And Here Is What Happened When They Decided To Cut Loose

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Something about the proposed Paulson $700 Billion bailout doesn’t seem right. You have very smart people making sound arguments against it, but I’m starting to wonder if there is another motive behind the bailout.

I can’t help but think of Law 3 from the book The 48 Laws of Power by Robert Greene:

Law 3 – Conceal Your Intentions

Keep people off-balance and in the dark by never revealing the purpose behind your actions. If they have no clue what you are up to, they cannot prepare a defense. Guide them far enough down the wrong path, envelope them in enough smoke, and by the time they realize your intentions, it will be too late.

When I hear Paulson, Bernanke and Bush discuss the banking crisis, I can’t help but to think of this Law. Get the public hot and bothered over executive compensation or some other minor issues while the real plan unfolds. What is the real intent?

I did several more hours of reading and found an alternate theory which makes more sense to me. Granted I am an arm-chair economist, so I could be 100% wrong. I’ll do my best to explain my current thoughts.

  1. The United States runs a deficit to the tune of $2 Billion a day. To get the $2 Billion, we sell Treasuries. Most of the $2 Billion comes from China.
  2. Moving $2 Billion worth of Treasuries every day is not an easy task. The Federal Reserve hands this task out to Primary Dealers. Primary Dealers (PD) are large banks and investment houses. The Federal Reserve of New York has a full list of Primary Dealers.
  3. As the economy slows the projected annual deficit is expected to get large. By some estimates it could be as high as $1 Trillion next year. This means the PD’s will need to sell a lot more Treasuries to fund our government.
  4. Some PDs have already gone under and there is speculation that more failures may be imminent.
  5. If our need to sell Treasuries will be greater next year and there is the risk that we can lose a few PDs, then the government runs the risk of not having a way to fund itself. In other words, Paulson and Bernanke fear the next Primary Dealer failure could impair the ability of the United States to raise money.
  6. So the $700 Billion would go directly to the Primary Dealers to push Treasuries to make up for the projected $1 Trillion deficit. In exchange the PDs would then get to unload $700 Billion in toxic loans. Stressed banks that aren’t PDs would be left to implode and have their assets picked clean by the PDs.

This theory is my overview of many comments I read over on Ticker Forum in 2 threads:

The big question that is still left unanswered to me is why doesn’t the Federal Reserve of New York start finding new stronger financial institutions to become Primary Dealers? Are the banks that weak or are they out of time? The Federal Reserve is often called the banker of bankers. Doesn’t it make sense that they would back a plan that would show favoritism to their Primary Dealers?

This post is speculation, but it makes more sense that what I’ve heard from our leaders. How would most Americans respond knowing that our country is a slave to foreign bankers? Ignorance is an easier pill to digest than living within our means.

8 thoughts on “And Here Is What Happened When They Decided To Cut Loose

  1. I admit to knowing FAR less than you about the economy, so take this for what its worth. If they let the banks fail… wouldn’t someone (ie JP Morgan Chase) come in and get a really good deal (ie WaMu)?

    my only hope is that this all gets better by the time I am ready to retire.

    and thanks for the posts on the economy. you make the information palatable and I can actually follow along with what you say. YOU should write a book….

  2. Exactly. Businesses, be they banks or whatever, that have strong balance sheets can always acquire distressed businesses at the bottom for cheap.

    I worked for a multi-billion dollar telecom back in the day. They loaded up on debt and tried to acquire a very small business. The little business had no debt and declined the offer. My telecom went into bankruptcy and had billions in market cap wiped out. That little company walked into the bankruptcy court room and bought the telecom for pennies on the dollar – with cash.

    Today’s renters that are saving money and improving their own balance sheet will have similar opportunities in residential real estate. I plan to buy a silly-nice condo at the bottom. 🙂

  3. Jim

    Hmmm …I find it hard to buy this theory for a couple of reasons:
    1) $700 B released on the US economy is going to make treasuries cheaper and cheaper to foreigners, since it will force another drop in the US $.
    2) Someone will resell treasuries regardless. There may be additional consolidation as healthy banks continue to swallow unhealthy banks, but there will still be banks out there to play this role.
    3) As the market crashes further, more people will flock to treasuries as a risk free asset. This will drive returns further into the ground, but the alternatives are gold and cash.
    4) Finally, I think you give Paulson and Bernanke too much credit. You would expect people at their level to be 10 moves ahead, but they have been behind the curve at every move so far (e.g., subprime is contained, the economy is strong, blah, blah, blah). I think they had this plan worked out in advance waiting for the next crisis, but they are mainly just trying to save their buddies on Wall Street.

