eyes, it is the
homeowners, not the bankers and financial
technocrats, that deserve much of the approbation
for the current crisis.
I have always been committed to the
principle that it is not the duty of government
to bail out and reward those who act
irresponsibly, whether they are big banks or
small borrowers ... Any assistance must be
temporary and must not reward people who were
irresponsible at the expense of those who
weren't … Homeowners should be able to
understand easily the terms and obligations of a
mortgage. In return, they have an obligation to
provide truthful financial information and
should be subject to penalty if they do not …
Policies should move toward ensuring that
homeowners provide a responsible down payment of
equity at the initial purchase of a home. I
therefore oppose reducing the down-payment
requirement for FHA mortgages and believe that,
as conditions allow, the down payment
requirement should be raised.
Then
like the Pope referencing Jesus in an address from
the Vatican balcony, McCain genuflects, and then
prostrates himself before the Right’s true
divinity, tax cuts skewed towards the rich, as a
solution to the subprime, and, for that matter,
any other crisis.
I have spoken at length in other
settings about the need to keep taxes low on our
families, entrepreneurs, and small businesses;
to make the tax code simpler and fair by
eliminating the Alternative Minimum Tax that the
middle class was never intended to pay; to
improve the ability of our companies to compete
by reducing our corporate tax rate, which today
are the second highest rates in the
world.
In the final week of the month,
the joy of the first week of the new regime seemed
to be a bit more tempered. As more and more
details of the Bear Stearns rescue emerged, some,
most notably former Fed chairman Paul Volcker,
questioned the precedent that the Bernanke Fed was
setting. Surely, if similar situations arose
again, the Fed would be called on to act in a
similar fashion; if this happened over and over
again, could you really then say that the USA
still had a private-sector financial system? If
so, when would government’s now velvet glove
transform into the iron fist? The stock market
reflected these doubts; both the general market
indexes such as the Dow, along with the banking
and financial sector specific indexes such as the
BIX, lost about half their gains of the previous
week.
It is in the renewed decline of the
banking sector that the most challenging questions
can be raised. Is the market saying that another
wounded Wall Street titan is soon to stumble and
fall, perhaps Lehman Brothers?
If so,
wouldn’t the Fed be forced back into the market
again? And would that be a good or bad thing? Like
a dog who learns that doing a trick that its
master enjoys, like rolling over, will earn it a
nice meaty treat, have the trials and tribulations
of March, 2008 led the markets to believe that all
they have to do is roll over every few weeks or
so, and the Fed will then give it a juicy treat,
namely, a few more billions in taxpayer largesse?
But like the pet bird who sings a lovely
tune from behind the bars of a gilded cage, with
every rescue, with every step further down the
road of Federal Reserve intervention, the bars of
the cage grow thicker. Granted, right now it’s a
very comfortable cage; no moral hazard sanction so
severe is being imposed that you’re likely to see
any of Wall Street’s elite in a thrift store
anytime soon. But to answer the implied question
posed by the title of Maya Angelou’s autobiography
I Know Why the Caged Bird Sings, in the
case of the increasingly confined US financial
services industry, more and more they are singing
because the US Federal Reserve is telling them to
do so, and richly rewarding them when they do.
Perhaps, deep down in those dusty dank
bowels of the Fed’s law library, Bernanke has
charged his young Ivy League factotums with
another mission - find another Section
11(r)(3)(ii)(I) that will allow the Fed to buy up
and clean out the entirety of the subprime
portfolios of American finance. If anything, March
2008 has proved that few will seriously object,
especially if it leads to a big stock market
rally.
But if the Fed does essentially
engineer a one-time nationalization of the US
housing finance industry, who will believe that,
when the next credit crisis comes down the road in
10 years or so, it won’t do so again? Even Lenin,
in his 1921 private-sector friendly New Economic
Policy (NEP), came to realize that it was hard to
attract private capital if there was ever present
in investors’ minds the belief that soon their
stakes might be readily nationalized away.
In the meantime, I see in Ten Days That
Shook the World, that, after the Revolution,
Leon Trotsky posed this probably only partially
rhetorical question:
If we are going to nationalize the
banks, can we then tolerate the financial
journals? The old regime must die; that must be
understood once and for all.
Watch
this space - while you can.
Julian
Delasantellis is a management consultant,
private investor and educator in international
business in the US state of Washington. He can be
reached at juliandelasantellis@yahoo.com.
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