Friday, October 24, 2008

Bail-outs are bad for you and me

When politicians and central bankers of all stripes and nationalities rush to provide "liquidity", and "secure" or "stabilise" the economy, it is best that you don't take their word for it.

These rushed emergency measures always involve giving new powers to the central bank, transferring taxpayer wealth to financial markets, or transferring some of the risks from financial markets onto the taxpayer.

In March, Bear Sterns collapsed - due to their balance being sheets full of derivatives ($13.4 trillion!) and they had a leverage ratio of 35 to 1.

On March 14 2008, JPMorgan Chase, in conjunction with the Federal Reserve Bank of New York, provided a 28-day emergency loan to Bear Stearns in order to prevent the potential market crash that would result from Bear Stearns becoming insolvent.[23] Two days later, Bear Stearns signed a merger agreement with JP Morgan Chase in a stock swap worth $2 a share or less than 10 percent of Bear Stearns' market value.[24]

This sale price represented a staggering loss as its stock had once traded at $172 a share as late as January 2007, and $93 a share as late as February 2008. In addition, the Federal Reserve agreed to issue a non-recourse loan of $29 billion to JP Morgan Chase.

The Fed intervened to broker the acquisition by JP Morgan of Bear Stearns for $10 a share, and made a non-recourse loan to JP Morgan of $29b. This was secured by $29b of so called 'assets'.

Idiots like Christopher Cox from the SEC always suggest the deal is necessary and wise. The typical 'crony capitalists' (who are not capitalists in any sense of the word!) always support these bailouts, they put out the line that taxpayers might stand to profit from these deals because the assets should be worth more in the future! Hank Paulson and Bernanke themselves used this reasoning when putting forward their proposal for the recent $700b bailout package.

But they aren't serious, and there is no way they would put their own wealth behind their words.

Calculated Risk was very astute to observe that American tax payers just lost $2.5b this week as the Fed wrote down the value of Bear Sterns assets from $29.5b to $26.8b.

I will end this post with one last request.

Whenever you hear presidents, prime ministers and central bankers reassure you that providing guarantees, liquidity and bailouts are a good thing, just remember Henry Hazlitt's words about credit, from his book "Economics in One Lesson".

Government "encouragement" to business is sometimes as much to be feared as government hostility. This supposed encouragement often takes the form of a direct grant of government credit or a guarantee of government loans.


But there is a decisive difference between the loans supplied by private lenders and the loans supplied by a government agency. Each private lender risks his own funds. (A banker, it is true, risks the funds of others that have been entrusted to him; but if money is lost he must either make good out of his own funds or be forced out of business.) When people risk their own funds they are usually careful in their investigations to determine the adequacy of the assets pledged and the business acumen and honesty of the borrower.

If the government operated by the same strict standards, there would be no good argument for its entering the field at all. Why do precisely what private agencies already do? But the government almost invariably operates by different standards.

The whole argument for its entering the lending business, in fact, is that it will make loans to people who could not get them from private lenders. This is only another way of saying that the government lenders will take risks with other people’s money (the taxpayers’) that private lenders will not take with their own money. Sometimes, in fact, apologists will freely acknowledge that the percentage of losses will be higher on these government loans than on private loans. But they contend that this will be more than offset by the added production brought into existence by the borrowers who pay back, and even by most of the borrowers who do not pay back.