    If they really wanted to avert disaster they would buy up bad debt at the mortgage level. This action would inflate the value of the larger securities they are packaged in and would slow down the “base jump” in housing prices.

    Instead they chose to inject the funds at a higher level on the food chain, which benefits the banks directly …and they want to do it with impunity, giving the money to whoever they choose at whatever prices they decide upon.

    This could be to avert a disaster in T-bills, but I don’t buy it. They can print T-bills until such point that it becomes hyperinflationary …but this bill speeds up that process. Until that time, T-bills will be the only risk free asset and will always be sellable. Put another way, when they are no longer sellable I hope you have a gun to protect your $1000 and all the canned goods, because you will need it.

    Anyway, I don’t pretend to have all the answers either, but that is my 2 cents (at the moment).

  4. Jim

    Fannie Mae, whoa, whoa, she slipped away
    Freddie Mac caught up to her the very next day
    They got the money, hey, you know they got away
    They got nationalized and they’re still running today
    Singin’ go on take the money and run…

    Sorry, I couldn’t resist! 🙂

    As a general comment, does it blow your mind that 8 years of a Republican president and 6 years of a Republican congress we will end up with a country that is more socialist than at any other previous period in our history?

  5. Jim – nice parody.

    As for my theory, it isn’t about saving the economy or the price of Treasuries. It is about saving a Primary Dealer (or several PDs) in order to facilitate the actual sale of Treasuries.

    In order to sell subs at Subway, you need to have someone working the register. The USA needs PDs to sell $2B a day or else.

    I think Paulson and Bernanke have bungled every move, but I can’t discount the fact they have inside information on the financial health of some key institutions and that could be driving their motives now.

    We will see soon enough.

  6. Jim

    Currently the banks won’t loan to each other due to counterparty risk (same reason you sold your 2*shorts). If treasury buys up their bad debt, then (they hope) banks will loan to each other again.

    I don’t know if this plan will solve this problem though …many banks are technically insolvent, so if someone buys all their bad debt they will have to admit they are insolvent …unless the Treasury pays a premium beyond their true value.

    That’s the rub …
    – if they pay true value very few banks will sell (they will be proven insolvent).
    – if they pay enough that the banks remain in business, then they probably paid too much (i.e. the taxpayer gets shafted).

    So Paulson wants to pay too much, so he can (at taxpayer expense)…
    – unclogs the credit markets
    – helps bank buddies stay in business

    Sure, in the end it keeps more PDs (t-bill middle men) around, but they could find another method of selling T-bills and that is still 4-5 innings in the future before that becomes a problem. They are currently in the 2nd inning, down by 5 and just trying to get someone on base at the moment.

    Using your Subway metaphor, your bank is closed and your buddy is the cashier. You can replace the cashier if you really need to, but you really want to keep your buddy working …and you really need that damn bank opened NOW!

    Again, just my 2 cents …have a great weekend MAS!

  7. Great summary. You are correct. In the end, how close to true value for the toxic debt will dictate how this all plays out.

    You have smart people on both sides of this issue. Mish and Denninger are opposed to the bailout. John Mauldin is for it. Both sides think the other option is suicide. And both sides are smarter than me.

    This may be a case where there is no winning hand.

  8. Jim

    I would add Krugman and Roubini to your list of smart people I listen to …they favor some sort of bail-out, but hate the Paulson Plan.

    I think you are right that there is no winning hand though …it’s like your unemployed brother stole $50,000 from you and already spent it. Do you have him thrown in jail or just eat it? Either way, the money is gone and life is going to suck for everyone involved.

    Of all people, I just heard Nancy Pelosi came up with some idea that will protect the taxpayers interests (heard on CNN). Will she prove smarter than our favorite Economists (or maybe take one of their ideas)?

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