Someone Has to Pay

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Dean Baker
The Guardian Unlimited, March 31, 2008

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If the US taxpayer gets the pain while Wall Street keeps its gain, it's time for us to think about putting an end to those multi-million dollar salaries.

The bailout for the millionaires and billionaires who brought their financial institutions and the financial system to the brink continued last week. The highlight was the renegotiation of the terms of JP Morgan's takeover of Bear Stearns. The buying price went up fivefold, fetching Bear Stearn's stockholders $1.2bn instead of the $236m in the agreement brokered by the Federal Reserve last week.

While Bear Stearns shareholders may still have been unhappy about their losses (the stock had been worth more than ten times as much a year earlier), in reality this was a very generous gift from US taxpayers. As an inducement to carry through the takeover, the Fed gave JP Morgan up to $30bn in guarantees, in case the bank has to make good on Bear Stearns' liabilities. In other words, JP Morgan is being given the opportunity to do some gambling, with the taxpayers committed to making good any losses. The money that JP Morgan paid for this privilege went to Bear Stearns shareholders, not the taxpayers.

Some of Bear Stearns shareholders made out quite well due to our generosity. High on this list is James Cayne, Bears chairman and until recently, its chief executive. Cayne saw the value of his stock increase by almost $50m as a result of the higher price paid by JP Morgan. To put the taxpayer's gift to Cayne in some context, this is approximately equal to what the amount paid through the Temporary Assistance for Needy Families programme to 10,000 working mothers over the course of a year.

Of course, Cayne and the rest of the Bear Stearns stockholders are not the only incredibly rich people benefiting from the taxpayers generosity these days. The Fed's actions are reining down taxpayer money all over Wall Street. When Fed Chairman Ben Bernanke rushed in to save Bear Stearns, he made two other important policy changes. He indicated a commitment to protecting other major investment banks and he opened the Fed's discount window to the investment banks. These are both huge taxpayer subsidies to these titans of free market capitalism.

The story of the discount window is straightforward. The Fed is allowing investment banks, who are subject to none of the restrictions or disclosure requirements of commercial banks, to borrow at a government subsidized interest rate. Currently the discount rate is 2.5%. Those seeking to refinance mortgages, most of whom are probably better credit risks these days than the investment banks, may want to call Mr. Bernanke and ask for the same deal.

While the subsidy involved in the below market lending is easy to see, the commitment to support the investment banks is probably the bigger subsidy to the Wall Street crew. The basis story here is that the investment banks made commitments, mostly in the form of credit default swaps, that they lack the resources to honor. These credit default swaps are essentially a form of insurance. The investment banks promise to make payments to bondholders in the event that there is a default on the bonds they hold.

The banks were prepared to deal with an occasion default, but they don't have the resources to deal with the sort of large-scale collapse that we are now witnessing as a result of the bursting of the housing bubble. Mr. Bernanke has effectively told the banks' creditors not to worry, because the Fed will make good on these credit default swaps, even if Bear Stearns, Lehman Brothers, or Goldman Sachs can't.

This is a very nice deal for the investment banks, because they got the fees for selling the credit default swaps, not the Fed. And they were very big fees, making the banks and the bank's executives extremely wealthy. In effect, the investment banks sold insurance that they actually were not in a position to provide. Instead the Fed is providing the insurance, but the investment banks get to keep the money they got from selling the insurance: nice work, if you can get it.

This is yet another episode of the conservative "nanny state", the story of the how the government intervenes in the market to redistribute income from those at the middle and bottom to those at the top. In this case, the media would have us applaud Mr. Bernanke and the Fed for keeping the financial system from freezing up and preventing the economic chaos that would follow.

While the Fed deserves some credit for preventing worse financial distress in the face of the collapsing housing bubble, government handouts for the very richest people in the country are difficult to justify. In other areas, we usually expect to see some quid pro quo, for example serious regulations on lending and perhaps some restrictions to accomplish social goals, like a cap on executive compensation ($1m a year should attract a much more competent crew). Thus far, the rich have only been on the receiving end. It remains to be seen whether this will stand.


Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of The Conservative Nanny State: How the Wealthy Use the Government to Stay Rich and Get Richer (www.conservativenannystate.org). He also has a blog, "Beat the Press," where he discusses the media's coverage of economic issues. You can find it at the American Prospect's web site.