Financial Eugenics: The Paulson Plan for Survivor Bias

As I write this I don’t know the outcome of the attempt to ram through legislation for looting the US Treasury of $700 billion before the end of the Bush administration.  I suspect that Congress will force the passage of the bill in some form because the media and political narrative on the necessity of the measure is unremitting and so horribly biased.

No alternatives will be considered.

No constraints on the unilateral executive authority of Hank Paulson will be considered.

No assurances that funds will be used to unlock credit markets or promote lending to the real economy (as opposed to the financial robber barons) will be considered.

Instead, the bill will get laden with an additional 300 pages of pork to sway the dissenters, adding to the tab imposed on the American taxpayer.

Having listened to all 42 minutes of the late night Treasury briefing of investment banks on Sunday, there is no doubt in my mind that this legislation represents the sort of federal largesse for Goldman Sachs, Morgan Stanley, Citibank and JPMorgan Chase that the Iraq war provided for Halliburton and Blackwater.

The most cynical moment in the call is when the Treasury official confirms, ”our preference would be to help the healthy banks become even healthier” rather than helping troubled banks or illiquid banks.

America is now a centrally planned economy where the Treasury will determine which firms survive and prosper through allocation of scarce capital to an undercapitalised financial sector.

Clearly what is going on here has nothing to do with kick starting the credit markets or stabilising the equity markets or restoring depositor confidence in banks.  (Treasury official:  “No provision in the legislation that mandates re-lending.”)  What is going on here is a blatant attempt to provide government funds to a select cadre of firms (not all banks) which are chosen to be the survivors feasting off the carcasses of their less fortunate and less well-connected brethren as the downturn intensifies in the years to come.

The crash in equities will still happen.  The debt deflation of the economy leading to mass commercial and consumer credit defaults will still happen.  The collapse of many national, regional and local financial institutions will still happen.  The bankruptcy of many municipalities and shortfalls in state budgets will still happen.

This bill is about engineering survivor bias to friends of the Bush administration so that they profit disproportionately from the collapse of these markets using the funds provided by the taxpayer via the unreviewable and unconditional authority of the Secretary of the Treasury.

The basic plan is to set up a federal money laundering operation.  Bad assets come in, get laundered by the Treasury and put in a new AAA “wrapper” (as it’s termed on the call), and good assets go out, issued as Treasury guaranteed securities.  Whether the final value of the legislation this week is $700 billion or $150 billion is irrelevant as long as the laundering operation can accommodate the throughput, as that number is only a cap on total extensions at any one time.

The SEC will support the plan and survivor bias by relaxing FASB 157 on mark to market accounting.  If there is no agreement on what an asset is worth, it is worth whatever the firm holding it says in its Level 3 accounts or the Treasury Secretary accepts in buying it.

The Federal Reserve will support the plan by relaxing the definition of “control stake” in US banks and bank holding companies to allow secretive cabals to hold through private equity and offshore hedge funds.  No one knows the beneficial owners of these ill-transparent private equity investors, and so it is the ideal way to reward loyal and helpful insiders, legislators and officials – as well as cede further ownership of American assets to foreign stakeholders who would be politically unacceptable if publicly acknowledged.  Many foreign creditors are irate at the losses their funds, banks and pensioners have sustained from investments in the United States, and this plan provides a secret way to buy them off and keep them lending and investing as their own economies are roiled by the deflation to come.

For the past year the survivor bias has been orchestrated from the Federal Reserve, with its extension of innovative credit facilities and selectively engineered rescues or forced mergers.  That has been very useful, but that well is now dry.  The Fed has no more good assets to trade for the bad assets the banks can offer.  And the supply of bad assets just keeps growing as market illiquidity spreads further from the core of the mortgage backed securities market.  Instability is now leading to a realistic threat that the Fed and Treasury could lose control of the deflationary process.

Part of the reason the Paulson Plan is so attractive is that it recapitalises the Fed by promoting the unwinding of repos and lending facilities which left the Fed holding toxic assets.  As the repos and credit facilities gradually unwind, these toxic assets can now be taken back by the banks and exchanged for good cash.  The Fed gets its balance sheet Treasuries and cash back to restore its flexibility to intervene anew.

Favoured private equity and insiders who swap US dollars for equity in the banking system will presumably be aware of the survivor bias being engineered on their behalf.  Sovereign wealth funds, investment funds and private equity investors ripped off in the first round of recapitalisation may be willing to come back in once it is clear to them that the next round will benefit from official favouritism.  Warren Buffett’s timely stake in Goldman Sachs is clearly linked to his confidence the Paulson Plan will benefit them disproportionately.

