Plus a Change You Can Believe In Why the Bailout is Not Socialism

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Reports of the Treasury Department’s proposed bailout legislation are focusing on the cost to the US taxpayer, the "socialist" nature of this intervention in the supposedly free market, and the question whether it will work, but not on exploring just how it’s going to work. It is important to understand just how far the proposal is from real socialism, because it is actually far more shocking than socialism. It’s a continuation of what we already have — creating profit-making opportunities for the wealthy off of the backs of taxpayers.

Socialism — actual nationalization or governmental joint ownership — would at least theoretically be an improvement over the current bailout proposals, because the government might then demand actual financial integrity and actually prosecute company officers and managers whose misdeeds and recklessness cause the government to lose its share of the company’s profits. There is nothing in the proposed legislation that indicates that the federal government will end up with ownership interests in financial institutions. The bailout is controlled by the Federal Reserve, which is a private organization looking out for private interests, NOT a government entity supposedly protecting the public interest.

The reality of how the bailout is actually going to work is highlighted by a provision found in Senator Dodd’s proposed alternative to the Treasury’s bailout legislation. To my knowledge, the significance of this relatively obscure provision has escaped media comment. But first, some context. A 1932 provision of the Federal Reserve Act allows the Fed to lend funds to non-banks (e.g., private companies and partnerships) at a discounted rate "in unusual and exigent circumstances." Specifically, 12 U.S.C. 343 provides, in pertinent part, as follows:

In unusual and exigent circumstances, the Board of Governors of the Federal Reserve System, by the affirmative vote of not less than five members, may authorize any Federal reserve bank, during such periods as the said board may determine, at rates established in accordance with the provisions of section 357 of this title, to discount for any individual, partnership, or corporation, notes, drafts, and bills of exchange when such notes, drafts, and bills of exchange are indorsed or otherwise secured to the satisfaction of the Federal reserve bank: Provided, That before discounting any such note, draft, or bill of exchange for an individual or a partnership or corporation the Federal reserve bank shall obtain evidence that such individual, partnership, or corporation is unable to secure adequate credit accommodations from other banking institutions. All such discounts for individuals, partnerships, or corporations shall be subject to such limitations, restrictions, and regulations as the Board of Governors of the Federal Reserve System may prescribe. [Editorial comment: note that the Fed prescribes its own rules and is "regulated" by itself, not by Congress. In other words, it does what it likes. No one in Congress and neither McCain nor Obama is talking about changing this.]

Section 19(a)(2) of Senator Dodd’s original bill provides that if the Federal Reserve Board exercises this authority, it must notify the Senate Committee on Housing, Banking and Urban Affairs and the House Committee on Financial Services of "the specific terms of the actions of the Board, including the size and duration of the lending, the value of any collateral held with respect to such a loan, the recipient of warrants or any other potential equity in exchange for the loan, and any expected cost to the taxpayer for the cost of such exercise."

The first thing to notice about the Dodd language is that it contemplates the possibility that both stock or other equity and warrants may be acquired and transferred by the Board to private parties, and not to the government. Under 12 U.S.C. 343, the Fed already has this power to structure loans as it sees fit in unusual and exigent circumstances. The Dodd bill simply requires that the Senate and House be informed what the Fed has done, and provides no authority to Congress to control it. So the vaunted Congressional "oversight" consists simply of being informed of what has been done after the fact. But note this well: The bailout bill provides no mechanism for assuring that the federal government acquires any ownership stake in the companies it bails out for the funds it provides. It is not nationalization. What will happen is that the Fed will have the power to preserve and make new kings of finance on the backs of taxpayers.

