by Dr. Gary North
As a conservative, I grew up in the threat of socialism: the
nationalization of the tools of production. What no one warned
me was that this could be accomplished by way of a unique form of
nationalization: the nationalization of insolvency.
We have lived through this process in 2008. The process
will continue for several more years.
Insolvency is being transferred from the banking sector to
the government sector. How much insolvency? So far in 2008, the
government and the Federal Reserve System are on the hook for as
much as an additional $7.7 trillion.
Solvency is being retained by the bailed-out banks: the
private sector. Insolvency is being transferred to the those who
depend on Social Security and Medicare, and also to future
investors in U.S. government debt.
This is being done with full compliance of Congress, both
Administrations, Wall Street, and most voters, who do not
understand the nature of the transfer process.
One man does understand it. He shares a common bond with
Treasury Secretaries Henry Paulson and Robert Rubin: he served as
CEO of Goldman Sachs. His name is John Whitehead. He has
watched the financial markets for seven decades. On November 12,
he offered his assessment. The United States faces a slump
deeper than the Great Depression. Unlike the Great Depression,
however, this will be accompanied by the downgrading of Treasury
We’re talking about reducing the credit of the United
States of America, which is the backbone of the
economic system. I see nothing but large increases in
the deficit, all of which are serving to decrease the
credit standing of America. . . .
The public is not prepared to increase taxes. Both
parties were for reducing taxes, reducing income to
government, and both parties favored a number of new
programs — all very costly and all done by the
All this has taken place behind the scenes this year. It
has taken place on five Sundays. Then, on five Mondays, the
announcement of the transfer of insolvency to the U.S. government
has been announced by Treasury Secretary Paulson. The public
It happened again last weekend: another Sunday surprise.
The government on Sunday guaranteed the survival of Citigroup,
which was about to go bankrupt. Citigroup includes Citibank.
Citigroup in 2006 had a capitalized value of $274 billion.
By Thursday afternoon, this was down to $26 billion.
This was not much of a surprise. The stock market had
already anticipated it. The Dow rose by almost 500 points late
on Friday in expectation of the bailout. It was up another 400
points on Monday.
American investors believe in bailouts. For them, salvation
happens on Sunday.
As taxpayers, they shrug it off. “We’ll grow our way out of
this.” They really mean, “Our children will grow their way out
of this, and will pay us our Social Security and pensions as our
government has promised on their behalf.” Think of this as the
equivalent of the United Auto Workers’ faith in the pension
guarantees made by the Big Three American automakers.
As investors, they cheer. “No more losses!” Think of this
as the United Auto Workers’ view of competition in 1965.
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It goes on like this for two pages. Inspirational!
Investors believe in government bailouts with the same
confidence that readers are expected to believe this promotional
piece by Citi.
Before I comment on the Citi bailout, let me review the
history of recent Sunday deliverances. I call these Sunday
THE FIRST SURPRISE
The first Sunday surprise took place on March 16. The “New
York Times” described it late that afternoon.
Bear Stearns, pushed to the brink of bankruptcy by what
amounted to a run on the bank, agreed late Sunday to
sell itself to JPMorgan Chase for a mere $2 a share,
narrowly averting a collapse that threatened to cascade
through the financial system.
The price represents a startling 93 percent discount to
Bear Stearns’ closing stock price on Friday on the New
York Stock Exchange.
Bankers and policy makers raced to complete the deal
before financial markets in Asia opened on Monday, as
fears grew that the financial panic could spread if
Bear Stearns failed to find a buyer.
The deal, done at the behest of the Federal Reserve and
the Treasury Department, punctuates the stunning
downfall of one of Wall Street’s biggest and most
Less than a week earlier, the CEO of Bear Stearns, Alan
Schwartz, had assured the public that the company was solvent,
that there was no problem. A Reuters story was typical of the
press’s handling of the story.
Schwartz, in a televised interview on CNBC, also said
he is comfortable with the range of analysts’ earnings
estimates for the fiscal first quarter ended Feb. 29.
Results for the quarter are due next week.
“We don’t see any pressure on our liquidity, let alone
a liquidity crisis,” he said.
Bear finished fiscal 2007 with $17 billion of cash
sitting at the parent company level as a “liquidity
cushion,” he said.
