CHESSNOID

We are in a recession and the federal reserve is taking action that is construed as a moral hazard. Moral hazard is defined by wikipedia as:

Financial bail-outs of lending institutions by governments, central banks or other institutions can encourage risky lending in the future, if those that take the risks come to believe that they will not have to carry the full burden of losses. Lending institutions need to take risks by making loans, and usually the most risky loans have the potential for making the highest return. A moral hazard arises if lending institutions believe that they can make risky loans that will pay handsomely if the investment turns out well but they will not have to fully pay for losses if the investment turns out badly. Taxpayers, depositors, other creditors have often had to shoulder at least part of the burden of risky financial decisions made by lending institutions.^[1]

The latest example is the federal reserve’s quick action to step in and rescue Bear Stearns from a financial collapse. This is a private company being rescued with government funds. JP Morgan & Chase bought the company overnight for $2 a share. This is a free capitalistic society and we need to let the business cycle run its course. The subprime debacle and housing bust was essentially created by the federal reserve with its reckless fiscal policies that lead to incredible speculation. Now all the companies that help create this housing bubble and profited handsomely in the last 5 years are being bailed out indirectly with taxpayer money. In as sense, they made money by reckless spending and now that the time has come to bear the losses of their bad decisions, the federal government says not to worry because we will absorb your losses and take away your risks and pass them on to the American public. According to CNN.Money:

Bear Stearns was on the brink of financial collapse Friday when JPMorgan (JPM, Fortune 500) and the Federal Reserve Bank of New York said they would provide the brokerage a short-term loan. Bear was dealing with a classic run-on-the-bank: The firm’s short-term creditors refused to lend the firm any more money and simultaneously demanded repayment of outstanding debt. The one-two punch overwhelmed Bear’s cash position.

Treasury Secretary Henry Paulson said on Sunday that talks about how to rescue Bear had continued throughout the weekend. He defended the Fed’s bailout on Friday as “the right decision” and said the Bush administration was ready to take other actions to bring stability to the financial markets.

The fast-track deal is expected to close by the end of June, the statement said.

Bear Stearns has approximately 14,000 employees worldwide.

A deep, fast fall

The deal marks an inglorious chapter for 85-year-old Bear Stearns, a storied Wall Street firm whose unraveling has been fast and furious.

Rumors that Bear Stearns was on the verge of collapse started buzzing around Wall Street trading desks last Monday. Chief Executive Alan Schwartz - who took over as CEO in early January from longtime chief Jimmy Cayne - appeared on television on Wednesday afternoon to reassure the markets that the firm was stable.

But by Thursday night, Bear was in a severe crunch. Some firms that trade with it effectively stopped offering it credit because they feared that Bear was running short of short-term funding, or liquidity.

Shares of Bear Stearns opened last week at $69.75 and traded as high as $159 last year.

We had some other behind the scenes deal when Bank of America was allowed to buy out Countrywide Mortgage overnight without normal government approvals just to avoid the largest lending company from going bankrupt after making many bad loans for the last 5 years. This was not a true merger but a disguised rescue. Although, the government’s role isn’t as transparent in this situation it follows the exact same pattern of moral hazard where JPMorgan rescues Bear Stearns.

The problem we face are two fold. First, our reckless fiscal policies of reducing interest rates and increasing liquidity are causing the US Dollar to collapse. Other countries no longer want our currency if we keep devaluing it. From their perspective the dollar is a free fall and it is best to buy other currencies and commodities. According to Bloomberg:

The dollar fell to as low as 96.58 yen, the weakest since Aug. 28, 1995, before trading at 96.71 yen at 9:32 a.m. in Tokyo from 99.09 yen late in New York on March 14. Against the euro, the dollar fell to a record low of $1.5807. The dollar fell to an all-time low of 0.9804 Swiss francs.

The dollar also set record lows against the euro the previous four days as investor confidence tumbled, sending U.S. stocks lower for a third straight week and driving gold to a record high of $1,009 an ounce.

What this translates into is higher costs for commodities including Crude Oil which is hovering at $110 per barrel. Everything a consumer buys in the supermarket and gas station continues to rise daily like a flashback from the 1970’s.

The second problem we face with the bailout is many more major companies who are experiencing the same issues from bad decisions they profited from the last 5 years and are on the brink of bankruptcy will expect the same actions. After all, if the federal government bailed out their competitor why wouldn’t it bail it out. Exactly how many major companies will the federal government step in to rescue. The S&P claimed we were at the bottom of the subprime debacle after $285 billion dollars of losses. Although I don’t have actual figures to quote from, but my guess is it is closer to a trillion dollars in exposure based on national mortgage reset charts I have seen. This week Wall Street brokerages are due to announce their earnings (or losses):

Bear Stearns is in the center of the bulls eye. On Friday, the brokerage firm said a serious liquidity crisis had prompted it to secure an emergency loan from rival JPMorgan Chase. Bear’s stock plummeted 47% and the firm ended the week imperiled.

Far from winding down, as some of the optimistic had predicted last year, the credit crisis has engulfed even more sectors of the financial services industry since the start of 2008. Investors now are second-guessing the value of debt backed by student loans, municipal bonds, commercial real estate and even mortgages issued by Fannie Mae and Freddie Mac. On top of this, the trading of leveraged loans, a popular way for companies with weak credit ratings to finance the high-flying corporate buyouts of recent years, has lost its appeal.

I believe our once robust economy has become a fragile one because of the federal reserve’s moral hazard. We are a free capitalistic country and the business cycle should not be mucked up over and over as it tries to balance itself by squeezing out the excesses of the bubble. As the housing market comes back down to reality to affordable prices through slower sales or foreclosures, the government should avoid creating new problems of inflation just to save a few wall street companies from going bankrupt. Bailing out these companies is the same as an indirect government bailout. The last 5 years these companies made record profits at the consumers expense, so it is ironic that consumers’ tax money should be used to rescue them.