What in the Hell just happened?
It's the usual question that someone asks after getting hit over the head and mugged, or if they were in the immediate vicinity of an explosion.
For the American taxpayer, both of those things happened during these past two weeks.
So many unprecedented events took place in such a short period of time that it was hard to keep up. Lots of people said lots of scary things, but few stopped to break down the most important issues, which are: a) how did we get here, b) what exactly is being done, and c) what does it all mean.
I'm going to try to help with those question.
To tell the story of how we arrived at the bailout and virtual nationalization of Fannie Mae and Freddie Mac you have to go back to March 20, when the Bush Administration decided that it was going to use Fannie and Freddie's reserve capital to bail out the entire real estate sector. The capital reserves were supposed to help in the event of a catastrophic financial event, like the meltdown of the real estate market.
"Additional capital will enable the companies to help more homeowners and will strengthen the underlying fundamentals of the mortgage market."- Treasury Secretary Paulson
Strike 1 for the bailout team.
Which proves that neither the Bush Administration, nor the financial media, really understand the markets.
Strike 2 for the bailout team.
A week ago Fannie and Freddie got bailed out for a minimum of $200 Billion in taxpayer dollars. Most likely it is going to cost a lot more than that.
End of story, right? Wrong.
It turns out that the White House gang that can't shoot straight, in forcing Fannie and Freddie into default, and then nationalizing them, caused an even larger problem.
Let me introduce you to the concept of credit default swaps.
Basically they are an insurance policy on debt (ie bonds) that a third party sells in case the debtor defaults on their obligations.
To give you a quick and dirty explanation, Fannie and Freddie handled the largest source of debt in the entire world (ie mortgages). That makes it also the source of the largest need for insurance (ie credit default swaps) on that debt in the world. And who is going to handle all that insurance? Why the largest insurance company in the world - AIG.
Which brings us to the problem of the Fannie and Freddie bailout.
The U.S. government's seizure of Fannie Mae and Freddie Mac has triggered more than $1 trillion of credit default swaps tied to the mortgage giants.By nationalizing the mortgage giants we also triggered an event that caused $1.5 Trillion in credit default swaps to be paid out to their holders, and AIG was right in middle of that.
The International Swaps and Derivatives Association said in a memo on Monday that 13 major credit default swap dealers unanimously agreed that a credit event had occurred.
Strike 3 for the bailout team.
Within just a few days AIG was getting bailed out by the American taxpayer to the tune of $85 Billion.
Oh, one other thing about that AIG that didn't get much press: the Fed suspended a few rules that exist to protect shareholders. What does this mean?
The conglomerate financial firms are permitted at this point to use private individual brokerage account funds to relieve their own liquidity pressures. This represents unauthorized loans of your stock account assets. So next, if the conglomerate fails, your stock account is part of the bankruptcy process.
Not everyone got bailed out this week.
Lehman Brothers were allowed to fail, the largest bankruptcy in American history, thus moral hazard was reintroduced to the market place...well, sort of.
The Federal Reserve Bank of New York took the unusual step of providing some $87 billion in financing to units of bankrupt Lehman Brothers Holdings Inc to prevent disruption in trading markets as customers flee, according to a filing on Tuesday.Oh, yeah. Did we forget to mention the $87 Billion that we loaned Lehman Brothers after they went broke? Why would we do something like that?
Despite the $87 Billion loan, Lehman still couldn't manage to pay its bills. It seems that Lehman Brothers still owed Freddie Mac a $1.2 Billion, due yesterday.
After the market closed Friday, the 12th bank of the year was taken over by the FDIC.
All year long the Federal Reserve has been swapping out the liquid treasury bonds in its portfolio for somewhat questionable mortgage-backed securities from investment banks. This week the Fed expanded this program to include largely worthless and illiquid securities from banks.
So why is this important? Because the Fed portfolio was largely already poisoned with illiquid assets and the treasury bonds were mostly depleted. Which brings up the problem of how the Fed can expand this program. The answer: more borrowing by the treasury.
The Treasury has added almost $300 billion in extra borrowing to offset the impact of central bank programs aimed at helping troubled financial markets and the economy, Karthik Ramanathan, director of the Treasury's debt management office, said in the text of a speech at a conference in New York.What this means is that the Treasury is borrowing money from the Federal Reserve, at interest that the taxpayer is paying, that it doesn't need to borrow. To put it another way, the taxpayer is now subsidizing the Federal Reserve so it can bail out the Wall Street banks.
Russia's stock market crashed this week. You didn't notice? In fact Russia completely suspended all trading for two days. Both the Russian government and the Chinese government are now actively buying equities in order to prop up their markets.
As the credit markets seized up, interbank lending rates (ie LIBOR) literally doubled overnight.
All this caused Mayro Bloomberg to ask, who is going to buy our debt? He's not the only one asking - China is too.
BEIJING (Reuters) - Threatened by a "financial tsunami," the world must consider building a financial order no longer dependent on the United States, a leading Chinese state newspaper said on Wednesday.This nervousness at the increasing size of federal bailouts has caused our foreign creditors to demand higher interest rates on their loans due to the increasing chance of America going bankrupt. The market now judges our chances of going bankrupt at twice the levels of Austria, Finland and Sweden.
Which brings us to the massive government bailout that Paulson proposed on Friday.
WASHINGTON - The Bush administration is asking Congress to let the government buy $700 billion in toxic mortgages in the largest financial bailout since the Great Depression, according to a draft of the plan obtained Saturday by The Associated Press.This isn't just the largest bailout in American history, it's the largest in human history. It's a huge transfer of wealth from the working class to the investment class. Simple as that.
There is a winner in all this - foreign investors.
Further, since I assume the plan will apply to all mortgage debt, U.S. taxpayers will also be on the hook to bail out foreign institutions that loaded up on the financial sludge. However, once the government takes them off the hook, do not expect them to re-invest the windfall back into other U.S. dollar denominated assets. This get-out-of-jail free card will likely scare them straight. The global mass exodus from the U.S. dollar and Treasury debt is about to begin.If this bailout happens, not only will it fail to rescue the financial economy (like all the bailouts that have happened so far), not only will it fail to rescue the real estate market (like all the bailouts that have happened so far), it will end up making things worse (like all the bailouts that have happened so far).
What's more, it will ensure that America's near future will end in bankruptcy and the destruction of the dollar.
It's time to stop trying to avoid the consequences of our actions by pushing out the costs onto our children and grandchildren. It's time to do the moral thing and accept the consequences for living beyond our means for years and years.
The alternative, as being pitched by the Bush Administration, will only make things worse for the working American family anyway. We need to tell Congress "no" to this bailout, and we need to do it this week. Any other option leads to an inflationary depression in America that will start with the next presidency.