The Government Is Not Promoting Stability

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When criticizing the recent bailouts on Wall Street, it’s easy to get distracted by the numbers. The wiseguy Glenn Beck actually made a really great point on this: He reminded us of how "costly" we were warned that the rebate stimulus plan was, and it was less than $170 billion. Well that’s chump change now. Last week alone the government made promises that will cost over $1 trillion (with a T) if things don’t turn around in the real estate market. Paulson has expertly placed himself in a position analogous to a military commander; nobody in Congress will have the temerity to vote against the plan he says is necessary to avert financial destruction.

However, it’s best not to get awestruck by the sheer amount of dollars being thrown around, even though next year’s deficit could easily pass $500 billion. In this article I want to tackle the primary justification for these actions, namely that they will (allegedly) restore stability to the volatile financial markets. I will show that this is exactly backwards, that the government’s actions of the past year have independently contributed greatly to the credit crunch. So not only are these bailouts examples of massive theft in favor of politically connected fat cats, but they also are a fresh source of harm to the economy.

First let’s focus on the SEC’s ban of short-selling of 799 financial stocks. Now this is an incredibly dumb move; even the high-fiving talking heads on CNBC were willing to venture a meek suggestion that maybe the government was wrong on this one. Short-selling provides a vital role in the stock market. When a stock becomes too high in the opinion of a speculator, he shorts the stock and pushes it back down. (Over time, the market weeds out bad speculators, so at any moment those still risking money are probably fairly good at picking overvalued stocks.) On the other hand, if a stock is undervalued in the analyst’s opinion, then he buys shares, pushing up the price. Taking away one end of that mechanism will make share prices more volatile.

Yet a ban on short sales also hampers another function, that of hedging. In other words, it is not merely speculators who short a stock, hoping to gain from an anticipated move. On the contrary, many people short a stock to limit their exposure to a downward price move. For example, suppose a firm sells a credit default swap on huge investment bank XYZ. The swap is basically an insurance contract, because a default by XYZ on its own bonds will trigger the swap to give a payout. So the existence of these credit default swaps makes investors more willing to buy the bonds of (i.e. lend money to) investment bank XYZ, because those investors can buy a credit default swap and insure themselves (perhaps partially) against default.

Now what is the connection to the ban on short sales? Well, suppose that the insuring firm issues a large amount of credit default swaps on XYZ, and then the next day a rumor circulates that XYZ is heavily loaded with "toxic" mortgage-backed assets. Then XYS’s share price would plummet, and it would have trouble raising short-term funds to continue operations. It would be much more likely to default on its bonds, and thus the insuring firm might suffer big losses because the credit default swaps are triggered.

Hang in there folks, we’re almost to the punchline: In order to protect itself from such quick share price movements, the insuring firm might short a few thousand shares of investment bank XYZ. This way, the insuring firm is partially hedged against sudden drops in the shares of XYZ, meaning its gains on the short sales would partially offset the losses on the triggered credit default swaps. So, if the SEC now comes in and bans short selling, then the insurer will find it riskier to sell credit default swaps on investment banks like XYZ that are most vulnerable to rumors. In other words, the SEC’s move will effectively take away one of the market’s methods of containing risk. The very firms most vulnerable to a credit crunch are now less able to find buyers of their bonds, meaning they are less able to raise outside capital. This is the exact opposite of what the SEC claims to be doing.

Last point about shorting: Back in July the SEC imposed a completely pointless ban on "naked" short selling. At the time I guessed that this useless gesture served to soften up the public, and get them prepared for much more sweeping measures. We’ll never know for sure, but I wonder if the public outcry over the new ban would have been louder had the SEC never imposed the previous, weaker ban.

So we see that the government’s ban on shorting is counterproductive, and will only make the financial markets more volatile, and make it harder for the most at-risk institutions to raise capital. Unfortunately the same is true for the other shenanigans that Paulson and Bernanke have been up to. These actions too are causing the very financial crisis they are supposedly trying to calm.

Just stop and reflect on what the government has done, even in the last few weeks. It has literally seized (the press’ word, not mine) companies tied to trillions of dollars in assets. Furthermore, these seizures were truly a "hostile takeover." For example, the common shareholders of Fannie and Freddie were quite simply robbed. The government came in and assured injections of capital to keep the firms afloat. In exchange, it acquired "senior preferred equity" shares, placing it higher on the totem pole vis-à-vis the original preferred equity shareholders, in the case of losses. However, if the real estate market turns around and the share prices of Fannie and Freddie start rising, then the government will exercise its warrants giving it ownership of 79.9% of the common stock. (Note how people are speculating that the government might make money on the deal.) Before, shareholders of Fannie and Freddie knew they were probably going to lose everything, but there was still a sliver of hope. Now there is no hope.

And yet, there is no rhyme or reason to the government’s decisions. Lehman Brothers was allowed to fail. In essence, you’ve got a massive beast stalking the financial markets. This creature has many trillions of dollars ultimately at its disposal, and oh yes, I should add: It is not afraid to send armed men to your house if you should ever really cross it. In this environment, is it any wonder that the credit markets are "frozen"? When the SWAT team bursts into your kitchen window, you freeze up, right? Why should things be so different on Wall Street?

There are many horrible implications of what Henry Paulson and Ben Bernanke have unleashed over the last few weeks. What is truly depressing is that these costs are balanced by nonexistent "benefits." As in other arenas, so too in the financial markets we see that the government’s trampling of property rights exacerbates the very insecurity and fear that prompted the power grab in the first place.

I don’t want to sound like an alarmist, but folks things are moving fast. If the financial system should collapse, it will happen very quickly. Even if the basic infrastructure remains, nonetheless I expect double-digit price inflation. (If people are telling you the bond markets aren’t forecasting inflation, don’t believe it.) If you agree, then you should seriously consider acquiring several weeks’ of gold and silver coins — and don’t store them in your safe deposit box, because if the banks are closed, you might not have access to them. Yes it would be awful if things came to that, but by the same token it’s awful if your spouse dies. You still buy life insurance, right? So people should seriously consider stocking up on failed-fiat-currency insurance, i.e. gold and silver coins that other Americans will recognize.

Bob Murphy [send him mail] runs the blog Free Advice.

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