Chapter Two: The Name of the Game Is Bailout
The analogy of a spectator sporting event as a means of explaining the rules by which taxpayers are required to pick up the cost of bailing out the banks when their loans go sour.
It was stated in the previous chapter that the Jekyll Island group which conceived the Federal Reserve System actually created a national cartel which was dominated by the larger banks. It was also stated that a primary objective of that cartel was to involve the federal government as an agent for shifting the inevitable losses from the owners of those banks to the taxpayers. That, of course, is one of the more controversial assertions made in this book. Yet, there is little room for any other interpretation when one confronts the massive evidence of history since the System was created. Let us, therefore, take another leap through time. Having jumped to the year 1910 to begin this story, let us now return to the present era.
To understand how banking losses are shifted to the taxpayers, it is first necessary to know a little bit about how the scheme was designed to work There are certain procedures and formulas which must be understood or else the entire process seems like chaos. It is as though we had been isolated all our lives on a South Sea island with no knowledge of the outside world. Imagine what it would then be like the first time we traveled to the mainland and witnessed a game of professional football. We would stare with incredulity at men dressed like aliens from another planet; throwing their bodies against each other; tossing a funny shaped object back and forth; fighting over it as though it were of great value, yet, occasionally kicking it out of the area as though it were worthless and despised; chasing each other, knocking each other to the ground and then walking away to regroup for another surge; all this with tens of thousand of spectators riotously shouting in unison for no apparent reason at all. Without a basic understanding that this was a game and without knowledge of the rules of that game, the event would appear as total chaos and universal madness.
The operation of our monetary system through the Federal Reserve has much in common with professional football. First, there are certain plays that are repeated over and over again with only minor variations to suit the special circumstances. Second, there are definite rules which the players follow with great precision. Third, there is a clear objective to the game which is uppermost in the minds of the players. And fourth, if the spectators are not familiar with that objective and if they do not understand the rules, they will never comprehend what is going on. Which, as far as monetary matters is concerned, is the common state of the vast majority of Americans today.
Let us, therefore, attempt to spell out in plain language what that objective is and how the players expect to achieve it. To demystify the process, we shall present an overview first. After the concepts are clarified, we then shall follow up with actual examples taken from the recent past.
The name of the game is Bailout. As stated previously, the objective of this game is to shift the inevitable losses from the owners of the larger banks to the taxpayers. The procedure by which this is accomplished is as follows:
Rules of the Game
The game begins when the Federal Reserve System allows commercial banks to create checkbook money out of nothing. (Details regarding how this incredible feat is accomplished are given in Chapter Ten entitled The Mandrake Mechanism.) The banks derive profit from this easy money, not by spending it, but by lending it to others and collecting interest.
When such a loan is placed on the bank’s books it is shown as an asset because it is earning interest and, presumably, someday will be paid back. At the same time an equal entry is made on the liability side of the ledger. That is because the newly created checkbook money now is in circulation, and most of it will end up in other banks which will return the canceled checks to the issuing bank for payment. Individuals may also bring some of this checkbook money back to the bank and request cash. The issuing bank, therefore, has a potential money pay-out liability equal to the amount of the loan asset.
When a borrower cannot repay and there are no assets which can be taken to compensate, the bank must write off that loan as a loss. However, since most of the money originally was created out of nothing and cost the bank nothing except bookkeeping overhead, there is little of tangible value that is actual lost. It is primarily a bookkeeping entry.
A bookkeeping loss can still be undesirable to a bank because it causes the loan to be removed from the ledger as an asset without a reduction in liabilities. The difference must come from the equity of those who own the bank. In other words, the loan asset is removed, but the money liability remains. The original checkbook money is still circulating out there even though the borrower cannot repay, and the issuing bank still has the obligation to redeem those checks. The only way to do this and balance the books once again is to draw upon the capital which was invested by the bank’s stockholders or to deduct the loss from the bank’s current profits. In either case, the owners of the bank lose an amount equal to the value of the defaulted loan. So, to them, the loss becomes very real. If the bank is forced to write off a large amount of bad loans, the amount could exceed the entire value of the owners’ equity. When that happens, the game is over, and the bank is insolvent.
