Why the bailouts won't work

Each morning lately brings new revelations about how the U.S. government is trying to save Wall Street and the economy from falling into complete disarray. Examples from Friday's (9/19/08) news: a ban on short selling, the government guaranteeing money market funds up to $50 billion and promising to buy distressed mortgages from banks and institutions. Prior to these plans, the Fed announced it would bail out the huge mortgage guarantors, Fannie Mae and Freddie Mac. Bob Prechter supplies some much-needed perspective about the plan to bail out Fannie and Freddie in his most recent Elliott Wave Theorist.

Excerpted from The Elliott Wave Theorist, September 2008

More Q&A: Righting Some Misconceptions About The Latest BailoutNow that the government is bailing out Fannie and Freddie…

The government is not “bailing out Fannie and Freddie.” If these companies were allowed to fail, all that would happen is that creditors would divvy up their assets and sell them off, taking their lumps in the process. The speculators in credit default swaps (CDSs) who were right would justly win their bets, and the losers would have to pay. If the losers over-promised, they would have to sell off their own assets.

So whom are the feds bailing out? They are bailing out the creditors who bought the IOUs that these companies created and the insurers who collected premiums on insurance against a fall in the value of Fannie and Freddie’s mortgages and mortgage-backed bonds. The guilty parties won’t have to pay, and the Chinese government, the “top foreign holder of Fannie Mae and Freddie Mac bonds,” won’t have to learn a lesson about investing.

Politicians are shifting all that greed and stupidity onto the innocent, the by-definition prudent, American taxpayer and saver. To be even more precise, the government is bailing out the dumbest creditors. Smart ones got out early. As EWFF reported in July 2004, “The European Central Bank has already eliminated its holdings of bonds issued by Fannie and Freddie and urged other European banks to do the same.” Only the dumbest investors own this stuff, and the government is disallowing them from learning something useful. In exchange, it is teaching taxpayers and savers a brutal lesson in civics.

Wasn’t the bailout necessary to save the financial system?
Government officials and newspaper editorials, even those from skeptical writers, have been unanimous in claiming that a bailout, no matter how unpleasant, was “necessary.” But this is nonsense. The only thing that has changed, the only thing the government can ever change, is who pays. A week ago, people on the hook were speculators who voluntarily took responsibility for losses when they grabbed the opportunity for gains.

In fact, they have already booked years of gains, in the form of interest payments, along the way. Now, those on the hook are people who had nothing to do with the transactions in the first place. This bailout will drain money from people who are solvent and thereby damage the financial system more in the long run.

Producers and savers are the very people upon whom recoveries depend. By shifting the losses onto them, the government has now assured the ultimate devastation of the entire financial system. The bailout is not just unnecessary; it is another disaster.

Don’t many banks and funds have supplemental insurance to protect themselves?

Tons of it. Insurers have written $62 trillion worth of credit-default swaps. Banks have private deposit insurance. But you have to understand: These seeming guarantees have been part of the problem, because they have given speculators a false sense of security. Insurers wrote them when they believed the system was risk-free. CDSs became speculative vehicles, and the liabilities at this point are way too big to cover. Additionally, many of the deals are complex and nearly opaque as to who owes what to whom. Insurance is always available when there is nothing to fear, but it goes away when big trouble looms.

A subsidiary of Warren Buffett’s Berkshire Hathaway company just announced (9/10) that it will stop offering supplemental deposit insurance to the 1500 banks it was covering. As you can see, it offered the insurance to make money, not to protect banks. Now that banks need protection, there is no more insurance. Still, one can hardly blame an insurance company for getting out of the business. Insurance is supposed to provide a way for prudent people voluntarily to socialize their risks. But when profligacy puts everyone at risk, insurance is impossible. In a depression, insurance companies stop insuring because they fail. Washington Mutual bank, reportedly in trouble, is 7.5 times as big as the biggest bank that’s ever failed in the U.S. Buffet is just acting ahead of the disaster. The government never acts ahead of disaster, so when the FDIC stops providing insurance, it will be because it has no choice.