Yet another federal bailout for the rich

Last Tuesday, the Federal Reserve Board said that it would guarantee up to $300 billion worth of the highly devalued assets held by those banks that had been speculating in the subprime real estate market, thus enabling those banks to borrow money because of the federal guarantee. Nobody else would accept the subprime mortgage portfolios as collateral for loans. So in effect the taxpayers were being put on the hook if the loans could not be repaid. The stock market that day reacted with glee, skyrocketing upwards. (I explained what was going on here.)

That party ended on Friday. The big investment bank Bear Stearns said that it could not meet its obligations and requested a loan from another big investment bank JPMorgan Chase. The latter, unlike the general public, was aware of the nature of the assets held by Bear Stearns and said nothing doing, unless the Federal Reserve was willing to guarantee that loan too. The Fed, always eager to please the big financial interests on Wall Street, readily agreed and in a single day the whole transaction was approved. This is pretty amazing speed when you consider that $30 billion of taxpayer money was involved.

But the news of Bear Stearns’ troubles, which came just two days after a cheery message of confidence by its head just two days earlier that everything was just fine and dandy, sent jitters down the spine of investors who wondered how bad the situation really was and what dark secrets existed in the vaults of other big financial institutions.

They found out on Sunday when it was announced that JPMorgan Chase was actually buying Bear Stearns for the astoundingly low price of $2 per share, with the Fed once again guaranteeing the transaction. Just last year that stock had been trading at $172 per share. In just one year, the bank had lost almost 99% of its value, a collapse of Enron-sized proportions, but this time affecting one of the oldest and largest investment banks in the country. The total cost to JPMorgan Chase to buy this former financial powerhouse was only $236 million. Given that the Bear Stearns’ fancy headquarters building alone was estimated to be worth about a billion dollars, this fire sale price indicates that Bear Stearns was in even more terrible shape than previously thought.

To understand what is going on here, we need to know that banks invest the money deposited in them to make money for themselves and their depositors. They do this by buying and selling securities of various types. But they are expected to keep a certain percentage of that money in cash to meet the routine demands of depositors who need to withdraw money for whatever reason. As long as not too many people want too much money at once, the banks are said to have sufficient ‘liquidity’ and the system works well. Even if the banks run out of cash, they can get short-term loans from the Fed or other banks using their securities as collateral. The interest on these loans is what is called the ‘discount rate’ and it is much less than the interest that we pay on loans. These kinds of loans are routinely done and are meant to ease any short-term liquidity problems.

But if there are suspicions that a bank is in trouble, that can lead to a stampede of depositors all demanding their money at the same time and we have a ‘run’ on the bank. If the banks cannot convert enough of their securities to cash or raise large enough loans, it can go bankrupt. This can happen even if a bank is perfectly sound. All it requires is a rumor of trouble to cause a run.

It was to prevent such problems that the FDIC system was set up. This said that whatever happened to a bank, the government would guarantee to reimburse depositors up $100,000 each. This was meant to reassure depositors so that they need not panic and withdraw their money suddenly. This is what possibly saved Countrywide Bank last year when it was discovered to have had huge losses by investing in subprime portfolios. I, for example, have an account at Countrywide but did not panic and ask for my money back when I heard the news of its troubles, precisely because of the guarantee.

In return for this government guarantee, the commercial banks have to submit to supervision by the government to make sure that they are not making too many risky investments, though we see in the case of Countrywide that the system is not foolproof.

But investment banks like Bear Stearns are not like the commercial banks ordinary people deal with. There are two kinds of investors in banks like Bear Stearns, those who buy shares in the bank and those who give the bank their money to manage. These banks are outside the FDIC system and the federal government has not previously assumed any responsibility for them or their depositors. Those banks are not like the ones where most ordinary people have accounts. These are meant for very wealthy investors for whom $100,000 is just pocket money. It is presumed that these wealthy depositors and investors are financially savvy people who are capable of evaluating for themselves the risks involved and do not need the government to protect their interests.

These investment banks can and do take much greater risks with their investments in return for much higher rates of return than we get on our checking and savings account. This is capitalism in theory, where there is supposed to be a correlation between risk and reward.

