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Do we really want to socialize our financial system? [Part 3, updated]

vincent.jpgSeptember 29, 2008
By Vincent Gioia

Speaker Nancy Pelosi has released a draft proposal of the "save the United States" plan for government to nationalize a large segment of our economy, seemingly agreed to by those we had assumed represent Democrat opponents. Here are the sound bites we will here on TV about the plan:

"The Three Phases of a Financial Rescue with Strong Taxpayer Protections

  • Reinvest in the troubled financial markets ... to stabilize our economy and insulate Main Street from Wall Street
  • Reimburse the taxpayer ... through ownership of shares and appreciation in the value of purchased assets
  • Reform business-as-usual on Wall Street with strong Congressional oversight and no golden parachutes."

Don't believe it.

For good measure Pelosi also tells us that giving government control by tax payer acquisition of "toxic" mortgages will benefit Americans in the following ways:

Protecting taxpayers by ensuring THEY share IN ANY profits

Cutting the original $700 billion requested for the ‘bailout' to $350 billion (not an insignificant amount of money); and conditions future payments on Congressional review

Giving taxpayers an ownership stake and profit-making opportunities with participating companies (meaning; it gives the government an opportunity to receive more money to squander away on ‘feel-good' programs in the future - tax payers will never actually get any money to pay their bills)

‘Guaranteeing taxpayers are repaid in full' if other protections have not actually produced a profit (from whom?)

Allowing the government to purchase troubled assets from pension plans, local governments, and small banks that serve low- and middle-income families" (thereby further enlarging government socialistic take over of businesses)

Limiting compensation of the new managers (while doing nothing to recover the millions scammed by previous managers like Democrats Raines, Johnson, Gorelick, and the politicians, largely Democrats, who were rewarded for not interfering with management of Fannie Mae and Freddie Mac). Of course there is other window dressing to give the appearance the government "will monitor against corruption" to make it more palatable to a gullible public.

Now let's consider what is not told to the public about the government take-over scheme.

First, the $350 or $700 billion fund will likely be managed by either Goldman Sachs (where Democrat Paulson came from) or Morgan Stanley, for a fee, of course, but the government will not pay the low, real-world prices for the bad debt. The market price of the bad assets is what Bernanke calls a "fire-sale" price; and "that is bad." (Why?)

The banks owning the securities will be forced to sell at fire-sale prices, which don't improve their capital position. Note also, it is the government requirement that banks use the real world fire-sale prices to identify their assets that led to the cash and credit problems leading to the so-called "crisis" in the first place, but the government wants the tax payer to pay the "hold-to-maturity" price for the securities. That price, as you might guess, is much higher than the "fire sale" (market) price.

What is the "hold-to-maturity" price? No one knows! Paulson and Bernanke argue that many of the mortgages will come good once the crisis is over, and that the assets the taxpayer buys today at "hold-to-maturity" price might actually be a good investment in the proverbial "long term"; what do you think now that you know this? Are Paulson and Bernanke making any sense paying higher than market price for securities bought by the government?

In principal I don't see anything wrong with Government coming to the rescue of financial institutions where mismanagement has caused risk of failure in a way that jeopardizes the stability of the entire financial system. However what is wrong, partly because is both a violation of public trust and rewards professional incompetence, is that it uses taxpayer money to benefit managers and owners of these companies rather than the taxpayers.

We now know that these financial firms manufactured, distributed, and inventoried near-fraudulent debt (financial securities) at 30:1 leverage. Investors don't want to buy these securities at the current high offer price, and if the securities were priced and bought at a realistic market clearing price, it would likely bankrupt the sellers.

Paulson and Ben Bernanke are orchestrating a plan that provides huge sums of taxpayer money to Paulson's buddies at Goldman Sachs, along with various others, including Morgan Stanley, to purchase the unwanted securities in a manner that directly enriches the management and shareholders of these nearly bankrupt companies. With AIG it was demanded that taxpayers be rewarded with any profits of the rescue but the current plan sticks taxpayers with the downside, while management, creditors and shareholders of these firms reap tens of billions in stock and bond appreciation.

Paulson and Bernanke could have handled the financial system as they did with AIG by taking ownership (I don't agree with this practice but simply note the difference in the treatment of AIG and Goldman Sachs/Morgan Stanley) but then their buddies would not have gained. Instead, of rescuing the financial system in a responsible way, they rescued their rich friends who created the mess and left the taxpayer holding the bag.

