Bank Bailouts or Bull?

With all that's happened with the real estate and banking crisis, the word "bailout" has been plastered throughout the media with little discussion of exactly what a bailout entails. Supplying money to a distressed company does not by itself represent a bailout. It all depends on where the money is coming from, and whether or not a moral hazard has been created.

Bear Stearns vs. LTCM

Let's look at some "bailouts" from the past. Let me just tell you right off the bat - Bear Stearns (BSC) did not receive a bailout. Forget what you've read. They're all wrong. Why do I say this? A true bailout creates a "free ride" for the recipient via government assistance. In other words, a bailout creates a moral hazard - the tendency to behave irresponsibly and/or take on excessive risk - because the penalty for failure has been removed.

Thus a moral hazard causes the bailed out company to act irresponsibly in the future, knowing that failure will be forgiven by taxpayer dollars. Rather than a real bailout, the Bear Stearns deal was a gift to the "kingpin" of the Federal Reserve banking system – JP Morgan (JPM) - and likely the Fed's punishment to Bear for not participating in the "bailout" of Long Term Capital Management [LTCM] a decade ago.

In the case of LTCM, participating banks received a 90% stake in the fund for money THEY CONTRIBUTED. But similar to the Bear Stearns deal, there was no moral hazard created for LTCM because it had to exchange ownership for cash. In the Bear Stearns deal, the Fed handed JP Morgan $30 billion of taxpayer money, while guaranteeing JP Morgan's potential losses would not exceed $1 billion.

Considering Bear's clearing and prime brokerage units are most likely worth $18 billion, plus Bear's $1 billion Madison Ave. headquarters, plus JP Morgan's ability to keep Bear's best employees (probably valued around $2 billion including revenues from client accounts), minus restructuring and retention charges of say $2 billion - JP Morgan will net somewhere around $18 billion on the deal with virtually no risk. Make no mistake about it - this deal will be recorded as one of the biggest financial heists in U.S. banking history once people truly understand what really happened.

The point is that neither LTCM nor Bear Stearns received real bailouts because each was forced to sell all it had to suitors, which eliminated any possibility of a moral hazard. You won't create a moral hazard if your business has been shut down or handed over to another firm. Rather than being bailed out, they were put on the auction block with no "get out of jail free" card.

In contrast, the "Chrysler bailout" in '79 was truly a bailout because Washington supplied funds to the company while permitting management to maintain control. Now, if you want to see the effects of moral hazard due to a bailout, take a look at the state of Chrysler. Similar to Ford (F) and GM (GM), management has run these once highly esteemed auto makers into the ground because a bailout precedent was created three decades ago. Ever since then, the Big 3 realized they would be bailed out if they failed.

Homebuyers vs. Banks

Washington insists that homebuyers shouldn't be bailed out because it would create a moral hazard. Therefore, Washington is using the concept of moral hazard to define what a bailout is. Okay so, what about the banking system? Apparently, the issue of moral hazard was never a factor in the Fed's decision to supply the banks with over $1.2 trillion of taxpayer funds, nor is it being considered by Paulson's proposal to bailout Fannie and Freddie.

Critics of this argument might counter with the argument used by the Fed – "a bailout is needed because if they are permitted to fail it would create a global financial crisis." Too bad. That's the risk you take if you want a free market economy. And this bailout is going to cause a much more severe crisis at some point – I'll guarantee it. Finally, I can't see consumers suffering more from a collapse in the banking system than they already are from the effects of this bailout.

What the Fed has not told you is that this banking bailout has only been extended to America's banking cartel – JP Morgan, Citigroup (C), Bank of America (BAC), Morgan Stanley (MS), Merrill Lynch (MER), Goldman Sachs (GS), Lehman (LEH), and now Fannie (FNM) and Freddie (FRE). Meanwhile, the Fed plans to let the other banks fall flat on their face just like they did with Indy Mac. And when hundreds of banks fail, the banking cartel will pick and chose which ones they decide to buy with taxpayer dollars. Over the next couple of years, Washington will likely try to bail out one or more of the Big 3, as well as the airlines.

Washington needs to practice what it preaches and let the free markets work things out. By forcing taxpayers to bailout the banks or any other corporations, Washington is effectively telling Americans that our free market system is broken.

But don't expect to see any real changes. They've proposed the same "preemptive" gimmicks many times in the past, each resulting in bigger blowouts thereafter. Washington laid down the rules of the game, and voters assumed they would play by these rules instead of changing them to help out their friends. You either run a real free market economy or you socialize it. You don't make exceptions. You cannot have a real free market economy without the risks and consequences of failure.

I prefer a free market economy for all industries except those that supply basic necessities. As I have detailed in previous articles, if you allow the current free market system control over the distribution of basic necessities, industry players will engage in collusion, fraud, and profiteering, knowing that consumers will have no choice but to pay the prices asked. We continue to see this behavior in the energy and healthcare industries.

Shortly after WWI, Washington learned the harsh lessons of letting the agriculture industry function in the free market system. The devastating effects of mismanagement ultimately led to government subsidies, which are much more prevalent today. It should be clear that this industry is government-controlled. And if you think food prices are high now, I'll guarantee you they would be much higher without subsidies.

The Fed needs to stop destroying the dollar by protecting the mistakes made by the banking system. These actions have caused massive inflation. This has not only led to record oil prices, but it's wiped out trillions of dollars of retirement assets for millions of Americans who are on the verge of retirement – the same thing that happened a few years ago when the dotcom bubble imploded. In response, Washington tries to suppress inflation data so consumers will be kept in the dark.

When are Americans going to stand up and demand this charade be put to an end? Taxpayers are already on the hook for trillions of dollars in debt that will be inherited by future generations. Why should taxpayers have to absorb the mistakes made by corporations? I didn't see bankers share their multimillion dollar bonuses with taxpayers after making record profits from sticking them with loans they couldn't repay on overvalued homes. I don't believe in bailouts because I prefer a free market economy. And you cannot have both without eventually creating anarchy.

Stock Position: None.