This concern would be sufficient to motivate most bankers to be very conservative in their loan policy, and in fact most of them do act with great caution when dealing with individuals and small businesses. But the Federal Reserve System, the Federal Deposit Insurance Corporation, and the Federal Deposit Loan Corporation now guarantee that massive loans made to large corporations and to other governments will not be allowed to fall entirely upon the bank’s owners should those loans go into default. This is done under the argument that, if these corporations or banks are allowed to fail, the nation would suffer from vast unemployment and economic disruption. More on that in a moment.
The Perpetual-Debt Play
The end result of this policy is that the banks have little motive to be cautious and are protected against the effect of their own folly. The larger the loan, the better it is, because it will produce the greatest amount of profit with the least amount of effort. A single loan to a third-world country netting hundreds of millions of dollars in annual interest is just as easy to process — if not easier — than a loan for $50,000 to a local merchant on the shopping mall. If the interest is paid, it’s gravy time. If the loan defaults, the federal government will
protect the public and, through various mechanisms described shortly, will make sure that the banks continue to receive their interest.
The individual and the small businessman find it increasingly difficult to borrow money at reasonable rates, because the banks can make more money on loans to the corporate giants and to foreign governments. Also, the bigger loans are safer for the banks, because the government will make them good even if they default. There are no such guarantees for the small loans. The public will not swallow the line that bailing out the little guy is necessary to save the system. The dollar amounts are too small. Only when the figures become mind-boggling does the ploy become plausible.
It is important to remember that banks do not really want to have their loans repaid, except as evidence of the dependability of the borrower. They make a profit from interest on the loan, not repayment of the loan. If a loan is paid off, the bank merely has to find another borrower, and that can be an expensive nuisance. It is much better to have the existing borrower pay only the interest and never make payments on the loan itself. That process is called rolling over the debt. One of the reasons banks prefer to lend to governments is that they do not expect those loans ever to be repaid. When Walter Wriston was chairman of the Citicorp Bank in 1982, he extolled the virtue of the action this way:
If we had a truth-in-Government act comparable to the truth-in-advertising law, every note issued by the Treasury would be obliged to include a sentence stating:This note will be redeemed with the proceeds from an identical note which will be sold to the public when this one comes due.
When this activity is carried out in the United States, as it is weekly, it is described as a Treasury bill auction. But when basically the same process is conducted abroad in a foreign language, our news media usually speak of a country’s
rolling over its debts. The perception remains that some form of disaster is inevitable. It is not.
To see why, it is only necessary to understand the basic facts of government borrowing. The first is that there are few recorded instances in history of government — any government — actually getting out of debt. Certainly in an era of $100-billion deficits, no one lending money to our Government by buying a Treasury bill expects that it will be paid at maturity in any way except by our Government’s selling a new bill of like amount.
The Debt Roll-Over Play
Since the system makes it profitable for banks to make large, unsound loans, that is the kind of loans which banks will make. Furthermore, it is predictable that most unsound loans eventually will go into default. When the borrower finally declares that he cannot pay, the bank responds by rolling over the loan. This often is stage managed to appear as a concession on the part of the bank but, in reality, it is a significant forward move toward the objective of perpetual interest.
Eventually the borrower comes to the point where he can no longer pay even the interest. Now the play becomes more complex. The bank does not want to lose the interest, because that is its stream of income. But it cannot afford to allow the borrower to go into default either, because that would require a write-off which, in turn, could wipe out the owners’ equity and put the bank out of business. So the bank’s next move is to create additional money out of nothing and lend that to the borrower so he will have enough to continue paying the interest, which by now must be paid on the original loan plus the additional loan as well. What looked like certain disaster suddenly is converted by a brilliant play into a major score. This not only maintains the old loan on the books as an asset, it actually increases the apparent size of that asset and also results in higher interest payments, thus, greater profit to the bank.
The Up-the-Ante Play
Sooner or later, the borrower becomes restless. He is not interested in making interest payments with nothing left for himself. He comes to realize that he is merely working for the bank and, once again, interest payments stop. The opposing teams go into a huddle to plan the next move, then rush to the scrimmage line where they hurl threatening innuendoes at each other. The borrower simply cannot, will not pay. Collect if you can. The lender threatens to blackball the borrower, to see to it that he will never again be able to obtain a loan. Finally, a
compromise is worked out. As before, the bank agrees to create still more money out of nothing and lend that to the borrower to cover the interest on both of the previous loans but, this time, they up the ante to provide still additional money for the borrower to spend on something other than interest. That is a perfect score. The borrower suddenly has a fresh supply of money for his purposes plus enough to keep making those bothersome interest payments. The bank, on the other hand, now has still larger assets, higher interest income, and greater profits. What an exciting game!
