Bailout Nation (4 page)

The rescue of Lockheed in 1971 ($250 million) led to loan guarantees for Penn Central in 1974 ($676.3 million in loan guarantees), which paved the way for the $1.5 billion rescue of Chrysler in 1980 and then Continental Illinois Bank in 1984 ($1.8 billion loss). This led to the original mother of all government insurance payouts—the savings and loan (S&L) crisis of the early 1990s (total taxpayer cost: $178.56 billion), which led to the stock market rescue of 2000, and so on. Each bailout has had negative consequences, and the repercussions have often led to the next bailout. Each negative impact seems to have the perverse effect of making future bailouts less surprising and more tolerable—and therefore more likely.

The Federal Reserve's attempted rescue of the credit markets in August 2007 ultimately led to the $29 billion rescue of a single firm—the investment bank Bear Stearns in March 2008. The Fed not only was rescuing Bear Stearns but, indirectly, JPMorgan Chase, the largest derivatives counterparty of Bear Stearns. More important, the Fed was also protecting its original decision to rescue the credit markets. The housing bailout package of July 2008 rationalized the interest rate policies of the early 2000s, and led indirectly to the nationalization of Fannie Mae and Freddie Mac, which not only cost $200 billion, but put more than $5.5 trillion worth of debt back on the books of the U.S. government. Then came the takeover of AIG ($173 billion and counting), the $700 billion Troubled Assets Relief Program (TARP), which featured the forced injection of $250 billion into the nation's largest banks. November 2008 brought another $20 billion capital injection into Citigroup (total $45 billion) and guarantees for $250 billion of its toxic assets. Bank of America also saw its cash injection upped to $45 billion and guarantees of $306 billion on its toxic assets. There was $30 billion for the automakers. 2009 saw a $75 billion rescue for homeowners, and a $770 billion dollar economic stimulus plan.

Perhaps it's best to stop calling these numbers “astronomical.” A better term might be “economic numbers”—dollar amounts so vast they dwarf time and space. When you are tossing around those kinds of numbers, what is another $800 billion program for mortgage-backed securities and credit-related assets? And as long as we still have some checks left, we might as well do a government-engineered takeover by JPMorgan Chase of Washington Mutual. The government tried to do the same with Citigroup and Wachovia, but Wells Fargo swooped in with a higher offer, suggesting that even in Bailout Nation, private capital still has its place.

As a nation, we went from never bailing out anyone to somehow finding a seemingly inexhaustible supply of bailout candidates.

I can't wait to see what the hell is gonna happen next month.

—President Woodrow Wilson
¹

 

 

A
s much as I tried to steer clear of writing a history of central banking, it was all but impossible. Any examination of bailouts in the United States would be incomplete if the role of the Federal Reserve System were omitted. I will endeavor to keep it brief and relatively painless.

It is crucial to understand the role of the Fed, and how it has radically expanded over time, if you are to have any hope of comprehending the modern era of Bailout Nation. Since March 2008, so many different financial bailouts have been funded directly by the Fed—into investment banks, government-sponsored enterprises (GSEs), brokerage firms, money market funds, even the overall stock market—that we could not discuss bailouts intelligently and avoid mentioning the Fed. It is front and center in this mess.

The role of emergency fixer was not part of the Fed's original mission statement. At the end of the eighteenth century, prior to the creation of a central bank, currencies from as many as 50 nations were circulating in the United States. A single currency, backed by a strong authority, was needed to maintain some semblance of order. For any young and growing country, this was a necessity.

As originally conceived, the central bank had a narrow task. It was brought into existence for eminently reasonable and defensible purposes: to establish financial order, to allow for the creation of needed credit for the country, and to resolve the issue of the fiat currency (money that has value by virtue of the government declaring it has value).

From those relatively modest monetary and fiscal powers, the Federal Reserve has evolved into something that would be unrecognizable to its founders. Under the guise of economic expediency, the Fed has grabbed power, dramatically widening the areas of its responsibility. Since the 1990s, the Federal Reserve System, a private corporation registered in the State of Delaware, has behaved as though it were in charge of anything economic—moderating the swings of the business cycle, maintaining interest rates, supporting the value of depreciating assets, even intervening in the stock market.

