Let Them Go Bankrupt

From Obama’s honest and humble speech today:

Just as black anger often proved counterproductive, so have these white resentments distracted attention from the real culprits of the middle class squeeze - a corporate culture rife with inside dealing, questionable accounting practices, and short-term greed; a Washington dominated by lobbyists and special interests; economic policies that favor the few over the many. And yet, to wish away the resentments of white Americans, to label them as misguided or even racist, without recognizing they are grounded in legitimate concerns - this too widens the racial divide, and blocks the path to understanding. And this, in the midst of what looks to be one of the fastest cascades into depression that we’ve seen in more than half a century.

Cynematic’s earlier post has done the hard work: she has outlined in awesome details the various nefarious dealings that have gone on in the past week, the repeated attempts by one UNELECTED government employee to systematically weaken the United States. There have been, in just over one week… ONE WEEK… no less than 5 separate actions by Bernanke to bail out the very financial institutions that have brought us to this point:

(1) Friday 3/7: $200 billion short term loan program
(2) Monday 3/10: An additional $200 billion short term loan program
(3) Sunday 3/16: $30 billion credit line to help JP Morgan take over Bear Stearns
(4) Sunday 3/16: Expansion of last weeks short term loan program, now with no limit!
(5) Tuesday 3/18: ¾ point drop in interest rate

That queasy feeling that we’re all starting to get in our stomachs – that would be the feeling that we’re seeing America’s future going bye-bye towards the distant horizon.

But men far smarter than us are telling us that this is just a liquidity crunch, a credit crunch, that these are banks too big to fail.

I’ll spell it out in three words: they’re fucking wrong.

If we look at this problem superficially, it is a liquidity crunch. Let's deconstruct the subprime mess: subprime mortgages were mortgages given to people to buy homes they could not afford. In addition, many of these mortgages had adjustable rates and were interest only. This created a true moral hazard (btw, have we been counting how many times this phrase has popped up in the news over the past two weeks?): when the rates reset and/or housing prices dropped, there was absolutely no incentive to continue to pay into the mortgages. Not only were the payments now beyond what the original borrower could afford, their debt in the home now exceeded the value of the home. So borrowers start to walk away from their homes, leaving the homes to be foreclosed upon.

Now all of these subprime mortgages were gathered up and turned into asset backed securities (collateralized debt obligations or CDOs and collateralized mortgage obligations or CMOs are two kinds of asset backed securities) that were sold to the world at large. These asset backed securities act like bonds: you pay money to own the security and in return you get a monthly payment. But the payments aren’t guaranteed: they fluctuate, depending on how much the original mortgage holder is paying on his mortgage. When a borrower stops paying his mortgage, the asset backed securities also stop paying out.

Now, lots and lots of financial institutions (like the structure investment vehicles or SIVs) bought up lots and lots of these asset backed securities. In fact, they lurved these securities so much that they borrowed money to buy them. And, believe it or not, they used the securities as collateral on the loans they were taking out to buy them. When the securities stopped paying out, the value of the securities dropped, which violated certain ratio requirements in their loan agreements. So the banks that lent these financial institutions money made “margin calls”, basically demanding that more collateral be put up for the loans, or else the borrower would be in default.

When a financial institution gets a margin call, and they have no more assets to use as collateral, their only option is to dump all of those asset backed securities that they had bought. But if everyone is selling all at the same time, then prices go to shit. In fact, prices go so badly to shit, that you almost can’t sell these assets anymore. This is the liquidity crunch.

At the same time, all those banks that had lent money to the financial institutions to buy the asset backed securities? They’re in trouble too, because defaults are bad news. Remember, banks are not lending out their own money, they are lending out depositor’s money. And whereas banks profit from only the interest payments, when they lose a loan, they lose the interest and the principal. Banks get nervous, they stop lending. This is the credit crunch.

Now here’s the big secret. All these financial institutions and banks and lenders and borrowers and investment vehicles &c, &c….. they’re all the same group of people. Even worse, sometimes, they were the same people. The end of the Glass Steagall Act in 1999 meant that commercial banks could be investment banks and vice versa.

It was just one big incestuous orgy – when the money was good.

Short term gains for them, long term losses for us.

So I’ve just argued that there is a liquidity crunch and a credit crunch, so why shouldn’t Bernanke be doing just what he is doing? Because, ultimately, the liquidity and credit crunch mostly affects a bunch of large financial institutions that have spent several decades reaping fistfuls of fortune from the structure they built. I’m not going to deny the trickle down effect of financial institutions going bankrupt, but wait until I show you how much more devastating inflation is going to be compared to the effect of losing 300, 400, or 2000 points on the Dow Jones Industrial Average.

What Bernanke is doing with his 5 step (and going on 10 step) plan to save the investment banks is systematically destroying the value of the American dollar. He is drastically cutting interest rates (to 2.25% as of today), which helps you if you are a borrower, but helps you nought at all if you are a saver. The Central Bank is taking on a huge amount of risk from all these short term loans they are giving out – because they are taking in mortgage backed securities as collateral. The same mortgage backed securities that the open market has already said was worthless. If these loans are not repaid, or if the Fed simply runs out of money to bail out another Bear Stearns, their only option would be to print money, further devaluing the dollar, driving up inflation.

