QUESTION: We hear that the feds HAD to bail out Fannie and Freddie because
of the terrible consequences of letting them fail. How much of that is real and
how much is bunk? I’d have thought that if the companies go bankrupt, their
stock sells for pennies on the dollar and the new owners can re-negotiate
loans down to lower interest rates for people who can afford to pay something,
while foreclosing and selling (cheap) those homes that had been bought on false
pretences and weren’t going to be paid off at any positive interest rate. Where’s
the catastrophe? Am I missing something important?

ANSWER: Yes, you are missing something important. Banking is a confidence game
because banks borrow short to lend long, making their income on the spread of
interest rates. That means they are at all times technically insolvent, so when
confidence hangs by a thread the whole system can crash, even though for
years it has operated smoothly.

They insure all this with a cushion of capital and surplus that is a small
fraction of their liabilities, well under 10%. So if a small fraction of their
borrowers default it wipes out their capital and surplus, and they stop

When they move too much of their funds into long-term investments like
buildings, plus land purchases which are even slower to pay out, their loan
turnover slows down so every year they have fewer funds to finance current
production. This is the case today, and it chokes off lots of productive

Superficially the lower (commercial) banks avoid this slowdown by selling
their assets to higher (investment) banks, but that just blows dust over what
is really happening. The higher banks end up holding the bag, as now, and they
collapse, as now.

Since FDR, strict banking regulations held the system in check. The Glass-
Steagall Act of 1933 separated commercial banks from investment banks
precisely to protect consumers and commercial borrowers from the risky
behavior of higher banks. Since Newt Gingrich and Rush Limbaugh and Tom DeLay
took over, these regs have been repealed, including Glass-Steagall in 1999.
The ensuing crash, set up by doctrinaire neocons blinded by Chicago-school
economic theology and Bush imperialism, is likely to match 1929.

In previous busts the U.S. Treasury could hold the final bag. Now, however,
the U.S. Treasury itself is vulnerable, depending on loans from foreign
nations. So we inflate the currency and devalue the dollar in a vain effort to
prevent further collapse of real estate values and further seizing up of the
commercial banking system.

Bernanke and Paulson, no fools, are making lemonade as best one could hope. I
would nonetheless fault them for cooperating with an administration that
refuses to raise taxes or cut military spending and related puppet-propping
subventions. We need to do what Clinton did: “reverse crowding out”–paying off
government bonds to put money back into the hands of consumers and, especially, investors.

Of course this leads right into income tax reform, which is more Paulson’s
business than Bernanke’s. We need steeply progressive income and corporate
taxes and an end to special treatment of real estate, oil and other natural

Bernanke’s business should be to promote selective credit controls, especially
to restrict bank lending on real estate collateral.

Mason Gaffney
21 September 2008