Too Big to Bail

In listening to the myriad of U.S. lawmakers this past week, it’s pretty clear to see that panic has officially set in…and it ain’t budging. But with all these meddlers and world-improvers about, we’re convinced it’s only going to get worse. Bill Bonner explains…

"Bankruptcy of Neo-Capitalism," shouted a headline in Wednesday’s Paris press. Scarcely since Hitler blew his brains out has the type been bigger or the contentment broader.

Almost everyone everywhere is enjoying the show. Each headline brings more laughs. The financial markets give people neither what they expect nor what they want, but what they deserve. What a treat to see people getting it – good and hard.

Near to home, that galling "millionaire next door" – many will take pleasure in seeing his portfolio of stocks marked down. "Stocks for the long run," he used to say, smugly; the silly old coot will be dead before his stocks come back! He’ll have to work until he drops dead, just like the rest of us.

On Wall Street, the masters of the universe – who had the pay slips to prove it! – are now getting blown up by their own debt bombs. The top five firms on Wall Street were thought to be "too big to fail." But Bear Stearns has been blown to smithereens. Lehman is exploding into small pieces. Merrill ducked and missed the blast. Then, the last big capitalist desperadoes – J.P. Morgan and Goldman – waved the white flag. They petitioned the government to allow them to become regulated, deposit taking banks!

And George Bush will leave behind the biggest nationalization program in history. Surely, that’s worth a snide chuckle. The takeover of Fannie and Freddie alone leaves half the country living in what are effectively, government-subsidized housing projects. Meanwhile, the coordinated takeover of Wall Street, put together by his apparatchiks, left even the hardened lefties at France’s Liberation in shock and awe: "This enormous statist intervention…is the work of the most ideological and extremist administration that the US has ever had."

How heartwarming to see that the meddlers and world-improvers get a second wind. It’s like driving around in a ’33 Lincoln…or throwing rocks at the gendarmes in ’68. The old, gray Bolshies feel young again! Impetuous! Brainless!

And every capitalist is behind the bail out program too. All over the world, markets are out – state-sponsored meddling is in. Free market principles are fine – until prices start going down!

And there’s the breathtaking chutzpah of it! After proposing a $700 billion program, in which the government buys up Wall Street’s mistakes – otherwise known as "cash for trash" – Henry Paulson says he had no choice: "We did this to protect the taxpayer," said the former Goldman chief.

Even Russia got into the act. New to counterfeit capitalism, it’s getting the hang of it fast, pledging $20 billion in the fight to keep stock prices from falling to what they are really worth.

Then, not be left behind in general hysterical absurdity, SEC honcho Christopher Cox announced a list of 799 financial stocks on which shorting is banned until Oct. 2nd. In Britain, the FSA’s ban on shorting financial shares lasts until Jan 16. But Pakistan gets the King Canute Memorial Prize; by law in that benighted land, stocks can’t go below their August 27th close.

And what a bunch of numbskulls – Greenspan, Paulson and Bernanke! Every word they’ve said so far has been financial poison. "Greenspan relaxed about house prices…" reported the Financial Times in 2005. "Most negatives in housing are probably behind us…" said the same sage in October 2006. "We believe the effect of the troubles in the subprime sector…will be likely limited…" said Bernanke in March 2007. It’s "not a serious problem…I think it’s going to be largely contained," added Paulson in April 2007.

But these are the same numbskulls who now say they are saving capitalism from itself. Ah, there’s the rub…amid all this giddy merriment is a serious threat. The feds have bailed out the bankers, the insurers, the mortgage lenders, and half of Wall Street. But who will bail out the feds?

Since 1971, the world’s money system rests on the dollar. And the dollar rests on nothing but faith, hope and the kindness of strangers. And while the full faith and credit of the United States of America is elastic, it can snap.

Last week, the price of gold popped up $120 in two days. Then, on Monday, it added another $43. Oil gushed up 44% in the space of barely a week. Investors felt the geyser of liquidity coming from Washington and beat a retreat from the dollar.

For the last 15 years, the U.S. money supply has grown about twice as fast as GDP. Federal government liabilities, meanwhile, have grown three times as fast. As a result, the USA now has more financial obligations than assets. It is, effectively, broke. Nevertheless, the debit side of its ledgers grow heavier and heavier. This year’s US government deficit will add about half a trillion. The US trade deficit is about $700 billion. The U.S. bailout plan will probably cost at least $1 trillion more.

Where will the government get that kind of money? There are only two possibilities – one honest and depressing, the other corrupt and alarming. Whether it borrows the money, or prints it up, the world enjoys no net increase in financial resources. Borrowing takes resources from projects that might have been worthwhile and diverts them to the losers. Interest rates rise, as a consequence of the extra borrowing; higher rates generally worsen the economic picture. And while the U.S. borrows, long term, at almost 5%, it lends at barely 2%. It’s like a bank that has gotten its business model badly mixed up. The more it borrows and lends, the faster it goes broke.