“That cushion has been virtually unchanged. We have $17
billion or so excess cash on the balance sheet,” he
Schwartz denied speculation that other brokers were
turning down Bear’s credit on trades for fear of
According to an article published weeks later, this
“speculation” was introduced by the CNBC interviewer, who cited
an anonymous source that Goldman Sachs had turned down a Bear
Stearns trade. Schwartz denied it.
“There’s been a lot of volatility in the market, a lot
of disruption. That’s causing some administrative
pressure, getting trades settled. We’re in constant
dialogue with all the major dealers, and I have not
been made aware of anybody not taking our credit,” he
The Reuters article went on the describe the state of the
As one of the largest players in mortgage-backed bond
markets, investors have assumed Bear’s exposure would
lead to crippling losses.
“None of that speculation is true,” Schwartz said. When
speculation starts in a market, one that has a lot of
emotion in it and people concerned with volatility,
“they will sell first and ask questions later,” he
said. “That creates its own momentum.”
The critic of this chain of events argues that there never
was verifiable evidence that Goldman Sachs or any other firm had
turned down Bear Stearns’ business.
The market did not care. This supposed solvency turned out
to be irrelevant within hours. Bear Stearns’ stock price
continued to fall on Thursday and Friday. By Monday morning,
Bear Stearns was no more.
A rumor cannot create this outcome except when fears are
rampant and leverage is high. Bear Stearns was the victim of
high leverage and bad forecasts. It took a fire sale on Sunday,
initiated by the New York Federal Reserve Bank, to keep Bear from
going bankrupt on Monday, March 17: St. Patrick’s Day.
To sweeten the deal, the Federal Reserve absorbed the risk
for $29 billion of Bear Stearns’ debt.
The public outcry and the threat of shareholder’ lawsuit
against the $2 per share price later led to Morgan upping the
price to $10.
As for the $17 billion in liquidity, Morgan must have gotten
it as part of the firm’s assets. We never heard any more about
Paraphrasing Bunker Hunt’s statement in 1980, as he was
going bankrupt, when the FED had to lend him a billion dollars,
“Seventeen billion just doesn’t go as far as it used to.”
THE SECOND SURPRISE
On Sunday, September 7, Treasury Secretary Paulson announced
that Fannie Mae and Freddie Mac had been taken over by the U.S.
government. He issued this press release.
Before I turn to Jim to discuss the action he is taking
today, let me make clear that these two institutions
are unique. They operate solely in the mortgage market
and are therefore more exposed than other financial
institutions to the housing correction. Their statutory
capital requirements are thin and poorly defined as
compared to other institutions. Nothing about our
actions today in any way reflects a changed view of the
housing correction or of the strength of other U.S.
Note these words: “Nothing about our actions today in any
way reflects a changed view of the housing correction or of the
strength of other U.S. financial institutions.” A week later,
Paulson & Co. were at it again. They tried — and failed — to
keep Lehman Brothers Holdings from going bankrupt.
Paulson’s press release then made a statement that will
haunt the financial markets for the news two years — maybe
I have long said that the housing correction poses the
biggest risk to our economy. It is a drag on our
economic growth, and at the heart of the turmoil and
stress for our financial markets and financial
institutions. Our economy and our markets will not
recover until the bulk of this housing correction is
I can think of no more accurate statement from Mr. Paulson
during his term of office. The housing correction is in its
early phase. As it accelerates, so will the “the turmoil and
stress for our financial markets and financial institutions.”
Count on it.
This was the nationalization of America’s mortgage industry.
By September 2008, Fannie and Freddie were supplying 90% of all
residential mortgages in the United States. But Paulson did not
use the N-word. He picked another.
I support the Director’s decision as necessary and
appropriate and had advised him that conservatorship
was the only form in which I would commit taxpayer
money to the GSEs.
“Conservatorship.” How reassuring. Nationalization would
have seemed so crass, so anti-free market.
Then he admitted what is still true: the mortgage market is
at the heart of the U.S. economy. The economy was heading for a
And let me make clear what today’s actions mean for
Americans and their families. Fannie Mae and Freddie
Mac are so large and so interwoven in our financial
system that a failure of either of them would cause
great turmoil in our financial markets here at home and
around the globe. This turmoil would directly and
negatively impact household wealth: from family
budgets, to home values, to savings for college and
retirement. A failure would affect the ability of
Americans to get home loans, auto loans and other
consumer credit and business finance. And a failure
would be harmful to economic growth and job creation.
That is why we have taken these actions today.