The Rescheduling Play
The previous plays can be repeated several times until the reality finally dawns on the borrower that he is sinking deeper and deeper into the debt pit with no prospects of climbing out. This realization usually comes when the interest payments become so large they represent almost as much as the entire corporate earnings or the country’s total tax base. This time around, roll-overs with larger loans are rejected, and default seems inevitable.
But wait. What’s this? The players are back at the scrimmage line. There is a great confrontation. Referees are called in. Two shrill blasts from the horn tell us a score has been made for both sides. A voice over the public address system announces:
This loan has been rescheduled.
Rescheduling usually means a combination of a lower interest rate and a longer period for repayment. The effect is primarily cosmetic. It reduces the monthly payment but extends the period further into the future. This makes the current burden to the borrower a little easier to carry, but it also makes repayment of the capital even more unlikely. It postpones the day of reckoning but, in the meantime, you guessed it: The loan remains as an asset, and the interest payments continue.
The Protect-the-Public Play
Eventually the day of reckoning arrives. The borrower realizes he can never repay the capital and flatly refuses to pay interest on it. It is time for the Final Maneuver.
According to the Banking Safety Digest, which specializes in rating the safety of America’s banks and S&Ls, most of the banks involved with
problem loans are quite profitable businesses:
Note that, except for third-world loans, most of the large banks in the country are operating quite profitably. In contrast with the continually-worsening S&L crisis, the banks’ profitability has been the engine with which they have been working off (albeit slowly) their overseas debt … At last year’s profitability levels, the banking industry could, in theory,buy outthe entirety of their own Latin American loans within two years.
The banks can absorb the losses of their bad loans to multinational corporations and foreign governments, but that is not according to the rules. It would be a major loss to the stockholders who would receive little or no dividends during the adjustment period, and any chief executive officer who embarked upon such a course would soon be looking for a new job. That this is not part of the game plan is evident by the fact that, while a small portion of the Latin American debt has been absorbed, the banks are continuing to make gigantic loans to governments in other parts of the world, particularly Africa, Red China, and Eastern European nations. For reasons which will be analyzed in Chapter Four, there is little hope that the performance of these loans will be different than those in Latin America. But the most important reason for not absorbing the losses is that there is a standard play that can still breathe life back into those dead loans and reactivate the bountiful income stream that flows from them.
Here’s how it works. The captains of both teams approach the referee and the Game Commissioner to request that the game be extended. The reason given is that this is in the interest of the public, the spectators who are having such a wonderful time and who will be sad to see the game ended. They request also that, while the spectators are in the stadium enjoying themselves, the parking-lot attendants be ordered to quietly remove the hub caps from every car. These can be sold to provide money for additional salaries for all the players, including the referee and, of course, the Commissioner himself. That is only fair since they are now working overtime for the benefit of the spectators. When the deal is finally struck, the horn will blow three times, and a roar of joyous relief will sweep across the stadium.
In a somewhat less recognizable form, the same play may look like this: The president of the lending bank and the finance officer of the defaulting corporation or government will join together and approach Congress. They will explain that the borrower has exhausted his ability to service the loan and, without assistance from the federal government, there will be dire consequences for the American people. Not only will there be unemployment and hardship at home, there will be massive disruptions in world markets. And, since we are now so dependent on those markets, our exports will drop, foreign capital will dry up, and we will suffer greatly. What is needed, they will say, is for Congress to provide money to the borrower, either directly or indirectly, to allow him to continue to pay interest on the loan and to initiate new spending programs which will be so profitable he will soon be able to pay everyone back.
As part of the proposal, the borrower will agree to accept the direction of a third-party referee in adopting an austerity program to make sure that none of the new money is wasted. The bank also will agree to write off a small part of the loan as a gesture of its willingness to share the burden. This move, of course, will have been foreseen from the very beginning of the game, and is a small step backward to achieve a giant stride forward. After all, the amount to be lost through the write-off was created out of nothing in the first place and, without this Final Maneuver, the entirety would be written off. Furthermore, this modest write down is dwarfed by the amount to be gained through restoration of the income stream.