But the trouble was that Bear Stearns was one of the worst culprits causing the subprime mortgage debacle, underwriting many of the transactions and causing the inflation in values of those securities that had little relationship to the actual value of the properties. So when the party ended, they got stuck holding a lot of securities which they had paid high prices for and which were now worthless. When investors started suspecting that things were not going well and started trying to take out their money, Bear Stearns did not have the money and could not sell its securities to raise anywhere near enough money, and nobody would lend them money using those worthless securities as collateral.

Except the government. In an unprecedented move, the Federal Reserve decided that they would intervene to try and prop up, at least partially, Bear Stearns so that it did not go bankrupt by offering guarantees for loans given to it, essentially putting an artificial value on its securities. In essence, the government is using taxpayers’ money to try and protect the wealthy financial interests associated with these investment banks. It is true that the people who held shares in Bear Stearns have lost money due to declining share prices but there is little the government can do about that. But by guaranteeing the value of the mortgage collateral, it bought those investors some time

So rather than seeing capitalism in practice what we have is capitalism in theory but a perverse socialism in practice, where the risk is borne by all taxpayers but the benefits in the form of profits accrue to just a few. All those people in government and business who preach financial discipline to the poor and say that people should be held accountable for their decisions, tend to conveniently change their tune when it is themselves or their friends who are affected.

I have shown this clip by British comedians John Bird and John Fortune before but I am showing it again because they describe precisely how we got into this mess and mention by name Bear Stearns and discuss the two funds owned by them that lie at the heart of their problems.

It is unnerving that two comedians in another country in October 2007 could finger the problem that is just now rocking the financial markets in the US.

Once again, I am not an economist so people who are more knowledgeable can chime in with corrections.

The propaganda machine-3: The third tier pundits’ role and purpose

(For previous posts in this series, see here.)

In my previous post in this series, I described the kinds of arguments put out by some of the better-known third tier pundits. You can probably discern a characteristic common to all of them. They start by identifying an enemy (people or ideas) and then throw everything at it, using any spurious argument they can think up, hoping that something will stick. Their purpose seems to be to fill the airways and print media with noise and confusion. The idea is not to make a cogent case but to create a fog through which the public is encouraged to see the designated enemy as vaguely disreputable even if no one can say exactly why. One enemy they have agreed upon is ‘liberal’, a word with an honorable ancestry but now so muddied that they can use it in almost any way they like. So they assert that liberals are weak, fascistic, atheistic, immoral, anti-American, terrorist-loving appeasers. It does not even matter if their assertions contradict one another. The third tier pundits are glib and have a superficial cleverness that seems to be convincing to some people but they lack good rhetorical forensic skills, instead using the equivalents of sledgehammers.
[Read more…]

Dog whistle politics

In an article written in 2000, William Greider said something that really stuck in my mind: “An enduring truth, a wise friend once explained to me, is that important social change nearly always begins in hypocrisy.”

This is very true. When we look back at the improvement in our attitudes to race and gender, at some point indulging in crude stereotypes, offensive humor, and derogatory remarks against this or that hitherto discriminated group becomes seen as unacceptable behavior and the people making them are viewed as ignorant and become ostracized, outside the bounds of decent society. As a result, we then go through a long period when people who harbor such offensive views feel forced to hide them or even say things that are opposite to what they truly feel. As Greider says “[T]he powerful are persuaded to say the appropriate words, that is, to sign a commitment to higher values and decent behavior.”
[Read more…]

More on bubble economics

Dean Baker (co-director of the Center for Economic and Policy Research in Washington, DC) argues that the US is heading towards a recession, if not already in one, and he says that the main cause is the collapse of the housing bubble and not the spending on the Iraq war, though that is not helping either.

The villains in this story are the economists who somehow couldn’t see an $8 trillion housing bubble, the banks that fueled the bubble with bad and often predatory loans, the regulatory institutions that did nothing to prevent the growth of the bubble and the spread of predatory loans, and most of all, Alan Greenspan and the Fed who blessed the whole thing.

We have to hold these folks responsible for their bubble economics. The best place to start would be to remove them from positions where they are still making economic policy.

On Tuesday, we saw the Federal Reserve decide to pump $200 billion into the financial system to try and alleviate the crisis and it sent stock prices soaring that day.

I didn’t understand exactly what they did or how it was supposed to work because the news was reported in a very obscure way. Fortunately for people like me, in another article Baker explains clearly what is going on here and argues that the media is not characterizing this action for what it really is: a federal bailout of the banks that were partly responsible for this mess.

