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Bailouts Charged To The Taxpayer

A look back at recent history shows that J.P. Morgan is itself a product of a secretive backroom sweetheart deal between the bank, the troubled Bear Stearns and the Federal Reserve. And it's exactly this sort of deal which exacerbated the crisis by creating moral hazard, consolidating risk, and creating exactly the conditions which led to the necessity of the $700 billion TARP bailout.

The the first majot bank to suffer severe consequences for dealing in subprime mortgages, Bear Stearns needed an emergency loan to avoid bankruptcy. The bank looked to J.P. Morgan CEO Jamie Dimon. After researching Bear, Dimon instead asked the Federal Reserve Board for the funding. Availing themselves of legislative powers that hadn't been used since the 1930's, Fed Officials facilitated the transfer of Bear Stearns to J.P. Morgan. Saving Bear Stearns from bankruptcy cost the Federal Reserve Board $29 billion.

While a bankruptcy for Bear Stearns would certainly have been unpleasant, its effect on the worldwide banking system would have been minimal and temporary. In fact, evidence suggests that the real possibility of bankruptcy is an excellent motivator for prudence on the part of banks.

Bailing out failing banks creates a risk snowball. First, bailouts which consolidate banks consolidate risk, making each subsequent failure more catastrophic. Second, allowing banks to fail without failing means that to compete, all other banks must take on similar levels of risk in order to attract customers and please shareholders. The actions of the Federal Reserve Board here epitomize penny wise and pound foolish.

Despite this, as the crisis unfolded Treasury Secretary Hank Paulson and New York Fed President Tim Geithner and other federal officials multiplied risk by encourage emergency acquisition to save bankers from the consequences of their actions.

All that saving totaled up to a $700 billion bailout of the U.S. banking system. Then the US taxpayers bailed out Fannie Mae and Freddie Mac to the tune of $188 billion. Instead of letting three dominoes fall, the US government used taxpayer money to set them back up, and then align them in a row so that when they fell again, they'd take even more banks down with them.

It's true that J.P. Morgan and Bear Stearns broke laws. Better Markets wants the Department of Justice to determine, and make public, which laws were broken. But getting the information requires examining thousands of transactions by multiple banks and institutions worth trillions of dollars. And for what? Of the $13 billion the DoJ has fined J.P. Morgan, the vast majority is going right back to the government. Neither the taxpayers nor the individual investors will see a cent.

Punishing misbehaving banks might feel good, but it will do nothing to help prevent the next boom and bust. Better Markets might succeed in forcing the US government to levy harsher fines after the fact in this instance. But the moral hazard bank bailouts create, combined with the risk-multiplying effect of government-sponsored bank consolidation is the real problem to address. If Better Markets wants to sue someone, perhaps it should look at Federal Reserve Board instead.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: The information contained herein is public knowledge