The Guaranteed-Payment Play
One of the standard variations of the Final Maneuver is for the government, not always to directly provide the funds, but to provide the credit for the funds. That means to guarantee future payments should the borrower again default. Once Congress agrees to this, the government becomes a co-signer to the loan, and the inevitable losses are finally lifted from the ledger of the bank and placed onto the backs of the American taxpayer.
Money now begins to move into the banks through a complex system of federal agencies, international agencies, foreign aid, and direct subsidies. All of these mechanisms extract payments from the American people and channel them to the deadbeat borrowers who then send them to the banks to service their loans. Very little of this money actually comes from taxes. Almost all of it is generated by the Federal Reserve System. When this newly created money returns to the banks, it quickly moves out again into the economy where it mingles with and dilutes the value of the money already there. The result is the appearance of rising prices but which, in reality, is a lowering of the value of the dollar.
The American people have no idea they are paying the bill. They know that someone is stealing their hub caps, but they think it is the greedy businessman who raises prices or the selfish laborer who demands higher wages or the unworthy farmer who demands too much for his crop or the wealthy foreigner who bids up our prices. They do not realize that these groups also are victimized by a monetary system which is constantly being eroded in value by and through the Federal Reserve System.
Public ignorance of how the game is really played was dramatically displayed during a recent Phil Donahue TV show. The topic was the Savings and Loan crisis and the billions of dollars that it would cost the taxpayer. A man from the audience rose and asked angrily:
Why can’t the government pay for these debts instead of the taxpayer? And the audience of several hundred people actually cheered in enthusiastic approval!
Prosperity Through Insolvency
Since large, corporate loans are often guaranteed by the federal government, one would think that the banks which make those loans would never have a problem. Yet, many of them still manage to bungle themselves into insolvency. As we shall see in a later section of this study, insolvency actually is inherent in the system itself, a system called fractional-reserve banking.
Nevertheless, a bank can operate quite nicely in a state of insolvency so long as its customers don’t know it. Money is brought into being and transmuted from one imaginary form to another by mere entries on a ledger, and creative bookkeeping can always make the bottom line appear to balance. The problem arises when depositors decide, for whatever reason, to withdraw their money. Lo and behold, there isn’t enough to go around and, when that happens, the cat is finally out of the bag. The bank must close its doors, and the depositors still waiting in line outside are … well, just that: still waiting.
The proper solution to this problem is to require the banks, like all other businesses, to honor their contracts. If they tell their customers that deposits are
payable upon demand, then they should hold enough cash to make good on that promise, regardless of when the customers want it or how many of them want it. In other words, they should keep cash in the vault equal to 100% of their depositors’ accounts. When we give our hat to the hat-check girl and obtain a receipt for it, we don’t expect her to rent it out while we eat dinner hoping she’ll get it back — or one just like it — in time for our departure. We expect all the hats to remain there all the time so there will be no question of getting ours back precisely when we want it.
On the other hand, if the bank tells us it is going to lend our deposit to others so we can earn a little interest on it, then it should also tell us forthrightly that we cannot have our money back on demand. Why not? Because it is loaned out and not in the vault any longer. Customers who earn interest on their accounts should be told that they have time deposits, not demand deposits, because the bank will need a stated amount of time before it will be able to recover the money which was loaned out.
None of this is difficult to understand, yet bank customers are seldom informed of it. They are told they can have their money any time they want it and they are paid interest as well. Even if they do not receive interest, the bank does, and this is how so many customer services can be offered at little or no direct cost. Occasionally, a thirty-day or sixty-day delay will be mentioned as a possibility, but that is greatly inadequate for deposits which have been transformed into ten, twenty, or thirty-year loans. The banks are simply playing the odds that everything will work out most of the time.
We shall examine this issue in greater detail in a later section but, for now, it is sufficient to know that total disclosure is not how the banking game is played. The Federal Reserve System has legalized and institutionalized the dishonesty of issuing more hat checks than there are hats and it has devised complex methods of disguising this practice as a perfectly proper and normal feature of banking. Students of finance are told that there simply is no other way for the system to function. Once that premise is accepted, then all attention can be focused, not on the inherent fraud, but on ways and means to live with it and make it as painless as possible.
