Delusions of Debt

Includes: DIA, QQQ, SPY
by: James Quinn

Make no mistake. Our country is in the midst of a financial crisis of epic proportions. We are in a long national emergency. In the last 6 months, we have been on the brink of financial collapse twice.

First, Bear Stearns (NYSE:BSC) was going to declare bankruptcy unless it was taken over by the end of the weekend. If this had occurred, it is believed the thousands of transactions with other banks throughout the world would have led to multiple bank failures and a freezing up of the financial system. Ben Bernanke and Hank Paulson came to the rescue with $29 billion of our tax dollars, guaranteeing the Bear Stearns mortgage portfolio on behalf of JP Morgan (NYSE:JPM). Ben then opened the Fed discount window to all Investment banks.

So, these prestigious institutions can now exchange their toxic waste mortgage derivatives for Treasuries. You and I are on the hook for the inevitable losses. A government that spends $12 billion a month on a war that shouldn’t have been fought – but won’t exit until we win, figures that the numbers have become so large that the public can’t tell the difference between $29 million, $29 billion, or $29 trillion.

Two weeks ago, Helicopter Ben and Hammering Hank swooped in and saved the day again. Fannie Mae (FNM) and Freddie Mac (FRE), who originate 80% of all the mortgages in the U.S., were on the brink of collapse. Yet again, they were deemed too big to fail. They have in excess of $5 trillion in mortgage debt on their books, virtually no capital, and billions of losses to be recorded in the next few years. Hank committed your tax dollars to buying their stock.

Your government has essentially guaranteed the $5 trillion of debt, to go with the $9 trillion already on the books. The same weekend, IndyMac was taken over by the FDIC. This is the 2nd biggest bank failure in the history of the U.S. Depositors will lose $500 million of uninsured deposits. The scenes of average Americans lined up at IndyMac branches were reminiscent of the 1930s.

Get used to it. There will be many more bank collapses in the next few years. The years of bad decisions and risk-taking will inflict pain on many people.

Congress passed a housing rescue plan that will cost you, your children, and grandchildren at least $300 billion. George Bush again showed his moral backbone by signing a bill he had said for months that he would veto. It is amazing how free market capitalism is the mantra when prices are going up, but big government socialism is the answer when our multi-million dollar corporations make drastic risk management mistakes in search of obscene profits. We are now on the hook for all the past and future bad decisions of Fannie Mae and Freddie Mac. The Congressional Budget Office estimates that backing these two awful institutions will cost taxpayers $25 billion. Remember the government estimate for the Iraq War of $50 billion. We are at $700 billion and counting. ]

Our politician leaders continue to spend our money with absolutely no plan to pay for these initiatives. At the end of the day, two companies that have lost a combined $13 billion in the last 9 months can now lose billions more without a worry. It is good to see that their CEOs really believe in pay for performance.

As you can see from the chart below, they have certainly earned their multi-million dollar salaries.


A congressman with a moral backbone, Representative Ron Paul, voted against the $325 billion bailout boondoggle bill. His view of this bill hits at the heart of the issue:

It is neither morally right nor fiscally wise to socialize private losses in this way. The solution is for government to stop micromanaging the economy and let the market adjust, as painful as that will be for some. We should not force taxpayers, including renters and more frugal homeowners, to switch places with the speculators and take on those same risks that bankrupted them. It is a terrible idea to spread the financial crisis any wider or deeper than it already is, and to prolong the agony years into the future. Socializing the losses now will only create more unintended consequences that will give new excuses for further government interventions in the future. This is how government grows – by claiming to correct the mistakes it earlier created, all the while constantly shaking down the taxpayer. The market needs a chance to correct itself, and Congress needs to avoid making the situation worse by pretending to ride to the rescue.

At a recent closed-door fundraiser in Texas, where he thought it was safe to tell the truth, President Bush summed up the financial crisis in his usual blunt manner: "There’s no question about it, Wall Street got drunk, that’s one of the reasons I asked you to turn off the TV cameras. It got drunk and now it’s got a hangover."

So, the man who spoke these words last week will buy a drunkard $325 billion of Jack Daniels by signing the bailout bill. A little hair of the dog that bit you is good for a hangover.

This 600 page "Mother of all Bailouts" monstrosity, as Ron Paul has described it, has some interesting tidbits buried in the fine print. Mr. Paul’s summary of the bill is as follows:

  • While this bill is often referred to in the news as a "$25 billion" plan, the final amount will likely be much, much higher. The Treasury’s previously limited $2.5 billion line of credit to Fannie Mae / Freddie Mac, which in 2001 Ron Paul proposed be abolished, has instead been increased to unlimited. The Treasury can now buy an unlimited amount of Fannie / Freddie housing securities and stock. While this may help "bolster confidence" in these companies, as the LA times mentions, don’t expect it to do much for the dollar! Once upon a time, our national currency was backed by gold. More recently, it has been backed by US Treasury securities. Now it will be backed – at least in part – by Fannie Mae / Freddie Mac housing securities – securities that are collapsing on the open market because no one else wants them.
  • In yet another example of persistent, big brother, big government, police state creep, anyone working in the mortgage industry will now be required to be fingerprinted.
  • Finally, buried deep within the bill, and not mentioned in any MSM source that I am aware of, is the provision that every credit card transaction will now be reported to the IRS. How this fits in to the housing crisis is anyone’s guess.
  • A provision to increase the national debt ceiling by $800 billion. This is something Congress has to do every few years, as spending is clearly out of control.

