The Unheard Case Against the Bailout Plan

The bailout package is worse than wrong; it is unnecessary

As you well know, our government is about to spend a whopping $700 billion of taxpayer money to bail out the major financial institutions. The obvious objections you have surely encountered already. Why should we have to spend anything, much less a gigantic sum like this, to save a bunch of failed financiers who lost a ton of money making risky bets? More importantly, do we really want to create a state-sponsored financial system where private banks reap the rewards from their risk-taking while all losses are shoved onto the taxpayer?

Our Treasury Secretary and Fed Chairman feel our pain. Yes, it is a shame we have come to this. However, they exhort, without it we will descend into the abyss. The financial system will collapse and take the rest of the economy with it. The bailout plan, they claim, is like having your hemorrhoids removed - painful but necessary. (And the parallels between the financial crisis and proctology do not end there; see my previous post, "Financial Market Chaos Explained.")

I am currently overseas in Estonia, a real market economy as opposed to the one in which you apparently reside. But I would imagine that in the last few days you have heard this line about painful-yet-necessary medicine plenty of times.

What you have not heard is that there is a far cheaper and less damaging solution than the one currently under discussion. Its author is Luigi Zingales, the Robert C. McCormack Professor of Entrepreneurship and Finance at the University of Chicago. Writing in the new issue of The Economists’ Voice, he sets forth in simple terms a plan which would resolve the banks’ problems while punishing those responsible for them. Best of all, it would not cost the taxpayers a single dime.

To understand it, however, requires some background in corporate finance. So here is a primer. You can thank me later by wiring to my bank account a portion of the tax dollars you will save in the happy circumstance that the bailout package fails to pass. Those already familiar with these basics can feel free to skip down to the meat of Zingales’ plan.

A corporation receives financing from two sources: debt and equity. Debt refers to any loans from a bank. It can also consist of bonds the business issues to investors in return for cash. Similarly to a loan, the bonds have to be redeemed at a later date – that is, the money must be repaid. Until that point, the bondholders receive a stream of interest payments as their reward for helping finance the business.

The other source of financing is the “equity holders,” meaning the shareholders. No bank or bondholder will offer you all the money you need to start your business. They rather demand that you put up a portion of the money yourself. The money you and your partners personally invest represents the equity, and it is divided into shares you now own. By paying for these shares, you are offering the company money it can use to finance its operations. In return, you are entitled to the profits.

If the business flourishes, the equity holders reap the rewards. But they also take a big risk. If the business fails, they get nothing. Any assets that are left over go instead to the bondholders and the banks that provided the loans. In bankruptcy law, this is called a Chapter 7 liquidation. In a Chapter 7, the business is dissolved entirely and its assets sold. The cash raised from the sale of the assets is then distributed to the bondholders and the banks.

But there is another type of bankruptcy called a Chapter 11. It is reserved for situations where the core business remains solid yet the company does not have the cash to pay all its debts. A bankruptcy judge oversees a reorganization in which some of the debts are forgiven and the company gets a fresh start.

In some Chapter 11 bankruptcies, however, the business is not merely short of cash. The value of all its “assets” – plant equipment, intellectual property and, of course, mortgage-backed securities – falls below the value of its “liabilities,” or the total value of everything it owes to creditors. In these bankruptcies, the shareholders lose everything while the debtholders are given new shares in the business in return for forgiving the debts they are owed. The debtholders are thereby exchanging debt for equity, or the right to share in the company’s future profits.

This is the situation many Wall Street financial institutions currently find themselves in; at least part of their underlying business remains profitable, but the value of their liabilities exceeds that of their assets. So why not put them into Chapter 11? The obvious answer is that conventional Chapter 11 proceedings take a long time to sort out – creditors have to negotiate with one another over the remaining spoils, and this can take months. Currently, our financial system is teetering on the brink. It has not months, but days.

That is where Professor Zingales comes in. These are extraordinary times and, as the absurd “rescue package” attests, our Fed and Treasury officials are already in the mood for extraordinary solutions. So, he asks, why not set up a special committee of bankruptcy judges that will force a quick solution down the creditors’ throats? This is typically what a bankruptcy judge does when negotiations among the creditors have become too drawn out. There is no apparent reason why it cannot be done now as well.

