In my recent article, “The FED’S End Run,” I wrote this:

Beginning late Friday evening, March 29, we have been in the midst of an end run by the Federal Reserve System around Congress. The FED is about to be given authority to regulate the nation’s largest non-commercial financial institutions, including stocks and commodities.

The goal of the FED, as with all central banks, is three-fold: (1) to protect the largest commercial banks from their depositors, who occasionally exercise their contractual right to withdraw currency (the ungrateful cads); (2) to control entry of newcomers into the bankers’ cartel (interlopers); (3) to keep the stock market from collapsing in a panic, thereby persuading depositors to withdraw currency.

With the Federal Reserve System’s latest proposal, presented to the public by Secretary of the Treasury Henry “Goldman Sachs” Paulson, the FED is asking the United States government to make it the Great Protector of Capital.

Think of the bank run scene in It’s a Wonderful Life. Ben Bernanke wants us to view him as kindly Jimmy Stewart, handing out his honeymoon money to save the family business from fearful depositors who want their money back. Sorry, but the best I can mentally conjure is an image of Donna Reed with a beard.

The Federal Reserve System has always been presented to the voters as the lender of last resort, the provider of the national safety net. But because of the now-admitted fragility of the present leveraged financial system, the FED has become the deal-doer of first resort. When the New York FED intervened on Sunday, March 17, to cobble together an emergency deal for J. P. Morgan Chase to buy out Bear Stearns’ investors for $2 a share (the price had been $10 on March 15 and $68 on March 11), the New Domestic Order was made visible. The FED, not the capital markets, will set prices of financial institutions whenever the FED’s bureaucrats deem this necessary.

Anyone who says that the FED is not using its government-granted monopolistic power over money to protect the capital markets from the now-unpleasant effects of the FED’s actions under Alan Greenspan deserves to be a Bear Stearns investor.

MORAL HAZARD AND UNCLE SCROOGE

“Moral hazard” is the phrase that describes one negative effect of guaranteeing the survival of a group of companies or an entire industry that have made bad investments, but which are then bailed out by the government or its licensed agent, the Federal Reserve System.

What is this negative effect? To promote future high-risk loans or investment strategies that offer above-market rates of return because of this risk.

The decision-makers, knowing that their rich uncle has previously guaranteed that several large firms were not allowed to go bankrupt, now pursue investment strategies which they would not pursue if they believed that they would be held fully accountable for their actions. Senior managers see that their peers were bailed out. They think, “We will be bailed out, too.”

Uncle Sam is the rich uncle. And also Uncle Ben — not the rice fellow: the FED fellow.

There is another Uncle with a lot of money: Uncle Scrooge. Uncle Scrooge was never dumb enough to offer his nephew Donald an insurance policy for Donald’s schemes to make money. If he had, he would have found himself handing out a lot of money.

Uncle Scrooge understood the effects of insuring profit-seeking schemes by people who have been given security from their own mistakes.

How do I know what Uncle Scrooge thought? Because I knew him personally. Well, not quite. I knew his advisor.

For many years, the man who wrote the story lines for the Uncle Scrooge comic books was Vic Lockman. He was a professional cartoonist. Back in 1969, he published a cartoon booklet on the Federal Reserve System, The Official Counterfeiter. That booklet deserves to be posted on some website, or lots of websites.

Uncle Scrooge had a vault full of gold coins. So does the Federal Reserve System, or so we are told. Uncle Scrooge owned his coins. The FED holds gold bullion bricks as a reserve for a part — a fixed part — of the money supply of the United States. It does this on behalf of the United States (it says here). That gold may still be in the vault at the New York FED, or it may not. Members of Congress do not know, nor do they know what, if anything, is in the vault at Fort Knox. Congress is assured that the gold is there. By whom? By the handful of Treasury and Federal Reserve bureaucrats who have access to these vaults.