A factor which is probably critical but has received little discussion is that literally thousands of Bush administration apparatchiks will need jobs come January, and a fair selection of GOP House and Senate legislators and their aides too.  What better way to enahance their CVs in their final months in power than to distribute $700 billion or so in pre-Christmas largesse to the most remunerative employers in the world?  And what better way to ensure the corporate largesse is returned to the GOP to win back the White House and Congress in 2012 as the recession fuels public anger?

And then there is a huge arbitrage opportunity as well so that everyone makes money.  According to the conference call, the pricing on offer from the Treasury will be a bit below Level 3 pricing.  The toxic assets will be repackaged and resold with a new AAA wrapper, possibly priced well below what the Treasury paid, assuring a huge profit on both immediate liquidation by the banks and ultimate maturity by investors.  The Fed gets its cash and Treasuries back; the banks make huge profits; the foreigners and off-shore tax avoiders get disguised ownership of the American financial system; the taxpayer gets ripped off.  What’s not to love?

Think back to Fisher’s Theory of Debt Deflation in Great Depressions.  Dollars become “bigger” as deflation takes hold because each dollar can buy more assets as assets deflate.  That means that as these clowns crash the markets, their $700 billion of liquid cash funnelled to their friends and recycled through the Treasury laundrymat can progressively buy up the rest of the pieces on the gameboard at low discount prices.  Game over with those who caused the crash and robbed the bank winning.

Deflation is going to happen – globally.  Either we can use the course of deflation to shape healthy economies that will provide growth and employment and productive returns on investment in future, or we can allow deflation to further enrich those miscreants whose irresponsible policies led to the violent financial collapse we are about to experience.

There is a fundamentally healthy economy in America – somewhere underneath all the financial excess and chicanery and all the financial/oil/military/healthcare/developer corruption of local, state and federal politics.  It will be a painful and slow process to kill off the metastasising cancerous growths on the economy, but if Americans achieved that, they could embrace a healthier and more productive and more prosperous future.

I would like to believe Americans expressed the courage to change over last weekend when they 25 to 1 rejected an unconstrained and unconditional bailout of Wall Street in favour of cold turkey deleveraging of the economy.  I wish I could believe that it mattered in the political calculus, but the result of the House vote on the bill will tell us that.

Fight the survivor bias.  It’s not your survival they’re engineering.

29 Responses to "Financial Eugenics: The Paulson Plan for Survivor Bias"

  1. r0tiNeK   October 3, 2008 at 2:02 am

    Nice Post LB. We shall see tomorrow what becomes of this “Bailout Bill”. Even if it gets through, I don’t believe that 6 months from now we’re going to see much difference.

  2. r0tiNeK   October 3, 2008 at 2:07 am

    The situation is now disintegrating into a very Politically charged environment as people start to get off their bums & get vocal about the destruction of their Wealth at the hands of The Fed (overseen by Treasury & Congress). It’s going to get very interesting…

  3. Guest   October 3, 2008 at 7:45 am

    To all. These people ( Bush FRB Wall St. ) are looking to obliterate the constitution and free market system and a going to implement a new currency. New laws new constitution.They already accomplished that in Europe.Problem is you all have no say about it.The FRB must be abolished. It has become a government within the government with its own agenda.

  4. villager   October 3, 2008 at 8:30 am

    I posted your article over on the Politics Forum of because it provides an “eyes open” interpretation of the government plan. In my own way, I have been trying to persuade Americans against support of the Paulson plan and I have been pointing out that there are better alternatives. Unfortunately, Americans can be ‘rigid’ in their party politics. Consequently, I was pleased to see Dr. Roubini avoid the ‘politics’ and ‘ideology’ pitfalls in a recent interview by referring to ‘practical’. Your article certainly takes a ‘practical’ or pragmatic view. I suspect more people are going to become ‘practical’ as the severity of the recession bites home.You realize that both you and President Bush have one similarity – you both ride mountain bikes!

    • London Banker   October 3, 2008 at 8:49 am

      The difference between me and President Bush, among others, is that I can also ride a Segway.