Some examples, all of which appear to be permissible under the terms of the proposed bailout bills, will help illustrate how this is going to play out. In order to save a financial institution that is actually bankrupt because it doesn’t have the reserves to absorb the losses from the toxic $500 million mortgage-backed security portfolio, the Fed purchases the $500 million portfolio at face value. In order to minimize the Fed’s ultimate loss, and because the Fed is not equipped to actually deal with the mortgages in this pool, the Fed sells the portfolio to some other institution or a new private vulture fund created for this purpose. Naturally, the mortgage pool is risky, so it has to be sold at a deep discount with sufficient room in it that the private interests that will purchase it can expect to make a profit from taking this on. Let’s suppose that the Fed sells it at $.20 on the dollar. The taxpayers have therefore lost $400 million on the bailout. Ultimately, the pool collects $.60 on the dollar and makes a profit of, say, $.20 on the dollar. By shifting the losses to the taxpayers (for which they receive nothing), a new profit making opportunity has been created for the big boys. Essentially, the taxpayers financed the new profits by absorbing losses in excess of the amounts that are fully and finally realized. Congress receives a report.

Suppose, instead, that the Fed, using its authority to lend money to businesses "in unusual and exigent circumstances," loans a troubled financial institution $500 million at a very low interest rate secured by $500 million, face value, of the company’s "toxic" mortgage backed securities. The terms of the loan provide that as payments are received on the securities, they are applied against the interest and principal amount of the loan, and that the loan is otherwise nonrecourse, that is, the company is liable only to the extent of the value of the collateral pledged as security. Thus the U.S. treasury can expect to recoup some portion of the funds and the taxpayers are only on the hook ultimately for the portion of the loan that can’t be paid for from collections on the securities and for the time value of the money, which is hopefully substantially less than the full amount loaned. In addition, suppose that part of the deal is that the Fed also receives warrants (options) to acquire, say 50%, of the company’s stock at $X per share, which can be paid either in cash or, by what is its equivalent, by canceling the same amount of debt on the loan. The warrants are transferable, as is the stock that is obtained by exercising the warrants.

Perhaps you begin to see the possibilities. First, suppose the ailing company needs even more money. The Fed exercises the warrants and pays even more taxpayer money to purchase the company’s stock. Thus, the $700 billion bailout is in fact only the beginning, and this eventuality is expressly acknowledged by the Dodd proposal. But consider the next step. The Fed now holds 50% of the company’s stock, which it may sell at a price determined by the Fed in order to recoup part of the loss on the loan. Naturally, the company still may not be in the greatest shape, so the stock has to be sold at a depressed value, with sufficient margin so that the purchaser will be motivated to buy because he expects to make a handsome profit. Again, because the loss was shifted to the taxpayers, a new profit making opportunity has been created for the big boys. Congress receives a report.

Or finally, consider this alternative variation on the loan scenario just mentioned. The Fed’s financial analysts issue a report concluding that, ultimately, the toxic mortgage-backed securities that are collateralizing the Fed’s $500 million loan will pay $.0.80 on the dollar. Let’s assume that the exercise price on the warrants is effectively $0.10 on the dollar amount of the debt, and the Fed sells the warrants for $0.05 on the dollar amount of the debt, or an amount which, when added to the exercise price the warrant holder will have to pay to buy the stock, effectively equals $.15 on the dollar amount of the debt. (The Fed can’t ask for too much, because investors won’t buy if they don’t have a realistic chance of making a profit!) The Fed reports to Congress that it expects that the loss to the Treasury on this transaction will only be 15%, because it expects to collect $.80 and it has sold the warrants at $.05. A few years go by. It turns out (who knew?) that that the toxic mortgage-backed securities are only yielding $.40 on the dollar, and since this is a nonrecourse loan, the remainder of the debt is just a loss to the US taxpayers. Meanwhile, the company, freed from its toxic contingent losses, has been able to rebuild itself into a financial titan. Turns out that the warrants are now worth five times the amount the investors paid for them, and the investors are going to make a killing! Ha ha! Now that’s what America is all about! Being rewarded for taking risks!

With hundreds of billions at its disposal, the Fed has the ability to preserve and create new titans of finance. The bailout process will not be unlike Russia’s creation of overnight billionaires through the public sale of rights to its national resources for ludicrously low sums of money, all accomplished at the expense of the taxpayer. I believe we here in the US call this "crony capitalism" when practiced in Russia. The taxpayers will bear the losses, receive nothing for it, while new profit opportunities are created for the ruling class. Nothing prevents this. Congress will receive reports.

