No Bailout for Financial Firms

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What a week
was the week of September 14. Bankruptcy and bailout were the words
of the week. Lehman Brothers went bankrupt and American International
Group (AIG) was bailed out by the Federal Reserve (by the holders
of American dollars and dollar denominated savings and investments)
while earlier in the month Fannie Mae and Freddie Mac were bailed
out by the US Treasury (by the American taxpayer) and earlier in
the year Bear Stearns was bailed out by the Federal Reserve. Then
the US Treasury and the Federal Reserve put together the mother
of all bailout programs proposing another Resolution Trust Corporation,
similar to the one used during the administration of the senior
Mr. Bush to bail out the savings and loan industry. This Resolution
Trust II will take over all the "toxic" mortgages and
other bad deals made by some of the financial buccaneers on Wall
Street and some other international financiers. These debts will
ultimately have to be liquidated at cents on the dollar. The US
taxpayer will be responsible for the almost $1 trillion cost of
this bailout program. This is in addition to the cost of the bailout
of Fannie Mae, Freddie Mac and Bear Stearns. Does anyone truly believe
that there will be only a $1 trillion cost for this when your objective
is to bail out the malinvestments made by some of the world's financiers?
How long will be the line for a bailout? Will the line end with
the financiers or will it include other industries as well (the
automotive industry has been actively seeking its own bailout by
Congress)?

As the Austrian
economists know, the root cause of this financial crisis is the
spendthrift US government and the resulting inflation by the Federal
Reserve which created this bubble. Ron Paul has spoken at length
about this. A lot of money was made available by the Federal Reserve
so the wizards on Wall Street invested in high-risk investments
and the investments ultimately went terribly wrong. To compound
the problem some investment firms such as Bear Stearns and AIG insured
the bad investments against defaults. They were the insurers of
last resort if you will that is until Hank and Ben arrived on the
scene to help Wall Street clean up its mess. Ben and Hank should
abandon their bailout plan and let Wall Street experience the consequences
of their actions.

We
should feel no sorrow for the Wall Street financiers and swap traders.
They were playing in the risk market and ultimately lost when the
market turned against them. Since the companies such as Bear Stearns
and AIG made the profit from insuring against the risk why should
the American taxpayer now be asked to foot the bill for the defaults?
These were experienced financial risk (hedging) managers and valuers
of risk supported by teams of bright lawyers, accountants and other
professionals. They wrongly assumed that the inflation would continue
forever and that consequently homeowners would forever be prosperous
and continue to pay their mortgages. They learned nothing from the
dot com bubble nor did they understand the long history of financial
bubbles. Rather than taking their profits (they made a lot of money
on the way up) minimizing their exposure and exiting from this risky
business they continued and got caught as they tried to wring the
last bit of profit from their business (they lost a lot of money
on the way down). There is a saying in the futures business that
"bulls make money, bears make money, pigs get slaughtered"
and so it happened to these financiers and traders. They should
all attend a course in Austrian economics at the Mises
Institute
so they understand the business cycle.

Ironically
the firm least affected by the crisis, J P Morgan Chase, was the
one that created the derivative called Credit
Default Swaps
(CDS) in the early 1990s as a means to hedge their
loan risks. Having created this derivative perhaps J P Morgan Chase
understood the inherent long-term risks. The derivatives market
is a private contractual market functioning in what is referred
to as the Over the Counter market (OTC). The sole purpose of the
derivatives market is the allocation, hedging, valuation and pricing
of risk pure and simple. It has no other function. A CDS is an insurance
policy (called protection in the swaps market) against default on
a debt such as a bond or loan. An initial premium and thereafter
annual premiums are paid for 5 years by a protection buyer to a
protection seller to cover any loss on the face amount of the bond
or loan for which the insurance is written. If ultimately the seller
of the CDS is not financially capable of paying the protection buyer
in the event of a default then the buyer of the CDS insurance is
out the premiums paid and has no coverage for the default. The protection
buyer is no longer hedged against the default and must so indicate
such in its financial statements. It is estimated by the International
Swaps and Derivatives Association (ISDA) that there is currently
$62 trillion worth of CDS in the market.

