THE CREATURE FROM JEKYLL ISLAND
A Second Look at the Federal Reserve
by G. Edward Griffin
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 mad.? 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
I hose 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 out" the entirety of their own Latin
American loans within two years.1
1- "Overseas Lending ... Trigger for A Severe Depression?" The Banking Safety
Digest (U.S. Business Publishing/Veribanc, Wakefield, Massachusetts), August,
1989, p. 3.
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!
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 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 numb-skull 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 arc 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.
The FDIC "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.
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."1 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.
1. "How Safe Are Deposits in Ailing Banks, S&L's?" U.S. News & World Report, March 25,1985, p. 73.
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."
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.
In the previous chapter, we offered the whimsical analogy of a sporting event to clarify the maneuvers of monetary and political scientists to bail out those commercial banks which comprise the Federal-Reserve cartel. The danger in such an approach is that it could leave the impression the topic is frivolous. So, let us abandon the analogy and turn to reality. Now that we have studied the hypothetical rules of the game, it is time to check the scorecard of the actual play itself, and it will become obvious that this is no trivial matter. A good place to start is with the rescue of a consortium of banks which were holding the endangered loans of Penn Central Railroad.
The arrangement was convenient in many ways, not the least of which was that the bankers sitting on the board of directors were privy to information, long before the public received it, which would affect the market price of Penn Central's stock. Chris Welles, in The Last Days of the Club, describes what happened:
On May 21, a month before the railroad went under, David Bevan, Penn Central's chief financial officer, privately informed representatives of the company's banking creditors that its financial condition was so weak it would have to postpone an attempt to raise $100 million in desperately needed operating funds through a bond issue. Instead, said Bevan, the railroad would seek some kind of government loan guarantee. In other words, unless the railroad could manage a federal bailout, it would have to close down. The following day, Chase Manhattan's trust department sold 134,300 shares of its Penn Central holdings. Before May 28, when the public was informed of the postponement of the bond issue, Chase sold another 128,000 shares. David Rockefeller, the bank's chairman, vigorously denied Chase had acted on the basis of inside information.1
1. Chris Welles, The Last Days of the Club (New York: E.P. Dutton, 1975), pp. 398-99.
More to the point of this study is the fact that virtually all of the major management decisions which led to Penn Central's demise were made by or with the concurrence of its board of directors, which is to say, by the banks that provided the loans. In other words, the bankers were not in trouble because of Penn Central's poor management, they were Penn Central's poor management. An investigation conducted in 1972 by Congressman Wright Patman, Chairman of the House Banking and Currency Committee, revealed the following: The banks provided large loans for disastrous expansion and diversification projects. They loaned additional millions to the railroad so it could pay dividends to its stockholders. This created the false appearance of prosperity and artificially inflated the market price of its stock long enough to dump it on the unsuspecting public. Thus, the banker-managers were able to engineer a three-way bonanza for themselves. They (1) received dividends on essentially worthless stock, (2) earned interest on the loans which provided the money to pay those dividends, and (3) were able to unload 1.8 million shares of stock—after the dividends, of course—at unrealistically high prices.2 Reports from the Securities and Exchange Commission showed that the company's top executives had disposed of their stock in this fashion at a personal savings of more than $1 million.
2. "Penn Central," 1977 Congressional Quarterly Almanac (Washington, D.C.: Congressional Quarterly, 1971), p. 838.
Had the railroad been allowed to go into bankruptcy at that point and been forced to sell off its assets, the bankers still would have been protected. In any liquidation, debtors are paid off first, stockholders last; so the manipulators had dumped most of their stock while prices were relatively high. That is a common practice among corporate raiders who use borrowed funds to seize control of a company, bleed off its assets to other enterprises which they also control, and then toss the debt-ridden, dying carcass upon the remaining stockholders or, in this case, the taxpayers.
It was as though everyone was a part of a close knit club in which Penn Central and its officers could obtain, with very few questions asked, loans for almost everything they desired both for the company and for their own personal interests, where the bankers sitting on the Board asked practically no questions as to what was going on, simply allowing management to destroy the company, to invest in questionable activities, and to engage in some cases in illegal activities. These banks in return obtained most of the company's lucrative banking business. The attitude of everyone seemed to be, while the game was going on, that all these dealings were of benefit to every member of the club, and the railroad and the public be damned.
The banking cartel, commonly called the Federal Reserve
System, was created for exactly this kind of bailout. Arthur Burns,
who was the Fed's chairman, would have preferred to provide a
direct infusion of newly created money, but that was contrary to
the rules at that time. In his own words: "Everything fell through.
We couldn't lend it to them ourselves under the law.... I worked on
this thing in other ways."
[It should be noted this is the exact crap they pulled in 2008,but on an even larger scale D.C]
The company's cash crisis came to a head over a weekend and, in order to avoid having the corporation forced to file for bankruptcy on Monday morning, Burns called the homes of the heads of the Federal Reserve banks around the country and told them to get the word out immediately that the System was anxious to help. On Sunday, William Treiber, who was the first vice-president of the New York branch of the Fed, contacted the chief executives of the ten largest banks in New York and told them that the Fed's Discount Window would be wide open the next morning. Translated, that means the Federal Reserve System was prepared to create money out of nothing and then immediately loan it to the commercial banks so they, in turn, could multiply and re-lend it to Penn Central and other corporations, such as Chrysler, which were in similar straits.1 Furthermore, the rates at which the Fed would make these funds available would be low enough to compensate for the risk, speaking of what transpired on the following Monday, Burns boasted: "I kept the Board in session practically all day to change regulation Q so that money could flow into C.D's at the banks." Looking back at the event, Chris Welles approvingly describes it as "what is by common consent the Fed's finest hour."
1. For an explanation of the multiplier effect, see chapter eight, The Mandrake Mechanism.
Finest hour or not, the banks were not that interested in the proposition unless they could be assured the taxpayer would co-sign the loans and guarantee payment. So the action inevitably shifted back to Congress. Penn Central's executives, bankers, and union representatives came in droves to explain how the railroad's continued existence was in the best interest of the public, of the working man, of the economic system itself. The Navy Department spoke of protecting the nation's "defense resources." Congress, of course, could not callously ignore these pressing needs of the nation. It responded by ordering a retroactive, 13 per cent pay raise for all union employees. After having added that burden to the railroad's cash drain and putting it even deeper into the hole, it then passed the Emergency Rail Services Act of 1970 authorizing $125 million in federal loan guarantees.2
3. "Congress Clears Railroad Aid Bill, Acts on Strike," 1970 Congressional Almanac (Washington, D.C.: 1970), pp. 810-16.
None of this, of course, solved the basic problem, nor was it really intended to. Almost everyone knew that, eventually, the railroad would be "nationalized," which is a euphemism for becoming a black hole into which tax dollars disappear. This came to pass with the creation of AMTRAK in 1971 and CONRAIL in 1973. AMTRAK took over the passenger services of Penn Central, and CONRAIL assumed operation of its freight services, along with five other Eastern railroads. CONRAIL technically is a private corporation. When it was created, however, 85% of its stock was held by the government. The remainder was held by employees. Fortunately, the government's stock was sold in a public offering in 1987. AMTRAK continues under political control and operates at a loss. It is sustained by government subsidies—which is to say by taxpayers. In 1997, Congress dutifully gave it another $5.7 billion and, by 1998, liabilities exceeded assets by an estimated $14 billion. CONRAIL, on the other hand, since it was returned to the private sector, has experienced an impressive turnaround and has been running at a profit—paying taxes instead of consuming them.
A bailout plan was quickly engineered by Treasury Secretary
John B. Connally which provided the credit. The government
agreed to guarantee payment on an additional $250 million in
loans—an amount which would put Lockheed 60% deeper into the
debt hole than it had been before. But that made no difference now.
Once the taxpayer had been made a co-signer to the account, the
banks had no qualms about advancing the funds.
The not-so-obvious part of this story is that the government now had a powerful motivation to make sure Lockheed would be awarded as many defense contracts as possible and that those contracts would be as profitable as possible. This would be an indirect method of paying off the banks with tax dollars, but doing so in such a way as not to arouse public indignation. Other defense contractors which had operated more efficiently would lose business, but that could not be proven. Furthermore, a slight increase in defenses expenditures would hardly be noticed.
By 1977, Lockheed had, indeed, paid back this loan, and that fact was widely advertised as proof of the wisdom and skill of all the players, including the referee and the game commissioner. A deeper analysis, however, must include two facts. First, there is no evidence that Lockheed's operation became more cost efficient during these years. Second, every bit of the money used to pay back the loans came from defense contracts which were awarded by the same government which was guaranteeing those loans. Under such an arrangement, it makes little difference if the loans were paid back or not. Taxpayers were doomed to pay the bill either way.
In 1975, New York had reached the end of its credit rope and was unable even to make payroll. The cause was not mysterious. New York had long been a welfare state within itself, and success in city politics was traditionally achieved by lavish promises of benefits and subsidies for "the poor." Not surprisingly, the city also was notorious for political corruption and bureaucratic fraud. Whereas the average large city employed thirty-one people per one-thousand residents, New York had forty nine. That's an excess of fifty-eight per cent. The salaries of these employees far outstripped those in private industry. While an X-ray technician in a private hospital earned $187 per week, a porter working for the city earned $203. The average bank teller earned $154 per week, but a change maker on the city subway received $212. And municipal fringe benefits were fully twice as generous as those in private industry within the state. On top of this mountainous overhead were heaped additional costs for free college educations, subsidized housing, free medical care, and endless varieties of welfare programs.
City taxes were greatly inadequate to cover the cost of this utopia. Even after transfer payments from Albany and Washington added state and federal taxes to the take, the outflow continued to exceed the inflow. There were now only three options: increase city taxes, reduce expenses, or go into debt. The choice was never in serious doubt. By 1975, New York had floated so many bonds it had saturated the market and could find no more lenders. Two billion dollars of this debt was held by a small group of banks, dominated by Chase Manhattan and Citicorp.
When the payment of interest on these loans finally came to a halt, it was time for serious action. The bankers and the city fathers traveled down the coast to Washington and put their case before Congress. The largest city in the world could not be allowed to go bankrupt, they said. Essential services would be halted and millions of people would be without garbage removal, without transportation, even without police protection. Starvation, disease, and crime would run rampant through the city. It would be a disgrace to America. David Rockefeller at Chase Manhattan persuaded his friend Helmut Schmidt, Chancellor of West Germany, to make a statement to the media that the disastrous situation in New York could trigger an international financial crisis.
