Government Bailouts, Guarantees and Other Financial Machinations

Nothing New…But What‚ Why‚ When and How

The Hoover Administration created the Reconstruction Finance Corporation (RFC) to stimulate economic activity in 1932. In 1957‚ when its tenure came to an end‚ the RFC had loaned approximately $50 billion without burdening taxpayers significantly. Under FDR in 1933‚ as part of the New Deal‚ the government actually made a small profit when it formed the Home Owners’ Loan Corporation to buy $3 billion worth of bad mortgages and refinance more than a million additional mortgages to stem the tide of rising foreclosures.

A series of government rescues occurred in the 1970s and 1980s‚ the most highly touted of which was the 1979 bailout of the nation’s tenth largest company‚ the Chrysler Corporation. The Carter Administration arranged $1.2 billion in subsidized loans for the automaker and netted the government a profit when Chrysler paid off its obligations.

In 1989‚ the U.S. Congress established a government-owned asset management company‚ the Resolution Trust Corporation‚ to resolve the Savings and Loan crisis and pay depositors $125 billion in taxpayer money (approximately $200 billion in today’s dollars).

Obviously‚ government bailouts‚ guarantees and other financial machinations aren’t anything new. However‚ the time has come for us to ask some critical questions.

J. P. Morgan gets Bear Stearns and Washington Mutual‚ the government gets IndyMac and AIG‚ and Pimco makes a whole lot of money on Fannie and Freddie

The Federal Reserve has guaranteed $29 billion of Bear Stearns’ assets in conjunction with a government-sponsored sale to J. P. Morgan Chase & Company. Billions of dollars of equity were transferred to the balance sheet of one of the top five banks in America while the liabilities were guaranteed by the government (spelled U-S-t-a-x-p-a-y-e-r-s). It has been reported that the executives of Bear Stearns walked away with bonuses and severance packages. Government officials say that disaster was averted.

On July 11th‚ IndyMac Bank’s assets were seized by Federal regulators. The Federal Deposit Insurance Corporation estimates the cost of the intervention at about $8.9 billion as IndyMac became runner up to the largest bank collapse in history at that point in time‚ namely Continental Bank. [In 1984‚ Congress took over Continental Illinois National Bank and Trust and the FDIC paid $4.5 billion to buy bad loans.] The IndyMac debacle is devouring a large portion of FDIC reserves‚ and if too many other banks fail in the year ahead‚ taxpayers will be required to “help out.”

As I write this article‚ Washington Mutual Inc.‚ has surpassed Continental when it was seized by government regulators on September 25. Its branches and assets (not liabilities) were sold to J. P. Morgan Chase & Company for $1.9 billion in what is NOW the biggest bank failure in U.S. history and makes J. P. Morgan the biggest U.S. bank in terms of deposits. We are being told that the net result of these bailouts is that the banking system is saved for now

Fannie Mae and Freddie Mac (not such cute sounding names anymore) were seized by the Treasury Department and temporarily put into a government conservatorship on September 7 with plans to inject up to $100 billion into each. Investors like Bill Gross from Pimco had indicated that they would stop buying bonds unless the Treasury guaranteed all Fannie and Freddie obligations. Gross and his firm are now $8 billion richer and the American taxpayers take on $200 billion (and probably more) in potential losses.

On September 16‚ the government announced an $85 billion emergency loan to rescue American International Group Inc.‚ a major insurance company‚ in return for a 79.9 percent stake.

Eight critical questions (among many) that need answers

There are some serious questions that need answers regarding government bailouts‚ guarantees and over the top financial assistance. I can’t include all of them in this article‚ but here are eight to start the process:

