It's the Derivatives, Stupid! Why Fannie, Freddie and AIG Had to Be Bailed Out

"[I]t's the best game in town. Take a huge amount of risk, be paid exceedingly well for it and if you screw up -- you have absolute proof that the government will come in and bail you out at the expense of the rest of the population (who did not share in your profits in the first place)."4

Desperate Measures for Desperate Times 

It was the best game in town until September 14, when Treasury Secretary Paulson, Fed Chairman Ben Bernanke, and New York Fed Head Tim Geithner closed the bailout window to Lehman Brothers, a 158-year-old Wall Street investment firm and major derivatives player.  Why?  "There is no political will for a federal bailout," said Geithner.  Bailing out Fannie and Freddie had created a furor of protest, and the taxpayers could not afford to underwrite the whole quadrillion dollar derivatives bubble.  The line had to be drawn somewhere, and this was apparently it. 

Or was the Fed just saving its ammunition for AIG?  Recent downgrades in AIG's ratings  meant that the counterparties to its massive derivatives contracts could force it to come up with $10.5 billion in additional capital reserves immediately or file for bankruptcy.  Treasury Secretary Paulson resisted advancing taxpayer money; but on Monday, September 15, stock trading was ugly, with the S & P 500 registering the largest one-day percent drop since September 11, 2001.  Alan Kohler wrote in the Australian Business Spectator:

"[I]t's unlikely to be a slow-motion train wreck this time. With Lehman in liquidation, and Washington Mutual and AIG on the brink, the credit market would likely shut down entirely and interbank lending would cease."5

Kohler quoted the September 14 newsletter of Professor Nouriel Roubini, who has a popular website called Global EconoMonitor.  Roubini warned:

"What we are facing now is the beginning of the unravelling and collapse of the entire shadow financial system, a system of institutions (broker dealers, hedge funds, private equity funds, SIVs, conduits, etc.) that look like banks (as they borrow short, are highly leveraged and lend and invest long and in illiquid ways) and thus are highly vulnerable to bank-like runs; but unlike banks they are not properly regulated and supervised, they don't have access to deposit insurance and don't have access to the lender of last resort support of the central bank."

The risk posed to the system was evidently too great.  On September 16, while Barclay's Bank was offering to buy the banking divisions of Lehman Brothers, the Federal Reserve agreed to bail out AIG in return for 80% of its stock.  Why the Federal Reserve instead of the U.S. Treasury?  Perhaps because the Treasury would take too much heat for putting yet more taxpayer money on the line.  The Federal Reserve could do it quietly through its "Open Market Operations," the ruse by which it "monetizes" government debt, turning Treasury bills (government I.O.U.s) into dollars.  The taxpayers would still have to pick up the tab, but the Federal Reserve would not have to get approval from Congress first.

Time for a 21st Century New Deal? 

Another hole has been plugged in a very leaky boat, keeping it afloat another day; but how long can these stopgap measures be sustained?  Professor Roubini maintains:

"The step by step, ad hoc and non-holistic approach of Fed and Treasury to crisis management has been a failure. . . . [P]lugging and filling one hole at [a] time is useless when the entire system of levies is collapsing in the perfect financial storm of the century. A much more radical, holistic and systemic approach to crisis management is now necessary."6

We may soon hear that "the credit market is frozen" – that there is no money to keep homeowners in their homes, workers gainfully employed, or infrastructure maintained.  But this is not true.  The underlying source of all money is government credit – our own public credit.  We don't need to borrow it from the Chinese or the Saudis or private banks.  The government can issue its own credit – the "full faith and credit of the United States."  That was the model followed by the Pennsylvania colonists in the eighteenth century, and it worked brilliantly well.  Before the provincial government came up with this plan, the Pennsylvania economy was languishing.  There was little gold to conduct trade, and the British bankers were charging 8% interest to borrow what was available.  The government solved the credit problem by issuing and lending its own paper scrip.  A publicly-owned bank lent the money to farmers at 5% interest.  The money was returned to the government, preventing inflation; and the interest paid the government's expenses, replacing taxes.  During the period the system was in place, the economy flourished, prices remained stable, and the Pennsylvania colonists paid no taxes at all.  (For more on this, see E. Brown, "Sustainable Energy Development: How Costs Can Be Cut in Half," webofdebt.com/articles, November 5, 2007.) 

Today's credit crisis is very similar to that facing Herbert Hoover and Franklin Roosevelt in the 1930s.  In 1932, President Hoover set up the Reconstruction Finance Corporation (RFC) as a federally-owned bank that would bail out commercial banks by extending loans to them, much as the privately-owned Federal Reserve is doing today.  But like today, Hoover's ploy failed.  The banks did not need more loans; they were already drowning in debt.  They needed customers with money to spend and invest.  President Roosevelt used Hoover's new government-owned lending facility to extend loans where they were needed most – for housing, agriculture and industry.  Many new federal agencies were set up and funded by the RFC, including the HOLC (Home Owners Loan Corporation) and Fannie Mae (the Federal National Mortgage Association, which was then a government-owned agency).  In the 1940s, the RFC went into overdrive funding the infrastructure necessary for the U.S. to participate in World War II, setting the country up with the infrastructure it needed to become the world's industrial leader after the war. 

The RFC was a government-owned bank that sidestepped the privately-owned Federal Reserve; but unlike the Pennsylvania provincial government, which originated the money it lent, the RFC had to borrow the money first.  The RFC was funded by issuing government bonds and relending the proceeds.  Then as now, new money entered the money supply chiefly in the form of private bank loans.  In a "fractional reserve" banking system, banks are allowed to lend their "reserves" many times over, effectively multiplying the amount of money in circulation.  Today a system of public banks might be set up on the model of the RFC to fund productive endeavors – industry, agriculture, housing, energy -- but we could go a step further than the RFC and give the new public banks the power to create credit themselves, just as the Pennsylvania government did and as private banks do now.  At the rate banks are going into FDIC receivership, the federal government will soon own a string of banks, which it might as well put to productive use.  Establishing a new RFC might be an easier move politically than trying to nationalize the Federal Reserve, but that is what should properly, logically be done.  If we the taxpayers are putting up the money for the Fed to own the world's largest insurance company, we should own the Fed.

Proposals for reforming the banking system are not even on the radar screen of Prime Time politics today; but the current system is collapsing at train-wreck speed, and the "change" called for in Washington may soon be taking a direction undreamt of a few years ago.  We need to stop funding the culprits who brought us this debacle at our expense.  We need a public banking system that makes a cost-effective credit mechanism available for homeowners, manufacturing, renewable energy, and infrastructure; and the first step to making it cost-effective is to strip out the swarms of gamblers, fraudsters and profiteers now gaming the system.

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