Congress, understandably, did not want to turn New York into a zone of anarchy, nor to disgrace America, nor to trigger a world-wide financial panic. So, in December of 1975, it passed a bill authorizing the Treasury to make direct loans to the city up to $2.3 billion, an amount which would more than double the size of its current debt to the banks. Interest payments on the old debt resumed immediately. All of this money, of course, would first have to be borrowed by Congress which was, itself, deeply in debt. And most of it would be created, directly or indirectly, by the Federal Reserve System. That money would be taken from the taxpayer through the loss of purchasing power called inflation, but at least the banks could be repaid, which is the object of the game.
There were several restrictions attached to this loan, including an austerity program and a systematic repayment schedule. None of these conditions was honored. New York City has continued to be a welfare utopia, and it is unlikely that it will ever get out of debt.
The timing was doubly bad. America was also experiencing high interest rates which, coupled with fears of U.S. military involvement in Cambodia, had led to a slump in the stock market. Banks felt the credit crunch keenly and, in one of those rare instances in modern history, the money makers themselves were scouring for money.
[This BS tightening of credit in 08 as they called it in the media was actually the crooks had found themselves in the same place,scouring for so called money DC]
Chrysler needed additional cash to stay in business. It was not interested in borrowing just enough to pay the interest on its existing loans. To make the game worth playing, it wanted over a billion dollars in new capital. But, in the prevailing economic environment, the banks were hard pressed to create anything close to that kind of money.
Managers, bankers, and union leaders found common cause in Washington. If one of the largest corporations in America was allowed to fold, think of the hardship to thousands of employees and their families; consider the damage to the economy as shock waves of unemployment move across the country; tremble at the thought of lost competition in the automobile market, of only two major brands from which to choose instead of three.
Well, could anyone blame Congress for not wanting to plunge innocent families into poverty nor to upend the national economy nor to deny anyone their Constitutional right to freedom-of-choice? So a bill was passed directing the Treasury to guarantee up to $1.5 billion in new loans to Chrysler. The banks agreed to write down $600 million of their old loans and to exchange an additional $700 million for preferred stock. Both of these moves were advertised as evidence the banks were taking a terrible loss but were willing to yield in order to save the nation. It should be noted, however, that the value of the stock which was exchanged for previously noncollectable debt rose drastically after the settlement was announced to the public. Furthermore, not only did interest payments resume on the balance of the old loans, but the banks now replaced the written down portion with fresh loans, and these were far superior in quality because they were fully guaranteed by the taxpayers. So valuable was this guarantee that Chrysler, in spite of its previously poor debt performance, was able to obtain loans at 10.35% interest while its more solvent competitor, Ford, had to pay 13.5%. Applying the difference of 3.15% to one and-a-half billion dollars, with a declining balance continuing for only six years, produces a savings in excess of $165 million. That is a modest estimate of the size of the federal subsidy. The real value was far greater because, without it, the corporation would have ceased to exist, and the banks would have taken a loss of almost their entire loan exposure.
The FDIC has three options when bailing out an insolvent bank. The first is called a payoff. It involves simply paying off the insured depositors and then letting the bank fall to the mercy of the liquidators. This is the option usually chosen for small banks with no political clout. The second possibility is called a sell off , and it involves making arrangements for a larger bank to assume all the real assets and liabilities of the failing bank. Banking services are uninterrupted and, aside from a change in name, most customers are unaware of the transaction. This option is generally selected for small and medium banks. In both a payoff and a sell off, the FDIC takes over the bad loans of the failed bank and supplies the money to pay back the insured depositors.
The third option is called bailout, and this is the one which deserves our special attention. Irvine Sprague, a former director of the FDIC, explains: "In a bailout, the bank does not close, and everyone—insured or not—is fully protected.... Such privileged treatment is accorded by FDIC only rarely to an elect few."1
Irvine H. Sprague, Bailout: An Insider's Account of Bank Failures and Rescues (New York: Basic Books, 1986), p. 23.
That's right, he said everyone—insured or not—is fully protected. The banks which comprise the elect few generally are the large ones. It is only when the number of dollars at risk becomes mind numbing that a bailout can be camouflaged as protection of the public. Sprague says:
The FDIC Act gives the FDIC board sole discretion to prevent a bank from failing, at whatever cost. The board need only make the finding that the insured bank is in danger of failing and "is essential to provide adequate banking service in its community."... FDIC boards have been reluctant to make an essentially finding unless they perceive a clear and present danger to the nation's financial system.1
1. Sprague, pp. 27-29
Favoritism toward the large banks is obvious at many levels. One of them is the fact that, in a bailout, the FDIC covers all deposits, whether insured or not. That is significant, because the banks pay an assessment based only on their insured deposits. So, if uninsured deposits are covered also, that coverage is free—more precisely, paid by someone else. What deposits are uninsured? Those in excess of $100,000 and those held outside the United States. Which banks hold the vast majority of such deposits? The large ones, of course, particularly those with extensive overseas operations.2 The bottom line is that the large banks get a whopping free ride when they are bailed out. Their uninsured accounts are paid by FDIC, and the cost of that benefit is passed to the smaller banks and to the taxpayer. This is not an oversight. Part of the plan at Jekyll Island was to give a competitive edge to the large banks.
2. The Bank of America is the exception. Despite its size, it has not acquired foreign deposits to the same degree as its competitors.
With only $11.4 million on its books, the bank was small by current standards. Normally, the depositors would have been paid back, and the stockholders—like the owners of any other failed business venture—would have lost their investment. As Sprague, himself, admitted: "If market discipline means anything, stockholders should be wiped out when a bank fails. Our assistance would have the side effect ... of keeping the stockholders alive at government expense."1 But Unity Bank was different. It was located in a black neighborhood and was minority owned. As is often the case when government agencies are given discretionary powers, decisions are determined more by political pressures than by logic or merit, and Unity was a perfect example. In 1971, the specter of rioting in black communities still haunted the halls of Congress. Would the FDIC allow this bank to fail and assume the awesome responsibility for new riots and bloodshed? Sprague answers:
1.Sprague, pp. 41-42. 2
Neither Wille [another director] nor I had any trouble viewing the problem in its broader social context. We were willing to look for a creative solution.... My vote to make the "essentiality" finding and thus save the little bank was probably foreordained, an inevitable legacy of Watts.... The Watts riots ultimately triggered the essentiality doctrine.
On July 22, 1971, the FDIC declared that the continued operation of Unity Bank was, indeed, essential and authorized a direct infusion of $1.5 million. Although appearing on the agency's ledger as a loan, no one really expected repayment. In 1976, in spite of the FDIC's own staff report that the bank's operations continued "as slipshod and haphazard as ever," the agency rolled over the "loan" for another five years. Operations did not improve and, on June 30, 1982, the Massachusetts Banking Commissioner finally revoked Unity's charter. There were no riots in the streets, and the FDIC quietly wrote off the sum of $4,463,000 as the final cost of the bailout.
Chase officers ... suggested that Commonwealth was a public
interest problem that the government agencies should resolve. That
unsubtle hint was the way Chase phrased its request for a bailout by
the government.... Their proposal would come down to bailing out
the shareholders, the largest of which was Chase.1
1. Sprague, p. 68.
The bankers argued that Commonwealth must not be allowed to fold because it provided "essential" banking services to the community. That was justified on two counts: (1) it served many minority neighborhoods and, (2) there were not enough other banks in the city to absorb its operation without creating an unhealthy concentration of banking power in the hands of a few. It was unclear what the minority issue had to do with it inasmuch as every neighborhood in which Commonwealth had a branch was served by other banks as well. Furthermore, if Commonwealth were to be liquidated, many of those branches undoubtedly would have been purchased by competitors, and service to the communities would have continued. Judging by the absence of attention given to this issue during discussions, it is apparent that it was merely thrown in for good measure, and no one took it very seriously.
In any event, the FDIC did not want to be accused of being indifferent to the needs of Detroit's minorities and it certainly did not want to be a destroyer of free-enterprise competition. So, on January 17,1972, Commonwealth was bailed out with a $60 million loan plus numerous federal guarantees. Chase absorbed some losses, primarily as a result of Commonwealth's weak bond portfolio, but those were minor compared to what would have been lost without FDIC intervention.
Since continuation of the bank was necessary to prevent concentration of financial power, FDIC engineered its sale to the First Arabian Corporation, a Luxembourg firm funded by Saudi princes. Better to have financial power concentrated in Saudi Arabia than in Detroit. The bank continued to flounder and, in 1983, what was left of it was resold to the former Detroit Bank & Trust Company, now called Comerica. Thus the dreaded concentration of local power was realized after all, but not until Chase Manhattan was able to walk away from the deal with most of its losses covered.
The bank had experienced rapid growth and handsome profits largely due to the aggressive leadership of its chief executive officer, John Bunting, who had previously been an economist with the Federal Reserve Bank of Philadelphia. Bunting was the epitome of the era's go-go bankers. He vastly increased earnings ratios by reducing safety margins, taking on risky loans, and speculating in the bond market. As long as the economy expanded, these gambles were profitable, and the stockholders loved him dearly. When his gamble in the bond market turned sour, however, the bank plunged into a negative cash flow. By 1979, First Penn was forced to sell off several of its profitable subsidiaries in order to obtain operating funds, and it was carrying $328 million in questionable loans. That was $16 million more than the entire stockholder investment. The bank was insolvent, and the time had arrived to hit up the taxpayer for the loss.
The bankers went to Washington and presented their case. They were joined by spokesmen from the nation's top three: Bank of America, Citibank, and of course the ever-present Chase Manhattan. They argued that, not only was the bailout of First Penn essential" for the continuation of banking services in Philadelphia, it was also critical to the preservation of world economic stability. The bank was so large, they said, if it were allowed to fall, it would act as the first domino leading to an international financial crisis. At first, the directors of the FDIC resisted that theory and earned the angry impatience of the Federal Reserve. Sprague recalls:
We were far from a decision on how to proceed. There was strong pressure from the beginning not to let the bank fail. Besides hearing from the bank itself, the other large banks, and the comptroller, we heard frequently from the Fed. I recall at one session, Fred Schultz, the Fed deputy chairman, argued in an ever rising voice, that there were no alternatives—we had to save the bank. He said, "Quit wasting time talking about anything else!"...
