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Bear Stearns – First Steps to Socialism?

Updated on April 8, 2008

Bear Stearns – First Steps to Socialism?

I’m not sure how else I could characterize the intervention of the Federal Reserve in what appears to be an illegal as well as unregulated manner. The Federal Reserve System was never intended to provide bail out finance to struggling private investment companies. It certainly has every appearance of vastly exceeding its remit and authority.

Let’s recap for a moment. Bear Stearns is /was an investment bank, the type of bank which has nothing to do with the everyday bank that you and I use, which has insurance provided by the FDIC to protect our savings. Bear Stearns does not fall under this category, even though the borders were somewhat blurred by a law passed in 1999 which among other things basically rescinded the 1933 law which separated commercial banking (our type of bank) from investment banking. Need I remind you that this 1933 law was as a result of the Great Depression, when many savers lost their money? Bear Stearns has made some interesting mistakes, including letting two hedge funds fail in the middle of last year, and, when it declared a loss in the quarter, the CEO realized it was time to go, and resigned in January. Word on the Street got out, and investors were being advised in some quarters to divest themselves of their BS holdings.

Now the Federal Reserve Act mandates the Reserve to maintain a sound currency, and was later expanded to touch on employment. It does not say that it is supposed to bail out anyone who gets in financial trouble on Wall Street, or anywhere else, for that matter. It is well known that the heads of these companies have substantial bonus checks allocated, some even during the latest problems in the market, and they seem to behave with impunity and now with the help of government support to ensure that their company does not collapse, despite unsound business practices.

The unfortunate fact is that the system was virtually bound to fail at some point, because of the way sub-prime mortgages have been packaged together to make them acceptable to investors, a process called “securitization”. Sub-prime mortgages are risky, which is why they are called sub-, or less than, prime, but the financial machinations meant that the true nature of the investments was masked to those who didn’t ask the right questions.

The Federal Reserve has taken on, in underwriting the securities involved, the risk of the sub-prime loans, and hence has taken it on for the American citizen, who will ultimately pay for any default in those loans. In other words, the Feds are “socializing” the risk to the investment bank, but are leaving the profits “privatized”.

The fact is that there is nothing that is “Federal” about the Bear Stearns crisis – it’s just the nature of the business that the bank is highly leveraged, and that means that any glitch in the value has significant consequences to confidence. Bear Stearns was leveraged about 30:1, Morgan Stanley is leveraged about 32:1, and I bet they are feeling a whole lot less vulnerable now that the Feds have declared their hand.

Officially, the Feds by their action have averted a panic in the markets that would have caused some severe problems. Arguably, however, the Feds have added to the further destruction of the dollar by taking on devalued loans, that cannot be backed by equity. In fact, as Andy Beal, a Texas banker explains, Bernanke, and by extension, the American public, may have taken on more than he knows. Many AAA mortgage bonds have contracts that permit the loan servicers to advance payments on behalf of the defaulting homeowners at interest rates of 12% or more, for years to come. These “servicer advances” are repaid first from foreclosed home sales. This means that foreclosed home sales may result in little or no proceeds, or even a liability to the holder of the AAA mortgage!

All this takes place against the background of millions facing financial difficulties and even foreclosure, which makes you wonder why the Feds don’t do something similar to help the people at the root of the problem, the defaulting borrowers?

However, the real questions that are overlooked in the rush to “save” another financial institution are

- should the US government subsidize securities dealers?

- should the government decide the winners on Wall Street, by timely action?

- should the government have such power over private businesses?

- and aren’t governments that own the banks called socialist?

To have your say and learn about the stock market, you need to head on over to Stu Whisson at www.insightsupport.com, who is a trading expert, and always gives personal replies. His free trading course at the website is worth looking at, too!

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