So, with gold as a reserve — we hope — and with government debt as a reserve, and with mortgages handed over to the FED by banks and financial institutions in exchange for Treasury debt, the Federal Reserve System regulates America’s money supply, or tries to.

It now wants to regulate far more than the money supply. It wants to regulate the institutions that lend or invest large chunks of the nation’s money supply.

Why? Officially, because of the fragility of the financial system. That, at least, is the implication of Secretary Paulson’s published statements. The financial system was not seen as fragile in July, 2007, but it is now. On the contrary, the system was said to be A-OK in July, 2007, but not now. Everything is different today.

It isn’t different, of course. It is the same. What is different is that what was always implicit has now become explicit: the threat of falling dominoes.

If the proposed legislation passes — and it will — things will be even more different in the future.

BAD MORTGAGES? LET’S WRITE MORE!

Recently, a memo issued by Wachovia Bank indicated that it would no longer make high-risk loans to home buyers. This sounds to me like locking the barn door after the horses have escaped.

The memo got leaked. Then an amazing thing happened. Wachovia’s response was neither to confirm nor deny.

You think, “Wait a minute. Why not confirm it? Why not admit that making high-risk loans is a bad policy?” Because Wachovia is regulated by the United States government. It must be very careful about refusing to make high-risk loans.

There is a bank lending policy called red-lining. Banks in the past refused to make mortgage loans in neighborhoods where there is a past record of high default rates. This policy is today illegal. The Federal government subsumes it under racial discrimination.

It’s not that red-lining was aimed at the Sons of Tonto. It was aimed at high-risk neighborhoods. And, because birds of a feather are said by the U.S. government never to flock together, it’s illegal to discriminate against birds of a certain color.

We know that zip code marketing is very profitable. The Claritas company has broken the United States into 66 different neighborhood types: income, age, education, etc. These are tied to nine-digit zip codes. It sells this information to marketers who want to plan sales campaigns for certain products.

Claritas has been doing this for years. How? Because birds of a feather really do fly together. Response rates to direct-mail solicitations do differ in terms of zip codes, right down to all nine digits.

Wachovia is still making loans called option ARMs. These loans involve an offer to a borrower to pay less per month than is required to repay the loan. Each month, the money left unpaid is added to the loan’s principal. Then, at some contractual trigger price for principal, the loan’s monthly payment jumps. The borrower may have to pay twice what he had been paying. He may pay even more than double.

Why would anyone agree to accept such a loan? Two reasons: (1) he expects his income to rise sharply in the next year or two; (2) he is a person who does not read or understand contracts and also believes in something for nothing. Here is a description of who might reasonably take such a debt.

Option ARMs are best suited to sophisticated borrowers with growing incomes, particularly if their incomes fluctuate seasonally and they need the payment flexibility that such an ARM may provide. Sophisticated borrowers will carefully manage the level of negative amortization that they allow to accrue.

In this way, a borrower can control the main risk of an Option ARM, which is “payment shock”, when the negative amortization and other features of this product can trigger substantial payment increases in short periods of time.

We are now in a recession. The number of people who can expect big increases in their income next year is a small and declining figure. But Wachovia is still making option mortgages.

But aren’t option ARMs the most vulnerable to default of all mortgages? Yes.

So, Wachovia has a big problem. (1) It wants to make more of these loans; (2) it does not want to get prosecuted for red-lining.

This led to the memo. On the one hand, Wachovia made no bones about its desire to continue to make option ARM loans. Where? In California.

California? Where housing prices are plummeting? Yes.

Certain markets looked more risky than others. So, in these markets — Caucasian, middle-class places like Riverside County, where I lived for a decade — Wachovia decided it might be wise to cut back on such loans.

You and I know what happens to internal memos. They get leaked. But high-level people who write memos never catch on. So, the Los Angeles Times got a copy and published a story on it. The memo identified 17 counties where property values have fallen so far that the bank would no longer write new option ARMs.

When asked to explain this memo, a bank official refused to comment. The policy is merely “under consideration.” The memo was sent “prematurely.” This is a tried and true response to embarrassing memos that probably goes back to Middle Kingdom Egypt.