The Fed's role as lender of last resort first generated contention between the Fed and FDIC during this period. The Fed was lending heavily to First Pennsylvania, fully secured, and Fed Chairman Paul Volcker said he planned to continue funding indefinitely until we could work out a merger or a bailout to save the bank.
The directors of the FDIC did not want to cross swords with the Federal Reserve System, and they most assuredly did not want to be blamed for tumbling the entire world economic system by allowing the first domino to fall. "The theory had never been tested," said Sprague. "I was not sure I wanted it to be just then." So, in due course, a bailout package was put together which featured a $325 million loan from FDIC, interest free for the first year and at a subsidized rate thereafter; about half the market rate. Several other banks which were financially tied to First Penn, and which would have suffered great losses if it had folded, loaned an additional $175 million and offered a $1 billion line of credit. FDIC insisted on this move to demonstrate that the banking industry itself was helping and that it had faith in the venture. To bolster that faith, the Federal Reserve opened its Discount Window offering low-interest funds for that purpose.
The outcome of this particular bailout was somewhat happier than with the others, at least as far as the bank is concerned. At the end of the five-year taxpayer subsidy, the FDIC loan was fully repaid. The bank has remained on shaky ground, however, and the final page of this episode has not yet been written.
The gaudy fabric began to unravel during the Fourth of July weekend of 1982 with the failure of the Penn Square Bank in Oklahoma. That was the notorious shopping-center bank that had booked a billion dollars in oil and gas loans and resold them to Continental just before the collapse of the energy market. Other loans also began to sour at the same time. The Mexican and Argentine debt crisis was coming to a head, and a series of major corporate bankruptcies were receiving almost daily headlines. Continental had placed large chunks of its easy money with all of them. When these events caused the bank's credit rating to drop, cautious depositors began to withdraw their funds, and new funding dwindled to a trickle. The bank became desperate for cash to meet its daily expenses. In an effort to attract new money, it began to offer unrealistically high rates of interest on its C.D's. Loan officers were sent to scour the European and Japanese markets and to conduct a public relations campaign aimed at convincing market managers that the bank was calm and steady. David Taylor, the hank's chairman at that time, said: "We had the Continental Illinois Reassurance Brigade and we fanned out all over the world."1
1Quoted by Chernow, p. 657.
In the fantasy land of modern finance, glitter is often more important than substance, image more valuable than reality. The bank paid the usual quarterly dividend in August, in spite of the fact that this intensified its cash crunch. As with the Penn Central Railroad twelve years earlier, that move was calculated to project an image of business-as-usual prosperity. And the ploy worked for a while, at least. By November, the public's confidence had been restored, and the bank's stock recovered to its pre-Penn Square level. By March of 1983, it had risen even higher. But the worst was yet to come.
By the end of 1983, the bank's burden of non-performing loans had reached unbearable proportions and was growing at an alarming rate. By 1984, it was $2.7 billion. That same year, the bank sold off its profitable credit-card operation to make up for the loss of income and to obtain money for paying stockholders their expected quarterly dividend. The internal structure was near collapse, but the external facade continued to look like business as usual.
The first crack in that facade appeared at 11:39 A.M. On Tuesday, May 8, Reuters, the British news agency, moved a story on its wire service stating that banks in the Netherlands, West Germany, Switzerland, and Japan had increased their interest rate on loans to Continental and that some of them had begun to withdraw their funds. The story also quoted the bank's official statement that rumors of pending bankruptcy were "totally preposterous." Within hours, another wire, the Commodity News Service, reported a second rumor: that a Japanese bank was interested in buying Continental.
By Friday, the bank had been forced to borrow $3.6 billion from the Federal Reserve in order to cover its escaping deposits. A consortium of sixteen banks, lead by Morgan Guaranty, offered a generous thirty-day line of credit, but all of this was far short of the need. Within seven more days, the outflow surged to over $6 billion.
In the beginning, almost all of this action was at the institutional level: other banks and professionally managed funds which closely monitor every minuscule detail of the financial markets. The general public had no inkling of the catastrophe, even as it unfolded. Chernow says: "The Continental run was like some modernistic fantasy: there were no throngs of hysterical depositors, just cool nightmare flashes on computer screens."1 Sprague writes: "Inside the bank, all was calm, the teller lines moved as always, and bank officials recall no visible sign of trouble—except in the wire room. Here the employees knew what was happening as withdrawal order after order moved on the wire, bleeding Continental to death. Some cried."2
1- Chernow, p. 658.
2.Sprague, p. 153.
This was the golden moment for which the Federal Reserve and the FDIC were created. Without government intervention, Continental would have collapsed, its stockholders would have been wiped out, depositors would have been badly damaged, and the financial world would have learned that banks, not only have to talk about prudent management, they actually have to adopt it. Future banking practices would have been severely altered, and the long-term economic benefit to the nation would have been enormous. But with government intervention, the discipline of a free market is suspended, and the cost of failure or fraud is politically passed to the taxpayers. Depositors continue to live in a dream world of false security, and banks can operate recklessly and fraudulently with the knowledge that their political partners in government will come to their rescue when they get into trouble.
Although Continental Illinois had over $30 billion in deposits, 90 percent were uninsured foreign deposits or large certificates substantially exceeding the $100,000 insurance limit. Off-book liabilities swelled Continental's real size to $69 billion. In this massive liability structure only some $3 billion within the insured limit was scattered among 850,000 deposit accounts. So it was in our power and entirely legal simply to pay off the insured depositors, let everything else collapse, and stand back to watch the carnage.
That course was never seriously considered by any of the players. From the beginning, there were only two questions: how to come to Continental's rescue by covering its total liabilities and, equally important, how to politically justify such a fleecing of the taxpayer. As pointed out in the previous chapter, the rules of the game require that the scam must always be described as a heroic effort to protect the public. In the case of Continental, the sheer size of the numbers made the ploy relatively easy. There were so many depositors involved, so many billions at risk, so many other banks interlocked, it could be claimed that the economic fabric of the entire nation—of the world itself—was at stake. And who could say that it was not so. Sprague argues the case in familiar terms:
An early morning meeting was scheduled for Tuesday, May 15, at the Fed. .. We talked over the alternatives. They were few—none really.... [Treasury Secretary] Regan and [Fed Chairman] Volcker raised the familiar concern about a national banking collapse, that is, a chain reaction if Continental should fail. Volcker was worried about an international crisis. We all were acutely aware that never before had a bank even remotely approaching Continental's size closed. No one knew what might happen in the nation and in the world. It was no time to find out just for the purpose of intellectual curiosity.
At the May 15 meeting, Treasury Secretary Regan spoke eloquently about the value of a free market and the necessity of having the banks mount their own rescue plan, at least for a part of the money. To work out that plan, a summit meeting was arranged the next morning among the chairmen of the seven largest banks: Morgan Guaranty, Chase Manhattan, Citibank, Bank of America, Chemical Bank, Bankers Trust, and Manufacturers Hanover. The meeting was perfunctory at best. The bankers knew full well that the Reagan Administration would not risk the political embarrassment of a major bank failure. That would make the President and the Congress look bad at re-election time. But, still, some kind of tokenism was called for to preserve the Administration's conservative image. So, with urging from the Fed and the Treasury, the consortium agreed to put up the sum of $500 million—an average of only $71 million for each, far short of the actual need. Chernow describes the plan as "make-believe" and says "they pretended to mount a rescue."1 Sprague supplies the details:
1 Chernow, p. 659.
The bankers said they wanted to be in on any deal, but they did not want to lose any money. They kept asking for guarantees. They wanted it to look as though they were putting money in but, at the same time, wanted to be absolutely sure they were not risking anything.... By 7:30 A.M. we had made little progress. We were certain the situation would be totally out of control in a few hours. Continental would soon be exposing itself to a new business day, and the stock market would open at ten o'clock. Isaac [another FDIC director] and I held a hallway conversation. We agreed to go ahead without the banks. We told Conover [the third FDIC director] the plan and he concurred....
Later, we got word from Bernie McKeon, our regional director in New York, that the bankers had agreed to be at risk. Actually, the risk was remote since our announcement had promised 100 percent insurance.2
2- Sprague, pp. 159-60.
The final bailout package was a whopper. Basically, the government took over Continental Illinois and assumed all of its losses. Specifically, the FDIC took $4.5 billion in bad loans and paid Continental $3.5 billion for them. The difference was then made up by the infusion of $1 billion in fresh capital in the form of stock purchase. The bank, therefore, now had the federal government as a stockholder controlling 80 per cent of its shares, and its bad loans bad been dumped onto the taxpayer. In effect, even though Continental retained the appearance of a private institution, it had been nationalized.
FDIC director Irvine Sprague, while discussing the press release which announced the Continental bail-out package, describes the Fed's role this way:
The third paragraph ... granted 100 percent insurance to all depositors, including the uninsured, and all general creditors.... The next paragraph ... set forth the conditions under which the Fed, as lender of last resort, would make its loans.... The Fed would lend to Continental to meet "any extraordinary liquidity requirements." That would include another run. All agreed that Continental could not be saved without 100 percent insurance by FDIC and unlimited liquidity support by the Federal Reserve. No plan would work without these two elements.1
1. Sprague, pp. 162-63.
By 1984, "unlimited liquidity support" had translated into the
staggering sum of $8 billion. By early 1986, the figure had climbed
to $9.24 billion and was still rising. While explaining this fleecing of
the taxpayer to the Senate Banking Committee, Fed Chairman Paul
Volcker said: "The operation is the most basic function of the Federal Reserve. It was why it was founded."1 With those words,
he has confirmed one of the more controversial assertions of this
book.
p~Quoted by Greider, p. 628.