Under his proposal, existing shareholders in the failed financial institutions will get nothing, and the debtholders will become the new shareholders. That is, in exchange for relinquishing their rights to most of the debt, they will now be entitled to the future profits of the business instead. The debtholders should be happy with this outcome, since the bank’s core business remains sound and its future profitability is relatively assured.

American history offers up a precedent for a massive Chapter 11. In the Great Depression, Roosevelt forced through a similar arrangement after the end of dollar convertibility into gold put extreme burdens on companies’ abilities to service their debts. The Supreme Court later upheld it, and so it should have no problem with a similar solution now.

If it is that easy, then why have we not heard it proposed? “The major players in the financial sector do not like it,” replies Zingales. For they have large shareholdings in these companies, and such an arrangement would wipe out the value of their equity. They would rather the taxpayers be wiped out instead.

The solution we adopt right now will shape our financial system for decades to come. Zingales states the dilemma most articulately: “Do we want to live in a system where profits are private, but losses socialized? Where taxpayer money is used to prop up failed firms? Or do we want to live in a system where people are held responsible for their decisions, where imprudent behavior is penalized and prudent behavior rewarded?”

We cannot stand by and let a few Wall Street executives undermine the basic underpinnings of our capitalist system. “The time has come,” Zingales writes, “to save capitalism from the capitalists.”

Financial Market Chaos Explained

"It was a million-to-one shot, Doc. Million-to-one!"

The current financial crisis, like most that have come before it, has resulted largely from the excessive use by banks of something called “leverage.” If you have an MBA, you know what this word means. Evidently, however, an MBA does not qualify you to use it with any degree of prudence, as the near-collapse of our financial system has just shown.

Most people who buy stocks are accustomed to putting up all of the cash that is necessary to purchase it. The stock costs $5 a share, and you want to buy 100 shares, so you yourself fork over the $500 in cash to pay for it. But it does not have to be done this way. If you open a margin account with your broker, you only have to put up half the cash necessary to buy the stock. The portion that you deposit yourself is called “margin.” Your broker can put up the rest of the money for the stock purchase in the form of a loan to you.

Why do this? It enhances the potential return on your investment. Instead of buying 100 shares with my $500, I can now buy 200 shares. If I only bought 100 shares and the stock went up by $1 per share, I’d make a profit of 100 * $1, or $100. But if I were using leverage, and I bought 200 shares instead, I’d make a profit of 200 * $1, or $200. My potential return has now doubled; instead of 20 percent ($100/$500), it is now 40 percent ($200/$500). Or, perhaps I’ll use $250 to purchase 100 shares and the remaining $250 of my money to buy something else. Either way, the potential profit on my investment doubles, to 40 percent.

However, so does my risk. If the stock drops by $1, I lose 40 percent using leverage and only 20 percent using all cash. And if it goes down by more than $2.50, I’m broke and could even owe money to my broker. An SEC regulation, imposed after the 1929 stock market crash, prevents stock market participants from using more than 2:1 leverage; in other words, I am restricted to borrowing only double the amount that I put up myself, as in the above example. For other assets, these restrictions do not apply.

Losing your shirt, and then some

In a world where markets hardly ever exhibit extreme movements, using lots of leverage would not be particularly hazardous. Alas, we do not inhabit such a world. Most days, markets move up and down by small amounts. But quite frequently, markets can go wild, moving multiples of their normal volatility in a day, or even several days in a row. What’s worse, sometimes all markets go haywire in unison.

This is a statistical property that quant-types refer to as an “infinite variance.” What it means is that, in the financial markets, things that have never happened before happen all the time. Out there lurking somewhere is a much larger price movement than we have ever seen previously. The French mathematician Benoit Mandelbrot was the first to point this out. Nassim Nicholas Taleb has brilliantly expounded on it, as have others. Apparently, the last people to realize this were the legions of PhDs employed to "measure risk" in the trading departments of the major Wall Street banks.

How can a bunch of quants with advanced graduate degrees commit such an error of judgment, especially when so many others have long recognized the wild nature of markets? To use the fancy statistical methods they so enjoy requires the analyst to assume that market volatility never strays very far beyond the norm. Otherwise, the results these models produce are meaningless. And what the hell did I go to graduate school for if I can't even use these complicated statistical techniques? So they make the assumption that markets are generally placid and hope everything turns out alright.