  5. Anonymous   October 3, 2008 at 9:27 am

    Congressmen were threatened on Monday with the imposition of Martial Law if they failed to pass the bailout bill.Rep. Brad Sherman (D-OH):The only way they can pass this bill is by creating and sustaining a panic atmosphere. That atmosphere in not justified. Many of us were told in private conversations that if we voted against this bill, on Monday, that the sky would fall, the market would fall 2 or 3 thousand points the first day, another couple thousand the second day, and a few members were even told that there would be martial law in America if we voted no.That’s what I call fear-mongering. Unjustified. Proven wrong.We’ve got a week. We’ve got two weeks to write a good bill. The only way to pass a bad bill – keep the panic pressure on.

  6. PhilT   October 3, 2008 at 11:14 am

    Well done London Banker …

  7. Dave P   October 3, 2008 at 12:13 pm

    There is a fundamentally healthy economy in America – somewhere underneath all the financial excess and chicanery and all the financial/oil/military/healthcare/developer corruption of local, state and federal politics.

    I wish I could agree with that. What I see is not healthy at all, but a service economy that is functioning on credit, and a financial economy that is dead. I continue to assert that a nation that makes nothing is worth nothing. The US makes very little that the world would like to buy. Sure, the economy is great if you think we can continue selling each other insurance, cleaning toilets, drawing tatoos and doing fingernails and serving burgers. How much longer can we use our increasingly worthless money to buy goods not made in USA. When does the world say, “We don’t want your stinking dollars”?My best guess is that day is fast a-coming.

  8. Guest   October 3, 2008 at 12:29 pm

    The stinking dollar will soon be turning into the stinking Amero with built in inflation that will make what happened in Europe look like a piece of cake.

  9. London Banker   October 3, 2008 at 12:57 pm

    It passed. It’s a done deal. Warren Buffett will add to his fortune, as will Hank Paulson and his partners at Goldman Sachs. The Saudis and the Chinese will own more American banks, one step removed through their private equity partners. The GOP apparatchiks will all find cushy jobs on Wall Street and K Street come January (if martial law isn’t imposed before then).In a way, it’s not much of a change from yesterday. The US has been on the path to lawless oligarchy for the past eight years. Today is just one more step down the path.Here in the UK we are still blind to what is about to happen, believing hopefully in the good faith of our trusted ally across the Atlantic. Denial is still strong.In a way, it makes me optimistic. The British belief in fair play and loyalty is part of what makes living here wonderful, and part of what binds us together to rebuild after each disaster.As a good friend wrote to me earlier today, “As for the City, it has survived plague, fire, and more financial crises than you have teeth. It will survive this.”

  10. Guest   October 3, 2008 at 2:15 pm

    Now we’ll see if the Libor is affected and the banks start lending. If not it was a hijack and robbery.Prosecutions should abound.

  11. ttsing   October 3, 2008 at 2:34 pm

    Now that the TARP has been enacted, and following the above exposé by LB, would someone be good enough to illustrate by a diagram the cashflow trail that will ensue from the $700bn package.This would indeed be helpful in comprehending the mechanism put in place.

  12. ttsing   October 3, 2008 at 2:34 pm

    Now that the TARP has been enacted, and following the above exposé by LB, would someone be good enough to illustrate by a diagram the cashflow trail that will ensue from the $700bn package.This would indeed be helpful in comprehending the mechanism put in place.

  13. Guest   October 3, 2008 at 3:50 pm

    London Banker for President!

  14. dof   October 3, 2008 at 4:52 pm

    However discouraging your forecasts have been, I’ve always appreciated those tiny nuggets of promise buried in the magnitude of corruption and betrayal weighing down on humanity. Truth is the soundest foundation on which to build a new future and I’ve valued your dedication to unearthing the falsehoods that have obstructed humanity’s innate potential to rise above this heartbreaking period of utter failure.Thank-you for all your effort London Banker

  15. Gloomy   October 3, 2008 at 5:15 pm

    Yes, but one fine day soon a bloated Treasury auction will fail and the United States will be in default. On that day justice will be served: the cancer will die with the host.

  16. dof   October 3, 2008 at 9:39 pm

    Indeed. What a fitting metaphor.

  17. OuterBeltway   October 3, 2008 at 10:22 pm

    LB:Thanks for another excellent shot with the sledgehammer. Every clanging hit wakes up another 10 people. Some of them will soon be picking up sledges, too.We’ll get there. Some of us ‘merkins remember long, and work hard.

  18. DJ   October 3, 2008 at 11:40 pm

    I heard that the FDIC was guaranteeing ten cents on the dollar when it was guaranteed to $100,000.00; do you suppose now, it is twenty-five cents on the dollar?