Unfortunately because I like Christopher Cox, SEC Chairman, I believe the SEC was complicit in falsely pointing the blame for the near-demise of these financial institutions at short sellers who are a convenient scapegoat, but this was merely a diversion.

The real causes of the demise of these firms were:

Mismanagement by applying 30:1* leverage to volatile illiquid mortgage assets that these firms manufactured, distributed, and inventoried;

The failure of regulatory oversight, in allowing these firms to use 30:1 leverage on collateral known to more than occasionally suffer 30% to 50% downside fluctuations (real estate);

The failure to respond properly to the demise of Lehman and AIG and artificially increasing the value of share prices of distressed companies in a way that enriched management and shareholders at the direct expense of innocent market participants, their financial competitors who were prudent in avoiding overexposure to leveraged toxic debt, and at the expense of free market principles.

The SEC says that it is not responsible for market manipulation but John Mack at Morgan Stanley and Paulson's colleagues at Goldman Sachs have received tens of millions of upside stock profit in just two days.

All other businesses that take risks that don't work out fail and are not bailed out by the government. The difference I see here is that nationalizing these small businesses doesn't have the same socialist effect on our economy as nationalizing the huge financial system.

Goldman Sachs is known as one of the most opportunistic and predatory firms on Wall Street. When Goldman Sachs identifies companies in distress it has a long history of rushing in and providing assets in return for majority equity stakes, thereby earning the upside for this risk ahead of the existing management or owners. Paulson was the direct beneficiary of Goldman Sachs business practices while CEO at Goldman. He made more than $500 million selling Goldman Sachs stock, tax-free, when he accepted the job as Secretary of the Treasury. Now that Goldman Sachs has a problem, Paulson wants to hand Goldman Sachs taxpayer money without demanding a controlling equity stake for tax payers from Goldman Sachs in return. The public should ask Paulson who he is really working for. Paulson should resign or be fired.

Instead of getting an honest explanation about what is occurring, we are now being sold a story manufactured by government officials who have been complicit in irresponsible behavior. The question is; are the American people gullible enough to buy it?

Note: This morning we woke to one of those headlines I just dread. Right there, on the front page of the New York Times, "Breakthrough Reached in Negotiations on Bailout."

"We have made great progress toward a deal, which will work and be effective in the marketplace," announced Treasury Secretary Henry M. Paulson Jr.

That's the same Paulson who this past July told us that "It's a safe banking system, a sound banking system. Our regulators are on top of it. This is a very manageable situation."

It's also the same Paulson who told Chinese officials last year "The reality of the situation is that an open, competitive, and liberalized financial market can effectively allocate scarce resources in a manner that promotes stability and prosperity far better than governmental intervention..."

Americans had a chance three years ago to prepare for and avoid the financial calamity we now have when John McCain co-sponsored legislation to provide more oversight of Fannie Mae and Freddie Mac. This bill if not obstructed by congressional Democrats would have prevented the situation which Paulson, Bush, Senate Majority Leader Harry Reid, House Speaker Nancy Pelosi and gullible Republicans want House want Americans to accept. All they had to do was pay attention to the only man vying for the nation's top job who wanted to do something about this, John McCain.

In the debate Barach Obama said he warned about this pending problem but that is totally untrue, he actually wasn't yet in the Senate then; just like his attempt to have voters believe he warned against the Iraq war despite the fact he was in the Illinois legislature when the Iraq war began and hardly had Iraq in his sights at that time.

*Banks generally loan money based on a ratio that allows lending 12 time the assets owned by the banks; however, banking practices raised the ratio to 30:1, thus lending much more money than they had in assets. Since much of the assets are in bundled mortgages which include mortgage loans doomed to failure because they were made to borrowers unable to repay the loan, as home prices fell, these securities became lower valued assets under accounting practices force by law. The effect was that bundled securities could not be sold and the banks and other financial companies, like Lehman, and including insurance companies like AIG, failed.

Vincent Gioia is a retired patent attorney living in Palm Desert, California. His articles may be read at www.vincentgioia.com and he may be contacted at This email address is being protected from spambots. You need JavaScript enabled to view it. .

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