Can’t the media find any economists who don’t think that handing hundreds of billions of taxpayer dollars to the big banks and the incredibly rich people who own and manage them is a good idea? Apparently not, given the coverage so far to the Fed’s proposal to lend $200 billion to the banks using mortgage backed securities as collateral.

The workings of the Fed and the financial markets can appear complicated, so let’s simplify matters a bit to make it more clear what is going on here. Suppose that it was suddenly discovered that much of the wealth held by the country’s leading financial institutions was in fact counterfeit. Instead of having hundreds of billions of dollars of real currency in their vaults, institutions like Citigroup, Merrill Lynch, and Bears Stearns actually had hundreds of billions of dollars of counterfeit currency. Suppose further that the public did not know exactly who held what in terms of counterfeit currency, only that all of them had a lot of it. (The point here is that these banks hold mortgage backed securities, many of which are only worth a fraction of their face value, and therefore can be viewed as the equivalent of counterfeit currency.)

In such circumstances, investors would be very reluctant to accept the credit of any of the major financial institutions. They couldn’t know whether most of their assets were in fact counterfeit, and they were dealing with a bankrupt institution, or whether the counterfeit currency was only a limited share of the wealth, which would not jeopardize the institution’s ability to meet its obligations.

This is in fact the credit squeeze that we’ve have recently witnessed. The spread between the interest rates on a wide variety of assets and the interest rate on safe assets (U.S. government debt) has soared. As a result, the Fed’s effort to stimulate the economy, by lowering the federal funds rate, has been largely unsuccessful because other interest rates have remained high.

In response to this situation the Fed today announced that it would lend $200 billion to banks and other financial firms, accepting mortgage backed securities as collateral. This is effectively the same as saying that the Fed is going to lend money to banks and accept the counterfeit currency as collateral, treating it just as though it were real money.

The intended effect of this policy is to convince other investors that the counterfeit currency is in fact real currency, or at the very least that there is a really huge sucker out there (the Fed) which is prepared to treat the counterfeit currency as real currency.

So how does this story play out? Well, insofar as the Fed is successful, the counterfeit currency retains its value for a while longer. This allows Citigroup, Merrill Lynch, Bears Stearns and the rest of the big boys more time to dump their counterfeit currency on suckers who haven’t figured out how the game is played.

It is possible that they won’t be able to find enough suckers, in which case these banks will end up defaulting on their loans and the Fed (i.e. the government) has lost tens or hundreds of billions dollars paying good money for counterfeit currency. Alternatively, perhaps the big boys are successful and can offload enough of their counterfeit money to restore themselves to solvency before the music stops. Then the Fed is repaid, but the counterfeit money now sits in the hands of other, less informed, or less inside, investors.

You should really read the whole of this excellent article.

Baker shows how once again, we have the Federal Reserve colluding with the government to use taxpayer money to protect and enrich the wealthiest people in the country.

POST SCRIPT: The work of Satan

Almost everyone has had encounters with those annoying little plastic containers of milk that always seem to squirt onto your clothes when you try to open them. Stephen Fry and Hugh Laurie deal with this menace appropriately.

The propaganda machine-2: Examples of third tier pundit work

(For previous posts in this series, see here.)

One does not have to go very deep to understand why third tier pundits are not worth spending much time on. In making my criticisms of them, I have to confess that I do not take the time to read these people’s books, so readers will have to take that into account in weighing my comments on them. Fortunately there are people among the first-tier pundits and other commentators who freely and voluntarily take on this truly thankless task and document the bankruptcy of these people and their ideas. You couldn’t pay me enough to waste my time reading their books when there are so many worthwhile books to read. I have read enough articles written by them and about them and watched some interviews, sufficient I think to judge their caliber. It is of course theoretically possible that if I spend the hours necessary to wade through all the prolific output of these third tier pundits, I may find that they have produced works of extreme profundity and elegance that their critics have overlooked. But given the evidence from their other works, I would put the chances of that about as close to zero as you can imagine.
[Read more…]