2~ Sprague, p. 250. How true. Within the same week that the FDIC and the Fed were providing billions in payments, stock purchases, loans, and guarantees for Continental Illinois, it closed down the tiny Bledsoe County Bank of Pikeville, Tennessee, and the Planters Trust and Savings Bank of Opelousas, Louisiana. During the first half of that year, forty-three smaller banks failed without an FDIC bailout. In most cases, a merger was arranged with a larger bank, and only the uninsured deposits were at risk. The impact of this inequity upon the banking system is enormous. It sends a message to bankers and depositors alike that small banks, if they get into trouble, will be allowed to fold, whereas large banks are safe regardless of how poorly or fraudulently they are managed. As a New York investment analyst stated to news reporters, Continental Illinois, even though it had just failed, was "obviously the safest bank in the country to have your money in."3 Nothing could be better calculated to drive the small independent banks out of business or to force them to sell out to the giants. And that, in fact, is exactly what has been happening. Since 1984, while hundreds of small banks have been forced out of business, the average size of the banks which remain—with government protection—has more than doubled. It will be recalled that this advantage of the big banks over their smaller competitors was also one of the objectives of the Jekyll Island plan.
Perhaps the most interesting—and depressing—aspect of the Continental Illinois bailout was the lack of public indignation over the principle of using taxes and inflation to protect the banking industry. Smaller banks have complained of the unfair advantage given to the larger banks, but not on the basis that the government should have let the giant fall. Their lament was that it should now protect them in the same paternalistic fashion. Voters and politicians were silent on the issue, apparently awed by the sheer size of the numbers and the specter of economic chaos. Decades of public education had left their mark. After all, wasn't this exactly what government schools have taught is the proper function of government? Wasn't this the American way? Even Ronald Reagan, viewed as the national champion of economic conservatism, praised the action. From aboard Air Force One on the way to California, the President said: "It was a thing that we should do and we did it. It was in the best interest of all concerned."1
1. "Reagan Calls Rescue of Bank No Bailout," New York Times, July 29,1984.
The Reagan endorsement brought into focus one of the most amazing phenomena of the 20th century: the process by which America has moved to the Left toward statism while marching behind the political banner of those who speak the language of opposing statism. William Greider, a former writer for the liberal Washington Post and The Rolling Stone, complains:
The nationalization of Continental was, in fact, a quintessential act of modem liberalism—the state intervening in behalf of private interests and a broad public purpose. In this supposedly conservative era, federal authorities were setting aside the harsh verdict of market competition (and grossly expanding their own involvement in the private economy)....
In the past, conservative scholars and pundits had objected loudly at any federal intervention in the private economy, particularly emergency assistance for failing companies. Now, they hardly seemed to notice. Perhaps they would have been more vocal if the deed had been done by someone other than the conservative champion, Ronald Reagan.2
2. Greider, p. 631.
Four years after the bailout of Continental Illinois, the same play was used in the rescue of BankOklahoma, which was a bank holding company. The FDIC pumped $130 million into its main banking unit and took warrants for 55% ownership. The pattern had been set. By accepting stock in a failing bank in return for bailing it out, the government had devised an ingenious way to nationalize banks without calling it that. Issuing stock sounds like a business transaction in the private sector. And the public didn't seem to notice the reality that Uncle Sam was going into banking.
In 1970, Penn Central railroad became bankrupt. The banks which loaned the money had taken over its board of directors and had driven it further into the hole, all the while extending bigger and bigger loans to cover the losses. Directors concealed reality from the stockholders and made additional loans so the company could pay dividends to keep up the false front. During this time, the directors and their banks unloaded their stock at unrealistically high prices. When the truth became public, the stockholders were left holding the empty bag. The bailout, which was engineered by the Federal Reserve, involved government subsidies to other banks to grant additional loans. Then Congress was told that the collapse of Penn Central would be devastating to the public interest. Congress responded by granting $125 million in loan guarantees so that banks would not be at risk. The railroad eventually failed anyway, but the bank loans were covered. Penn Central was nationalized into AMTRAK and continues to operate at a loss.
In 1970, as Lockheed faced bankruptcy, Congress heard essentially the same story. Thousands would be unemployed, subcontractors would go out of business, and the public would suffer greatly. So Congress agreed to guarantee $250 million in new loans, which put Lockheed 60% deeper into debt than before. Now that government was guaranteeing the loans, it had to make sure Lockheed became profitable. This was accomplished by granting lucrative defense contracts at non-competitive bids. The banks were paid back.
In 1975, New York City had reached the end of its credit rope. It had borrowed heavily to maintain an extravagant bureaucracy and a miniature welfare state. Congress was told that the public would be jeopardized if city services were curtailed, and that America would be disgraced in the eyes of the world. So Congress authorized additional direct loans up to $2.3 billion, which more than doubled the size of the current debt. The banks continued to receive their interest.
In 1978, Chrysler was on the verge of bankruptcy. Congress was informed that the public would suffer greatly if the company folded, and that it would be a blow to the American way if freedom-of-choice were reduced from three to two makes of automobiles. So Congress guaranteed up to $1.5 billion in new loans. The banks reduced part of their loans and exchanged another portion for preferred stock. News of the deal pushed up the market value of that stock and largely offset the loan write-off. The banks' previously noncollectable debt was converted into a government backed, interest-bearing asset.
In 1972, the Commonwealth Bank of Detroit—with $1.5 billion in assets, became insolvent. It had borrowed heavily from the Chase Manhattan Bank in New York to invest in high-risk and potentially high-profit ventures. Now that it was in trouble, so was Chase. The bankers went to Washington and told the FDIC the public must be protected from the great financial hardship that would follow if Commonwealth were allowed to close. So the FDIC pumped in a $60 million loan plus federal guarantees of repayment. Commonwealth was sold to an Arab consortium. Chase took a minor write down but converted most of its potential loss into government-backed assets.
In 1979, the First Pennsylvania Bank of Philadelphia became insolvent. With assets in excess of $9 billion, it was nine-times the size of Commonwealth. It, too, had been an aggressive player in the '80's. Now the bankers and the Federal Reserve told the FDIC that the public must be protected from the calamity of a bank failure of this size, that the national economy was at stake, perhaps even the entire world. So the FDIC gave a $325 million loan—interest-free for the first year, and at half the market rate thereafter. The Federal Reserve offered money to other banks at a subsidized rate for the specific purpose of relending to First Penn. With that enticement, they advanced $175 million in immediate loans plus a $1 billion line of credit.
In 1982, Chicago's Continental Illinois became insolvent. It was the nation's seventh largest bank with $42 billion in assets. The previous year, its profits had soared as a result of loans to high-risk business ventures and foreign governments. Although it had been the darling of market analysts, it quickly unraveled when its cash flow turned negative, and overseas banks began to withdraw deposits. It was the world's first electronic bank run. Federal Reserve Chairman Volcker told the FDIC that it would be unthinkable to allow the world economy to be ruined by a bank failure of this magnitude. So, the FDIC assumed $4.5 billion in bad loans and, in return for the bailout, took 80% ownership of the bank in the form of stock. In effect, the bank was nationalized, but no one called it that. The United States government was now in the banking business.
All of the money to accomplish these bailouts was made possible by the Federal Reserve System acting as the "lender of last resort." That was one of the purposes for which it had been created. We must not forget that the phrase "lender of last resort" means that the money is created out of nothing, resulting in the confiscation of our nation's wealth through the hidden tax called inflation.
Next
HOME, SWEET LOAN
78S
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
[Take note of the year,it continues
to come up,and most of the activity connected with that year I have found seems to be nefariousat best DC]
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 numb-skull 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 arc 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. The FDIC "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
or 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."1 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.
1. "How Safe Are Deposits in Ailing Banks, S&L's?" U.S. News & World Report, March 25,1985, p. 73.
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."
SUMMARY
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
dose 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.
Chapter Three
PROTECTORS OF THE
PUBLIC
The Game-Called-Bailout as it actually has been
applied to specific cases including Penn Central,
Lockheed, New York City, Chrysler, Commonwealth
Bank of Detroit, First Pennsylvania Bank,
Continental Illinois, and others. In the previous chapter, we offered the whimsical analogy of a sporting event to clarify the maneuvers of monetary and political scientists to bail out those commercial banks which comprise the Federal-Reserve cartel. The danger in such an approach is that it could leave the impression the topic is frivolous. So, let us abandon the analogy and turn to reality. Now that we have studied the hypothetical rules of the game, it is time to check the scorecard of the actual play itself, and it will become obvious that this is no trivial matter. A good place to start is with the rescue of a consortium of banks which were holding the endangered loans of Penn Central Railroad.
PENN CENTRAL
Penn Central was the nation's largest railroad with 96,000
employees and a payroll of $20 million a week. In 1970, it also
became the nation's biggest bankruptcy. It was deeply in debt to
just about every bank that was willing to lend it money, and that
list included Chase Manhattan, Morgan Guaranty, Manufacturers
Hanover, First National City, Chemical Bank, and Continental
Illinois. Officers of the largest of those banks had been appointed to
Penn Central's board of directors as a condition for obtaining
funds, and they gradually had acquired control over the railroad's
management. The banks also held large blocks of Penn Central
stock in their trust departments. The arrangement was convenient in many ways, not the least of which was that the bankers sitting on the board of directors were privy to information, long before the public received it, which would affect the market price of Penn Central's stock. Chris Welles, in The Last Days of the Club, describes what happened:
On May 21, a month before the railroad went under, David Bevan, Penn Central's chief financial officer, privately informed representatives of the company's banking creditors that its financial condition was so weak it would have to postpone an attempt to raise $100 million in desperately needed operating funds through a bond issue. Instead, said Bevan, the railroad would seek some kind of government loan guarantee. In other words, unless the railroad could manage a federal bailout, it would have to close down. The following day, Chase Manhattan's trust department sold 134,300 shares of its Penn Central holdings. Before May 28, when the public was informed of the postponement of the bond issue, Chase sold another 128,000 shares. David Rockefeller, the bank's chairman, vigorously denied Chase had acted on the basis of inside information.1
1. Chris Welles, The Last Days of the Club (New York: E.P. Dutton, 1975), pp. 398-99.
More to the point of this study is the fact that virtually all of the major management decisions which led to Penn Central's demise were made by or with the concurrence of its board of directors, which is to say, by the banks that provided the loans. In other words, the bankers were not in trouble because of Penn Central's poor management, they were Penn Central's poor management. An investigation conducted in 1972 by Congressman Wright Patman, Chairman of the House Banking and Currency Committee, revealed the following: The banks provided large loans for disastrous expansion and diversification projects. They loaned additional millions to the railroad so it could pay dividends to its stockholders. This created the false appearance of prosperity and artificially inflated the market price of its stock long enough to dump it on the unsuspecting public. Thus, the banker-managers were able to engineer a three-way bonanza for themselves. They (1) received dividends on essentially worthless stock, (2) earned interest on the loans which provided the money to pay those dividends, and (3) were able to unload 1.8 million shares of stock—after the dividends, of course—at unrealistically high prices.2 Reports from the Securities and Exchange Commission showed that the company's top executives had disposed of their stock in this fashion at a personal savings of more than $1 million.