Based on the assumption that only a small percentage of the depositors will ever want to withdraw their money at the same time, the Federal Reserve allows the nation’s commercial banks to operate with an incredibly thin layer of cash to cover their promises to pay
on demand. When a bank runs out of money and is unable to keep that promise, the System then acts as a lender of last resort. That is banker language meaning it stands ready to create money out of nothing and immediately lend it to any bank in trouble. (Details on how that is accomplished are in Chapter Eight.) But there are practical limits to just how far that process can work. Even the Fed will not support a bank that has gotten itself so deeply in the hole it has no realistic chance of digging out. When a bank’s bookkeeping assets finally become less than its liabilities, the rules of the game call for transferring the losses to the depositors themselves. This means they pay twice: once as taxpayers and again as depositors. The mechanism by which this is accomplished is called the Federal Deposit Insurance Corporation.
The FDIC Play
The FDIC guarantees that every insured deposit will be paid back regardless of the financial condition of the bank. The money to do this comes out of a special fund which is derived from assessments against participating banks. The banks, of course, do not pay this assessment. As with all other expenses, the bulk of the cost ultimately is passed on to their customers in the form of higher service fees and lower interest rates on deposits.
The FDIC is usually described as an insurance fund, but that is deceptive advertising at its worst. One of the primary conditions of insurance is that it must avoid what underwriters call
moral hazard, That is a situation in which the policyholder has little incentive to avoid or prevent that which is being insured against When moral hazard is present, it is normal for people to become careless, and the likelihood increases that what is being insured against will actually happen. An example would be a government Program forcing everyone to pay an equal amount into a fund to Protect them from the expense of parking fines. One hesitates even to mention this absurd proposition lest some enterprising politician should decide to put it on the ballot. Therefore, let us hasten to point out that, if such a numbskull plan were adopted, two things would happen: (1) just about everyone soon would be getting parking tickets and (2), since there now would be so many of them, the taxes to pay for those tickets would greatly exceed the previous cost of paying them without the so-called protection.
The FDIC operates exactly in this fashion. Depositors are told their insured accounts are protected in the event their bank should become insolvent. To pay for this protection, each bank is assessed a specified percentage of its total deposits. That percentage is the same for all banks regardless of their previous record or how risky their loans. Under such conditions, it does not pay to be cautious. The banks making reckless loans earn a higher rate of interest than those making conservative loans. They also are far more likely to collect from the fund, yet they pay not one cent more. Conservative banks are penalized and gradually become motivated to make more risky loans to keep up with their competitors and to get their
fair share of the fund’s protection. Moral hazard, therefore, is built right into the system. As with protection against parking tickets, the FDIC increases the likelihood that what is being insured against will actually happen. It is not a solution to the problem, it is part of the problem.
Real Insurance Would Be a Blessing
A true deposit-insurance program which was totally voluntary and which geared its rates to the actual risks would be a blessing. Banks with solid loans on their books would be able to obtain protection for their depositors at reasonable rates, because the chances of the insurance company having to pay would be small. Banks with unsound loans, however, would have to pay much higher rates or possibly would not be able to obtain coverage at any price. Depositors, therefore, would know instantly, without need to investigate further, that a bank without insurance is not a place where they want to put their money. In order to attract deposits, banks would have to have insurance. In order to have insurance at rates they could afford, they would have to demonstrate to the insurance company that their financial affairs are in good order. Consequently, banks which failed to meet the minimum standards of sound business practice would soon have no customers and would be forced out of business. A voluntary, private insurance program would act as a powerful regulator of the entire banking industry far more effectively and honestly than any political scheme ever could. Unfortunately, such is not the banking world of today.
protection is not insurance in any sense of the word. It is merely part of a political scheme to bail out the most influential members of the banking cartel when they get into financial difficulty. As we have already seen, the first line of defense in this scheme is to have large, defaulted loans restored to life by a Congressional pledge of tax dollars. If that should fail and the bank can no longer conceal its insolvency through creative bookkeeping, it is almost certain that anxious depositors will soon line up to withdraw their money — which the bank does not have. The second line of defense, therefore, is to have the FDIC step in and make those payments for them.