The national debt ceiling is now $10.8 trillion. This is like giving a spendaholic an increase on their Amex credit line. Give Congress the ability to spend $10.8 trillion and they will.

Below is the National Debt.


The amount is $9.6 trillion. It was approximately $5.8 trillion when George Bush took office. These figures do not include the unfunded liabilities exceeding $50 trillion for Social Security and Medicare liabilities.

It appears from a quick perusal of the chart below that 90% of the national debt has been generated since 1980.

Republican Presidents have been in charge for 20 of those 28 years.

Of course, Democrats have been in control of Congress for most of this time period. This proves that when Presidents and Congress put their heads together they can achieve big things – pushing our great country to the brink of economic disaster.

At one time, not long ago, we owed this money to ourselves. U.S. citizens and U.S. financial institutions owned the debt of the U.S. government. This is no longer the case. Foreigners now own almost 50% of our debt. This has occurred because the U.S. has lived above its means for decades.

Our trade deficits have left us vulnerable to the people we owe. Warren Buffett describes the situation succinctly:

We were taught in Economics 101 that countries could not for long sustain large, ever-growing trade deficits ... our country has been behaving like an extraordinarily rich family that possesses an immense farm. In order to consume 4% more than they produce – that's the trade deficit – we have, day by day, been both selling pieces of the farm and increasing the mortgage on what we still own.

When a country has a massive amount of debt it is in their self interest to create inflation. By creating inflation, you pay back the debt with depreciated dollars. This makes the debt less burdensome.

It is not a coincidence that for the 1st 200 years of our glorious Republic we had very little inflation. The country had very little debt. The Federal Reserve was created in 1913.

As you can see in the following graph, inflation began to accelerate after the Federal Reserve took control of our currency; accelerated further after Roosevelt’s New Deal; popped after Nixon closed the gold window; and has skyrocketed since 1980 at the same time that our debt skyrocketed.

This persistent inflation has led to the dollar losing 95% of its purchasing power since the creation of the Federal Reserve. As the biggest debtor in the history of the universe, we are now at the mercy of China, Russia, Japan, and OPEC. They can start to call the shots.

Would gas be $4.00 per gallon if we were running surpluses and the Euro was .85 to the $1.00? Not a chance.

It amazes me that this country does not listen to the common sense principles regarding our economy put forth by Ron Paul:

The Fed creates new money and uses it to purchase securities from banks. Flush with funds, these banks seek to put this money to use. During the Fed's expansionary period, much of this money went to home loans. Through a combination of federal government inducements to lend to risky borrowers, and the Fed's supply of easy money, the housing bubble took shape. Fannie Mae and Freddie Mac were encouraged to purchase and securitize mortgages, while investors, buoyed by implicit government backing, rushed to provide funding. Money that could have been invested in more productive, less risky sectors of the economy was thereby malinvested in subprime mortgage loans.

The implicit guarantee from the Fed is quickly becoming explicit, as those institutions deemed "too big to fail" are bailed out at taxpayer expense. Wall Street made a killing during the housing bubble, reaping record profits. Now that the bubble has burst, these same firms are trying to dump their losses on the taxpayers. This approach requires more money creation, and therefore debasement of all dollars in circulation.

The Federal Reserve, a quasi-government entity, should not be creating money or determining interest rates, as this causes malinvestment and excessive debt to accumulate. Centrally planned, government-manipulated economies always fail eventually. The collapse of communism and the failure of socialism should have made this apparent. Even the most educated, well-intentioned central planners cannot plan the market better than the market itself. Those that understand economics best, understand this reality.

In free markets, both success and failure are options. If government interventions prevent businesses, like Bear Stearns, from failing, then it is not truly a free market. As painful as it might be for Wall Street, banks, even big ones, must be allowed to fail.

The end game for this policy of monetary inflation is that the money in your bank account loses purchasing power. So, by keeping failing banks afloat, the Fed punishes those who have lived frugally and saved. The power to create money is a power that should never be granted to government. As we can plainly see today, the Fed has abused this power, and taxpayers are paying the price.

If you are in a deep hole, the first thing you should do is stop digging. Our government keeps digging deeper and deeper. This delusion of debt will surely end in tears.

Disclosure: I have no positions related to this article.