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So many in the media seem to have swallowed the Kool-Aid that this bailout is necessary (or that the economy will self-destruct in mere days), but is it really?

IndyMac (IDMC.PK), Countrywide (CFC), Washington Mutual (WM), Merrill Lynch (MER), Lehman (LEH), AIG (AIG), Bear Stearns (BSC), Fannie (FNM) and Freddie (FRE) have all bitten the bullet, and the economy is still (sort of ... mostly) standing. JPMorgan (JPM) and Bank of America (BAC) seem to have developed voracious new appetites for new subsidiary operations, and Goldman Sachs' (GS) and Morgan Stanley's (MS) (simultaneous) announcements that they are converting to bank holding companies seems to imply that they too have their stomach juices churning for new goodies.

So who's left? Who's hurting? Where is this great self-immolation going to come from? The fact is that it isn't.

A week ago we learned that we had to cough up $700 billion in a few days with no strings attached, when just a week earlier no one knew a thing about this lurking monster. Now, a week later, the world still hasn't ended and, well ..., maybe a third up front, and they won't pay their execs so much, and maybe a little equity stake for the taxpayers, and yeah, we all can watch things real close too. Hmmm. Maybe we'll even get some mortgage renegotiations tossed in? That would be nice.

Stop right there. No way on that last point. No mortgage renegotiations. The banks say it mustn't be done, and that tells us something very important. Since mortgage renegotiations are hands down the best way to put REAL value back into this troubled paper (and would be the most palatable solution for the public), the only reason there is for the banks insisting that this not be in the bailout is that the banks don't want these properties returned to their owners, and they don't want to keep them either. That means that the banks simply want to raise cash quickly. But for what? What's the money for?

Two weeks back on Black Monday, the market jumped off a cliff and Bank of America swallowed Merrill Lynch whole. It was such a big news day with so many stories that a little tiny item, but for a single sentence buried nine paragraphs down in a Financial Times article, went entirely overlooked. The sentence read, "The Fed also suspended rules that prohibit banks from using deposits to fund their investment banking subsidiaries." THAT should have been the day's headline, and everything that has happened since can be explained by that sentence.

The sentence of course refers to our FDIC-insured deposits. The Gramm-Leach-Bliley Act of 1999 ended the strict separation of these deposits from unregulated investment banks, but even after that, only 30% of a bank's deposits could be used to back it's investment subsidiaries, and only 10% could back any individual subsidiary. Any more than that, even in the heydays of deregulation fever, was considered too risky to be backed by FDIC insurance.

All that went out the window on Black Monday. Merrill Lynch needed to be bought quickly and Bank of America was interested, but there was a problem. JPMorgan had gotten billions to back Bear Stearns' bad paper during that takeover, and Bank of America needed a similar deal. Trouble was that back during the Morgan-Bear deal, the government had $900 billion sloshing around in its accounts, but by Black Monday there was only $100 billion left that had not already been promised, and that couldn't be spared. In other words, the Fed had run out of money. That's when the deal was struck. Bank of America could use ALL of its FDIC-insured accounts as backing for Merrill's bad paper. The sale was made. Bank of America had its prize.

Of course, the Treasury couldn't just do this rule change for Bank of America; they had to do it for everyone, and all of a sudden, the entire landscape of banking had changed. Every bank that had FDIC-insured deposits was now worth a lot more money because its insured assets could now be effectively collateralized and used to back investment banking operations. Within days, Goldman Sachs and Morgan Stanley, seeking to stake their claims to the vein of gold that Bank of America had mined, converted from investment banks to bank holding companies. The Great Bank Rush of 2008 had begun.

Within days, JPMorgan, still digesting Bear Stearns, was next to score a prize when Washington Mutual (WM) was seized. It was a good deal all around. JPMorgan took only the $188 billion in FDIC-insured accounts, but in return for sticking us with the garbage, they agreed to cover all of these deposits without any money from FDIC funds. A real prize for JPMorgan, and it was nothing down for us; only time payments.

From here on out however, the pickings are likely to get smaller. There are (depending upon how you measure) 30 to 50 regional banks that will now be prime candidates for takeover by these four mega-banks, and of course perhaps thousands of lesser banks floating around. The question then becomes how to pay for all these little banks. International markets are really fed up with American financial institutions, and are not liable to loan on favorable terms, and the Fed and Treasury are simply tapped out. That leaves you, me, and a $700 billion bailout plan. And THAT'S why all of a sudden, they need the bailout. They want to buy little banks.

Two questions remain. First, will this work; will it save the system? Perhaps. Maybe if these folks can suddenly learn to be VERY conservative bankers. Fine, except that these people did not get to where they are because conservatism was an arrow in their quivers. Which leads to the second question: What happens if it doesn't?

It is important to understand what a massive gamble is being made with this. This rule change, allowing 100% of FDIC-insured deposits to be used to back investment banking transactions, effectively extends the coverage of FDIC insurance to all of these transactions, AND DOES SO WITHOUT REQUIRING ANY ADDITIONAL PREMIUMS TO BE PAID into the FDIC reserve fund. These investment transactions will now be covered by government insurance FOR FREE. We'd better not have too many of them fail.

Imagine this scenario. You have $80,000 in Bank of America when it collapses. (This is just a what-if; I'm not predicting this bank's failure.) You go in to get your money. After all, it is covered by FDIC insurance, isn't it? Sure enough, the clerk is about to hand you your $80,000 when a man steps up and grabs it from the clerk, claiming it is his. You protest, showing him your account. He's says he doesn't care; he's got an investment transaction at the bank and that makes him the first lien holder on the money that used to be in your account.

Obviously, this is a characterization. This scene would never occur. The net result, however, would be the same if any of these new mega-banks were to fail. Oh, you would get your money, but a hell of a lot more of it would have to be printed, and your money would be worth a hell of a lot less by the time you got it.

This is the risk that Paulson has taken; a risk taken without Congressional review, comment, or consent. Like the gambler he came to the Treasury as, he has bet all of your insured deposits that he can pull off a rescue of the American financial system. Maybe he can. Gamblers get lucky sometimes. Just ask them.

Disclosure: none

Source: The Great Bank Rush of 2008: What's the Money For?