If, on the other hand, it merely prints the money – or if it creates it "out of thin air," to use Lord Keynes’ handy phrase – the results are even worse. Inflating the money supply with new currency, a la Argentina or Zimbabwe, wipes out debts. But it destroys faith in the dollar and brings down the whole world’s money system.

Sooner or later, this is just what will probably happen. Not because capitalism doesn’t work – but because it does. Capitalism is doing just what it should do – it is separating fools from their money. But the fools vote. After a big bubble, there are more fools than sages…and, in the United States of America, more debtors than creditors. Sooner or later, Americans will realize that they are better off destroying their own money than preserving it…and that they would prefer to stiff their creditors rather than pay their bills. That is when deflation will gives way to inflation…and the world’s post-’71 dollar-based money system comes to an end.

Enjoy your weekend,

Bill Bonner
The Daily Reckoning
September 26, 2008

Bill Bonner is the founder and editor of The Daily Reckoning. He is also the author, with Addison Wiggin, of the national best sellers Financial Reckoning Day: Surviving the Soft Depression of the 21st Century and Empire of Debt: The Rise of an Epic Financial Crisis.

This has been a very good week for us. We can’t remember when we’ve laughed so hard.

"We’re not going to Christmas tree this bill," was how one senator – we think it was Chris Dodd – described how Congress would deal with the bailout plan.

We had never heard "Christmas tree" used as a verb. But leave it to a Washington hack to turn Christendom’s sentimental icon into a lobbyists’ grabfest. The boys on the hill began decorating the tree on Monday…they’ve been hanging baubles ever since. And according to today’s paper, they’ve agreed on the major issues; but they’re still going to take a few days to get the thing all trimmed out before it becomes law.

The Dow shot up 196 points yesterday as investors waited for the lighting ceremony. Oil rose $2.26. Gold dropped $13 to $882. The dollar held steady – in the Gare Montparnasse we paid the same $7 for our cup of coffee and pain aux raisins as we paid a week ago. And the yield on short-term government paper – 91-day T-bills – fell to exactly 0.27%, which is to say, nothing at all.

But getting back to the entertainment – everyone is getting in the act. Politicians, investors, comics…even the clergy. Yes, the archbishop of Canterbury said that men had put too much faith in the market…and that this faith had become a sort of "idolatry."

He thinks government should be held in higher esteem…while the decisions and plans of free men should be curbed. More regulation is needed, said he, praising Britain’s ban on selling financial firms short.

Yes, dear reader, the poor Church of England has a fool as its top man.

But you can hardly blame a man of the cloth for believing that markets have failed and that government must fix them; the idea is so widespread, he probably got it like one catches a cold or picks up a popular tune – that is, without having to think about it himself.

When everybody thinks the same thing, no one is thinking. And now, everyone thinks the market screwed up…and the bureaucrats rush in to unscrew things.

Typical is this from Garrison Keillor:

"[T]hat’s why we need government regulators. Gimlet-eyed men with steel-rim glasses and crepe-soled shoes who check the numbers and have the power to say, ‘This is a scam and a hustle and you either cease and desist or you spend a few years in a minimum-security federal facility playing backgammon.’"

Out on the prairie, one can imagine all sorts of things. But it’s not as if there were no bureaucrats on the job between 2000 and 2007. How does one imagine that these same regulators, who missed the biggest bamboozle in market history, are now going to be able to clean it up?

How does a bureaucrat – charged with protecting the public’s money – recognize a scam more readily than an investor whose own money is on the line? What information does he have that is not available to the public? What theory does he follow that is unknown to investors? What meat does he eat…what wine does he drink…that prevents him from falling prey to from the delusions and temptations to which all flesh is heir?

This is what Hayek termed the "fatal conceit," that public officials – armed with the power to force people do to what they say – will do a better job of running things than people can do for themselves.

Apparently, neither the masters of the universe on Wall Street, nor the geniuses at the rating agencies, nor the saints at the SEC…and certainly not the poor lumpeninvestor… understood what was going on. None had gimlet eyes. Instead, all their eyes bulged with admiration at the financial engineers’ handiwork…and with greed at how much money they could make.

And now we find, on page one of today’s International Herald Tribune, the bureaucrats’ practical challenge. "What’s this stuff worth?" The Paulson plan puts $700 billion in the hand of GS14s, clerks, hacks and appointees. What are they supposed to do with it? Buy "assets" that Wall Street wants to dump.

How are they supposed to know what it is worth? If they pay too much, the government takes a big loss. If they pay too little, at least according to the dim light coming from the Christmas treers, it won’t bail out Wall Street enough and the economy is likely to sink into recession.