This is the issue of systemic risk, or, as the old spiritual
put it, “the knee bone connected to the thigh bone. The thigh
bone connected to the. . . .” And so on. Paulson called for
government intervention to keep the market from imposing its
negative sanctions on bad decisions made by the leaders at Fannie
And policymakers must address the issue of systemic
risk. I recognize that there are strong differences of
opinion over the role of government in supporting
housing, but under any course policymakers choose,
there are ways to structure these entities in order to
address market stability in the transition and limit
systemic risk and conflict of purposes for the
long-term. We will make a grave error if we don’t use
this time out to permanently address the structural
issues presented by the GSEs.
There was no mention of the taxpayers’ price tag on this
“conservatorship.” Combined, the two outfits have guaranteed
over $5 trillion in mortgages. To this was added the Mortgage
Backed Securities (MBS) that had been sold — and borrowed
against — to buy these mortgages. What of these investments?
Because the U.S. Government created these ambiguities,
we have a responsibility to both avert and ultimately
address the systemic risk now posed by the scale and
breadth of the holdings of GSE debt and MBS.
The move was immediately praised by Ben Bernanke. Bond fund
manager Bill Gross also praised it.
THE THIRD SURPRISE
A week after the nationalization of the mortgage market,
there was another emergency meeting. This time, the survival of
the huge investment banking firm of Lehman Brothers Holdings was
at stake. So little known was this 160-year-old institution that
knowledgeable commentators still do not know how to pronounce
Lehman: “Leeman” or “Layman.” (“Leeman.”)
Another institution facing bankruptcy was Merrill Lynch, the
largest and most famous retail brokerage form in the United
The result of Sunday’s meeting: Lehman declared bankruptcy
on Monday morning and Merrill was bought by Bank of America for
$50 billion of BofA stock.
All of this was done behind closed doors over a weekend.
That was how desperate the government and the Federal Reserve
were to get the deals done by Monday morning. They failed with
Lehman. No deal.
Lehman had over $100 billion in bonds outstanding. It
reported its debts at $613 billion and its assets at $639
According to its former CEO, Richard Fuld, he took out $300
million in the eight years prior to the collapse of his company.
By the end of the week, September 21, two other investment
banks, Goldman Sachs and Morgan Stanley, filed with the FED for
bank holding company status. That was on a Saturday. This
switch was immediately granted. This entitled them to the
bailout money being offered by the Federal Reserve System and
anything Congress might pass. Congress passed a $700 bailout
plan, plus $150 billion in pork, by the end of September.
That was the last of the Big Five investment banks. The
survivors are minor players that only specialists have heard of,
such as Jeffries.
Goldman Sachs’ press release on September 21 is worth
considering. It mentioned that it had been founded in 1869. It
was a private banking firm open only to “high net worth
individuals.” No longer.
“When Goldman Sachs was a private partnership, we made
the decision to become a public company, recognizing
the need for permanent capital to meet the demands of
scale. While accelerated by market sentiment, our
decision to be regulated by the Federal Reserve is
based on the recognition that such regulation provides
its members with full prudential supervision and access
to permanent liquidity and funding,” said Lloyd C.
Blankfein, Chairman and CEO of Goldman Sachs. “We
believe that Goldman Sachs, under Federal Reserve
supervision, will be regarded as an even more secure
institution with an exceptionally clean balance sheet
and a greater diversity of funding sources.”
That said it all. The rich no longer could survive on their
own. From now on, they will need to be “under Federal Reserve
We are at the end of an era that stretches back to early
nineteenth-century America. The whole nation now looks to fiat
money and government bailouts. The era of American
entrepreneurship has ended in the financial markets.
THE FOURTH SURPRISE
On the weekend of September 27, FDIC officials met with
officials of America’s fourth largest bank, Wachovia, and
officials of America’s no longer largest bank, Citigroup. They
hammered out a merger. This was done with no public
announcement. The announcement came in a press release on Monday
morning, before the stock market opened.
Citigroup Inc. will acquire the banking operations of
Wachovia Corporation; Charlotte, North Carolina, in a
transaction facilitated by the Federal Deposit
Insurance Corporation and concurred with by the Board
of Governors of the Federal Reserve and the Secretary
of the Treasury in consultation with the President. All
depositors are fully protected and there is expected to
be no cost to the Deposit Insurance Fund. Wachovia did
not fail; rather, it is to be acquired by Citigroup
Inc. on an open bank basis with assistance from the
It was a sweet deal for Citigroup.
