[Reader-list] When the gamblers bail out the casino

[Jeebesh]

http://www.atimes.com/atimes/Global_Economy/JI23Dj06.html



  E pluribus hokum or

When the gamblers bail out the casino

By Spengler

Why should American taxpayers give US Treasury Secretary "Hank"  
Paulson a blank check to bail out the shareholders of busted banks?  
Why should the Treasury turn itself into a toxic waste dump for their  
bad loans? Why not let other banks join the unlamented Brothers Lehman  
in bankruptcy court, and start a new bank with taxpayers' money? Or  
have the Treasury pay interest on delinquent mortgages, and make them  
whole? Even better, why not let the Chinese, or the Saudis or other  
foreign investors take control of failed American banks? They've got  
the money, and they gladly would pay a premium for an inside seat at  
the American table.

None of the above will occur. America will give between US$700-$800  
billion to the Treasury to buy any bank assets it wants, on



any terms, with no possible legal recourse. It is an invitation to  
abuse of power unparalleled in American history, in which ill-paid  
civil servants will set prices on the portfolios of the banking system  
with no oversight and no threat of legal penalty.

Why are the voices raised in protest so shrill and few? Why will  
Americans fall on their fountain-pens for their bankers? If America is  
to adopt socialism, why not have socialism for the poor, rather than  
for the rich? Why should American households that earn $50,000 a year  
subsidize Goldman Sachs partners who earn $5 million a year?

Believe it or not, there is a rational explanation, and quite in  
keeping with America's national motto, E pluribus hokum. Part of the  
problem is that Wall Street, like the ethnic godfather in the old  
joke, has made America an offer it can't understand. The collapsing  
the mortgage-backed securities market embodies a degree of complexity  
that mystifies the average policy wonk. But that is a lesser,  
superficial side of the story.

Paulson's dreadful scheme will become law, because Americans love  
their bankers. The bankers enable their collective gambling habit.  
Think of America as a town with one casino, in which the only economic  
activity is gambling. Most people lose, but the casino keeps lending  
them more money to play. Eventually, of course, the casino must go  
bankrupt. At this point, the townspeople people vote to tax themselves  
in order to bail out the casino. Collectively, the gamblers cannot  
help but lose; individually they nonetheless hope to win their way out  
of the hole.

Americans are so deep in the hole that they might as well keep putting  
borrowed quarters into the one-armed bandit. They have hardly saved  
anything for the past 10 years. Instead, they counted on capital gains  
to replace the retirement savings they never put aside, first in tech  
stocks, then in houses. That hasn't worked out. The S&P 500 Index of  
American equities today is worth what it was in 1997, after adjusting  
for inflation (and a pensioner who sells stock purchased in 1997 will  
pay a 20% capital gains tax on an illusory inflationary gain of 40%).  
Home prices doubled between 1997 and 2007 before falling by more than  
20%, with no floor in sight.

As it is, many of the baby boomers now on the verge of retirement will  
spend their declining years working at Wal-Mart or McDonalds rather  
than cruising the Caribbean. Some of them still have time to tighten  
their belts and save 10% of their income (by consuming 10% less), plus  
a good deal more to compensate for the missing savings of the 1990s.

Altogether, they'd rather gamble, and if that requires a bailout of  
the house, they gladly will chip in to pay for it. After all, today's  
baby boomers won't pay for the bailout. The next generation of  
taxpayers will pay for Paulson's $700-$800 billion. If that enables  
the present generation to keep borrowing rather than saving, it is no  
skin off their back. If home prices continue to collapse, the baby  
boomers will die in debt anyway, working at low-paying jobs until the  
day before their funerals.

The homeowners of America hope against hope that somehow, sometime,  
the price of their one only asset will bounce back. The character of  
Mortimer Duke in the 1983 film Trading Places comes to mind. After  
losing his fortune in the frozen orange juice futures market, Duke  
screams, "I want trading reopened right now. Get those brokers back in  
here! Turn those machines back on! Turn those machines back on!" If a  
reverse takeover of the US government by Goldman Sachs is what it  
takes to turn the machines back on, the American public will support  
it. Sadly, there is no reason to expect the bailout of bank  
shareholders to have any effect at all on American home prices, which  
will continue to sink into the sand.