During the economic collapse and credit crises, there was a distinct lack of financial leadership in the United States. With President Bush's approval rating at historic lows, the White House showed little inclination to face the storm. As the many crises began heating up in 2007, the leadership vacuum was apparent. It was into this empty space that the Fed inserted itself, seizing more and more authority. It wasn't so much a power grab as a reluctant filling of the void. Steve Matthews, writing for Bloomberg, observed, “What started as a meltdown in the market for subprime mortgages has turned into a worldwide credit and economic crisis. Bernanke, now the Fed chairman, has responded with the most aggressive expansion of the Fed's power in its 95-year history.”
²

Paul Volcker, the well-regarded former Fed Reserve chair, was aghast at how much authority the central bank had claimed as its own. Following the Fed-financed shotgun wedding of Bear Stearns and JPMorgan Chase, he told The Economic Club of New York: “The Federal Reserve has judged it necessary to take actions that extend to the very edge of its lawful and implied powers, transcending in the process certain long-embedded central banking principles and practices.”
³

The Federal Open Market Committee (FOMC), the Federal Reserve's principal tool for implementing monetary policy, has even gone so far as to state that its charge includes preventing “panic” in the markets, a far cry from its official dual mandate of price stability and full employment.

None of these duties were ever part of the Fed's charter.

T
he fourth time's the charm: The institution we know as the United States Federal Reserve is actually the fourth attempt at creating a central banking system in the United States.

To truly appreciate how a limited facilitator of banks evolved into the most powerful central bank in the world, we need to understand a bit of its history. All three previous attempts at creating a central bank in the United States were met with equal measures of concern and controversy. Thomas Jefferson, the principal author of the Declaration of Independence, argued that since the Constitution did not specifically empower Congress to create a central bank, doing so would be unconstitutional. “Banking establishments are more dangerous than standing armies,” Jefferson famously declared, and went on to say:

The change from the Jeffersonian view toward the Federal Reserve to the modern public's attitude is nothing short of extraordinary.

Like Presidents Jefferson and Wilson, the American people genuinely feared giving this much power to a group of unelected, unaccountable private bankers. The fairly blasé response to the Fed's current expansion of its authority—and trillions in new Fed credit lines—is rather surprising. In light of the antipathy and worry previous central banks had historically evoked, the power grab by the Bernanke Fed and Treasury Secretaries Paulson and Geithner are all the more remarkable. Other than gold bugs and economists from the Austrian school, the public response has been tepid.

T
he first attempt at creating a central bank was made in 1791. The new nation needed a depository for the levies and taxes it collected, and the government required a way to take short-term loans to fill temporary revenue gaps. A simple fiscal institution was created and called the First Bank of the United States. But just to be safe, it had a 20-year charter, which expired in 1811.

Without the existence of a central lending authority, the War of 1812 left the underfinanced nation with a “formidable debt.”
⁵
Private banks issued an ever-increasing amount of notes, leading to a serious bout of monetary inflation. The need for some form of a central bank was readily apparent. Thus, the Second Bank of the United States was chartered in 1816, five years after the demise of the First Bank. It had more funding and therefore greater influence than its predecessor. While both banks were controversial, it was the Second Bank of the United States that was perceived as especially threatening. It became so powerful that “many citizens, politicians, and businessmen came to view it as a threat to themselves and a menace to American democracy.”
⁶

When the Second Bank's charter lapsed in 1836, there was hardly an appetite for a Third Bank of the United States. But as the young nation grew, its finance and banking system grew haphazardly. Lacking a coordinating central authority, the first hundred years of the country's financial development became a patchwork of private banks, notes, and currencies. Many individual states issued their own legal tender, and private banks had the authority to commission engravers to design banknotes. Insurance companies, railroads, import and export firms, and others all had a similar ability. The anarchy that ensued made the dozens of foreign currencies circulating in the republic's early days look almost organized. In
A Nation of Counterfeiters
, Stephen Mihm writes:

And those were just the legal currencies, notes, and specie. Counterfeiting was fairly commonplace. Estimates were that as much as 10 percent of all currency in circulation was fake.
⁸

Beyond forgery, bank runs were common, and bank failures occurred with increasing regularity. It was apparent that the financial system, left to its own devices, could not function properly. It was operating—quite literally—in the Wild West.