the destruction of the culture of accountability: a simple economics lesson part two

Last time we left off with large investment banks trying to pawn off these shitty mortgages to whoever would take them. From here, the Federal Reserve decided to take a number of bold steps beginning in the summer of 2007 to try to fix the situation. The first was to lower the rate that banks could borrow directly from the Federal Reserve. You see, a bank borrowing from the Federal Reserve used to be like a professional sports team holding open tryouts: you know the situation was in incredibly bad shape. The move to lower the rate encouraged a few of the more desperate banks to begin applying for loans from the Fed, yet the stigma involved with doing so was not removed. From there, the Fed proceeded to lower the federal funds rate from 5.75 to 1 percent, which it currently stands at now. The federal funds rate is simply the rate at which banks lend each other money. The reasons that banks would need funds is beyond the scope of this lesson. As this rate is lowered, it encourages people to save less(because they are getting a lower interest rate) and for them to invest and spend more.

After five rate cuts, the Feds realized that these moves were not working as well as they would have expected. From here, they began a series of moves that will be debated by both the financial community and general public for years to come. It began in late 2007 with the establishment of the term auction facility. As a side note, isn't it funny how they use incredibly vague titles to conceal the true nature of the beast? Basically, the term auction facility was used to "auction" off U.S. treasuries in return for the subprime mortgages that these large investment banks had acquired through risky gambles. In essence, the Feds quietly handed out a get out of jail free card to these large institutions through a fancy name and the ability to trade these US treasuries for cash if needed. This was far from the end though. In March, unsatisfied with the 70 billion they had already handed out, the Federal Reserve set up a new term auction facility to continue to hand out free money in exchange for worthless mortgages these companies had gambled on. It would be the equivalent of handing in all your failing grades in college and being able to get your tuition money.

March 16th will also remembered as a historic day. It began seven months of the destruction of the culture of accountability that we hold sacred in this country. It began with the federal involvment in the takeover of Bear Sterns. Essentially, Bear Sterns had run itself out of business by making far too many risky bets in subprime mortgages and was completely bankrupt. In turn, the Feds burned the midnight oil and eventually worked out a deal with JP Morgan in which they would assume a potential 29 billion dollars worth of losses from the subprime mess. Another handout gone wrong. In the next seven months, the Feds helped to bail out AIG, Merrill Lynch, National City, Fannie Mae, Freddie Mac, and Lehman Brothers. The defense time after time was that each of them was "too big to fail" or "too important to fail". All of them though? I'll admit that the rescue of Fannie and Freddie was probably necessary and Bear Sterns was possibly justifiable depending on who you talk to. As for the others though, it just seems to me that the Fed was overstepping its bounds by bailing out these companies. We live in a free market, capitalistic society. One of the assumptions of this society is that the companies that are the most productive using the least amount of resources will be the ones that stay in business. My question remains how can we justify that we live in a capitalistic society if we are not willing to accept the reprecussions of a major institution failing? Cries from far and wide said that without bailout packages we would enter another Great Depression. I would argue that the diversity of the financial instruments we have coupled with the lessons we learned from the Great Depression, the recessions of the 1970s, and major advancements in economic theory would have certainly prevented this. Without these packages, we would have certainly fallen into a recession. Workers would have lost their jobs. People ready to retire may have had to work several more years. It would have all come at a price that we will probably never know. And still I beg the question, was it better to destroy the fundamentals of market capitalism, the root of our economy, than to delay a recession for a year? That's all for now.



Until next time,

mh