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Friday, March 28, 2008

Bear Stearns Bailout Details

My previous post on the Bear Stearns Takeover has been pretty popular, according to Google Analytics. When economic ideas are applied to current events, it's easier for people to understand what is happening. Some mainstream media sources indicate a vague awareness that some funny business is occurring with the Bear Stearns bailout. No mainstream media source will give an analysis like the one I present here.

JP Morgan Chase increased its bid price for Bear Stearns from $2/share to $10/share. The details of the Federal Reserve loan guarantee were released.

Is JP Morgan paying $10/share for Bear Stearns, or $10/share for the Federal Reserve guarantee? The Federal Reserve bailout is a put option combined with a subsidized loan. The value of this loan/option is a lot more than $10/share.

This bailout isn't free. It's paid by everyone else as inflation. The Federal Reserve is printing new money and giving it to JP Morgan Chase to finance the bailout.

The bailout isn't an outright gift. It's a loan. The discount rate is a negative real interest rate. The assets underlying the shaky debt will increase in value at the true inflation rate of 7%-30%/year. Negative real interest rates are the equivalent of a massive subsidy of the financial industry.

Federal Reserve subsidized negative real interest rates don't show up as an expense on government bookkeeping. The Federal Reserve makes a profit when it "monetizes the debt". Every American loses his purchasing power due to inflation. The benefits of inflation don't accrue to the government, where new money could be spent on projects that benefit everyone. Instead, new money is printed by the financial industry via the Federal Reserve. The wealth stolen via inflation accrues primarily to the financial industry instead of the government.

People incorrectly blame the Federal government for inflation. Congress controls the Federal Reserve in theory but not in practice. Congress could repeal or amend the Federal Reserve Act at any time. However, it isn't politically feasible for Congress to reform the Federal Reserve. Most Congressmen don't understand the complicated issues. Lobbying by the financial industry guarantees that reform will never occur.

JP Morgan Chase is putting up $1 billion to buy the shaky debt. The Federal Reserve is putting up the remaining $29 billion. It is a 10 year loan. The interest rate charged is the discount rate, currently 2.5%. When the discount rate changes, the interest rate charged for the loan changes. The first repayment of principal isn't due for approximately 2 years. The rate at which the loan must be repaid is unspecified.

Normally, banks can only borrow at the discount rate overnight. The Federal Reserve Term Auction Facility is a recent invention. It allows banks to borrow for 1-3 months at the discount rate. JP Morgan Chase is getting a 10 year loan at the discount rate. That is a great deal!

The Federal Reserve is assuming all the downside risk, and JP Morgan Chase gets all the upside. If, after 10 years, the loans/assets cannot be sold for more than $30 billion, then JP Morgan Chase will assume the first $1 billion of losses and the Federal Reserve will assume the remaining losses. If they can be sold for more than $30 billion, then JP Morgan Chase will get all the upside.

However, the Federal Reserve and JP Morgan Chase are assuming no risk at all. In 10 years, there will likely be substantial inflation. The inflation will be far greater than the discount rate, the interest rate that JP Morgan Chase is being charged. It is practically guaranteed that, in 10 years, the assets backing those shaky loans can be sold for a profit, after compensating for inflation.

Suppose real inflation rates are 13%. This means that JP Morgan Chase is receiving a Federal Reserve subsidized bailout of $2.9 billion per year. If you use reconstructed M3 as your index of inflation, the inflation rate is 15%-20%. If you use the price of gold as your inflation index, inflation may be as high as 30%!

Borrowing for a 10 year term at the discount rate is a great deal! Where can I sign up? Why can't I borrow for 10 years at the discount rate?

JP Morgan Chase is using a 30:1 leverage ratio. They are putting up $1 billion and the Federal Reserve is putting up $29 billion. As an individual, if I want to buy stock on margin, I am charged an interest rate of around 8% and I can only use a 1:1 leverage ratio.

Further, JP Morgan Chase doesn't have to "mark down" these assets to the fair market value. As an individual, if I borrow to buy stock, I am forced out of my position via margin calls. This makes borrowing very risky, because there will eventually be an economic bust and declining prices. A bank doesn't have to "mark to market". It can remain operating even though it is technically bankrupt. Since real interest rates are negative, insolvent banks eventually profit via inflation. This is the whole point of the Level 3 Assets Scam.

This is the fundamental injustice of the US monetary system. Large banks can borrow at an artificially low interest rate. If individuals want to borrow, they have to go through the middleman of a bank, paying a higher interest rate. Banks and hedge funds get to borrow at the cheapest rate. Large corporations get to borrow at pretty attractive rates. Individuals and small businesses have to borrow at relatively high rates. This places individuals at a disadvantage compared with banks and large corporations. Even worse, individuals pay the cost of the subsidy in the form of inflation.

Individuals pay higher interest rates than banks. Individuals can't use high leverage ratios like banks. Individuals who borrow are forced out of their positions due to margin calls during an economic bust. Banks get to borrow cheaply. Banks get to use high leverage ratios. Banks can continue operating even when they're technically bankrupt. Banks receive a *MASSIVE* government subsidy. Banks are guaranteed substantial profits.

The financial industry is a parasite that leeches off the productivity of the rest of the economy. Banks have the unique power to print money. This allows them to enslave and buy out the rest of the society, via the Compound Interest Paradox.

The Federal Reserve bailout offer applies *ONLY* to JP Morgan Chase. It's unclear if another large bank would get an identical bailout offer, if they decided to also bid for Bear Stearns. Even if I could raise $1B in capital, I couldn't make a competing buyout offer for Bear Stearns. The Federal Reserve bailout is a key component of the buyout.

JP Morgan Chase is receiving a massive government subsidy, paid by everyone else as inflation. Does this mean JP Morgan Chase is a great investment? That isn't necessarily true. JP Morgan Chase management will pay themselves huge bonuses for their brilliant work. You really need great political connections to receive a massive government subsidy! Some leftovers will trickle down to shareholders.

The USA has an unfair monetary system. Once I understood the Compound Interest Paradox, I no longer wanted support a corrupt monetary system and a corrupt government. The US financial industry is *GUARANTEED* to be about 10% of the total economy. It's built into the rules of the economic system! The financial industry provides no tangible goods and services. Instead, they receive a massive government subsidy in the form of negative real interest rates.

The average person does not have the magic money printing power that banks have. This guarantees that individuals will always be slaves of the bankers. The only way to avoid supporting the Federal Reserve is agorism. Individuals need to use sound money and avoid paying income taxes.

Once you fully understand the corrupt nature of the US economic and political system, it is immoral to continue supporting it.

1 comment:

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This Blog Has Moved!

My blog has moved. Check out my new blog at realfreemarket.org.