Why the Bailout News is Failing to Prop Up the Market

Posted on October 2, 2008

In any restructuring or turnaround situation it is vital to understand what went wrong and what needs to be changed in order to restore stability and growth.

Unfortunately, the bailout that was recently passed by the Senate and now stands for a revote at the House, will do nothing in my opinion to restore stability or growth, since it does not address the issues which have caused this financial crisis, nor does it implement changes that are necessary to get us out of this crisis. Incidentally, the FDIC’s forced sale of weak commercial banks, such as WaMu, the consolidation of deposits into larger financial institutions, and the push for higher insurance on deposits, are about the only sensible things in the bailout proposal.


What Went Wrong?
So how did we get into this crisis? It’s actually quite simple: Lax lending policies, driven by a huge expansion in credit derivatives (such as CDS and CDO’s) and fancy securitizations, coupled with enormous leverage, led to to the creation of a massive credit ponzi scheme and the facilitation of gigantic financial fraud worldwide. Though there is a lot of focus put on the housing crisis in the US, the truth is that housing was really only the trigger or spark which started this financial crisis. If the financial system were not without weak foundations to begin with, if the financial system was not a house of cards, the housing crisis would not have had the effect it had and a larger financial crisis would have been averted.

To gain a good understanding of the credit ponzi scheme, as shaped by the enormous derivatives market, I recommend reading Traders, Guns & Money, by Satyajit Das. It’s available at Amazon.com.

But basically, the lending/credit situation was like this: Bank Peter borrows from Bank Paul to lend to John Doe, after which Bank Peter sells the loan (or the risk associated with that loan) to Hedge Fund Charles and on and on the circle goes. As long as asset/paper prices rise, via continued leverage and new people are brought into the pyramid scheme, the shadow banking system prospers. However, as in any ponzi scheme, at some point, some participants get worried and stop participating in the scheme, thereby causing the whole ponzi pyramid to collapse.

If you can believe it, the credit ponzi scheme, according to Das, led to the ridiculous situation whereby 70% of the lending in the US was done by different types of funds, with only 30% of lending done by traditional commercial banks with deposit bases. Since these funds do nothing more than gamble with other people’s money, is it any wonder that at some point the whole scheme would collapse.


Why the Bailout Won’t Work?

Ponzi Schemes Require an Infinite Amount of Money, So Throwing Money at a Ponzi Scheme Will Do No Good
The stupidity of the Paulson Plan is that you can’t fix a ponzi scheme by pouring in more money, since you need, in theory, an infinite amount of money to support a ponzi scheme. Considering the size of the shadow banking system, and the amount of leverage in the credit markets, $700 billion is surely a miniscule amount of money. It will be gobbled up by the shadow banking system and basically disappear overnight, as hundreds of billions of dollars already have disappeared since the collapse of Bear Stearns led to the new Fed lending rules.

Absolutely No Relief for the Main Street Housing Crisis

In addition, even though, the housing crisis was only the spark that led to this financial fire, fixing the housing crisis is still one of the most important things the government needs to do to begin a repair of the financial system. This is because housing the key component of the real economy and without a stable housing market, the real economy will continue to suffer. The financial system cannot recover if the real economy remains weak. Unfortunately, the Paulson plan does absolutely nothing to stem the housing crisis. The only way to do that is to provide systematic debt relief to households as we mentioned in a previous post, and as articulated in greater detail by Roubini (www.rgemonitor.com).


What Needs to Be Done

Once it is understood what caused the financial crisis, it is obvious that in order to fix the crisis a major restructuring of the banking system needs to take place, in order to place the system on a solid foundation. In other words, the financial system needs to rest on fundamentals, rather than on a ponzi scheme, supported by inveterate gamblers. Until the financial system is restructured and regulations are passed to reform the financial system, it’s doubtful we will see a sustained recovery.

Though the devil is in the details, the main things, I think that need to be implemented to ensure a long recovery are:

  • Provide Debt Relief to Consumers In Order to Put a Floor Under Housing Prices
  • Continued Sale and Fold Up of Failed Commercial Banks into Larger Commercial Banks so that strong Deposit Bases can Be Maintained Upon Which a Real Credit Market Can Begin to Grow Again
  • Continued Bankruptcy of Shadow Banks, like Hedge Funds, and a Strong Signal to the Market that These Ponzi Scheme Banks will Not be Saved
  • Pass Strict Legislation Eliminating the Use of Securitizations and other Debt Derivatives

    • Credit should only be allowed to be created by deposit institutions and all institutions should be required to keep the loans on their balance sheet.

  • Pass Strict Legislation Reducing the Amount of Leverage that a Financial Institution Can Carry
  • Oversight of the Treasury and Fed by People Who Do Not Have Conflicts of Interest with Major Financial Institutions
    Our financial regulatory bodies should not be run by Goldman Sachs, and other people people who played a key role in creating the credit ponzi scheme.

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