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Bailouts Killing Free Market Capitalism

Stock-Markets / Government Intervention Sep 14, 2008 - 07:39 AM GMT

By: Money_and_Markets

Stock-Markets

Best Financial Markets Analysis ArticleBack on August 1, I asked the question: "When is enough, enough?" I wrote:

It seems like every week we get another borrower bailout initiative.

Or another multi-billion dollar package of legislation.


Or another whiz-bang Federal Reserve program that keeps U.S. banks and brokers on the dole for a few more months.

Or more recently, a blatantly transparent attempt by the Securities and Exchange Commission to squeeze short-sellers and drive stock prices higher ... but only for a select group of 19 financial companies.

And things have only gotten dicier since then! The number of companies and executives lining up at the Fed's doorstep ... or the Treasury's ... or Congress' ... looking for bailouts gets longer every day.

The U.S. auto industry, for example, is panhandling in D.C. for $50 billion or more in federally subsidized loans to revamp their factories and product lines to produce more fuel-efficient cars.

Several banks are essentially living off the Fed, with borrowing at the discount window surging to an average of $19 billion per day in the week ended September 3. That's the highest in U.S. history and a huge increase from $1.1 billion a year ago.

And of course, we just saw Treasury bailout Fannie Mae and Freddie Mac.

According to the terms of the deal ...

Fannie Mae
Freddie Mac
Bailouts of the week. The cost: Nobody knows!
  • The government will place the two Government Sponsored Enterprises into conservatorship, essentially taking them over.
  • Common and preferred share dividends will be eliminated, and the government will buy a new class of preferred shares. This has left the original shares with little value.
  • The senior and subordinated debt securities of Fannie and Freddie will be backed.
  • The Treasury is going to open another secured, short-term funding facility that will be accessible to Fannie, Freddie, and the 12 Federal Home Loan Banks that support various private banking activities.
  • The Treasury has also announced plans to buy mortgage backed securities in the open market. This is an attempt to manipulate the market in such a way as to drive down consumer mortgage rates.

But what's the cost of these bailouts? Nobody knows!

Now here's the thing: With each bailout, we the American taxpayers are told, this is in the best interest of the country. And with each bailout, we're told these bailouts are necessary to save the financial system.

Fed Chairman Bernanke paints a gloomy picture for financials.
Fed Chairman Bernanke paints a gloomy picture for financials.

Heck, if you think we've been bearish about the prospects for the financials, get a load of what Fed Chairman Bernanke had to say a few weeks ago about what would have happened if the Fed had let Bear Stearns collapse ...

"Although not an extraordinarily large company by many metrics, Bear Stearns was deeply involved in a number of critical markets, including (as I have noted) markets for short-term secured funding as well as those for over-the-counter (OTC) derivatives. One of our concerns was that the infrastructures of those markets and the risk- and liquidity-management practices of market participants would not be adequate to deal in an orderly way with the collapse of a major counterparty.

"With financial conditions already quite fragile, the sudden, unanticipated failure of Bear Stearns would have led to a sharp unwinding of positions in those markets that could have severely shaken the confidence of market participants. The company's failure could also have cast doubt on the financial conditions of some of Bear Stearns's many counterparties or of companies with similar businesses and funding practices, impairing the ability of those firms to meet their funding needs or to carry out normal transactions.

"As more firms lost access to funding, the vicious circle of forced selling, increased volatility, and higher haircuts and margin calls that was already well advanced at the time would likely have intensified. The broader economy could hardly have remained immune from such severe financial disruptions."

I happen to agree with him. But how come the shareholders of Bear ended up getting $10 out of the deal? How come the bondholders didn't get a big haircut?

More importantly, we have no idea what the Bear bailout will ultimately cost. The same goes for the Fannie Mae and Freddie Mac bailout. There literally is no precise, accurate estimate of the cost to taxpayers now or in the future.

3 important bailout questions people aren't asking

There are three more important questions people should be asking too:

  1. If these firms truly are "Too Big to Fail," how in the heck did the government let them get that way?
  2. Where the heck were the regulators when these chowderheads were piling up so much counterparty risk on derivatives and complex securities, that their failures would force the government's hand?
  3. Why were they allowed to make tens of billions of dollars financing crummy subprime mortgages ... loan huge amounts of money against overpriced commercial real estate ... take on gigantic risk financing stupid leverage buyouts ... during the boom times, then come crying to the Fed and Treasury when things head south?