2. "Penn Central," 1977 Congressional Quarterly Almanac (Washington, D.C.: Congressional Quarterly, 1971), p. 838.
Had the railroad been allowed to go into bankruptcy at that point and been forced to sell off its assets, the bankers still would have been protected. In any liquidation, debtors are paid off first, stockholders last; so the manipulators had dumped most of their stock while prices were relatively high. That is a common practice among corporate raiders who use borrowed funds to seize control of a company, bleed off its assets to other enterprises which they also control, and then toss the debt-ridden, dying carcass upon the remaining stockholders or, in this case, the taxpayers.
THE PUBLIC BE DAMNED
In his letter of transmittal accompanying the staff report,
Congressman Patman provided this summary: It was as though everyone was a part of a close knit club in which Penn Central and its officers could obtain, with very few questions asked, loans for almost everything they desired both for the company and for their own personal interests, where the bankers sitting on the Board asked practically no questions as to what was going on, simply allowing management to destroy the company, to invest in questionable activities, and to engage in some cases in illegal activities. These banks in return obtained most of the company's lucrative banking business. The attitude of everyone seemed to be, while the game was going on, that all these dealings were of benefit to every member of the club, and the railroad and the public be damned.
[It should be noted this is the exact crap they pulled in 2008,but on an even larger scale D.C]
The company's cash crisis came to a head over a weekend and, in order to avoid having the corporation forced to file for bankruptcy on Monday morning, Burns called the homes of the heads of the Federal Reserve banks around the country and told them to get the word out immediately that the System was anxious to help. On Sunday, William Treiber, who was the first vice-president of the New York branch of the Fed, contacted the chief executives of the ten largest banks in New York and told them that the Fed's Discount Window would be wide open the next morning. Translated, that means the Federal Reserve System was prepared to create money out of nothing and then immediately loan it to the commercial banks so they, in turn, could multiply and re-lend it to Penn Central and other corporations, such as Chrysler, which were in similar straits.1 Furthermore, the rates at which the Fed would make these funds available would be low enough to compensate for the risk, speaking of what transpired on the following Monday, Burns boasted: "I kept the Board in session practically all day to change regulation Q so that money could flow into C.D's at the banks." Looking back at the event, Chris Welles approvingly describes it as "what is by common consent the Fed's finest hour."
1. For an explanation of the multiplier effect, see chapter eight, The Mandrake Mechanism.
Finest hour or not, the banks were not that interested in the proposition unless they could be assured the taxpayer would co-sign the loans and guarantee payment. So the action inevitably shifted back to Congress. Penn Central's executives, bankers, and union representatives came in droves to explain how the railroad's continued existence was in the best interest of the public, of the working man, of the economic system itself. The Navy Department spoke of protecting the nation's "defense resources." Congress, of course, could not callously ignore these pressing needs of the nation. It responded by ordering a retroactive, 13 per cent pay raise for all union employees. After having added that burden to the railroad's cash drain and putting it even deeper into the hole, it then passed the Emergency Rail Services Act of 1970 authorizing $125 million in federal loan guarantees.2
3. "Congress Clears Railroad Aid Bill, Acts on Strike," 1970 Congressional Almanac (Washington, D.C.: 1970), pp. 810-16.
None of this, of course, solved the basic problem, nor was it really intended to. Almost everyone knew that, eventually, the railroad would be "nationalized," which is a euphemism for becoming a black hole into which tax dollars disappear. This came to pass with the creation of AMTRAK in 1971 and CONRAIL in 1973. AMTRAK took over the passenger services of Penn Central, and CONRAIL assumed operation of its freight services, along with five other Eastern railroads. CONRAIL technically is a private corporation. When it was created, however, 85% of its stock was held by the government. The remainder was held by employees. Fortunately, the government's stock was sold in a public offering in 1987. AMTRAK continues under political control and operates at a loss. It is sustained by government subsidies—which is to say by taxpayers. In 1997, Congress dutifully gave it another $5.7 billion and, by 1998, liabilities exceeded assets by an estimated $14 billion. CONRAIL, on the other hand, since it was returned to the private sector, has experienced an impressive turnaround and has been running at a profit—paying taxes instead of consuming them.
LOCKHEED
In that same year, 1970, the Lockheed Corporation, which was
the nation's largest defense contractor, was teetering on the verge
of bankruptcy. The Bank of America and several smaller banks had
loaned $400 million to the Goliath and they were not anxious to
lose the bountiful interest-income stream that flowed from that; nor
did they wish to see such a large bookkeeping asset disappear from
their ledgers. In due course, the banks joined forces with Lockheed's
management, stockholders, and labor unions, and the group
descended on Washington. Sympathetic politicians were told that,
if Lockheed were allowed to fail, 31,000 jobs would be lost,
hundreds of sub contractors would go down, thousands of suppliers
would be forced into bankruptcy, and national security would
be seriously jeopardized. What the company needed was to borrow
more money and lots of it. But, because of its current financial
predicament, no one was willing to lend. The answer? In the
interest of protecting the economy and defending the nation, the
government simply had to provide either the money or the credit. The not-so-obvious part of this story is that the government now had a powerful motivation to make sure Lockheed would be awarded as many defense contracts as possible and that those contracts would be as profitable as possible. This would be an indirect method of paying off the banks with tax dollars, but doing so in such a way as not to arouse public indignation. Other defense contractors which had operated more efficiently would lose business, but that could not be proven. Furthermore, a slight increase in defenses expenditures would hardly be noticed.
By 1977, Lockheed had, indeed, paid back this loan, and that fact was widely advertised as proof of the wisdom and skill of all the players, including the referee and the game commissioner. A deeper analysis, however, must include two facts. First, there is no evidence that Lockheed's operation became more cost efficient during these years. Second, every bit of the money used to pay back the loans came from defense contracts which were awarded by the same government which was guaranteeing those loans. Under such an arrangement, it makes little difference if the loans were paid back or not. Taxpayers were doomed to pay the bill either way.
NEW YORK CITY
Although the government of New York City is not a corporation
in the usual sense, it functions as one in many respects,
particularly regarding debt. In 1975, New York had reached the end of its credit rope and was unable even to make payroll. The cause was not mysterious. New York had long been a welfare state within itself, and success in city politics was traditionally achieved by lavish promises of benefits and subsidies for "the poor." Not surprisingly, the city also was notorious for political corruption and bureaucratic fraud. Whereas the average large city employed thirty-one people per one-thousand residents, New York had forty nine. That's an excess of fifty-eight per cent. The salaries of these employees far outstripped those in private industry. While an X-ray technician in a private hospital earned $187 per week, a porter working for the city earned $203. The average bank teller earned $154 per week, but a change maker on the city subway received $212. And municipal fringe benefits were fully twice as generous as those in private industry within the state. On top of this mountainous overhead were heaped additional costs for free college educations, subsidized housing, free medical care, and endless varieties of welfare programs.
City taxes were greatly inadequate to cover the cost of this utopia. Even after transfer payments from Albany and Washington added state and federal taxes to the take, the outflow continued to exceed the inflow. There were now only three options: increase city taxes, reduce expenses, or go into debt. The choice was never in serious doubt. By 1975, New York had floated so many bonds it had saturated the market and could find no more lenders. Two billion dollars of this debt was held by a small group of banks, dominated by Chase Manhattan and Citicorp.
When the payment of interest on these loans finally came to a halt, it was time for serious action. The bankers and the city fathers traveled down the coast to Washington and put their case before Congress. The largest city in the world could not be allowed to go bankrupt, they said. Essential services would be halted and millions of people would be without garbage removal, without transportation, even without police protection. Starvation, disease, and crime would run rampant through the city. It would be a disgrace to America. David Rockefeller at Chase Manhattan persuaded his friend Helmut Schmidt, Chancellor of West Germany, to make a statement to the media that the disastrous situation in New York could trigger an international financial crisis.
Congress, understandably, did not want to turn New York into a zone of anarchy, nor to disgrace America, nor to trigger a world-wide financial panic. So, in December of 1975, it passed a bill authorizing the Treasury to make direct loans to the city up to $2.3 billion, an amount which would more than double the size of its current debt to the banks. Interest payments on the old debt resumed immediately. All of this money, of course, would first have to be borrowed by Congress which was, itself, deeply in debt. And most of it would be created, directly or indirectly, by the Federal Reserve System. That money would be taken from the taxpayer through the loss of purchasing power called inflation, but at least the banks could be repaid, which is the object of the game.
There were several restrictions attached to this loan, including an austerity program and a systematic repayment schedule. None of these conditions was honored. New York City has continued to be a welfare utopia, and it is unlikely that it will ever get out of debt.
CHRYSLER
By 1978, the Chrysler Corporation was on the verge of bankruptcy.
It had rolled over its debt to the banks many times, and the
game was nearing an end. In spite of an OPEC oil embargo which
had pushed up the cost of gasoline and in spite of the increasing
popularity of small-automobile imports, the company had continued
to build the traditional gas hog. It was now saddled with a
mammoth inventory of unsaleable cars and with a staggering debt
which it had acquired to build those cars. The timing was doubly bad. America was also experiencing high interest rates which, coupled with fears of U.S. military involvement in Cambodia, had led to a slump in the stock market. Banks felt the credit crunch keenly and, in one of those rare instances in modern history, the money makers themselves were scouring for money.
[This BS tightening of credit in 08 as they called it in the media was actually the crooks had found themselves in the same place,scouring for so called money DC]
Chrysler needed additional cash to stay in business. It was not interested in borrowing just enough to pay the interest on its existing loans. To make the game worth playing, it wanted over a billion dollars in new capital. But, in the prevailing economic environment, the banks were hard pressed to create anything close to that kind of money.
