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Land of the Freebie

Welcome to America, now known as "Bail-Out Nation"...

THE LAND OF THE FREE is quickly becoming the "Land of the Freebie", most especially for members of that millionaire corporate elite which makes multi-billion dollar mistakes...with somebody else's money.

   This sorry state of affairs is now jeopardizing the Dollar's value, as well as its hard-won reserve-currency status.

   Once upon a time, American-style capitalism resembled a bare-knuckled fistfight – a continuous "Ultimate Fighting" match in which competitors would pummel each another until a victor emerged. But modern American-style capitalism is more like "arts and crafts" as practiced in Manhattan's pricier nursery schools.

   Every coddled kid's "artistic" creation – no matter how inept or ghastly it may be – elicits praise from the nursery school instructors. Indeed, every grunt elicits praise...and every boo-boo finds a Band-aid, quick.

   Outside the walls of the nursery school, however, capitalism is just as brutal and Darwinian as it has always been – perhaps even more so. But on the inside, the privileged kiddies never shed a tear without receiving an immediate hug and a "There, there. It's okay. It wasn't your fault...

   "And even if it was your fault, Uncle Ben will make it all better."

   As for discipline, you can forget it. The coddled capitalists of America's high finance never receive a slap on the wrist for any misdeed whatsoever. That would be child-abuse. Nor do they ever even receive a time-out for bad behavior. Worst case, punishment arrives in the form of a multi-million dollar severance package.

   Just who are these "nursery school" capitalists? They are the folks who receive millions of dollars each year to preside over public corporations and/or to speculate with shareholders' capital. That makes you and me the "somebody else" in "somebody else's money".

   American corporations are now crawling with these leeches. They engage in moronic speculation using other people's money, knowing that success will multiply their net worth dramatically and that failure will produce negligible negative consequences. For them, at least.

   And sometimes even failure produces success, thanks to the Federal Reserve's well-earned reputation for bailing out speculators.

   Because Wall Street's privileged speculators receive continuous coddling, they never really learn to behave themselves. Thus, when the multi-millionaire, Nobel-prize winning operators of Long Term Capital Management fell down and got an "owy" in 1998, Alan Greenspan's Federal Reserve rushed to their sides with Band-aids aplenty and emergency doses of financial Bactine.

   Easy Al slashed interest rates, while also cajoling Wall Street's leading banks to provide a multi-billion dollar bailout.

   Everyone called it a rescue plan for the capital markets. But the capital markets of 1998 required no rescuing. They had worked flawlessy; they had separated fools from their money. The fools in question, however, hailed from leading Wall Street institutions – and because the Wall Street institutions themselves stood to lose billions of dollars, LTCM would not be allowed to fail.

   In short, the bailout of 1998 was nothing more than government-sponsored collusion to rescue speculators from the consequences of their ill-conceived speculations. But the bailout succeeded in sparking a robust year-end rally, which made lots of people very happy...and Alan Greenspan very popular.

   Few folks cared that the bailout would lead directly to the largest stock market bubble of the preceding 60 years – a bubble that would produce an epic bust and erase hundreds of billions of dollars from the savings accounts of unsuspecting private investors.

   During the early years of the 21st century, the Fed continued to coddle Wall Street's privileged few, by slashing short-term interest rates to unnecessarily low levels. Who benefited? Lots of banks and lots of speculators...and lots of speculating bankers.

   The speculators devised numerous ways to capitalize upon ultra-cheap short-term financing. The speculators become overnight investment geniuses...borrowing short-term and speculating long-term. But the sort of genius that relies on short-term financing often perishes at maturity. Only a complete moron would borrow short-term and invest long-term, without preparing an emergency back-up plan or exit strategy first.

   Only a complete moron...or a coddled capitalist safe from the outcomes of his own reckless actions.

   Fast-forward to the summer of 2007 – the financial "Summer of Love" – and we find the same playpen of privileged kiddies making the same poopies in their diapers. All the biggest banks and brokers on Wall Street found themselves on the losing side of some kind of ill-conceived loan. They had put themselves on the hook for billions of dollars worth of loans that no individual of moderate intelligence would have ever issued with his own money.

   But not only had Wall Street's genius bankers issued billions of dollars worth of idiotic loans, they also packaged the loans into billions of dollars worth of idiotic mortgage-backed securities (MBS). The bankers then sliced, diced and reformulated various types of mortgages into various categories (tranches) of collaterized debt obligations CDOs and other asset-backed exotica. (For the full story, read about Investment Landfill here...)

   Why did the whiz kids go to such great lengths to repackage mortgage loans? Because it was a great way to move these things off their own companies' balance sheets, straight onto someone else's. By moving the loans elsewhere, the bankers could originate new idiotic loans, create new idiotic mortgage-backed securities for public consumption...and collect hefty fees at each step of the way.

   And if the Wall Street bankers couldn't find any real buyers for their idiotic mortgages and MBS, they would create non-real buyers called structured investment vehicles (SIVs). These SIVs would borrow money, just like a corporation, then use the money to buy mortgage-backed securities from the Wall Street bankers who created the SIVs.

