Thursday, February 26, 2009

How the government is bailing out banks at your expense

Banks have made bad loans and are leveraged to the hilt so investors will no longer lend them money or invest in them. The fair thing to do when banks are in this condition would be to take them over and reorganize them to put the losses they have accrued in the hands of the shareholders and creditors where they belong. But, the banks have tied themselves in a Gordian knot by insuring loans with phony insurance called credit default swaps. So the government is afraid that reoganizing them could result in a cascade of bank failures that could jeopardize the whole financial system. So, instead, it has chosen to flood the financial system with free money from taxpayers by lowering interest rates to near zero and lending money to every bank that has a problem.

With rates low, banks can get nearly free money from depositors and they can borrow from the government without limit, as long as the congress is willing to appropriate the funds. These funds are used to make new loans at very attractive spreads. These interest earnings have gone way up over the last several months. The government looks at this and says, Hey! These banks are really making money. All that's needed is for us to keep pouring money into the system and keep interest rates low until they get well. As the income flows in, banks can improve their balance sheets and gradually write off their bad debts instead of paying dividends. What the government doesn't seem to care about is that banks are able to do this because the government has driven deposit rates down to near zero and is running up debt at the expense of taxpayers. In this way the same people who caused the problem are benefiting from the government solution.

Since the government probably can't supply enough money for the whole bailout, because taxpayers won't allow congress to appropriate the necessary funds, the government has devised a clever way to get private investors to participate in the bailout. As banks write down their bad loans, they can sell them off to private investors, who in turn can buy them at a price which allows them to renegotiate the loans and make a nice profit. Some private hedge funds are already doing this. But most are still sitting on the sidelines, spooked by the possibility that they will get burned by the bad loans. To sweeten the deal enough to get private investors cash into the game, government has decided to lend these private investors money to leverage the deal, thus increasing their returns. And, on top of that, it will guarantee the loans from downside risk, another gift from the taxpayers to the capitalists.

An interesting point illustrated here is that it's not necessary to be a recipient of bailout funds to profit from bailout deluge. If banks don't have too many bad investments they can use the windfall profits afforded them by the government dictated low deposit rates to get well and claim they did it without a government bailout. But, this is hardly the case, and I'm sure they're not going to volunteer to help pay off the national debt the government has run up to afford them the windfall profits.

It's all one big oligarchy. Once the taxpayers have paid a big price to buy time for the banks to work off their bad investments, the people at the Fed and Treasury can go back to the banks where they used to work and get fat salaries and bonuses for saving the banks with taxpayer money. And, we and our descendants will be left to pay off the federal debt they have run up.

Saturday, February 14, 2009

What will the stimulus bill accomplish?

The financial crisis does not yield easily to stimulus because it's primary cause is an overhang of debt built up over several decades. How this occurred is explained in a previous post on this blog, My Short Explanation of the Financial Crisis. Consumers are no longer spending on discretionary purchases and businesses are not investing because demand is declining. As the government pumps money into the system to replace that previously supplied by consumers and businesses, only that which is given to consumers that are just getting by will be spent to sustain demand. Consumers that are meeting their basic needs will use the money to pay off debt or save it. Businesses that are burdened with debt will use it to pay off debt, which may be due to bad investing or a result of the crisis. Those that are not will pay it out in dividends or bonuses, since opportunities for expansion are limited due to reduced demand for their products. The primary useful effect of the stimulus will be to keep workers in productive jobs rather than just pay them to be unproductive. In this sense it is not really a stimulus program, but a program to reduce the severity of the consequences of the crisis and shorten the recovery time, as the debt overhang is worked off. To not have any government spending could worsen the consequences and possibly lead to a deflationary spiral that could lead to a depression.

The key to how the stimulus should be used relates to who should be helped and who should not. Banks and investors that invested unwisely should suffer the losses. Right now this segment is sitting on the sidelines with their money in treasuries making little or nothing. They are not investing, because demand is dying and investing would be unproductive. But, they have reaped large rewards over the last several decades through leveraging, which caused the crisis, and should now be willing to now take their losses. Reducing capital gains and dividend taxes, especially retroactively, would just be a windfall for banks and other large investors that have reaped the gains, but now want to socialize the losses. Income tax rebates for wealthy investors will not stimulate the economy. They will be used to pay down debt from leveraging bad investments. Consumers are already paying the consequences for their spending euphoria over the last several decades. They are not being bailed out. And they will continue to suffer the consequences, for as long as the recovery takes.

So, is the stimulus package configured right? To the extent that tax cuts are going to investors who made bad decisions, it's not. To the extent that the cuts are going to people just getting by, it is stimulative. There appears to be an argument over specific spending projects in the package and how quickly the money is spent. Since the primary effect of the program will not be to stimulate the economy, but to reduce the severity of the consequences while debt is being worked off, any programs that keep people employed productively are worthwhile. If the money is spent so quickly that it becomes inefficient and wasteful, it will be counterproductive. If is spent so slowly that people are not employed productively, it will be inefficient, cause more pain, and lengthen the recovery period. Since it will take considerable time to work off the debt, the most important consideration is to keep the spending at a pace that keeps people employed productively without waste or undue hardship.