Bankers, of course, do not want this to happen. It is a last resort. If the bank is rescued in this fashion, management is fired and what is left of the business usually is absorbed by another bank. Furthermore, the value of the stock will plummet, but this will affect the small stockholders only. Those with controlling interest and those in management know long in advance of the pending catastrophe and are able to sell the bulk of their shares while the price is still high. The people who create the problem seldom suffer the economic consequences of their actions.
The FDIC Will Never Be Adequately Funded
The FDIC never will have enough money to cover its potential liability for the entire banking system. If that amount were in existence, it could be held by the banks themselves, and an insurance fund would not even be necessary. Instead, the FDIC operates on the same assumption as the banks: that only a small percentage will ever need money at the same time. So the amount held in reserve is never more than a few percentage points of the total liability. Typically, the FDIC holds about $1.20 for every $100 of covered deposits. At the time of this writing, however, that figure had slipped to only 70 cents and was still dropping. That means that the financial exposure is about 99.3% larger than the safety net which is supposed to catch it. The failure of just one or two large banks in the system could completely wipe out the entire fund.
And it gets even worse. Although the ledger may show that so many millions or billions are in the fund, that also is but creative bookkeeping. By law, the money collected from bank assessments must be invested in Treasury bonds, which means it is loaned to the government and spent immediately by Congress. In the final stage of this process, therefore, the FDIC itself runs out of money and turns, first to the Treasury, then to Congress for help. This step, of course, is an act of final desperation, but it is usually presented in the media as though it were a sign of the system’s great strength. U.S. News & World Report blandly describes it this way:
Should the agencies need more money yet, Congress has pledged the full faith and credit of the federal government, Gosh, gee whiz. Isn’t that wonderful? It sort of makes one feel rosy all over to know that the fund is so well secured.
Let’s see what
full faith and credit of the federal government actually means. Congress, already deeply in debt, has no money either. It doesn’t dare openly raise taxes for the shortfall, so it applies for an additional loan by offering still more Treasury bonds for sale. The public picks up a portion of these I.O.U.s, and the Federal Reserve buys the rest. If there is a monetary crisis at hand and the size of the loan is great, the Fed will pick up the entire issue.
But the Fed has no money either. So it responds by creating out of nothing an amount of brand new money equal to the I.O.U.s and, through the magic of central banking, the FDIC is finally funded. This new money gushes into the banks where it is used to pay off the depositors. From there it floods through the economy diluting the value of all money and causing prices to rise. The old paycheck doesn’t buy as much any more, so we learn to get along with a little bit less. But, see? The bank’s doors are open again, and all the depositors are happy — until they return to their cars and discover the missing hub caps!
That is what is meant by
the full faith and credit of the federal government.
Although national monetary events may appear mysterious and chaotic, they are governed by well-established rules which bankers and politicians rigidly follow. The central fact to understanding these events is that all the money in the banking system has been created out of nothing through the process of making loans. A defaulted loan, therefore, costs the bank little of tangible value, but it shows up on the ledger as a reduction in assets without a corresponding reduction in liabilities. If the bad loans exceed the size of the assets, the bank becomes technically insolvent and must close its doors. The first rule of survival, therefore, is to avoid writing off large, bad loans and, if possible, to at least continue receiving interest payments on them. To accomplish that, the endangered loans are rolled over and increased in size. This provides the borrower with money to continue paying interest plus fresh funds for new spending. The basic problem is not solved, but it is postponed for a little while and made worse.
The final solution on behalf of the banking cartel is to have the federal government guarantee payment of the loan should the borrower default in the future. This is accomplished by convincing Congress that not to do so would result in great damage to the economy and hardship for the people. From that point forward, the burden of the loan is removed from the bank’s ledger and transferred to the taxpayer. Should this effort fail and the bank be forced into insolvency, the last resort is to use the FDIC to pay off the depositors. The FDIC is not insurance, because the presence of
moral hazard makes the thing it supposedly protects against more likely to happen. A portion of the FDIC funds are derived from assessments against the banks. Ultimately, however, they are paid by the depositors themselves. When these funds run out, the balance is provided by the Federal Reserve System in the form of freshly created new money. This floods through the economy causing the appearance of rising prices but which, in reality, is the lowering of the value of the dollar. The final cost of the bailout, therefore, is passed to the public in the form of a hidden tax called inflation.
So much for the rules of the game. In the next chapter we shall look at the scorecard of the actual play itself.