   The process would be something like setting up a shell company to buy your house from you. As long as the shell company could obtain financing, it could easily buy your house, and might not even quibble about the price. (But that's a topic for another day...)

   Unfortunately, if the shell company suddenly lost access to financing, it would have no choice but to sell the house it bought from you at whatever price it could obtain.

   And that's now exactly where we are today.

   Typically, SIVs borrowed short-term money in the commercial paper market, rolling over their obligations every few months. In essence, therefore, the SIVs financed their long-term mortgage assets with short-term liabilities. The process worked brilliantly...until it stopped.

   In mid-August, the asset-backed commercial paper market tumbled into a deep-freeze, thereby eliminating the SIVs' primary source of funding. What happens to an SIV that cannot borrow in the commercial paper market, you may wonder?

  1. It liquidates its portfolio of mortgage securities at fire-sale prices;
  2. It goes knocking on the door of its original underwriter for emergency funding.

   Unfortunately, "Option 1" includes the distasteful side-effect of putting real-world prices on the billions of dollars worth of illiquid securities that still carry Wall Street's fantasy prices.

   Replacing fantasy prices with real-world prices would force many American financial institutions to fess up to the billions of dollars of additional mark-to-market losses – losses that the institutions are pretending they have not already incurred.

   "Option 2" therefore seems like the lesser of two evils, but only in small doses. Large doses of "Option 2" could cause serious indigestion on bank balance sheets.

   Enter the beefy "Master Liquidity Enhancement Conduit", or M-LEC, to save the day. This $80 billion fund-to-be, according to Bloomberg News, "will help SIVs, which own $320 billion of assets, avoid selling their holdings at fire-sale prices."

   Here's how the whole thing is supposed to work:

   Citigroup, Bank of America, JP Morgan and a few lending institutions to be named later will kick $80 billion into a fund. The fund will buy AA- or AAA-rated SIVs. Once these highly credit-worthy vehicles become the M-LEC's property, they cease to require financing from the commercial paper market. Nor, more importantly, will they need money from the lending institutions providing the $80 billion bailout in the first place.

   In effect, the banks are bailing out themselves.

   To the skeptical observer, therefore, the M-LEC merely puts a happy face on a grim inevitability. These banks would be on the hook for billions of dollars worth of financing anyway. So while pretending to "provide liquidity to the SIV market", the M-LEC is merely a ruse...and not even a very good one.

   For one thing, Goldman Sachs is conspicuously absent from the consortium of participating banks, even though former Goldman CEO, and current US Treasury Secretary, Henry Paulson, brokered the deal. Presumably, Goldman demurred because it has no interest whatsoever in stepping into the SIV tar pit that has ensnared its competitors...and will continue to ensnare its competitors.

   The second problem with the M-LEC ruse is that it will not commence operations for 90 days. That's an eternity in the commercial paper world where the SIVs are fighting for their survival. The 90-day lead-time reveals the insincerity – or incompetence – of the M-LEC proposal. Many, many SIVs could implode over the next 90 days – many more, in fact, than an $80 billion fund could hope to rescue.

   The entire SIV market totals more than $320 billion in assets, most of which relies on financing of less than 270 days. You do the math.

   The third glaring problem with the M-LEC ruse is that it will buy only AA- or AAA-rated SIVs, where the least of the problems reside. A genuine bailout fund would buy the most toxic securities first, and leave the highly rated stuff out in the marketplace to find real-world buyers. This curious aspect of the M-LEC, therefore, elicits the thought, "Gosh, maybe the banks are trying to support the prices of the highly rated stuff they haven't marked to market, rather than the lowly-rated stuff they don't own."

   Net-net, the M-LEC is a joke – a very bad joke. It is the kind of joke that attempts to rescue well-heeled speculators from the consequences of their recklessness...without providing any benefit whatsoever to the capital markets overall.

   The SIV world doesn't need a bailout; it needs a mark-to-market. If SIVs were reflecting their real-world pricing, instead of Wall Street's government-sponsored fantasy pricing, then REAL capitalists would be lining up to purchase them or to provide financing.

   The American capital markets do not need M-LECs, they do not need bailouts; they do not need rescuing...except from the "nursery school" capitalists who consider their wealth an entitlement, and who believe that their failures and their successes both deserve multi-million dollar paydays.

   The "Bail-Out Nation" is costing us all dearly. Every bailout undermines the Dollar's value and international prestige. That's a very heavy price tag.

   If the "Bail-Out Nation" does not allow its coddled capitalists to fail, the US Dollar itself might fail. And soon.

   To be continued...

Eric J.Fry has been a specialist in international equities since the early 1980s. A professional portfolio manager for more than 10 years, he wrote the first comprehensive guide to American Depositary Receipts, International Investing with ADRs. Today he reports on Wall Street from California for the renowned Daily Reckoning email service.

See full archive of Eric Fry articles

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