Managers, bankers, and union leaders found common cause in Washington. If one of the largest corporations in America was allowed to fold, think of the hardship to thousands of employees and their families; consider the damage to the economy as shock waves of unemployment move across the country; tremble at the thought of lost competition in the automobile market, of only two major brands from which to choose instead of three.
Well, could anyone blame Congress for not wanting to plunge innocent families into poverty nor to upend the national economy nor to deny anyone their Constitutional right to freedom-of-choice? So a bill was passed directing the Treasury to guarantee up to $1.5 billion in new loans to Chrysler. The banks agreed to write down $600 million of their old loans and to exchange an additional $700 million for preferred stock. Both of these moves were advertised as evidence the banks were taking a terrible loss but were willing to yield in order to save the nation. It should be noted, however, that the value of the stock which was exchanged for previously noncollectable debt rose drastically after the settlement was announced to the public. Furthermore, not only did interest payments resume on the balance of the old loans, but the banks now replaced the written down portion with fresh loans, and these were far superior in quality because they were fully guaranteed by the taxpayers. So valuable was this guarantee that Chrysler, in spite of its previously poor debt performance, was able to obtain loans at 10.35% interest while its more solvent competitor, Ford, had to pay 13.5%. Applying the difference of 3.15% to one and-a-half billion dollars, with a declining balance continuing for only six years, produces a savings in excess of $165 million. That is a modest estimate of the size of the federal subsidy. The real value was far greater because, without it, the corporation would have ceased to exist, and the banks would have taken a loss of almost their entire loan exposure.
FEDERAL DEPOSIT
INSURANCE CORPORATION
It will be recalled from the previous chapter that the FDIC is not
a true insurance program and, because it has been politicized, it
embodies the principle of moral hazard and it actually increases the
likelihood that bank failures will occur. The FDIC has three options when bailing out an insolvent bank. The first is called a payoff. It involves simply paying off the insured depositors and then letting the bank fall to the mercy of the liquidators. This is the option usually chosen for small banks with no political clout. The second possibility is called a sell off , and it involves making arrangements for a larger bank to assume all the real assets and liabilities of the failing bank. Banking services are uninterrupted and, aside from a change in name, most customers are unaware of the transaction. This option is generally selected for small and medium banks. In both a payoff and a sell off, the FDIC takes over the bad loans of the failed bank and supplies the money to pay back the insured depositors.
The third option is called bailout, and this is the one which deserves our special attention. Irvine Sprague, a former director of the FDIC, explains: "In a bailout, the bank does not close, and everyone—insured or not—is fully protected.... Such privileged treatment is accorded by FDIC only rarely to an elect few."1
Irvine H. Sprague, Bailout: An Insider's Account of Bank Failures and Rescues (New York: Basic Books, 1986), p. 23.
That's right, he said everyone—insured or not—is fully protected. The banks which comprise the elect few generally are the large ones. It is only when the number of dollars at risk becomes mind numbing that a bailout can be camouflaged as protection of the public. Sprague says:
The FDIC Act gives the FDIC board sole discretion to prevent a bank from failing, at whatever cost. The board need only make the finding that the insured bank is in danger of failing and "is essential to provide adequate banking service in its community."... FDIC boards have been reluctant to make an essentially finding unless they perceive a clear and present danger to the nation's financial system.1
1. Sprague, pp. 27-29
Favoritism toward the large banks is obvious at many levels. One of them is the fact that, in a bailout, the FDIC covers all deposits, whether insured or not. That is significant, because the banks pay an assessment based only on their insured deposits. So, if uninsured deposits are covered also, that coverage is free—more precisely, paid by someone else. What deposits are uninsured? Those in excess of $100,000 and those held outside the United States. Which banks hold the vast majority of such deposits? The large ones, of course, particularly those with extensive overseas operations.2 The bottom line is that the large banks get a whopping free ride when they are bailed out. Their uninsured accounts are paid by FDIC, and the cost of that benefit is passed to the smaller banks and to the taxpayer. This is not an oversight. Part of the plan at Jekyll Island was to give a competitive edge to the large banks.
2. The Bank of America is the exception. Despite its size, it has not acquired foreign deposits to the same degree as its competitors.
UNITY BANK
The first application of the FDIC essentiality rule was, in fact, an
exception. In 1971, Unity Bank and Trust Company in the Roxbury
section of Boston found itself hopelessly insolvent, and the federal
agency moved in. This is what was found: Unity's capital was
depleted; most of its loans were bad; its loan collection practices
were weak; and its personnel represented the worst of two worlds:
over staffing and inexperience. The examiners reported that there
were two persons for every job, and neither one had been taught
the job. With only $11.4 million on its books, the bank was small by current standards. Normally, the depositors would have been paid back, and the stockholders—like the owners of any other failed business venture—would have lost their investment. As Sprague, himself, admitted: "If market discipline means anything, stockholders should be wiped out when a bank fails. Our assistance would have the side effect ... of keeping the stockholders alive at government expense."1 But Unity Bank was different. It was located in a black neighborhood and was minority owned. As is often the case when government agencies are given discretionary powers, decisions are determined more by political pressures than by logic or merit, and Unity was a perfect example. In 1971, the specter of rioting in black communities still haunted the halls of Congress. Would the FDIC allow this bank to fail and assume the awesome responsibility for new riots and bloodshed? Sprague answers:
1.Sprague, pp. 41-42. 2
Neither Wille [another director] nor I had any trouble viewing the problem in its broader social context. We were willing to look for a creative solution.... My vote to make the "essentiality" finding and thus save the little bank was probably foreordained, an inevitable legacy of Watts.... The Watts riots ultimately triggered the essentiality doctrine.
On July 22, 1971, the FDIC declared that the continued operation of Unity Bank was, indeed, essential and authorized a direct infusion of $1.5 million. Although appearing on the agency's ledger as a loan, no one really expected repayment. In 1976, in spite of the FDIC's own staff report that the bank's operations continued "as slipshod and haphazard as ever," the agency rolled over the "loan" for another five years. Operations did not improve and, on June 30, 1982, the Massachusetts Banking Commissioner finally revoked Unity's charter. There were no riots in the streets, and the FDIC quietly wrote off the sum of $4,463,000 as the final cost of the bailout.
COMMONWEALTH BANK OF DETROIT
The bailout of the Unity Bank of Boston was the exception to
the rule that small banks are dispensable while the giants must be
saved at all costs. From that point forward, however, the FDIC
game plan was strictly according to Hoyle. The next bailout
occurred in 1972 involving the $1.5 billion Bank of the Commonwealth
of Detroit. Commonwealth had funded most of its phenomenal growth through loans from another bank, Chase
Manhattan in New York. When Commonwealth went belly up,
largely due to securities speculation and self dealing on the part of
its management, Chase seized 39% of its common stock and
actually took control of the bank in an attempt to find a way to get
its money back. FDIC director Sprague describes the inevitable
sequel: 1. Sprague, p. 68.
The bankers argued that Commonwealth must not be allowed to fold because it provided "essential" banking services to the community. That was justified on two counts: (1) it served many minority neighborhoods and, (2) there were not enough other banks in the city to absorb its operation without creating an unhealthy concentration of banking power in the hands of a few. It was unclear what the minority issue had to do with it inasmuch as every neighborhood in which Commonwealth had a branch was served by other banks as well. Furthermore, if Commonwealth were to be liquidated, many of those branches undoubtedly would have been purchased by competitors, and service to the communities would have continued. Judging by the absence of attention given to this issue during discussions, it is apparent that it was merely thrown in for good measure, and no one took it very seriously.
In any event, the FDIC did not want to be accused of being indifferent to the needs of Detroit's minorities and it certainly did not want to be a destroyer of free-enterprise competition. So, on January 17,1972, Commonwealth was bailed out with a $60 million loan plus numerous federal guarantees. Chase absorbed some losses, primarily as a result of Commonwealth's weak bond portfolio, but those were minor compared to what would have been lost without FDIC intervention.
Since continuation of the bank was necessary to prevent concentration of financial power, FDIC engineered its sale to the First Arabian Corporation, a Luxembourg firm funded by Saudi princes. Better to have financial power concentrated in Saudi Arabia than in Detroit. The bank continued to flounder and, in 1983, what was left of it was resold to the former Detroit Bank & Trust Company, now called Comerica. Thus the dreaded concentration of local power was realized after all, but not until Chase Manhattan was able to walk away from the deal with most of its losses covered.
FIRST PENNSYLVANIA BANK
The 1980 bailout of the First Pennsylvania Bank of Philadelphia
was next. First Penn was the nation's twenty-third largest bank
with assets in excess of $9 billion. It was six times the size of
Commonwealth; nine hundred times larger than Unity. It was also
the nation's oldest bank, dating back to the Bank of North America
which was created by the Continental Congress in 1781. The bank had experienced rapid growth and handsome profits largely due to the aggressive leadership of its chief executive officer, John Bunting, who had previously been an economist with the Federal Reserve Bank of Philadelphia. Bunting was the epitome of the era's go-go bankers. He vastly increased earnings ratios by reducing safety margins, taking on risky loans, and speculating in the bond market. As long as the economy expanded, these gambles were profitable, and the stockholders loved him dearly. When his gamble in the bond market turned sour, however, the bank plunged into a negative cash flow. By 1979, First Penn was forced to sell off several of its profitable subsidiaries in order to obtain operating funds, and it was carrying $328 million in questionable loans. That was $16 million more than the entire stockholder investment. The bank was insolvent, and the time had arrived to hit up the taxpayer for the loss.
The bankers went to Washington and presented their case. They were joined by spokesmen from the nation's top three: Bank of America, Citibank, and of course the ever-present Chase Manhattan. They argued that, not only was the bailout of First Penn essential" for the continuation of banking services in Philadelphia, it was also critical to the preservation of world economic stability. The bank was so large, they said, if it were allowed to fall, it would act as the first domino leading to an international financial crisis. At first, the directors of the FDIC resisted that theory and earned the angry impatience of the Federal Reserve. Sprague recalls:
We were far from a decision on how to proceed. There was strong pressure from the beginning not to let the bank fail. Besides hearing from the bank itself, the other large banks, and the comptroller, we heard frequently from the Fed. I recall at one session, Fred Schultz, the Fed deputy chairman, argued in an ever rising voice, that there were no alternatives—we had to save the bank. He said, "Quit wasting time talking about anything else!"...