Technology guerilla warfare

One of the interesting things about technology is the way that it creates a kind of arms race between those who quickly adopt new technologies and those who feel that it impinges on their own freedom and want to thwart them. We know, for example, that the radar guns used by traffic police have spawned detectors that can tell drivers who like to speed when such devices are in use, leading to more sophisticated devices being developed for police, and so on. In this case, the radar detectors were being used by people who were trying to break the law for their own benefit and increasing the risk to other users of the road.
[Read more…]

The propaganda machine-1: The third tier pundits

When I was interviewed recently on Blog Talk Radio about my 2005 posts about the people I call third tier pundits and the baleful influence that they have on political discourse, I didn’t really have the time to go more deeply into how it is that they got to play the particular role they currently play. It would be a mistake to think that they are merely the flotsam brought to the surface by media currents. They play a vacuous but integral part in a propaganda machine.

Third tier pundits are those people who occupy almost the bottom rung of the punditry world, the value of their contributions rising just barely above that of the people who write graffiti on bathroom walls. The most prominent examples of this species are people like Michelle Malkin, Ann Coulter, Jonah Goldberg, and Dinesh D’Souza but unfortunately there are many, many more. In fact, it seems like there is a seemingly endless supply of such people, available at a moment’s notice to appear on TV and radio and fill up newspaper op-ed space or the shelves of bookstores, spouting a predictable line of nonsense. But while they add little, they fill a significant niche in the media world and it is interesting to see what the purpose of that niche is and how they fit into the overall structure of the media. As Jonathan Schwarz says about the whole species:
[Read more…]

The phony Social Security crisis-4: What needs to be done

(For previous posts in this series, see here.)

While Social Security is not in a crisis, it does require periodic adjustments to make it work, as the economy and demographics of the population change. It can be made solvent with minor tinkering at the edges such as removing entirely the cap on payroll tax income or increasing the rate of taxation by small amounts or by lowering the annual cost-of-living increases in benefits or, in the worst case, by slightly reducing the benefits. We are not facing the catastrophe the doomsayers predict.

The major problem with Social Security is not with the retirement benefits part but with rapidly rising Medicare costs. Currently the Social Security tax (the part that goes towards retirement benefits) is 12.4% of income up to the cap, which is $102,000 for 2008. The tax rate for Medicare is 2.9% of your gross income. Your employer pays half of this 15.3% total, unless you are self-employed in which case you are responsible for the entire amount.

It is the Medicare costs that are already outstripping Medicare revenues and rising rapidly, and thus straining the government’s finances. But this is largely a health care costs problem, caused by the hugely wasteful profit-making health system that currently exists in the US that has resulted in per capita costs that are at least twice as much as the costs in other developed countries and yet produces worse results. Introducing a single-payer system like that which exists in France or Canada would result in savings, greater ability to control costs, and better health care overall. (See the series of posts on health care where these arguments are presented in more detail.)

[Read more…]

The phony Social Security crisis-3: More realistic views of the alleged ‘crisis’

(For previous posts in this series, see here.)

In deciding whether Social Security is in trouble or not, it is important to bear in mind different measures. Let us start by assuming that no changes at all are made in the system and that current projections for future demographics hold for the next fifty years. This is a very big ‘if’ indeed, but a starting point for analysis. The alarmists look at the year in which projected Social Security benefits paid out in that year exceed the revenues from the payroll tax that same year. That is expected to occur around 2018. But that alone does not constitute a crisis. Social Security has been running a surplus all these years so by that time the trust fund will have about 3.7 trillion dollars in reserve. This fund earns interest and the interest can be used to supplement the payouts following the year when the expenditures start to exceed the revenues. At a 4.5% interest rate on the US treasury bonds, the accumulated trust fund can generate an annual growth of about $170 billion due to interest alone. Using this interest to pay benefits can be done for some time during which the size of the trust fund will remain the same or will still be increasing, though more slowly.

[Read more…]

The phony Social Security crisis-2: Double talk on Social Security

(For previous posts in this series, see here.)

We currently see this curious double-talk taking place about the US bonds that form the assets of the Social Security trust fund. When trying to scare people about Social Security, people in this administration talk about the bonds in the trust fund being ‘worthless’ pieces of paper. But when trying to actually sell the bonds in international markets to finance its deficits, the government talks about how robust the US economy is. Like all double-talking politicians, the two different faces are presented to two different audiences, with the hope that the audiences will not overlap.
[Read more…]