The Illusions of a Free Market, the Nonsense that it has become

One word captures my sentiment towards the events of the past week and few months on Wall Street, wow. The collapse of century old financial firms, unprecedented government bailouts of companies, careers lost and the sheer loss of capital, just boggles the mind. We are at a low point in our history, we, as voters are a disgrace, every single one of us. The people we voted in have not served us in any of our best interests, but instead have continued to allow illegal practices and gross market manipulation by entities in the financial sector, that they seem to favor. The other thing that perplexes me is the fact that the Fed is now really comfortable offloading toxic investment instruments from these entities to the taxpayer, without really penalizing the entity or fully understanding the true value of these investments, if you can call them that. These are investments that no private sector company would even dare to touch, even if was given to them for pennies on the dollar, just ask Mr. Buffett.

All this came about because this sector made loans to consumers without really checking on their ability to pay it back. Using that they leveraged themselves to extremely nonsensical levels. Of course, while real estate prices were rising, no one really defaulted or went into foreclosure. Those who couldn’t afford the mortgages simply sold their houses, banked the profit on equity and moved on, others banking on the rise of property values, used their homes as leverage and pulled out what little equity they had left. With these rising consumer debt levels and the over extending of banks by banks, the sector started booking massive profits, mostly paper profits, and started paying themselves huge bonuses. Once housing prices started to fall, this cycle went bust and the reality of the situation hit both consumer and banks. The consumer started defaulting and foreclosing while the banks took extensive measures to keep the losses away from their balance sheets and therefore from the investing public. They did so primarily by reporting most of it as level-3 assets, where the valuation is estimated by formulas that these entities create, anyone else notice a possible conflict of interest here?

Then came the bailouts, the brokering of the Bear Stearns sale, nationalizing Freddie and Fannie, etc. There is a very real difference between the bailout now vs. the bailouts during the S&L crisis. Back then the assets the government received after paying off depositors and shutting down insolvent institutions were by and large real assets like land or buildings. The shareholders and unsecured creditors were the ones who bore the brunt of the losses. In the current rescue the government is buying a lot of this level-3 assets at a so called substantial discount. Why so called, well because the real value of the assets are almost impossible to ascertain, so if the government (aka taxpayers) buy these at the currently trading value they are simply forcing the price discovery of the assets and not achieving much. If they buy it at a discount to the “original” value, lets say 50¢ on the dollar, then this becomes nothing but a large scale bailout and transfer of wealth to Wall Street². Since these instruments are so hard to value, no one really knows the extent to which the taxpayers will suffer, but one thing is certain, the people who benefit and make billions out of this, are the very people who caused this. You tell me, where is the parity that the free markets create in all this?

More on the destruction of free markets now. So this week the government intervened and stopped all short selling on 799 stocks, great, this coming on the heels of two 350+ point drops in the DJ Index.

Question: Why do they want to protect just 799 companies? Why not just ban short selling for the entire market?
Answer: Cronyism.

It’s as though they are blaming short sellers for the destruction and bailout of the financial sectors. If you look closely and as evidenced above, the short sellers have been correct about the underlying fundamentals of the sector. Banning them is not the answer. They play an important role in price discovery and make the markets more efficient. More importantly they provide the markets with a lot of liquidity. I don’t mean to exonerate all the short sellers here, there are obvious abuses by some of them, but even the longs have their share of abusers. Naked shorts without any kind of enforcement are a dumb idea, you are just inviting trouble.

There is also some irony in all this that makes this such a farce. The large entities that I talked about earlier, have been short selling as a part of their trading strategies, which has made them billions of dollars. Earlier when companies complained that short selling was ruining them, these entities just chalked it up as free market principles in play. Their attitude changes dramatically when they find themselves faced with the same situation, they work the phones and have their buddies bail them out. The SEC is now doing exactly what it claims to be against, manipulating markets and propping up failing companies. Why, because, suddenly since the taxpayer is now the bearer of all this “dead money”, it’s now politically important³.

What’s next? Another round of stimulus checks⁴? Right, because the taxpayers are not in enough debt already.

I’ll leave you with a humorous take on all this.

1 - Source: 24/7 Wall Street
2 - Source: Zacks.com
3 - Source: CBS Marketwatch
4 - Source: Trader Mark