"The reality is that we are not going to know what the right price is for years," the IHT quotes a portfolio manager.

Isn’t it amazing how fast things change, dear reader? Only a few months ago every portfolio manager in the world would have deferred to the market. What’s something worth? Exactly what willing buyers will pay for it! Not a penny more. Not a penny less.

But now we have a whole new theory…that the value of a financial asset is somehow unknowable…it is like the face of God…or the meaning of "is" – it floats in the ether; it plays cards with Jimmy Hoffa. According to this theory, the value of an asset is determined not by what willing buyers will pay for it…there is no such thing as a ‘market price.’ Instead, values are metaphysical…determined by what willing buyers MIGHT pay for years from now…if everything goes to plan.

Henry Paulson says that the government might even make a profit. How might this occur? Well, the bureaucrats might turn out to be shrewder than the Wall Street pros. Prices set by bureaucrats (with money that doesn’t belong to them) will be better than those set by willing buyers and sellers!

According to this new theory, the sellers don’t know what gems they are tossing out. You’ve heard of casting pearls before swine. According to the new theory, the pigs on Wall Street are casting out the pearls! And those canny bureaucrats are grabbing them up!

Now, get this… "the recent turmoil on Wall Street may be followed by a $900 billion aftershock as bank debt comes due next year…"

Oh happy day for the public sector…that great untapped reserve of investment wisdom…. Here comes more opportunity to buy up those pearls that the swine on Wall Street don’t want.

Now things are going to get interesting. Add another trillion-dollar bill to Christmas tree…only months after they Christmas treed the last one. Turn on lights! We can hardly wait to see what this new Christmas treed-up world looks like.

*** At least one person had something smart to say this week. Would you believe it, George W. Bush must have picked up the wrong speech on his way out of the door to the Capital. When he spoke on the debt crisis, his speechwriter actually seemed to know what he was talking about:

"First, how did our economy reach this point?

"Well, most economists agree that the problems we are witnessing today developed over a long period of time. For more than a decade, a massive amount of money flowed into the United States from investors abroad, because our country is an attractive and secure place to do business. This large influx of money to U.S. banks and financial institutions – along with low interest rates – made it easier for Americans to get credit. These developments allowed more families to borrow money for cars and homes and college tuition – some for the first time. They allowed more entrepreneurs to get loans to start new businesses and create jobs.

"Unfortunately, there were also some serious negative consequences, particularly in the housing market. Easy credit – combined with the faulty assumption that home values would continue to rise – led to excesses and bad decisions. Many mortgage lenders approved loans for borrowers without carefully examining their ability to pay. Many borrowers took out loans larger than they could afford, assuming that they could sell or refinance their homes at a higher price later on.

"Optimism about housing values also led to a boom in home construction. Eventually the number of new houses exceeded the number of people willing to buy them. And with supply exceeding demand, housing prices fell. And this created a problem: Borrowers with adjustable rate mortgages who had been planning to sell or refinance their homes at a higher price were stuck with homes worth less than expected – along with mortgage payments they could not afford. As a result, many mortgage holders began to default.

"These widespread defaults had effects far beyond the housing market. See, in today’s mortgage industry, home loans are often packaged together, and converted into financial products called "mortgage-backed securities." These securities were sold to investors around the world. Many investors assumed these securities were trustworthy, and asked few questions about their actual value. Two of the leading purchasers of mortgage-backed securities were Fannie Mae and Freddie Mac. Because these companies were chartered by Congress, many believed they were guaranteed by the federal government. This allowed them to borrow enormous sums of money, fuel the market for questionable investments, and put our financial system at risk.

"The decline in the housing market set off a domino effect across our economy…"

Our president was on solid ground. He sounded as though he had been reading The Daily Reckoning, commented colleague Dan Denning. But then he stepped into the mush, claiming – along with everyone else – that a bailout is needed to put the economy back on its feet.

"Our entire economy is in danger," said the chief executive.

*** New house sales plummeted to a 17-year low in August. But what was really shocking was the prices. We quote so we won’t be accused of making this up:

"The average price of a new home sold in August dropped by a record amount of 11.8% to $263,900 compared to the July average of $299,100." In other words, if they keep falling for that rate for a year, they’ll be nearly worthless by next summer.

*** And a Dear Reader offers sound advice:

"In your Reckoning of 24th Sept 08 you wrote that in your dream you couldn’t exchange your gold coins. William Davies (one time editor of Punch) wrote that when the chips are really down nobody wants gold, and as a native German living through the aftermath of the Second World War he knew this from personal experience. [Instead of gold] what constituted a viable currency…whisky and cigarettes. That chateau of yours, start filling the cellars now."

There you have it, dear reader. When the chips are down…you need whiskey and cigarettes.