The Invisible Bailout

Mary Bottari of BanksterUSA has written a post over here about how the Fed—not TARP—was the main channel through which the financial system was bailed out. Here's a chart she uses to make her point:

This is an tremendously underappreciated aspect of the financial meltdown. I actually wrote up an explanation of how it worked back in June, 2009, complete with an extremely similar chart. I think it stands up well and is complementary to what Bottari is writing about. So here you go.

Note that the media fell for the scam I describe completely. Even This American Life, which has done amazing journalism about the financial meltdown, produced an episode called "Another Frightening Show About the Economy" on October 3, 2008 that might as well have been dictated by the Federal Reserve (except no one at the Fed has the talent to present it this well). Moreover, to this day essentially no one in the media understands what happened.

Why Did the TARP Bailout Happen the Way It Did?

Here's my answer. It's partly conjecture, but the circumstantial evidence is very strong, and there should be more available with just a little digging.

After the bankruptcy of Lehman and the bailout of AIG in mid-September, Ben Bernanke and Hank Paulson were genuinely worried -- it was now obvious it would require gargantuan amounts of money, starting immediately, to bail out the banking system. Some of the money spent would eventually come back to the government, but inevitably the final losses would be in the hundreds of billions.

BUT -- what worried them was not finding the money. The weird truth is the Fed can literally create money from nothing. That's the way they expand the money supply.

In normal times, the Fed does this by purchasing government bonds. If they want to buy a bond for $100, they just electronically credit the seller, who then has $100 more in their bank account. And the Fed then has the bond in its portfolio. In the past, the total Fed portfolio (almost all government bonds) had been just under $1 trillion.

But in emergencies, the Fed has the legal authority to buy almost anything. As it had demonstrated up to last September, it can buy Citigroup bonds. It can buy $30 billion in crappy mortgage-backed securities from Bear Stearns. It can pay $85 billion for AIG.

So the money wasn't the problem. The problem was that they were going to spend over a trillion dollars, more than doubling the Fed portfolio. Now, if had been possible, the financial industry would have loved it if the Fed could have just taken care of it on its own. That would have been the best possible solution, with no meddling congress members asking questions about executive bonuses.

But $1-2 trillion is so much that even congress and the media would notice. Nancy Pelosi was already complaining about the AIG bailout. And Bernanke and Paulson were well aware that every person in America who didn't work for Goldman Sachs was going to loathe what was coming.

So what did Bernanke, Paulson, and the financial industry need at this point, if not the money?

THEY NEEDED SOMEONE TO SHARE THE BLAME.

That's the first rule of political catastrophes: if everyone's guilty, no one can be punished.

This was an opportunity to get everyone else on the hook with them: both parties in congress, and both presidential candidates, each of whom would be under enormous pressure not to look "irresponsible." Even better, getting some TARP money from congress would create a huge distraction from the gigantic amounts of non-TARP money the Fed was shoveling out the door.

So all they had to do now was make congress terrified the economy was about to collapse. And to do this, they needed a plausible story.

This part was tough. After all, if a few banks failed here or there, so what? Depositors were protected, and we were headed into a recession anyway, with a lower need for medium-term credit.

But there was one excellent candidate to be the WMD of the TARP bailout: the commercial paper market.

That's what the Fed, Paulson, and White House were selling to congress and the media. If you go back and look at all the cable news about the bailout, it's obvious "commercial paper" was the talking point. It comes up over and over again. Tom Brokaw, CNN's money reporter, Sen. John Kyl, Mitt Romney -- they all repeated the story like robots. Just like the scary WMD.

It goes like this: big corporations are like rich people with lots of assets and money coming in at irregular intervals but not much cash in the bank. In the same way a rich person like that would use a credit card to buy groceries and gas, big corporations borrow money in the commercial paper market to make payroll, pay vendors, etc. They're continually borrowing money and paying it back the next day or next week.

In normal times, the commercial paper market is extremely boring and extremely safe. But in the same week Lehman went bankrupt and AIG was bailed out, the commercial paper market was collapsing. The pension funds and university endowments that supply the money were spooked, pulling it out, and putting it in government bonds.

This WAS a real, frightening problem. No commercial paper market, and Wal-Mart can't pay for everything being delivered to its stores. Big grocery chains can't pay for food. And no one is paying their workers. The entire economy could grind to a halt, and no one knew how hard it would be to start it again.

But there's one thing Bernanke and Paulson left out, and that all the people talking about on TV didn't know: there was no need for congress to pass a bill to save the commercial paper market, because the Fed could buy it directly. We know this because the Fed DID buy giant amounts of it, over $300 billion -- but not until October, well after TARP had passed.

So in September, Bernanke was saying: "Help! We need $700 billion or else the commercial paper market will destroy the world!"

Then a month later in October, Bernanke quietly went ahead and saved the commercial paper market, using non-TARP money -- something he could have easily done the month before.

This can all be seen in the above graph that I made. The Fed balance sheet exploded starting in mid-September. They spent $500 billion by October 1st, two days before TARP passed. They spent $1 trillion by the time the first trickles of TARP money were allocated in late October. (This in itself is damning -- we had to give them the money or else Planet Earth would explode, and yet it took Paulson three weeks to dole out the first TARP sliver.) All along, the Fed side of the bailout had dwarfed TARP.

Yet it's been completely invisible. While we were all screaming about that little pink line, the Fed was carrying out the real bailout via the blue line and we never noticed.

And most of amazing of all, to this day the Fed refuses to say exactly what they've bought for $1.3 trillion. Seriously -- congress has asked, and the Fed has basically said: screw you. (NOTE: Since I wrote this, the Fed was forced, over its loud objections, to disclose what it purchased.)

Now, for the final proof this was a scam: several months after TARP passed, the New Yorker profiled Ben Bernanke. In the article, Bernanke claims he said this to Paulson on September 17th, after the AIG bailout: "We can’t keep doing this. Both because we at the Fed don’t have the necessary resources and for reasons of democratic legitimacy, it’s important that the Congress come in and take control of the situation."

Sounds good, doesn't it? But if you think about it for two seconds, it's obvious crap. #1, look at the graph --the Fed had the resources and wasn't shy about using them. #2, the high-pressure way they sold TARP and the Fed's ongoing secrecy demonstrates how much Bernanke cares about "democratic legitimacy."

—Jonathan Schwarz