It's enough to make your head spin.

I have another problem with all of these bailouts, too: If you keep weak institutions alive on the dole (by allowing them to keep swapping crummy assets to the Fed for Treasuries ... allowing them to keep rolling over short-term loans at the Fed to ensure liquidity, if not solvency ... and so on), you just make it harder for the stronger institutions to do business.

What do I mean? Go to Bankrate.com when you have a minute and look up rates on Certificates of Deposit. Or look at the ads in your local newspaper. Who is offering the highest rates? Generally speaking, it's the banks that are in the most trouble.

Bankrate showed a 1-year CD from Washington Mutual paying an Annual Percentage Yield of 5% yesterday. Washington Mutual is loaded down with bad mortgage debt. Stock market investors are so concerned, in fact, that they have driven WM shares down 86% year-to-date to around $2! Its main bank subsidiary has a "D+" Financial Strength Rating from TheStreet.com — fairly low on the A to F scale.

Next in line is Corus Bank of Chicago, offering a 4.6% APY. This institution was a huge lender to condominium developers and converters. It has significant exposure to the markets that experienced the biggest real estate bubbles — Florida, California, Las Vegas, and so on. Corus merits a "D" rating from TheStreet.com.

Troubled banks like these are paying so much for consumer deposits because other avenues of fundraising have been shut down. The problem is, as they offer higher and higher yields, it siphons deposits from other institutions that pay less. That forces even healthy banks to pay more for money, pressuring THEIR profitability.

In other words, it's bad enough that propping up weak institutions sends a bad message to the market — namely, that you can take huge risks during the good times and keep all that profit, then get bailed out during the bad. It also carries other unintended consequences.

Speaking of unintended consequences, the Fannie Mae and Freddie Mac bailout allows Treasury to directly intervene in the Mortgage Backed Securities market. It can buy up however many MBS it wants, whenever it wants, with the goal of driving down mortgage rates. Trading in the MBS market determines how much you and I pay for mortgages; when MBS yields go down, so do the mortgage rates we pay.

That part of the Fannie and Freddie bailout program incited a big rally in MBS. Thirty-year fixed rates have dropped about a half a percentage point as a result. Sounds good, right?

But here's the thing: I have never, ever seen such direct manipulation of a freely traded market by the government. You literally have the government saying: "Private investors have it 'wrong.' They don't know how MBS should be priced. We do. And we're going to manipulate this market as we see fit."

What kind of precedent is this setting? What does it say about our supposedly "free" markets — you know, the ones we keep being told are the envy of the world? And not to sound all "tin foil hat" here, but what if one day Secretary Paulson woke up and said, "You know what? Stocks are too cheap. Let's buy some S&P futures!" Is that really the direction we want to be headed in?

Where we go from here

I said a long time ago that my fear was we'd end up in a Japan-like situation — facing a long, drawn out period of economic weakness. I got some pushback there. People argued that we were different ... that America dealt with its economic problems quickly ... that we wouldn't just prop up so-called "zombie" companies for quarters or years on end, and instead let them fail. That, in turn, would let the stronger companies survive and thrive.

But look at what has happened in the past year and ask yourself: "Is that really true anymore?"

I think a case can be made that we're sacrificing the long-term principles (free markets, unfettered capitalism) that make America great just to avoid short-term pain. I also think you can make an argument that all these moves by the Fed, the Treasury, and Congress could be prolonging the crisis, rather than solving it.

So I really hope the politicians in Washington ... the big-wigs on Wall Street ... and the policymakers at the Fed and in Congress do some soul searching here. I really hope they start thinking more about the long term. And frankly, I really hope they just start letting some weaker companies fail, so that the rest of America can get back to business.

Until next time,

Mike

P.S. My good friend and Asian market expert, Tony Sagami, is about to release his #1 China recommendation, which he's sending to Asia Stock Alert subscribers. And there's still time for to you to receive it.

Not only is Tony naming the company, and giving all the important background details ... he's providing specific trading instructions.

If you're not a subscriber, you can still sign up now for a risk-free trial to Asia Stock Alert . But don't delay! You only have until 3 p.m. today to subscribe and get Tony's new China recommendation the minute he fires it off. Plus you'll be able to immediately download six special reports on other great Asian stocks. Click here for all the details. k.

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