J.P. Morgan Is the Latest Innocent Victim of the Public Mafia

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His trade is legendary now, so much so that the Wall Street Journal's Gregory Zuckerman penned a book about it titled The Greatest Trade Ever, but at one time John Paulson was something of a joke. Bulge bracket banks like Goldman Sachs took his calls and filled his orders in which he bought insurance on mortgage backed bonds, but in the eyes of his GS coverage Paulson was a "Muppet"or, as Michael Lewis put it in The Big Short, "he was a third-rate hedge fund guy who didn't know what he was talking about."

Of course one man's trash is another man's treasure, and Paulson saw an ugly future for mortgages that the broad marketplace did not. Paulson made $15 billion betting against mortgages not because his views were the consensus, but because he was once again a joke or, in the words of his Morgan Stanley coverage, "This guy [Paulson] is nuts." Had the markets not viewed Paulson as nuts, it's quite simply the case that he wouldn't have been able to make so much money on his bet against mortgages.

All of which brings us to J.P. Morgan and its sufferance of a lawsuit from New York State attorney general, Eric Schneiderman. As is well known now, now-defunct investment bank Bear Stearns collapsed under the weight of a balance sheet filled with newly "toxic" mortgages in the spring of '08, and with bankruptcy a certainty thanks to markets no longer trusting the aforementioned balance sheet, J.P. Morgan was asked by a panicked Bush administration and the Federal Reserve to purchase Bear in return for the Fed taking on its worst assets. This lawsuit is in a sense Morgan's cruel "payback" for doing what the free markets properly would not.

As the Wall Street Journal reported, "the lawsuit [against J.P. Morgan] alleges that Bear Stearns defrauded investors by packaging up and selling mortgages that it knew - or should have known - were highly likely to default." Basically J.P. Morgan will ultimately settle on New York State an enormous sum for a "crime" that allegedly occurred before its acquisition of Bear. The story is predictable, one wrought by the bailout culture that exists around financial institutions today.

Missed by Schneiderman is that when Bear Stearns packaged the mortgages to be sold, it had no clue that they "were likely to default." Though politicians and commentators are loath to admit it, Wall Street firms - including Bear - were aggressive eaters of their own cooking. That's the case given how many banks were made insolvent by exposure to mortgage securities that politicians say were doomed to fail - naturally in hindsight.

But back then, the market consensus was quite the opposite. Bear Stearns, in the business of profit, was not only aggressively selling the mortgage securities so demanded by its clients, it was also aggressively buying them for its own book. Had Bear been able to see into the future as Paulson did, it would never have loaded up its balance sheet with securities soon to collapse in value.

Here it should also be said that if it sales desk had the luxury of hindsight, Bear would not have eagerly packaged those same toxic securities for sale to its clients. The latter assertion is seemingly an impossible one for commentators and politicians to understand, and one reason may be that most have never worked on Wall Street, let alone in the private sector.

Needless to say, in the real world those who sell clients bad product or, in the case of Bear Stearns, toxic securities, very quickly don't have clients. Anyone who's worked on or knows someone who's worked on the institutional sales desk of an investment bank knows this intimately. Sell a big investor a security that goes south, and you'll soon find that the aforementioned investor will not pick up future calls from you.

Failure is not a crime, and failure describes what happened at Bear Stearns. Of the belief that mortgage securities were bulletproof, Bear sold them to a client base that wanted what it had to sell, plus it purchased similar securities for itself. If Bear was guilty of anything, it was naiveté for attaching value to securities that were soon enough valueless. The latter is once again not a crime, though J.P. Morgan will pay a fine as though it was.

The lesson for Morgan, along with all other financial institutions can be found in the words of the great 19th century British political economist, John Stuart Mill. Mill observed that "The only insecurity which is altogether paralyzing to the active energies of producers, is that arising from the government, or from persons vested with its authority. Against all other depredators there is hope of defending one's self."

Mill's point was that offers of security from politicians and governments are invariably far more expensive than any malady brought on them by the marketplace. Financial institutions are seeing this in high resolution now as governments come back to get payment for protecting them at a time when their solvency was questioned. Though banks were "saved" in 2008, they're now slowly being strangled by lawsuits and regulations that greatly inhibit their path to profitability. J.P. Morgan didn't need a bailout per se, but it did have access to cheap money from the Fed, and because it did, politicians now feel they can have their way with Wall Street's foremost bank.

Along the lines of the above, "End the Fed" is mocked as the mantra of cranks, but the greater truth is that the Fed was created precisely to prop up large money center banks suddenly weakened by competition inside and outside the banking system in the early part of the 20th century. In short, banks, including J.P. Morgan, have "security" in the form of a central bank that will lend to them in the time of need, but the end result is a government that can collect on its offer of protection.

The FDIC should be viewed in the same way. Banks are able to attract depositors who don't consider a bank's health when depositing, and they're able to do so because federal insurance protects their deposits should the bank itself go under. Both the Fed and the FDIC are paradoxically anti-banking precisely because they cushion or erase failure among banks that would, if allowed to stand, strengthen banks across the board.

The above is true because failure itself is what authors progress. Failure is the way that poorly run businesses are starved of capital and credit so that good ones can receive it in abundance. Banks, having accepted way too much in the way of government security (in a free market insurance companies would insure deposits, and then companies of all stripes would serve as lenders of last resort to solvent banks), have allowed their positive evolution to be halted by governments oh-so-eager to offer up near-term aid in return for long-term say in how they operate.

J.P. Morgan's story is but the latest ahead of many more whereby governments, like the Mafia, come in to expensively collect on their profit-sapping protection. J.P. Morgan is clearly innocent of wrongdoing, very few including Bear Stearns knew that mortgages were about to implode, but the truth when it comes to government is irrelevant. It's time for financial institutions to make plain that they'll no longer accept bailouts, federal deposit insurance, or any other kind of protection from governments of all levels so that they can pursue profits absent the shackles of politicians and regulators all too eager to put them in chains.


John Tamny is editor of RealClearMarkets, Political Economy editor at Forbes, a Senior Fellow in Economics at Reason Foundation, and a senior economic adviser to Toreador Research and Trading (www.trtadvisors.com). He's the author of Who Needs the Fed?: What Taylor Swift, Uber and Robots Tell Us About Money, Credit, and Why We Should Abolish America's Central Bank (Encounter Books, 2016), along with Popular Economics: What the Rolling Stones, Downton Abbey, and LeBron James Can Teach You About Economics (Regnery, 2015). 

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