Inflation is not just the price of bread and oil and gold going up. It is also assets appreciating in value. I know this seems counter-intuitive, but at some point, the dollar is worth so little, that a house that had been losing its value can’t lose any more value, because it’s priced in a worthless currency. But this appreciation comes at a cost. Something has to get devalued – our labor. When the US dollar loses value, so does the value of the work we do. Every dollar that we earn has less purchasing power. We are dooming a whole generation of today’s earners to prop up the value of those who have already earned and who already have assets.

Bernanke should have let Bear Stearns Fail.

What about banks being too big to fail? Although theoretically though not empirically true, what about the great secret that nobody is talking about? There is this great thing in bankruptcy called preference avoidance, which basically says that if you’re in bankruptcy, or insolvent, you must have known for some time. Therefore, any payments made to outsiders in the 90 days before filing bankruptcy or to insiders in the year before filing bankruptcy can be voided and the money has to be returned to the company to pay all the creditors and shareholders of the bankrupt company.

Guess who got paid billions of dollars in compensation at the end of 2007 for a lousy year of performance. Oh that’s right, Bear Stearns employees. 

If Bear Stearns had been allowed to go bankrupt, all of this money could be avoided and reclaimed. And don't forget the shareholder suits. You mean get the money from the executives steering the Titanic instead of the government?! What a shocking concept.

They’ve already had their cake. Now it’s time to let them go bankrupt.

The Candidates Need New Economic Plans What’s out there is not enough.

Because we’re in the deep doo-doo now:

• start by restoring the Glass-Steagall Act, one small step to prevent the financial shenanigans that have created all this havoc.
• increase the capital gains tax (at 15%, compared to the high 20s – 30% average income tax rate), which would shift the incentive back to labor and away from stupid attempts to securitize everything (and tax compensation schemes designed to look like capital gains).
• more transparency is always good (especially for the credit rating agencies).
• reign in Bernanke.

Steam is coming out of Kady's ears over at Loaded Dice.

Comments

[Michelle]

Please read past the headlines. While I appreciate the fact that you are well informed, its surface information! Rumors started the demise of Bear Stearns, and you drank the Kool Aid. Most of the 7000 employees loosing their jobs at Bear Stearns are "regular" employees who make between 60K-90K a year (including their bonuses). Talk about a recession, where will these 7000 people find jobs, they were innocent workers doing their best to provide for their families.
If JP Morgan had not stepped in and used the $30 Billion federal assistance to buy Bear Stearns, what do you think the market would have looked like yesterday and today? Where would Lehman be? Where would Merrill be? Talk about a domino effect!
Try thinking and becoming more informed before you speak.

[KL]

Michelle,

You are absolutely right that there are huge numbers of regular employees at Bear Stearns who would have lost their jobs had it filed for bankruptcy. However, (1) I don't believe that negates my premise that the pain about to be felt across the United States from a devalued dollar is going to have a far greater impact and (2) if you look at the news

http://www.reuters.com/article/gc03/idUSWEN454420080317

http://money.cnn.com/2008/03/17/news/companies/job_cuts/?postversion=2008031816

the sweetheart deal that JP Morgan made is not exactly expected to stem the tide of pink just around the corner.

In the end, bad bets are bad bets. You have to settle up sometime. That, or Vinny can come and break your leg.

[debbie - i obsess]

Damn, Kady. *bows*

You sure can hack it.

[Alton J. Jones]

My blog, How To Get Good Credit Gab, provides the opportunity to share thoughts, ideas and experiences about obtaining good credit and emphasizes the importance of building and maintaining good credit and the perils of personal financial mismanagement.

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[Lawyer Mama]

Kady, you need to explain this to John "I don't understand economics" McCain.

Oh yeah, guess where Bear Stearns chairman was when this fire sale/imminent collapse went down? At a bridge tournament. I know this because my mother was there too....

Oh, about the 90 day thing. Normally, payments made "in the ordinary course of business" aren't considered preference payments that have to be returned. Bonuses, however, are. So the ordinary worker making 60-90k isn't going to be affected in the way the head honchos are. Presumably, a lower level employee is making the majority of his/her salary from regular wages.

[cynematic]

Brazilliant, Kady. I was hoping you'd riff off my Recession for Poets Who Skipped Econ 101 post. You broke it down like nobody's business.

And absolutely, I think we need to reintroduce the concept of accountability to executive pay and bonuses and tie it to performance, stat. Enough of the pillaging of taxpayers and hollowing out people's pensions. (And Shrubya wanted to make Social Security an IRA-like account?!?!?! WTF??? 1) have you taken a look at your mutual fund-ish 401k or IRA lately, and 2) I guess Bush wants old people to live off cat food, or something.)

Mozilo (of Countrywide) needs to go down, Schwartz of Bear Stearns, anyone else who helped create and profited ridiculously from this mess and is still living free and easy, ready to come back another day and continue with the pillaging, needs to be stopped. And slapped.

[debbie - i obsess]

And -- oh, what was his name, the one who ran Enron into a deep-ass hole and got away? um. doy! nevermind - he died! of a heart attack.

how's them zillions of apples treating ya now, Kenny boy? not so much useful in hell? *shocked*

[debbie - i obsess]

oh, and I may I note that this is interesting - that K. Lay was on the verge of collecting a large chunk of lettuce from an investment with Goldman Sachs?

Probably good he hadn't invested that dough with Bear Stearns, eh?

http://www.washingtonpost.com/wp-dyn/content/article/2006/07/05/AR2006070500523_2.html

[nieuwe verzekering]

I agree this is really interesting and helpful report, provided data explained in this report is reliable and true.