A couple of years pass and a market crisis hits. In a few days, the investment bank manages to lose several multiples of all the trading profits it has accumulated over the last five years. A risk manager with a PhD from Berkeley is quoted in the press expressing his surprise that such an event has come to pass. For, according to his models, a market occurrence of this magnitude should happen only once every 10,000 years. He is summarily fired, along with the managers who hired him in the first place.

Financial markets eventually return to normal, and a new batch of PhDs are brought in. Employing the same fancy risk models, they once again place huge market bets using absurd leverage. After a few years, the next market blowup arrives. Once again, all the bank's hard-won trading profits since the last crisis are gone. Another risk manager with a Harvard PhD is quoted in the press expressing astonishment at this turn of events; his models predict such an extreme abberation to take place once every 25,000 years. He and his bosses are swiftly removed, and the proces begins anew.

One is reminded of Frank Costanza's explanation to the proctologist as to how a fusilli stauette of Jerry Seinfeld came to be lodged in his rectum: "Million-to-one shot doc, million to one!" If you need some evidence of this phenomenon from the credit crisis, see the following Financial Times article from August 2007. In it, Goldman Sachs utters bewilderment at a market event its models predict to occur once in 100,000 years.

In an environment where extreme price changes are frequent, excessive leverage is dangerous. Most people should never use more than 3:1 or 4:1 leverage trading anything. The financial institutions that just collapsed, or came near to collapse, were sometimes using leverage of 30:1. That’s ridiculous. With that kind of risk, a few positions that move against you at the same time can lead to huge losses. And that’s exactly what happened. Since real estate prices have started falling, big leverage has led to outsized losses on the mortgage-backed assets held by major financial institutions.

It remains to be seen what kind of long-term regulatory response the US government will come up with in response to this crisis. Whatever it is, it may very well include limits on the amount of leverage that any financial institution can take on. History shows this may not be as simple as it seems.

(Thus ends the short version of the crisis. Readers seeking a little more detail are invited to read on.)

Money and credit: More slippery than we think

Every asset price bubble is fueled by the expansion of credit, often beyond the limits central banks would like to impose. This was the thesis of Hyman Minsky, reproduced by late MIT economist Charles Kindleberger in his book, Manias, Panics, and Crashes, regarded as the classic text on the subject. Financial history, Kindleberger shows, is in large part a struggle between monetary authorities, who seek to limit the supply of money and credit, and private financial actors, who are continuously devising new and innovative ways of creating substitutes for cash. These cash substitutes are used to buy more assets and can occasionally bid their prices up to unseen heights, only to be followed by a crash once the dentists have finally decided to get in on the riches.

In the early 19th century, for example, financial institutions around the world began exchanging sterling bills of exchange instead of shipping the actual silver to one another. So when America started sending these bills to China as payment for goods, the silver itself could remain in the US. More silver enabled greater lending by banks, which led to an effective expansion in the money supply. This extra money had to go somewhere, so it contributed to a boom in asset prices.

In the mid-19th century, banks collectively established clearing houses to guarantee payments to each another. The clearing houses would issue clearing house certificates, which the banks could use in lieu of cash to settle payments to one another. The actual cash could then be diverted elsewhere, and in the 1850s it fueled a global boom in economic activity and asset prices. The excesses culminated in the Panic of 1857.

In the early 20th century, financial entrepreneurs established "trust companies," which were banks in all but name - except that they were not subject to traditional banking regulations and could engage in riskier forms of speculation. The trusts represented new ways of extending more credit, which spawned excessive commercial lending and stock market speculation. The failure of these trust companies precipitated the great Panic of 1907.

In the 1920s, the big innovation was "call money,” or funds that could be borrowed on margin to buy stocks. Under this system, you would only have to put up 10% of the value of your stock purchase. Your broker, borrowing call money from a bank, would put up the rest. As stock prices rose, brokerages had to attract more and more funds to support the continuing use of call money to buy stocks. To do so, the banks lending the call money to the brokerages raised the interest rates offered to depositors. By 1928-29, these interest rates had become so attractive that they began diverting massive amounts of funds away from normal consumption and investment. This, argues Kindleberger, was likely a major cause of the Great Depression.