The Fed's role as lender of last resort first generated contention between the Fed and FDIC during this period. The Fed was lending heavily to First Pennsylvania, fully secured, and Fed Chairman Paul Volcker said he planned to continue funding indefinitely until we could work out a merger or a bailout to save the bank.
The directors of the FDIC did not want to cross swords with the Federal Reserve System, and they most assuredly did not want to be blamed for tumbling the entire world economic system by allowing the first domino to fall. "The theory had never been tested," said Sprague. "I was not sure I wanted it to be just then." So, in due course, a bailout package was put together which featured a $325 million loan from FDIC, interest free for the first year and at a subsidized rate thereafter; about half the market rate. Several other banks which were financially tied to First Penn, and which would have suffered great losses if it had folded, loaned an additional $175 million and offered a $1 billion line of credit. FDIC insisted on this move to demonstrate that the banking industry itself was helping and that it had faith in the venture. To bolster that faith, the Federal Reserve opened its Discount Window offering low-interest funds for that purpose.
The outcome of this particular bailout was somewhat happier than with the others, at least as far as the bank is concerned. At the end of the five-year taxpayer subsidy, the FDIC loan was fully repaid. The bank has remained on shaky ground, however, and the final page of this episode has not yet been written.
CONTINENTAL ILLINOIS
Everything up to this point was but mere practice for the big
event which was yet to come. In the early 1980's, Chicago's
Continental Illinois was the nation's seventh largest bank. With
assets of $42 billion and with 12,000 employees working in offices in almost every major country in the world, its loan portfolio had
undergone spectacular growth. Its net income on loans had literally
doubled in just five years and by 1981 had rocketed to an annual
figure of $254 million. It had become the darling of the market
analysts and even had been named by Dun's Review as one of the
five best managed companies in the country. These opinion leaders
failed to perceive that the spectacular performance was due, not to
an expertise in banking or investment, but to the financing of shaky
business enterprises and foreign governments which could not
obtain loans anywhere else. But the public didn't know that and
wanted in on the action. For awhile, the bank's common stock
actually sold at a premium over others which were more prudently
managed. The gaudy fabric began to unravel during the Fourth of July weekend of 1982 with the failure of the Penn Square Bank in Oklahoma. That was the notorious shopping-center bank that had booked a billion dollars in oil and gas loans and resold them to Continental just before the collapse of the energy market. Other loans also began to sour at the same time. The Mexican and Argentine debt crisis was coming to a head, and a series of major corporate bankruptcies were receiving almost daily headlines. Continental had placed large chunks of its easy money with all of them. When these events caused the bank's credit rating to drop, cautious depositors began to withdraw their funds, and new funding dwindled to a trickle. The bank became desperate for cash to meet its daily expenses. In an effort to attract new money, it began to offer unrealistically high rates of interest on its C.D's. Loan officers were sent to scour the European and Japanese markets and to conduct a public relations campaign aimed at convincing market managers that the bank was calm and steady. David Taylor, the hank's chairman at that time, said: "We had the Continental Illinois Reassurance Brigade and we fanned out all over the world."1
1Quoted by Chernow, p. 657.
In the fantasy land of modern finance, glitter is often more important than substance, image more valuable than reality. The bank paid the usual quarterly dividend in August, in spite of the fact that this intensified its cash crunch. As with the Penn Central Railroad twelve years earlier, that move was calculated to project an image of business-as-usual prosperity. And the ploy worked for a while, at least. By November, the public's confidence had been restored, and the bank's stock recovered to its pre-Penn Square level. By March of 1983, it had risen even higher. But the worst was yet to come.
By the end of 1983, the bank's burden of non-performing loans had reached unbearable proportions and was growing at an alarming rate. By 1984, it was $2.7 billion. That same year, the bank sold off its profitable credit-card operation to make up for the loss of income and to obtain money for paying stockholders their expected quarterly dividend. The internal structure was near collapse, but the external facade continued to look like business as usual.
The first crack in that facade appeared at 11:39 A.M. On Tuesday, May 8, Reuters, the British news agency, moved a story on its wire service stating that banks in the Netherlands, West Germany, Switzerland, and Japan had increased their interest rate on loans to Continental and that some of them had begun to withdraw their funds. The story also quoted the bank's official statement that rumors of pending bankruptcy were "totally preposterous." Within hours, another wire, the Commodity News Service, reported a second rumor: that a Japanese bank was interested in buying Continental.
WORLD'S FIRST ELECTRONIC
BANK RUN
As the sun rose the following morning, foreign investors began
to withdraw their deposits. A billion dollars in Asian money
moved out that first day. The next day—a little more than
twenty-four hours following Continental's assurance that bankruptcy
was totally preposterous, its long-standing customer, the
Board of Trade Clearing Corporation, located just down the
street—withdrew $50 million. Word of the defection spread
through the financial wire services, and the panic was on. It became
the world's first global electronic bank run. By Friday, the bank had been forced to borrow $3.6 billion from the Federal Reserve in order to cover its escaping deposits. A consortium of sixteen banks, lead by Morgan Guaranty, offered a generous thirty-day line of credit, but all of this was far short of the need. Within seven more days, the outflow surged to over $6 billion.
In the beginning, almost all of this action was at the institutional level: other banks and professionally managed funds which closely monitor every minuscule detail of the financial markets. The general public had no inkling of the catastrophe, even as it unfolded. Chernow says: "The Continental run was like some modernistic fantasy: there were no throngs of hysterical depositors, just cool nightmare flashes on computer screens."1 Sprague writes: "Inside the bank, all was calm, the teller lines moved as always, and bank officials recall no visible sign of trouble—except in the wire room. Here the employees knew what was happening as withdrawal order after order moved on the wire, bleeding Continental to death. Some cried."2
1- Chernow, p. 658.
2.Sprague, p. 153.
This was the golden moment for which the Federal Reserve and the FDIC were created. Without government intervention, Continental would have collapsed, its stockholders would have been wiped out, depositors would have been badly damaged, and the financial world would have learned that banks, not only have to talk about prudent management, they actually have to adopt it. Future banking practices would have been severely altered, and the long-term economic benefit to the nation would have been enormous. But with government intervention, the discipline of a free market is suspended, and the cost of failure or fraud is politically passed to the taxpayers. Depositors continue to live in a dream world of false security, and banks can operate recklessly and fraudulently with the knowledge that their political partners in government will come to their rescue when they get into trouble.
FDIC GENEROSITY WITH TAX DOLLARS
One of the challenges at Continental was that, while only four
per cent of its liability was covered by FDIC "insurance," the
regulators felt compelled to cover the entire exposure. Which
means that the bank paid insurance premiums into the fund based
on only four per cent of its total coverage, and the taxpayers now
would pick up the other ninety-six per cent. FDIC director Sprague
explains: Although Continental Illinois had over $30 billion in deposits, 90 percent were uninsured foreign deposits or large certificates substantially exceeding the $100,000 insurance limit. Off-book liabilities swelled Continental's real size to $69 billion. In this massive liability structure only some $3 billion within the insured limit was scattered among 850,000 deposit accounts. So it was in our power and entirely legal simply to pay off the insured depositors, let everything else collapse, and stand back to watch the carnage.
That course was never seriously considered by any of the players. From the beginning, there were only two questions: how to come to Continental's rescue by covering its total liabilities and, equally important, how to politically justify such a fleecing of the taxpayer. As pointed out in the previous chapter, the rules of the game require that the scam must always be described as a heroic effort to protect the public. In the case of Continental, the sheer size of the numbers made the ploy relatively easy. There were so many depositors involved, so many billions at risk, so many other banks interlocked, it could be claimed that the economic fabric of the entire nation—of the world itself—was at stake. And who could say that it was not so. Sprague argues the case in familiar terms:
An early morning meeting was scheduled for Tuesday, May 15, at the Fed. .. We talked over the alternatives. They were few—none really.... [Treasury Secretary] Regan and [Fed Chairman] Volcker raised the familiar concern about a national banking collapse, that is, a chain reaction if Continental should fail. Volcker was worried about an international crisis. We all were acutely aware that never before had a bank even remotely approaching Continental's size closed. No one knew what might happen in the nation and in the world. It was no time to find out just for the purpose of intellectual curiosity.
THE FINAL BAILOUT PACKAGE
The bailout was predictable from the start. There would be
some preliminary lip service given to the necessity of allowing the
banks themselves to work out their own problem. That would be
followed by a plan to have the banks and the government share the
burden. And that finally would collapse into a mere public relations
illusion. In the end, almost the entire cost of the bailout
would be assumed by the government and passed on to the
taxpayer. At the May 15 meeting, Treasury Secretary Regan spoke eloquently about the value of a free market and the necessity of having the banks mount their own rescue plan, at least for a part of the money. To work out that plan, a summit meeting was arranged the next morning among the chairmen of the seven largest banks: Morgan Guaranty, Chase Manhattan, Citibank, Bank of America, Chemical Bank, Bankers Trust, and Manufacturers Hanover. The meeting was perfunctory at best. The bankers knew full well that the Reagan Administration would not risk the political embarrassment of a major bank failure. That would make the President and the Congress look bad at re-election time. But, still, some kind of tokenism was called for to preserve the Administration's conservative image. So, with urging from the Fed and the Treasury, the consortium agreed to put up the sum of $500 million—an average of only $71 million for each, far short of the actual need. Chernow describes the plan as "make-believe" and says "they pretended to mount a rescue."1 Sprague supplies the details:
1 Chernow, p. 659.
The bankers said they wanted to be in on any deal, but they did not want to lose any money. They kept asking for guarantees. They wanted it to look as though they were putting money in but, at the same time, wanted to be absolutely sure they were not risking anything.... By 7:30 A.M. we had made little progress. We were certain the situation would be totally out of control in a few hours. Continental would soon be exposing itself to a new business day, and the stock market would open at ten o'clock. Isaac [another FDIC director] and I held a hallway conversation. We agreed to go ahead without the banks. We told Conover [the third FDIC director] the plan and he concurred....
Later, we got word from Bernie McKeon, our regional director in New York, that the bankers had agreed to be at risk. Actually, the risk was remote since our announcement had promised 100 percent insurance.2
2- Sprague, pp. 159-60.