The present subprime mortgage crisis has been in full swing since August, 2007. Why in March was Wachovia still making these loans — in California, Missouri, or anywhere else?

This rule comes to mind: “When you’re in a hole, stop digging.” Why isn’t Wachovia honoring it? I don’t know about you, but my assessment is that option ARMs are really bad ideas today. I first heard of these loans 30 years ago. They were not called option ARMs. They were called backward-walking mortgages. They were written by sellers of homes who wanted to take back those homes after a hopeful buyer defaulted on his loan. It was an interim program to get a house sold when the seller expected the house’s price to rise. He wanted a buyer to occupy the house. A renter usually does not take care of a house as carefully as a buyer does. So, house sellers used backward-walking mortgages to get a down payment out of a person who was virtually guaranteed to default. The person moved in, took care of the house, and was evicted right on schedule.

No one ever sold a house with a backward-walking mortgage if he expected the house to fall in price. So, I understand Wachovia’s concern with 17 counties in California. Frankly, I think this concern applies to 3,000 other counties in the United States.

But I don’t understand this aspect of the deal. Wachovia, unlike a seller of a home who is in the business of buying and selling homes, does not want to foreclose. Wachovia is not in the house-flipping business, except as a lender to house-flippers — a bad idea these days. Wachovia presumably makes loans that it wants borrowers to pay off.

Then why does it still write option ARM loans?

My guess: because it can get more borrowers to sign the loans than if the borrowers understood that the loan contract they are signing is a backward-walking mortgage. They want borrowers now. They don’t care about foreclosures tomorrow. They expect enough borrowers to keep paying.

I think they are wrong. But I don’t make policy at Wachovia.

TOO BIG TO FAIL

The proposed expansion of Federal Reserve authority over American finance is based on the idea that some firms are too big to be allowed to fail. Bear Stearns was such a firm.

The big boys hope that they will not preside over bankrupt firms. To make sure of this, they are willing to let the FED impose new rules. These rules will be imposed on their competitors, too. That is suitable in their eyes.

If left to themselves, they will continue to make bad decisions in order to earn a little more money.

This is the effect of moral hazard. The FED has promoted moral hazard. Now it wants to regulate the operations of a financial system that has grown up under Greenspan’s administration to believe that some firms are too big to fail.

The implicit guarantee led to explicitly bad policies. Bear Stearns is a good example.

The FED is the genie who is out of the bottle, Congress relies on this genie to keep the inflation-created boom going. Congress is frightened of a full-scale recession in which the biggest firms fail. After all, who would fill up their Political Action Committees’ coffers if big firms were allowed to fail? That is why the big firms fill the coffers.

CONCLUSION

We are living in an era of government controls. These controls have created a hierarchy of winners (guaranteed) and losers (guaranteed). The option ARM is a manifestation of both.

The new proposals will centralize power over finance in the hands of an agency that is officially run by the government (www.federalreserve.gov) but in fact is run by agents of the largest fractional reserve banks. All of the regional FEDs are .org agencies, not .gov. The regional banks are a majority on the Federal Open Market Committee, which sets monetary policy. The FOMC’s policy is implemented by the New York FED (www.ny.frb.org).

We can expect more of the same. The idiocy that the banks have shown in making bad loans will spread to the entire financial sector.

Regulation by tenured staff economists will not make the system less fragile. It will make it more top-heavy and less flexible.

The bigger they are, the harder they fall. They will fall all at once. That is the curse of centralization and government regulation.

As Tom Lehrer sang in 1959, in a different context: “We’ll all go together when we go. Every Tom, Dick, and Harry, and every Joe.”

April 5, 2008

Gary North [send him mail] is the author of Mises on Money. Visit http://www.garynorth.com. He is also the author of a free 20-volume series, An Economic Commentary on the Bible.

Copyright © 2008 LewRockwell.com