David J. Bean

David J. Bean is a freelance writer living in California.

In an article in the June issue of this magazine we speculated that the legislation passed by Congress in March was not going to cure the economic problem. In fact, we predicted that it would make the problem worse. The bank rescue bill worth about $29 billion which bailed out the bondholders of Bear Stearns is now generally recognized as a mistake. After additional intrusion by the Federal Reserve and the Treasury Department we wrote in the October issue that the government was still on the wrong track. Now, with the $700 billion bailout passed and beginning to be felt, people are starting to believe that maybe, just maybe, they can see the light at the end of the tunnel. But all of the previous attempts to fix the problem including emergency interest rate cuts, lowering of required backing capital, direct lending to investment banks, forced mergers of financial institutions and promises to buy bad mortgage-backed assets all have not had a positive impact on the overall economy.

Various theories have been advanced as to the root cause of the problem with most centering on politicians' and Freddie and Frannie's frenzied efforts to get more basically unqualified people into housing ownership. But this push was actually a result of the real problem which was the Federal Reserve Bank's desire to keep the basic interest rate low. The Directors of the Federal Reserve and the Chairman Alan Greenspan felt that after 9/11 the rate had to be low to prevent a panic. Unfortunately they kept the rate too low for far too long. And Ben Bernanke has continued the low interest policy that continues to pump money into the system instead of raising the rate and letting the market clear the losses. Of course this would have been very painful, and some unhealthy, non-systemically important companies would have failed, but sooner or later the losses will still have to be dealt with. Had they allowed the interest rate to rise in 2007 the liquidity that fueled the home mortgage boom would probably have been curbed.

With the legislation passed beginning in March of 2008, and the low interest rate continuing for the rest of the year the political pressure was on for banks and Fred and Frannie to make use of all this easy money and put it to work. Even the shareholders insisted and the CEOs believed that if they could get money for two percent and put it out at six or seven percent, well, they had better do it. Certain politicians encouraged Fannie and Freddie to keep up the socially engineered buying frenzy. Both companies kept buying up these questionable mortgages, packaging them into securities and selling them back to investors who believed they were as good as gold. But it was the expansive monetary policy that had generated this boom in this asset. The easy money policy had induced ordinary people to say, "Well, it's so cheap to acquire a house that is bound to appreciate, I had better get on the bandwagon." When house prices fell, the bubble burst and many people with the subprime mortgages found that they owed more than the house was worth, so they just walked away. Holders of the mortgage-backed securities had no way of knowing what percentage of the mortgage packages they held was solid and how much was worthless.

So that is where we are today. Banks and other investors holding these securitized mortgages in their asset base have no idea as to their actual worth or how to show them on their books. They hesitate to "mark them to market" because the result may destroy their asset base and put them out of business. And banks soon quit lending to anyone that was not absolutely solvent. This prevented banks holding mortgage-based securities from being eligible for loans so interbank loans were effectively shut down. The Fed and Treasury Department became frantic to get the bank credit machine working again.

What the Treasury Department and the Federal Reserve are doing today with the $700 billion bail out is to gradually transfer all the accumulated losses to the taxpayers. Think about it: isn't that what is really going on? At first Secretary Paulson wanted to buy up the bad securities directly but that presented significant appearance problems. The current solution is to inject money directly into the banks that hold these securities and receive special stock in exchange. Supposedly, when the banks are solvent again (?) they can buy back the stock and the actual appearance of what has happened will be much less transparent and thus more acceptable to the people. Unfortunately the political social engineers now have their eyes on other industries such as pharmaceuticals, energy, and healthcare companies.

Several of the eleven large banks that had to agree to this plan did not need or want the money injection, but Paulson was concerned that if he didn't insist on the stronger banks participation that the weaker ones would still fail or at least be shunned as being suspect. The lending crunch is not because of a shortage of funds; it is that banks do not know for sure if the borrowing banks can repay the money. And the problem is that there still is no way of knowing what all those suspect mortgage packages are really worth. Some holders of debt like Bill Gross of Pimco are pushing for lower interest rates and a temporary government guarantee of all bank deposits with no dollar limits. In addition to keeping the money tap open, they also approve of the direct injection of public capital into the banking system. They understand what is going on and want to take advantage of the endless stream of public capital funds sloshing around the economy.

A few of our Senators and Representatives recognized the problem years ago. For instance in 2003, and again in 2005 Senator John Sununu from New Hampshire introduced legislation to give a new federal regulator power to oversee Fannie and Fred's holdings and to ratchet up their capital requirements. But Congress (Franks, Dodd, etc.) wouldn't even allow this legislation to come to a vote and Congress rejected his proposals. Finally they did incorporate some of his proposals in the current rescue legislation -- five years too late. Still, it is very doubtful that the economy is going to recover much until all of these losses are identified and transferred to the taxpayers. Even then they must be paid off by future national production that ultimately means more taxes.

Our economy is undergoing an overhaul that will probably be permanent. With all the government intrusions, mergers, and takeovers, Wall Street has been castrated and will never be the same again. Free markets are on the defensive even though it was free market politicians who tried to reign in Fannie and Fred. Government run banks will determine winners and losers on an unprecedented scale and our socialistic government will become more like that of Europe. Even so, it will probably be years before a stable, socialistic economy can emerge from the current wreckage. Businesses will have to adapt to an increased regulatory burden that will probably include direct subsidies. All of this is a result of our officials' loss of faith in the free market and their unwillingness to allow a very painful free market correction when the problem first appeared. Hang onto your wallet; we are still in for a rough ride. *

"Christmas casts its glow upon us, as it does every year. And it reminds us that we need not feel lonely because we are loved, loved with the greatest love there has ever been or ever will be." --Ronald Reagan