The final bailout package was a whopper. Basically, the government took over Continental Illinois and assumed all of its losses. Specifically, the FDIC took $4.5 billion in bad loans and paid Continental $3.5 billion for them. The difference was then made up by the infusion of $1 billion in fresh capital in the form of stock purchase. The bank, therefore, now had the federal government as a stockholder controlling 80 per cent of its shares, and its bad loans bad been dumped onto the taxpayer. In effect, even though Continental retained the appearance of a private institution, it had been nationalized.
LENDER OF LAST RESORT
Perhaps the most important part of the bailout, however, was
that the money to make it possible was created—directly or
indirectly—by the Federal Reserve System. If the bank had been
allowed to fail, and the FDIC had been required to cover the losses,
the drain would have emptied the entire fund with nothing left to
cover the liabilities of thousands of other banks. In other words,
this one failure alone, if it were allowed to happen, would have
wiped out the entire FDIC! That's one reason the bank had to be
kept operating, losses or no losses, and that's why the Fed had to be
involved in the bail out. In fact, that was precisely the reason the
System was created at Jekyll Island: to manufacture whatever
amount of money might be necessary to cover the losses of the
cartel. The scam could never work unless the Fed was able to create
money out of nothing and pump it into the banks along with
"credit" and "liquidity" guarantees. Which means, if the loans go
sour, the money is eventually extracted from the American people
through the hidden tax called inflation. That's the meaning of the
phrase "lender of last resort." FDIC director Irvine Sprague, while discussing the press release which announced the Continental bail-out package, describes the Fed's role this way:
The third paragraph ... granted 100 percent insurance to all depositors, including the uninsured, and all general creditors.... The next paragraph ... set forth the conditions under which the Fed, as lender of last resort, would make its loans.... The Fed would lend to Continental to meet "any extraordinary liquidity requirements." That would include another run. All agreed that Continental could not be saved without 100 percent insurance by FDIC and unlimited liquidity support by the Federal Reserve. No plan would work without these two elements.1
1. Sprague, pp. 162-63.
p~Quoted by Greider, p. 628.
SMALL BANKS BE DAMNED
It has been mentioned previously that the large banks receive a
free ride on their FDIC coverage at the expense of the small banks.
There could be no better example of this than the bail out of
Continental Illinois. In 1983, the bank paid a premium into the fund
of only $6.5 million to protect its insured deposits of $3 billion. The
actual liability, however—including its institutional and overseas
deposits—was ten times that figure, and the FDIC guaranteed
payment on the whole amount. As Sprague admitted, "Small banks
pay proportionately far more for their insurance and have far less
chance of a Continental-style bailout."2 2~ Sprague, p. 250. How true. Within the same week that the FDIC and the Fed were providing billions in payments, stock purchases, loans, and guarantees for Continental Illinois, it closed down the tiny Bledsoe County Bank of Pikeville, Tennessee, and the Planters Trust and Savings Bank of Opelousas, Louisiana. During the first half of that year, forty-three smaller banks failed without an FDIC bailout. In most cases, a merger was arranged with a larger bank, and only the uninsured deposits were at risk. The impact of this inequity upon the banking system is enormous. It sends a message to bankers and depositors alike that small banks, if they get into trouble, will be allowed to fold, whereas large banks are safe regardless of how poorly or fraudulently they are managed. As a New York investment analyst stated to news reporters, Continental Illinois, even though it had just failed, was "obviously the safest bank in the country to have your money in."3 Nothing could be better calculated to drive the small independent banks out of business or to force them to sell out to the giants. And that, in fact, is exactly what has been happening. Since 1984, while hundreds of small banks have been forced out of business, the average size of the banks which remain—with government protection—has more than doubled. It will be recalled that this advantage of the big banks over their smaller competitors was also one of the objectives of the Jekyll Island plan.
Perhaps the most interesting—and depressing—aspect of the Continental Illinois bailout was the lack of public indignation over the principle of using taxes and inflation to protect the banking industry. Smaller banks have complained of the unfair advantage given to the larger banks, but not on the basis that the government should have let the giant fall. Their lament was that it should now protect them in the same paternalistic fashion. Voters and politicians were silent on the issue, apparently awed by the sheer size of the numbers and the specter of economic chaos. Decades of public education had left their mark. After all, wasn't this exactly what government schools have taught is the proper function of government? Wasn't this the American way? Even Ronald Reagan, viewed as the national champion of economic conservatism, praised the action. From aboard Air Force One on the way to California, the President said: "It was a thing that we should do and we did it. It was in the best interest of all concerned."1
1. "Reagan Calls Rescue of Bank No Bailout," New York Times, July 29,1984.
The Reagan endorsement brought into focus one of the most amazing phenomena of the 20th century: the process by which America has moved to the Left toward statism while marching behind the political banner of those who speak the language of opposing statism. William Greider, a former writer for the liberal Washington Post and The Rolling Stone, complains:
The nationalization of Continental was, in fact, a quintessential act of modem liberalism—the state intervening in behalf of private interests and a broad public purpose. In this supposedly conservative era, federal authorities were setting aside the harsh verdict of market competition (and grossly expanding their own involvement in the private economy)....
In the past, conservative scholars and pundits had objected loudly at any federal intervention in the private economy, particularly emergency assistance for failing companies. Now, they hardly seemed to notice. Perhaps they would have been more vocal if the deed had been done by someone other than the conservative champion, Ronald Reagan.2
2. Greider, p. 631.
Four years after the bailout of Continental Illinois, the same play was used in the rescue of BankOklahoma, which was a bank holding company. The FDIC pumped $130 million into its main banking unit and took warrants for 55% ownership. The pattern had been set. By accepting stock in a failing bank in return for bailing it out, the government had devised an ingenious way to nationalize banks without calling it that. Issuing stock sounds like a business transaction in the private sector. And the public didn't seem to notice the reality that Uncle Sam was going into banking.
SECOND REASON TO ABOLISH
THE FEDERAL RESERVE
A sober evaluation of this long and continuing record leads to
the second reason for abolishing the Federal Reserve System: Far
from being a protector of the public, it is a cartel operating against the
public interest.
SUMMARY
The game called bailout is not a whimsical figment of the
imagination, it is for real. Here are some of the big games of the
season and their final scores. In 1970, Penn Central railroad became bankrupt. The banks which loaned the money had taken over its board of directors and had driven it further into the hole, all the while extending bigger and bigger loans to cover the losses. Directors concealed reality from the stockholders and made additional loans so the company could pay dividends to keep up the false front. During this time, the directors and their banks unloaded their stock at unrealistically high prices. When the truth became public, the stockholders were left holding the empty bag. The bailout, which was engineered by the Federal Reserve, involved government subsidies to other banks to grant additional loans. Then Congress was told that the collapse of Penn Central would be devastating to the public interest. Congress responded by granting $125 million in loan guarantees so that banks would not be at risk. The railroad eventually failed anyway, but the bank loans were covered. Penn Central was nationalized into AMTRAK and continues to operate at a loss.
In 1970, as Lockheed faced bankruptcy, Congress heard essentially the same story. Thousands would be unemployed, subcontractors would go out of business, and the public would suffer greatly. So Congress agreed to guarantee $250 million in new loans, which put Lockheed 60% deeper into debt than before. Now that government was guaranteeing the loans, it had to make sure Lockheed became profitable. This was accomplished by granting lucrative defense contracts at non-competitive bids. The banks were paid back.
In 1975, New York City had reached the end of its credit rope. It had borrowed heavily to maintain an extravagant bureaucracy and a miniature welfare state. Congress was told that the public would be jeopardized if city services were curtailed, and that America would be disgraced in the eyes of the world. So Congress authorized additional direct loans up to $2.3 billion, which more than doubled the size of the current debt. The banks continued to receive their interest.
In 1978, Chrysler was on the verge of bankruptcy. Congress was informed that the public would suffer greatly if the company folded, and that it would be a blow to the American way if freedom-of-choice were reduced from three to two makes of automobiles. So Congress guaranteed up to $1.5 billion in new loans. The banks reduced part of their loans and exchanged another portion for preferred stock. News of the deal pushed up the market value of that stock and largely offset the loan write-off. The banks' previously noncollectable debt was converted into a government backed, interest-bearing asset.
In 1972, the Commonwealth Bank of Detroit—with $1.5 billion in assets, became insolvent. It had borrowed heavily from the Chase Manhattan Bank in New York to invest in high-risk and potentially high-profit ventures. Now that it was in trouble, so was Chase. The bankers went to Washington and told the FDIC the public must be protected from the great financial hardship that would follow if Commonwealth were allowed to close. So the FDIC pumped in a $60 million loan plus federal guarantees of repayment. Commonwealth was sold to an Arab consortium. Chase took a minor write down but converted most of its potential loss into government-backed assets.
In 1979, the First Pennsylvania Bank of Philadelphia became insolvent. With assets in excess of $9 billion, it was nine-times the size of Commonwealth. It, too, had been an aggressive player in the '80's. Now the bankers and the Federal Reserve told the FDIC that the public must be protected from the calamity of a bank failure of this size, that the national economy was at stake, perhaps even the entire world. So the FDIC gave a $325 million loan—interest-free for the first year, and at half the market rate thereafter. The Federal Reserve offered money to other banks at a subsidized rate for the specific purpose of relending to First Penn. With that enticement, they advanced $175 million in immediate loans plus a $1 billion line of credit.
In 1982, Chicago's Continental Illinois became insolvent. It was the nation's seventh largest bank with $42 billion in assets. The previous year, its profits had soared as a result of loans to high-risk business ventures and foreign governments. Although it had been the darling of market analysts, it quickly unraveled when its cash flow turned negative, and overseas banks began to withdraw deposits. It was the world's first electronic bank run. Federal Reserve Chairman Volcker told the FDIC that it would be unthinkable to allow the world economy to be ruined by a bank failure of this magnitude. So, the FDIC assumed $4.5 billion in bad loans and, in return for the bailout, took 80% ownership of the bank in the form of stock. In effect, the bank was nationalized, but no one called it that. The United States government was now in the banking business.
All of the money to accomplish these bailouts was made possible by the Federal Reserve System acting as the "lender of last resort." That was one of the purposes for which it had been created. We must not forget that the phrase "lender of last resort" means that the money is created out of nothing, resulting in the confiscation of our nation's wealth through the hidden tax called inflation.
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