    • London Banker   October 4, 2008 at 3:45 am

      But even at 10 cents on the dollar of guarantee, it’s capital was 0.1 cents on the dollar to deposits. So how well capitalised is the FDIC now? That is a better question.

  19. DJ   October 3, 2008 at 11:42 pm

    continuation from last post: since it is now guaranteed up to $250,000.00 by the FDIC?

  20. lewy14   October 4, 2008 at 1:40 am

    The most cynical moment in the call is when the Treasury official confirms, ”our preference would be to help the healthy banks become even healthier” rather than helping troubled banks or illiquid banks.

    Um… that sounds an awful lot like professor Roubini’s call for rapid triage. What the heck is rapid triage if not “survivor bias”?

  21. Taxpayer   October 4, 2008 at 1:44 am

    I wonder if we are seeing a grand version of the Lloyds names affair where it has been alleged that the asbestos etc insurance booby prizes were allocated to one group whereas others were favoured with the less openended risk.”Rt. Hon. Peter Hain MP letter to Prime Minister John Major 15 July 1994 “…corruption in Lloyd’s is widespread and has caused considerable suffering to external investors who have quite literally been taken for a ride….” “…billions of pounds of losses ‘dumped’ on them [Names]…” “…amongst the 51 Tory MP’s are some big losers,…whilst others…..have been singled out for protection.” “…both leading Conservatives and leading figures in Lloyd’s have benefited from inside information to avoid incurring heavy losses in 1989, 1990 and 1991.” “

  22. Taxpayer   October 4, 2008 at 1:55 am

    Background.”BEING invited to become a Lloyd’s Name was once the ultimate meal ticket — a chance to join an elite group of wealthy individuals forming the financial backbone of the famous insurer. Names — who need access to $1 million in private wealth to join — underwrote insurance for companies through Lloyd’s of London syndicates. Australian Names include former prime minister Malcolm Fraser.They enjoyed healthy returns for two centuries, but in the 1980s, Names were besieged by asbestosis claims and, more recently, pay-outs after terrorist strikes. A series of disasters in the early 1990s left Names badly out of pocket, and many are at risk of bankruptcy. Even the wealth of Berkshire Hathaway investment guru Warren Buffett can’t help.In 1996, the Lloyd’s insurance market set up Equitas to cover its near-overwhelming liabilities that existed from before 1992. Last October, Berkshire — the investment vehicle controlled by US billionaire Buffett — agreed to take on Equitas’ liabilities, staff, operations and most assets.Equitas’ reserves run into billions but many fear that will not be enough, in which case the Names will have to stump up more cash. Few can.In the latest move, the head of the campaign, Sir William Jaffray, is fighting a legal loophole he says removes the right of Names to fight bankruptcy orders made against them. “It provides a fast-track bankruptcy regime for Names in the event of Equitas’ reserves running dry. It must be amended or repealed to give Names closure — some 34,000 families’ futures are at stake.” “

    • London Banker   October 4, 2008 at 3:51 am

      The Lloyd’s crisis was a very serious crisis indeed. But instead of studying just the cause of the crisis, it would be useful to study it’s resolution. Without government intervention or government funds, the Society of Lloyd’s implemented a mutual insurance and certification arrangement which resolved the crisis in a matter of years.I strongly believe that when a market has a valuable franchise, then mutuality can achieve effective self-regulation and mutual discipline. Lloyd’s survival – and 400 years without a default – is testimony to that.One of the lessons we may learn is that turning too much authority over to government interferes with market discipline rather than strenghens it. The professionalisation of regulation removes it from the responsibility of each member of the market, and so devalues it as part of the valuable market franchise.

      • Taxpayer   October 4, 2008 at 9:45 am

        Yes, you’re right, intervention should be kept to a minimum.The challenge is to instill some sort of civilized restraint in the market participants without holding a gun to their heads.Markets have been plundered by gluttons.Commission based markets don’t seem to encourage any restraint.

  23. Laisseraller   October 4, 2008 at 3:08 pm

    Great Article! new blog give deeper insight

  24. Guest   October 10, 2008 at 5:56 am

    “The basic plan is to set up a federal money laundering operation. Bad assets come in, get laundered by the Treasury and put in a new AAA “wrapper” (as it’s termed on the call), and good assets go out, issued as Treasury guaranteed securities. “The Bushies and Congress are protecting fraud.What is there to trust in this system?