Contrary to what the Bush administration says, it is not the case that  
banks' troubled mortgage assets cannot be sold in the private market.  
Those are the so-called "Level III" assets that banks say they cannot  
value. But that is only a dodge that the banks use to postpone taking  
losses. There is a ready bid for these assets from hedge funds, in  
multi-hundred-billion-dollar size. The trouble is that the market bid  
is 25% to 30% below the prices that banks carry these assets on their  
books. Traders at Wall Street boutiques who specialize in distressed  
securities say that US regional banks regularly make discreet offers  
to sell private mortgage-backed securities (not guaranteed by a  
federal agency) at prices, for example, of 75 to 80 cents on the  
dollar. Hedge funds bid, for example, 55 to 60 cents in return.

On rare occasions, the bank seller and the hedge fund buyer will meet  
in the middle, although very few transactions occur. Although many  
banks are desperate to sell, they cannot accept the offered price  
without taking losses over the threshold of mortality, for write-downs  
of this magnitude would destroy their shareholders' capital.  
Investment banks typically hold about $30 of securities for every $1  
of capital, so a 3% write-down would leave them insolvent. Lehman  
Brothers classified 14% of its assets as Level III at the end of the  
first quarter; Goldman Sachs was at 13%. Why is Lehman bankrupt, and  
Goldman Sachs still in business? If Secretary Paulson, the former head  
of Goldman Sachs, had not proposed a general bailout last week, we  
might already have had the answer to that question.

For the Paulson bailout to be helpful to the banks, it must buy their  
securities at much higher prices than the private market is willing to  
pay. Otherwise it makes no sense at all, for the banks could sell at  
any moment to the hedge funds. But that is a subsidy to private banks,  
administered at the whim of the Treasury Secretary, without oversight  
and without the possibility of legal recourse.

Some Democrats in Congress are asking for some form of oversight, but  
it is hard to imagine how they might use it, for a Treasury with $800  
billion to spend would constitute the whole market bid for low-quality  
mortgage assets, and would set whatever prices it wished.  
Professionals with years of experience set prices on these securities  
with great uncertainty. How would an overseer determine if it had set  
the correct price? And if the Treasury decided to bail out one bank  
(say, Goldman Sachs) rather than another, how would the overseer judge  
whether that decision was judicious, politically motivated, venal, or  
arbitrary?

Opposition to the Treasury plan is disturbingly thing. Bloomberg News  
on June 21 quoted the Democratic chairman of the Senate Banking  
Committee, Christopher Dodd, saying, "I know of nobody who is arguing  
over the amount of money or even about that the secretary ought to  
have the authority to purchase these toxic instruments, these bad  
debts."

Why the taxpayers of America would allow their pockets to be picked in  
this fashion requires a different sort of explanation than one finds  
in economics textbooks. My analogy of gamblers taxing themselves to  
bail out the casino is inspired, in part, by a remarkable new book by  
the Canadian economists Reuven and Gabrielle Brenner (with Aaron  
Brown), A World of Chance. In effect, the Brenners re-interpret  
economic theory in terms of gambling, showing how profoundly gambling  
figures into human behavior, especially in such matters as so-called  
life-cycle investing. The 50-ish householder who has not made enough  
to retire may take outsized chances, considering that as matters  
stand, he will work until he drops dead in any case. The Brenners write:

If people reach the age of fifty or fifty-five and have not "made it,"  
what are their financial options to still live the good life? Except  
for allocating a few bucks to buy lottery tickets, it is hard to think  
of any other option. If people find themselves down on their luck and  
see no immediate opportunities to get rich, what can they do to  
sustain their hopes and dreams? Allocating a fraction of their  
portfolios with a chance to win a large prize is among the options.  
And when people are leapfrogged - that is, when some "Joneses" who  
were "below" them jump ahead - how can they catch up? They will tend  
to challenge their luck for a while, taking risks that they might have  
contemplated before in business, financial markets, and other areas  
but did not follow up with action.

A World of Chance undermines our usual view of "economic man" and  
substitutes the angst-ridden, uncertain denizen of a world that offers  
no certainties and requires risk-taking as a matter of survival. I  
hope to offer a proper review of the work in the near future. As my  
marker, though, permit me to leave the thought that for providing a  
theoretical foundation for the counter-intuitive behavior of American  
taxpayers, the Brenners deserve the Nobel Prize in economics.

Alas for the gamblers of America: they will tax themselves to keep the  
casino in operation, but it will not profit them. Where, oh where, is  
America's Vladimir Putin, who will drive out the oligarchs who have  
stolen the country's treasure and debased its currency?