1. Will these huge bailouts really stabilize the markets?
   For some time now‚ there has been concern that Fannie Mae and Freddie Mac were building empires and operating with little oversight. (Imagine that‚ government entities building empires?) As the financial crisis hit‚ Treasury Secretary Henry Paulson called for a bailout‚ asking Congress to guarantee all their loans. If his approach works‚ the market will stabilize. If it does not‚ or the housing crisis deepens‚ taxpayers could pay tens of billions of dollars in bailouts. So far‚ none of the recent bailouts has affected the markets for very long.
2. Are some entities too big to be allowed to fail?
   Of course‚ we have already reviewed the Fannie and Freddie situation‚ and as I write this article‚ the U.S. auto industry will be receiving $25 billion in loan guarantees per U.S. Senate approval. Attached to legislation funding U.S. military involvement in Iraq and Afghanistan‚ the loan guarantees are intended to foster automotive innovation. Without intervention of some sort‚ General Motors might have been forced into bankruptcy; however‚ Chrysler Chairman Robert Nardelli has stated that the loan guarantees should not be considered a rescue package or bailout for struggling carmakers. The new legislation also applies to suppliers and foreign automakers with plants in the United States 20 years old or older (e.g.‚ Nissan and Honda).
3. Don’t bailouts‚ guarantees and the like give the government the power to choose the winners and losers—a role usually reserved for the marketplace?
   In 2001‚ Congress authorized $5 billion in cash after the September 11 terror attacks to help prop up the airline industry with an additional $10 billion in loan guarantees. While economists and airline experts agree that this was a unique case‚ how did the government decide to pick and choose? Why not bail out the car rental companies which lost enormous sums with the airport shutdown? Why not the airport hotels and restaurants? Why not various tourism destinations? Why not the television networks that lost hundreds of millions of advertising dollars as they ran advertisement-free coverage for days after the attacks?
4. What criteria determine who receives government support and who doesn’t?
   While the U.S. government has been involved in some manner with helping Bear Stearns‚ IndyMac‚ Fannie Mae and Freddie Mac and others‚ it allowed the market to do its job when it declined to back a deal that would have kept Lehman Brothers Holdings‚ Inc.‚ the country’s fourth-largest brokerage firm‚ from declaring bankruptcy. This earned the government praise from those who are concerned that government bailouts encourage various types of bad behavior because the taxpayer is always there to pick up the pieces.
5. Do government bailouts necessarily help troubled companies operate better‚ and isn’t it unfair to competitors who have been better managed?
   In 1971‚ the government bailed out Lockheed Aircraft‚ the nation’s largest defense contractor‚ saving it from bankruptcy with $250 million in government loan guarantees. Critics say the government set a bad precedent by rewarding an inefficient corporation. American carmakers‚ failing to meet competition from Japan‚ got government help through tariff protection in the late 1970s but did not respond with effective change. And‚ while the Chrysler bailout is generally regarded as a success‚ many argue that it exacerbated the decline of the auto industry as automakers made very little change rather than learning a needed lesson about Chrysler’s decline and rethinking fuel efficiency and manufacturing quality. Harley-Davidson‚ for example‚ instituted wholesale management changes‚ while the late 1970s auto industry did not.
6. Don’t government bailouts prevent the market from finding a bottom?
   Some financial experts worry that the government’s moves to bail out ailing companies are keeping the credit crisis from reaching a bottom‚ ultimately delaying an economic recovery. Anything that slows down the deleveraging process prolongs the agony. The government‚ by opening its coffers‚ may also be discouraging private sector lending and investing.
7. How should the government (which is supposedly made up of the people) be rewarded for helping?
   Should taxpayers (also known as government) merely put up money and provide guarantees‚ or will bureaucrats negotiate like hedge fund managers to make a big profit from taking on big risks? In the past the government has made some profit on bailouts‚ but the risks are getting higher and higher.
8. What is going to happen to the dollar?
   Currently United States is running about a $500 billion dollar annual budget deficit. This will be added to the national debt which currently stands at $10.2 trillion. And that doesn’t even take into account future Medicare and Social Security obligations‚ which now exceeds $50 trillion. Oh‚ and then there are all those pesky baby boomers waiting in the wings. Will we just run up the national debt to $15 trillion…$20 trillion…or more? It is not as if the government has surpluses from which to draw all the needed capital to meet these obligations. We will have to borrow or print it.

Can the U.S. dollar maintain world trust?

Can the U.S. dollar maintain world trust if the government continues to print‚ borrow and move dollars around from balance sheet to balance sheet ad infinitum? Today the dollar is a note to pay debt that is exploding and apparently can be wiped away by the Fed in an instant or transferred to the backs of U.S. workers in the form of taxes.

Russia‚ China and the Arab nations possess enormous amounts of oil‚ gold and U.S. dollars. What if these nations formed an alliance (much like NATO‚ WTO‚ etc.) and offered an “ARC” dollar backed by gold or oil? The currency could be exchanged for a specified amount of gold or oil. It is sobering to note that discussions are presently occurring with the Gulf Monetary Authority for just such a system.

In fact‚ the rumblings all over the world regarding the present financial situation in the United States are increasing and could serve to exacerbate global pressure.

• The Secretary General of the United Nations recently called for a new global financial system.
• A leading Chinese state newspaper reported in September‚ that threatened by a “financial tsunami‚” the world must consider building a financial order no longer dependent on the United States.
• Giulio Tremonti‚ finance minister of Italy’s conservative and pro-U.S. government party‚ has warned of a systemic breakdown and criticized the “voracious selfishness” of speculators and “stupid sluggishness” of regulators. Singling out former Fed chairman Alan Greenspan‚ he stated that “Greenspan was considered a master. Now we must ask ourselves whether he is not‚ after [Osama] bin Laden‚ the man who hurt America the most.…It is clear that what is happening is a disease. It is not the failure of a bank‚ but the failure of a system.”
• Prime Minister Vladimir Putin recently vowed to make relations with Latin America a top foreign policy priority (including nuclear energy cooperation with Venezuela)‚ a pledge backed by the first Russian naval deployment to the Caribbean since the Cold War. Putin and Venezuela’s Chavez suggested their countries are working to decrease U.S. global influence. “Latin America is becoming a noticeable link in the chain of the multi-polar world that is forming‚” Putin recently stated.
• German Finance Minister Peer Steinbrück‚ a Social Democrat and long-time champion of tougher financial market rules‚ told the German Parliament that “the U.S. will lose its status as the superpower of the world financial system” with the emergence of stronger‚ better-capitalized centers in Asia and Europe. “The world will never be the same again.”

In order to be fair and balanced‚ it should be noted that the more optimistic school of thought sees the current financial events as an inevitable period of reconfiguration from which the markets and U.S. economic dominance will emerge reasonably unscathed. “This time next year we’ll be seeing things back to normal‚” said Eamonn Butler‚ director of the Adam Smith Institute. From time-to-time‚ businesses fail and the worst thing a government can do is to bail them out because that just passes the cost on to the taxpayer and creates a moral hazard.”

The nation’s financial turmoil has many Americans worrying

Nevertheless‚ the nation’s financial turmoil has many Americans worrying about the security of their savings and investments. If the history of previous bailouts and other government financial interventions hold any single lesson‚ it’s that the outcomes are unpredictable and the problems will take years to work out.

Free markets permit failure. The government has a role to play when stakes are enormously high and the public welfare is in peril. But‚ even that is difficult to assess. We don’t know that the bailout plan just passed by Congress and signed by the President will actually accomplish anything…other than reward the bad players.

Diversification has never been more crucial

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