[R-G] [BillTottenWeblog] Media Overlook Fed Bailout in Plain View

[Bill Totten]

by Dean Baker

The American Prospect (March 11 2008)


Can't the media find any economists who don't think that handing
hundreds of billions of taxpayer dollars to the big banks and the
incredibly rich people who own and manage them is a good idea?
Apparently not, given the coverage so far to the Fed's proposal to lend
$200 billion to the banks using mortgage backed securities as collateral.

The workings of the Fed and the financial markets can appear
complicated, so let's simplify matters a bit to make it more clear what
is going on here. Suppose that it was suddenly discovered that much of
the wealth held by the country's leading financial institutions was in
fact counterfeit. Instead of having hundreds of billions of dollars of
real currency in their vaults, institutions like Citigroup, Merrill
Lynch, and Bears Stearns actually had hundreds of billions of dollars of
counterfeit currency. Suppose further that the public did not know
exactly who held what in terms of counterfeit currency, only that all of
them had a lot of it. (The point here is that these banks hold mortgage
backed securities, many of which are only worth a fraction of their face
value, and therefore can be viewed as the equivalent of counterfeit
currency.)

In such circumstances, investors would be very reluctant to accept the
credit of any of the major financial institutions. They couldn't know
whether most of their assets were in fact counterfeit, and they were
dealing with a bankrupt institution, or whether the counterfeit currency
was only a limited share of the wealth, which would not jeopardize the
institution's ability to meet its obligations.

This is in fact the credit squeeze that we've have recently witnessed.
The spread between the interest rates on a wide variety of assets and
the interest rate on safe assets (US government debt) has soared. As a
result, the Fed's effort to stimulate the economy, by lowering the
federal funds rate, has been largely unsuccessful because other interest
rates have remained high.

In response to this situation the Fed today announced that it would lend
$200 billion to banks and other financial firms, accepting mortgage
backed securities as collateral. This is effectively the same as saying
that the Fed is going to lend money to banks and accept the counterfeit
currency as collateral, treating it just as though it were real money.

The intended effect of this policy is to convince other investors that
the counterfeit currency is in fact real currency, or at the very least
that there is a really huge sucker out there (the Fed) which is prepared
to treat the counterfeit currency as real currency.

So how does this story play out? Well, insofar as the Fed is successful,
the counterfeit currency retains its value for a while longer. This
allows Citigroup, Merrill Lynch, Bears Stearns and the rest of the big
boys more time to dump their counterfeit currency on suckers who haven't
figured out how the game is played.

It is possible that they won't be able to find enough suckers, in which
case these banks will end up defaulting on their loans and the Fed (that
is, the government ) has lost tens or hundreds of billions dollars
paying good money for counterfeit currency. Alternatively, perhaps the
big boys are successful and can offload enough of their counterfeit
money to restore themselves to solvency before the music stops. Then the
Fed is repaid, but the counterfeit money now sits in the hands of other,
less informed, or less inside, investors.

Either way, this is a policy of dubious merit. Why wouldn't we want the
banks to be forced to come clean and eat their losses? This is always
the policy that the economists advocate when the parties in question are
not the big New York banks. Does anyone remember the East Asian
financial crisis when the media was full of condemnations of crony
capitalism and the IMF insisted imposed stringent conditions on South
Korea, Thailand, and Indonesia as a condition of getting bailed out? At
that time, everyone insisted on transparency. Aren't there any
economists who still have this perspective? If so, why aren't their
views appearing anywhere in the news?

There is one other issue that is extremely important that has been
completely omitted from the media's discussion of the Fed's actions.
There are people who have shorted the counterfeit notes (mortgage backed
securities and related assets) because they recognized that these assets
were in fact going to lose much of their value. While these short
sellers were trying to make money, they were actually performing a
valuable public service. They were pushing down the price of these
assets towards their true level. If we had many such short sellers in
the market we would not have seen the housing bubble grow to such
dangerous proportions. The same holds true of the stock bubble.

However, if the Fed acts to sustain bubbles even after they have started
to collapse under the pressure of their own weight, it makes it far more
risky for short sellers. This means that even investors who realize that
Citigroup has nothing but counterfeit currency will be reluctant to
short its stock or other assets supported by counterfeit currency. As a
result we can expect to see even bigger more dangerous bubbles in the
future.

This is not a pretty story and there are economists who can make this
point. The media should be talking to them, not just the cheerleaders
for the housing bubble.

(c) 2008 by The American Prospect, Inc.

http://www.prospect.org/csnc/blogs/beat_the_press_archive?month=03&year=2008&base_name=media_overlook_fed_bailout_in

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