Citigroup Inc. will acquire the bulk of Wachovia’s
assets and liabilities, including five depository
institutions and assume senior and subordinated debt of
Wachovia Corp. Wachovia Corporation will continue to
own Wachovia Securities, AG Edwards and Evergreen. The
FDIC has entered into a loss sharing arrangement on a
pre-identified pool of loans. Under the agreement,
Citigroup Inc. will absorb up to $42 billion of losses
on a $312 billion pool of loans. The FDIC will absorb
losses beyond that. Citigroup has granted the FDIC $12
billion in preferred stock and warrants to compensate
the FDIC for bearing this risk.
It was too sweet a deal. Wells Fargo sued Citigroup.
Citigroup was offering $2.2 billion for Wachovia. Wells Fargo
was offering $15 billion. Wells Fargo eventually triumphed.
That move gave Wells Fargo more branches than any other bank,
plus deposits equaling Bank of America.
THE FIFTH SURPRISE
Citigroup was the institutional heir of the Rockefeller
family, through William, the brother of John D. William’s son
James Stillman Rockefeller became chairman in 1959.
The bank’s history goes back to the War of 1812. So large
was this bank that it was the first contributor to the Federal
Reserve Bank of New York in 1914.
On November 4, 2007, its CEO, Chuck Prince, resigned. The
next day, I told my Website’s subscribers to get out of stocks
and short the S&P 500.
According to a report on Bloomberg, in late 2006, the
capitalized value of Citigroup was $274 billion. It was the
largest bank in the United States in terms of market value, with
Bank of America second. By September 21, 2008, its capitalized
value was in the range of $26 billion.
The extent of the bank’s condition was published only after
the Sunday bailout. At that point, the government and the
Federal Reserve had to come clean. The disaster could no longer
be concealed. What had been the largest bank in terms of market
value had slipped to #6, and was about to go bust. This is why
the government intervened.
The government (you and I) will shield the bank’s
shareholders and creditors against most of the losses in its
portfolio of toxic loans.
Terms of the asset guarantees mean Citigroup will cover
the first $29 billion of pretax losses from the $306
billion pool, in addition to any reserves it already
has set aside. After that, the government covers 90
percent of the losses, with Citigroup covering the rest
from assets that include leveraged loans and so-called
structured investment vehicles.
The government will pay $20 billion for $27 billion of
preferred stock, which will pay 8%. (It will pay 8% only because
the government will pay off the bad loans.)
The government has already provided $25 billion in the
Troubled Asset Relief Program, which is part of the $700 billion
bailout bill, passed in late September.
“This is a partial government takeover,” Christopher
Whalen of Institutional Risk Analytics, a Torrance,
California- based research firm, said in a Bloomberg
Radio interview. “We have been telling people for a
while that some of the top banks were going to end up
controlled by the government next year. It looks like
that’s happening sooner than even we expected.”
In a lengthy, detailed article published in the “New York
Times” on November 22 — two years too late — the reporters
trace the history of bad decisions made by senior managers at
Citi. The article shows that there were red flags, but no one
paid any attention. The article also indicates that there may be
more bad news to come.
Call it “Citi bailout, phase I.
America’s biggest banks are going bust or have gone bust.
Little banks are toppling each week. There is no end in sight.
The government, which is running a trillion-dollar deficit
this fiscal year, is adding ever more debt to save the favored
banks. It is buying the banks’ insolvency in the name of future
The buyers of Treasury debt and the Federal Reserve System
are funding all of this. They think future taxpayers will pay
them back. I don’t. I think there will be a tax revolt: mass
Meanwhile, every dollar that flows into the Treasury does
not flow into the private sector. The nationalization of
The authority of make decisions regarding who will get the
shrinking supply of private savings that the banks have not
already absorbed to keep their doors open have been transferred
to a new generation of capitalists, people who live in fear of
government regulators, not depositors.
The year 2008 has seen the end of free market financial
capitalism. Forget about efficiency. Forget about stable
economic growth. Forget about everything except solvency as
defined in fiat money.
Moral hazard is alive and well in the West. Free capital
markets are not.
It was nice while it lasted. But it could not last. State
capitalism always demands bailouts. It always gets what it asks
Senior managers got the gold mine. Taxpayers got the shaft.
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