Additional Thoughts on the Bailout

By Paul Craig Roberts

October 16, 2008

Just as the Bush regime’s wars have been used to pour billions of dollars into the pockets of its military-security donor base, the Paulson bailout looks like a Bush regime scheme to incur $700 billion in new public debt in order to transfer the money into the coffers of its financial donor base. The US taxpayers will be left with the interest payments in perpetuity (or inflation if the Fed monetizes the debt), and the number of Wall Street billionaires will grow. As for the US and European governments’ purchases of bank shares, that is just a cover for funneling public money into private hands.

The explanations that have been given for the crisis and its bailout are opaque. The US Treasury estimates that as few as 7% of the mortgages are bad. Why then do the US, UK, Germany, and France need to pour more than $2.1 trillion of public money into private financial institutions?

If, as the government tells us, the crisis stems from subprime mortgage defaults reducing the interest payments to the holders of mortgage backed securities, thus driving down their values and threatening the solvency of the institutions that hold them, why isn’t the bailout money used to address the problem at its source? If the bailout money was used to refinance troubled mortgages and to pay off foreclosed mortgages, the mortgage backed securities would be made whole, and it would be unnecessary to pour huge sums of public money into banks. Instead, the bailout money is being used to inject capital into financial institutions and to purchase from them troubled financial instruments.

It is a strange solution that does not address the problem. As the US economy sinks deeper into recession, the mortgage defaults will rise. Thus, the problem will intensify, necessitating the purchase of yet more troubled instruments.

If credit card debt has also been securitized and sold as investments, as the economy worsens defaults on credit card debt will be a replay of the mortgage defaults. How much debt can the Treasury bail out before its own credit rating sinks?

The contribution of credit default swaps to the financial crisis has not been made clear. These swaps are bets that a designated financial instrument will fail. In exchange for “premium” payments, the seller of a swap protects the buyer of the swap from default by, for example, a company’s bond that the swap buyer might not even own. If these swaps are also securitized and sold as investments, more nebulous assets appear on balance sheets.

Normally, if you and I make a bet, and I welsh on the bet, it doesn’t threaten your solvency. If we place bets with a bookie and the odds go against the bookie, the bookie will fail, as apparently happened to AIG, necessitating an $85 billion bailout of the insurance company, and to Bear Stearns resulting in the demise of the investment bank.

Credit default swaps are a form of unregulated insurance. One danger of the swaps is that they allow speculators to purchase protection against a company defaulting on its bonds, without the speculators having to own the company’s bonds. Speculators can then short the company’s stock, driving down its price and raising questions about the viability of the company’s bonds. This raises the value of the speculators’ swaps which can be sold to holders of the company’s bonds. By ruining a company’s prospects, the speculators make money.

Another danger is that swaps encourage investors to purchase riskier, higher-yielding instruments in the belief that the instruments are insured, but the sellers of swaps have not reserved against them.

Double-counting of assets is also possible if a bank purchases a company’s bonds, for example, then purchases credit default swaps on the bonds, and lists both as assets on its balance sheet.

The $85 billion Treasury bailout of AIG is small compared to the $700 billion for the banks, and the emphasis has been on banks, not insurance companies. According to news reports, the sums associated with credit default swaps are far larger than the subprime mortgage derivatives. Have the swaps yet to become major players in the crisis?

The behavior of the stock market does not necessarily tell us anything about the bailout. The financial crisis disrupted lending and thus comprised a threat to non-financial firms. This threat would reflect in the stock market. However, the stock market is also predicting a recession and declining earnings. Thus, people sell stocks hoping to get out before share prices adjust to the new lower earnings.

The bailout package is a result of panic and threats, not of analysis and understanding. Neither Congress nor the public knows the full story. If the problem is the mortgages, why does the bailout leave the mortgages unaddressed and focus instead on pouring vast amount of public money into private financial institutions?

The purpose of regulation is to restrain greed and to prevent leveraged speculation from threatening the wider society. Congress needs to restore financial regulation, not reward those who caused the crisis.