If
an investor wants to acquire the bonds of company X but is concerned
about company X's default on the bonds the investor can hedge the
investment by purchasing from a protection seller (such as Bear
Stearns or AIG) CDS insuring the investor against the default of
the bonds of company X. The investment house makes its money in
valuing and pricing the risk of default by company X. This is a
market populated by highly experienced and sophisticated risk valuers
who know how to value and price risk.

Ultimately
the value of CDS on referenced bonds impact on the ability of the
company to raise capital. For example if traders bid up the price
for CDS on the bonds of company X the CDS market is indicating that
company X is likely to default on its bonds. This makes borrowing
by company X more difficult and more expensive or impossible. This
is what ultimately happened in the case of AIG which explains why
initially AIG was seeking $20 billion, then $40 billion and by the
time that Ben took over AIG the company required $85 billion.

Now
imagine what happens when AIG and other investment firms issue CDS
to cover asset-backed security pools consisting of collateralized
debt obligations (CDOs), pools of subprime mortgages, pools of Alt-A
mortgages (Alternative A mortgages, which are more risky than prime
mortgages and less risky than subprime mortgages), prime mortgage
pools and collateralized loan obligations. You can begin to see
where this story is heading.

As the housing
market collapsed, foreclosures (mortgage defaults) began to rise.
As the mortgage defaults increased, the value of the pools of mortgages
insured by companies such as AIG and Bear Stearns began to fall.
As the credit crisis spread to other pools of loans a company insuring
against such defaults experienced more claims. As the claims began
to mount the losses began to increase. The company had to meet margin
calls on the CDS by putting up more collateral. As the downward
spiral continued the company had to meet more margin calls and put
up more collateral against its CDS exposure. In the business world
this is often called "the death spiral." What happens
to all the financial institutions with bonds or loans protected
against default by the CDS they purchased if the protection seller
(provider of the insurance) is unable to pay the protection buyer
(the insured) for any default claims? Soon all these financial institutions
and their balance sheets are exposed to defaults without any protection
against default. There is no longer any hedge of the risk. The financial
institutions are now forced to revalue and write down the value
of the assets on their balance sheet. This in a nutshell is what
has happened.

Should the
American taxpayer bail out these financial institutions? No. These
institutions are staffed by experienced and sophisticated financial
managers and risk takers who entered into these transactions on
behalf of their company. The nature of the business in which they
engage is RISK. The fact that they purchased CDS to provide insurance
protection or a hedge in the event of default is evidence of their
knowledge of the risky nature of the debt in which they were investing.
If there were no great risk then there would be no need to purchase
a hedge against the risk. The sellers of protection against default
valued and priced the insurance being provided in line with their
assessment of the risk of default. It is unfortunate for the holders
of such mortgage pools and providers of CDS insurance that the market
took the turn it did but that is the nature of the high-stakes business
in which they were engaged and the nature of rising markets which
ultimately come to an end.

Oil
and gas producers take the risk of dry holes (not being able to
produce commercial quantities of oil or gas) every time they drill
for oil or gas but they do not run to the government for bailouts
when they experience dry holes. They understand and accept the risk
associated with the exploration and production business. Every business
has risk associated with it. Retailers attempt to judge next year's
fashions when they commit to production or purchases of those fashions
this year. As the Kenny Rogers song goes you have to "know
when to hold them, know when to fold them, know when to walk away."
The American taxpayers must walk away from the bailouts proposed
by Messrs Paulson and Bernanke and the Bush administration and the
US government and Federal Reserve should cease their intervention
in financial markets.

September
26, 2008

Jacob
Steelman [send
him mail
], an American ex-pat, is President of International
Ventures Group a global investment, finance and development company
located in Sydney, Australia.

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