This is not socialism, but pure Americanism. The people trying to perpetrate this grand theft would like you to continue to think it’s socialism, because that mistake hides the reality of what it really is. Nowhere does the federal government end up with an actual ownership stake in the companies it is bailing out that would permit it, ultimately, to continue to recoup losses and even profit on its loan, theoretically lessening the burdens on taxpayers (way) down the road. I am not saying this rosy scenario would ever come to pass — we’re talking about government here after all — but that would be socialism.

The proposed bailout solutions are more of the same — plus ça change you can believe in. The game is rigged and we are the losers. Neither Republicans or Democrats are proposing to do anything to fix the real source of the problem that impoverishes all but the most wealthy — fractional reserve banking and the Federal Reserve. Without eliminating that system, more "regulation" can never eliminate the moral hazard or power to create unearned wealth that comes from the power to manufacture credit out of thin air. "Regulation" is just the mantra that politicians reach for to mollify you with a promise to prevent a recurrence of a nightmare enveloping us that they have helped create, in this case while they completely ignore or fail to see the real cause of the problem, guarantying that it will recur. Think about what politicians are actually promising. Regulation! Solution to all future problems! It does nothing for you now, it does not ameliorate one iota the suffering brought down on you now. For you, what’s done is done and you just have to suck it up! The politicians will take care of it by protecting you in the future! And if it doesn’t work, we won’t know that until later, when the next disaster occurs, when the politicians will promise more regulation or better regulation again! Eventually, after you’ve lost everything, they’ll get it right! Maybe! We’ll have to wait to see! For the titans of industry though, what’s done is not done, For you, regulation, for them, money. You will remediate them, now, for the damage they have inflicted on themselves, and pay for it the rest of your lives. It’s not socialism, it’s the American way of business.

The only candidates who are actually promising to address the root cause of the current financial disaster are third-party candidates Ralph Nader, Chuck Baldwin, and Cynthia McKinney who have signed, with Ron Paul, a statement of agreement on the actions they will take in the areas of foreign policy, privacy, the national debt and the Federal Reserve. To the American voter I say, if the bailout discussions don’t show you what the System really is and your place in it, your eyes are unopenable. But if this disgusts you, if you really want change and not more of the same ("regulation!"), if you really want to vote your pocketbooks and place yourselves on a path to financial security, you will have to abandon your favored system of Voting Only for Someone Who Can Win (yes, even though the winners will receive reports about what the Fed has done!), and vote for someone who will really address the conditions of your bondage to this country’s ruling class.

Clarification

In my article above on the "crony capitalism" aspects of the proposed bailout, I failed to make clear that, under the Dodd proposal, the Secretary of the Treasury would indeed be required to make arrangements on terms that could result in the acquisition by the Treasury of securities in financial companies that received bailout funds, complete with protective anti-dilution measures. As of yesterday, this was being vehemently resisted by the Secretary of Treasury Paulsen and by Federal Reserve Chairman Bernanke. The analysis in the article therefore reflects the possibilities inherent in the powers that Henry Paulsen and Bernanke are seeking to obtain from Congress, and which were included in their original proposal (which granted them unreviewable power), not what the original Dodd proposal mandated. Today, House leaders and others are meeting behind closed doors to hash out a final bill. Only the final bill will reveal whether the government may end up owning actual securities in companies that are bailed out, and what freedom the Treasury or Federal Reserve will have to price and sell the securities. Even if the Treasury obtains the securities, as long as it has the freedom to sell them on terms it deems acceptable, the "crony capitalism" possibilities inherent in government acquisition of these securities survives.

Jeff Snyder [send him mail] is an attorney who works in Manhattan. He is the author of Nation of Cowards — Essays on the Ethics of Gun Control, which examines the American character as revealed by the gun control debate. He occasionally blogs at The Shining Wire. Read this interview with him.

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