No Bailout for Financial Firms


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