“Doesn’t this seem like lunacy to you? The consequences of it are unbelievably bad in terms of public intrusion into the private sector. Is anybody thinking there? It’s too late, it’s not going to make any difference, and it’s aggravating as hell when there’s a better idea and you can't even get it in play.”
– Former Treasury Secretary John O’Neill in an October 1 interview with Bloomberg on the bank bailout plan
The bank bailout bill that just passed the Senate and is being deliberated in the House would turn the banks’ worst assets into good U.S. dollars. How many dollars? The figure was $700 billion a few days ago and has already climbed to $800 billion after the pork was added in. That’s nearly the cost of two Iraq wars, but it still won’t be enough, because the covered instruments eligible for conversion include the black hole of derivatives. Derivatives held by U.S. banks are now estimated at $180 trillion. How will the Treasury acquire the dollars to buy all these disastrously bad bank assets? The taxpayers are all taxed up and don’t have $800 billion to spare. The money will no doubt come from an issue of U.S. securities, or debt; but who will lend to a nation that already has the highest federal debt in the world, one that is growing exponentially? The likely answer is the Federal Reserve, the bankers’ bank that acts as “lender of last resort” when there are no other takers. The Federal Reserve is a private banking corporation owned by its member banks. The Fed returns the interest on the bonds it “monetizes” to the government, but only after deducting its operating costs and a 6% guaranteed return for each of its many bank shareholders. 1 The upshot is that we the people will be paying interest to the banks to bail out the banks from their own follies!
Why the Rush?
There must be a better way to unfreeze the credit system; but as former Treasury Secretary O’Neill observes, no other alternatives are on the table. Treasury Secretary Hank Paulson’s plan has been rushed through in a matter of days. Why the rush to push through a plan that could bankrupt the nation, without formal deliberations on the alternatives? Treasury Secretary Hank Paulson wanted a deal by last weekend. It didn’t happen, but the pressure has been on ever since.
Evidently the date the banks were trying to beat was Tuesday, September 30, the reporting day when they were required to reveal their “Tier 1” capital adequacy. To be adequately capitalized under federal bank regulations, a bank must have Tier 1 capital equal to at least 4% of its “risk-weighted assets.” “Assets” are things that produce cash flow, including loans and derivatives that actually represent liabilities of the bank – money the bank would have to come up with if the borrower did not pay, or the derivative bet were lost, or the other party to the derivative bet did not pay. Capital requirements vary depending on the “risk” of these assets. Tier 1 or “core” capital consists of shareholders’ equity (the amount originally paid to purchase the bank’s stock), plus retained profits, less accumulated losses. Since losses to the banks of late have been substantial, many banks could have trouble meeting the Tier 1 capital adequacy requirement. That means they would not be able to make new loans, which explains all the talk of a “credit freeze.” Indeed, on September 30, available credit was reduced to a trickle, with the London Interbank Offered Rate or LIBOR (the interest rate banks charge to lend to each other) rising sharply.
The collapse of the financial system has been blamed on the subprime crisis, but mortgage defaults are just the domino that triggered the fall. The real problem is the “d” word – something you don’t hear much mention of in the major media, the derivative Ponzi scheme. Derivatives got a bad name with the Long Term Capital Management fiasco. Derivatives are basically just bets, which vacuum up value without producing anything. The imploding derivatives bubble is a giant black hole that could suck all the productive assets of the nation into banking coffers.
Borrowing from the Banks to Bail Out the Banks?