The upshot of all this is that it may be a lot harder than we think for the US government to regulate future crises out of existence. People will always find new ways of engaging in excessive risk-taking. The cycle of booms followed by meltdowns will thus continue.

Derivatives

In recent times we've seen yet another innovative substitute for money and credit: derivatives. Derivatives allow you to place bets on the movement of asset prices without actually buying and selling the assets. Some derivatives are traded on established exchanges. An example is commodity futures. It would be somewhat impractical to bring live cattle onto the floor of the Chicago Board of Trade. To resolve this problem, a derivative of live cattle is traded instead. That is what a futures contract is; instead of trading the actual cow, you’re only buying or selling the right to take possession of a certain quantity of live cattle at a set price on some future date. Other commodities, like oil, gold, and soybeans, are traded in the same manner.

More recently we've seen the massive expansion of the market for over-the-counter (OTC) derivatives, which are traded not on exchanges but rather directly among major financial institutions and their clients. This market is worth many trillions of dollars and dwarfs the market for traditional exchange-traded derivatives. There are a number of good books out there that explain OTC derivatives in relatively clear language. The best I’ve seen is Traders, Guns, and Money by Satyajit Das. It has done much for my understanding of these arcane financial time-bombs.

CDOs

One example of an OTC derivative featuring prominently in the current crisis is the Collateralized Debt Obligation (CDO). The CDO enables lenders to offload onto somebody else the risk that borrowers may not pay their money back. Let's say a local mortgage lender extends a home loan to a "subprime" borrower whom the lender expects to default on his mortgage. The lender doesn't care, because upon finalizing the loan he sells the right to collect interest and principal payments to, say, Lehman Brothers. Lehman Brothers then takes a bunch of these mortgages, or corporate loans, or any other kind of asset, and packages them together into a CDO, which it then sells to customers.

Officially, however, Lehman Brothers itself does not perform this task. Rather, it sets up a Special Purpose Vehicle (SPV) to manage the restructuring process and subsequent sale to clients. What's the point of the SPV? First, the SPV is registered in an offshore tax haven. Second, much like the trust companies in 1907, it is a bank in everything but name and is completely unregulated. Third, by selling the rights to collect payments on these mortgages to the SPV, Lehman Brothers generates immediate cash flow. This is considered preferable to the long-term trickle of cash it would otherwise receive if it waited for the various mortgages to be paid off over time.

It hardly needs mentioning that this immediate cash flow translates directly into current profits for Lehman Brothers and, thus, bigger bonuses for its traders and executives. This commentator is not expecting them to give their bonuses back to shareholders now that the company has gone belly-up.

The SPV is basically structured as a bank, with assets on one side and liabilities on the other. The assets consist of the right to collect interest and principal payments on the mortgages. Let's say the CDO is worth $1bn and is composed of 100 loans of $10m each. (Recall that the SPV doesn't actually "own" the loans; it just owns the right to collect on these loans. This is what makes the CDO a "derivative.") Each of these loans has been granted to a different borrower, and the borrowers vary widely in their (perceived) ability to pay interest and principal on the loans.

The SPV raises the cash to "buy" this debt by selling the right to collect on these loans to customers - usually big financial institutions and wealthy individuals. This debt is divided into three categories. $920m of the $1bn total might consist of “super-senior” AAA-rated debt, considered very safe from the threat of default. Another $50m consists of "mezzanine" debt, which is subordinated debt, the principal on which can be collected only once the holders of the AAA-rated debt have been paid. The last $30m is equity. If any three of the 100 borrowers at the end of the debt chain default on their payments, the owners of the equity in the CDO do not get paid.

One might think that the holders of the equity and mezzanine debt are taking on all of the risk here. One would be mistaken. The current crisis has seen declines in the value of the “super-senior,” AAA-rated debt tranches as well. Remember: in the markets, things that have never happened before happen all the time. And because the financial institutions that trade these assets have taken on so much leverage, on the order of 30:1, the price of the assets has only to decline by a relatively small amount to produce massive losses for these firms. Goodbye, Lehman Brothers.

Conduits

In many cases, the large Wall Street banks do not even bother sell the assets on to long-term investors. They rather stash them in vehicles they have established called “conduits.” Conduits are similar to SPVs, in that they are located in offshore tax havens and buy the mortgages or other assets from the banks. But instead of selling these assets to long-term investors, the conduits raise the money to buy the assets by selling short-term “commercial paper." Commercial paper represents a promise by the conduit to pay the holder of the paper a stream of interest payments until the term, typically lasting a few weeks, expires. At this point the conduit gives the commercial paper holder, usually another big bank or money market fund, its money back. If the conduit is to keep holding onto the mortgage assets it owns, it has to issue more short-term commercial paper, and the process begins anew.

The sole point of conduits, so far as I can tell, is to generate immediate income for the bank and bonuses for its executives while hiding from investors the true extent of the risk the bank has taken on. For if the conduit fails to keep finding new short-term financing every few weeks, the bank must take the loss back onto its own books.

For years, the scam worked. Then came August 2007, when the market for short-term commercial paper seized up. Increasing defaults on subprime mortgage loans had spooked the holders of the commercial paper. So when the terms on the paper expired, as they routinely do, the banks could not find any more buyers. The same thing has happened several other times since then, including in the last week, causing very severe and very immediate problems for the major Wall Street banks. You see, the amount of money controlled by conduits amounts to $3 trillion. That’s trillion. A failure to find more financing for these assets could spell catastrophe. This has forced central banks to inject hundreds of billions of dollars into the financial system to help maintain an orderly market. They did the same thing back in March. But even this wasn’t enough to save Bear Stearns.

Credit-default swaps

Another important derivative involved in the current crisis is the credit-default swap. Let's say a bank makes a loan to a business but for some reason becomes concerned about the customer's ability to pay it back. Traditionally, the bank would have to call in the loan or sell it to another bank. This might antagonize the customer and jeopardize the bank's future relationship with him. Eventually, someone had the insight to offer to pay the bank a sum equal to the amount of the loan in the event that the customer defaulted. In return the bank would pay this person a premium. That way, the bank can dump the risk of default onto somebody else without actually selling the loan - or letting the customer know what it is doing.

This basically amounts to an insurance policy, but the person selling the insurance isn't licensed by the government to do so. So they call it a "credit-default swap" instead of insurance. When you read in the newspaper back in March that "the cost of insuring against a default by Bear Stearns has risen to $2.7m for each $10m of debt," the reference here is to the premium demanded by the issuers of credit-default swaps in return for insuring against a default by Bear Stearns.

“Too big to fail:” Avoiding financial Armageddon

Incidentally, Bear Stearns was the issuer of many credit default swaps. Its downfall threw into question the ability of banks to get the money they had been promised by Bear in the event that their customers default. If this were allowed to happen, then everybody who bought credit-default swaps from Bear Sterns would have panicked and sold the assets Bear was insuring, since they no longer had protection against default. With everyone a seller and nobody a buyer, this would have caused the prices of assets to spiral downward to zero.

If you’re a company and the prices of the assets you own start to plummet, this makes banks less willing to lend you the money you need to operate on a daily basis. You are put in a difficult position; you either raise enough cash to continue on, or you go bankrupt, and your assets are put on the market in a fire-sale. But when lots of companies start selling the same assets at the same time, the prices of these assets decline even further, causing more bankruptcies, more asset fire-sales, and yet more bankruptcies.

We have not seen this happen in the current crisis…yet. But history does offer up an example of what happens when this process is allowed to unfold. It was called the Great Depression, and it is precisely the scenario the Fed has been trying to avoid. When everybody wants to sell and nobody wants to buy, and the prices of assets are plummeting as a result, it is the Fed’s job to step in and lend money to solvent companies who are short of cash. That is what it means to be a “lender of last resort,” which is the Fed’s formal job description. However, insolvent companies – those whose debt obligations outstrip the value of their assets – should be allowed to fail.

In theory, at least. Some institutions have managed to make themselves “too big to fail.” That is, regardless of their solvency, they have to be bailed out, or the whole financial system goes to hell. Bear Stearns was considered too big to fail, and so the Fed bailed it out (actually, Bernanke prodded JP Morgan to buy Bear Stearns and and then guaranteed the investment. That’s basically a bail-out).

This was also the case with AIG, the world’s largest insurance company, which the Fed just saved from chaotic extinction with an $80 billion loan. The sheer size of this loan suggests that AIG’s problems may have gone beyond a mere need for short-term financing and extended to its very solvency. But AIG was too big to fail. It had become one of the market's biggest issuers of credit-default swaps, explained above. Since CDS are similar to insurance policies, AIG thought it wise to expand into these derivatives. Evidently, it got in over its head. Merrill Lynch was also too big to fail, which is why the Fed pushed Bank of America to absorb it. Lehman Brothers, on the other hand, had not quite managed to make itself too big to fail. So the Fed allowed it to collapse entirely.

A global solution?

After a few days, Fed and Treasury officials decided to stop bailing out institutions on a case-by-case basis and create a system-wide solution. The goal is to stop the prices of assets – mortgages and stocks – from falling way below the value they would obtain in an orderly market. So, under the new plan, the government will buy these assets, thereby putting a “floor” under their price. It will then invite private partners who specialize in distressed debt to restructure the assets and sell them. If all goes according to plan, the assets the government would now own will be sold at a profit, which will make up for the $700 billion the government has to shell out to buy the assets in the first place. $700 billion is a lot of money. Let’s hope it works.

The problem is, there are many other asset classes besides mortgages that have not yet entered the crisis. The major financial institutions continue to deal in CDOs and credit default swaps backed by corporate debt, auto-loans, credit card debt, and so on. There are untold billions of dollars in assets remaining that may yet go bad. If that happens, well, we're screwed.

Putin to world: I promise baby, I'll pull out

Georgia's president lets himself be drawn into Russia's trap.

A few friends have asked me to explain what's been happening in Georgia. What follows is a brief summary.

Georgia declared independence from the Soviet Union in late 1991. Soon afterward the United Nations recognized Georgia, along with the other 14 Soviet Republics, as an independent state. Aside from ethnic Georgians, the country contains a number of ethnic minorities, most prominent among whom are the Ossetians and the Abkhazis. Under Soviet rule, each of these two minorities were granted their own "autonomous republics" - the region where most Ossetians lived was now made into an administrative unit called "South Ossetia," while Abkhazis received "Abkhazia."

The autonomous republics were one step down in status from a "union republic" like Georgia, Ukraine, Lithuania, Kazakhstan, etc., each of which, like the autonomous republics, were named after an ethnic group residing there. Stalin, ever the master of divide-and-rule, created these smaller autonomous republics inside some of the union republics so that he would have some future way of sowing discord among the different ethnic groups inhabiting the Soviet Union.

While all the autonomous republics and union republics had their own formal government trappings - a legislature, an executive, a flag, etc., during most of the Soviet period they had no real autonomy; everything was controlled from Moscow. That all changed under Gorbachev, when power began devolving from the center to the regions. The republics began asserting themselves - the Soviet republics against Moscow, and the autonomous republics against the union republics.

This process of devolution was mostly peaceful, with a few exceptions. One of these exceptions was Georgia, where civil war erupted. After Georgia declared independence from the Soviet Union, the rulers of South Ossetia and Abkhazia declared independence from Georgia. This prompted the Georgian government to forcefully intervene in an attempt to prevent the two regions from seceding. It would have succeeded were it not for Russia, who sent "peacekeeping" troops into the two regions and drove out the Georgian forces. Local Russian-backed militias additionally expelled the ethnic Georgians living in these regions in a campaign of ethnic cleansing.

This all happened mostly in 1992 and 1993. Ever since then, a peaceful stalemate has prevailed. South Ossetia and Abkhazia, while not recognized as independent states by the United Nations, are independent in all but name. Backed by the Russian military, the two regions conduct their own affairs completely independently of the Georgian state.

While Abkhazia has at least proved functional as a state, South Ossetia has been described by one astute observer as a "joint venture between the KGB and a local gangster." The business this joint venture is engaged in is smuggling - drugs, people, and arms, which are free to pass through the territory under the protection of its political masters. Over the past 15 years there has been a seemingly endless series of initiatives led by the UN to form a conclusive peace settlement, but none of them has ever gotten off the ground; a few powerful people were making too much money from the status quo for that to happen.

Eduard Shevardnadze, when he was president of Georgia from 1995 to 2003, tended not to interfere in the situation. But his successor, Mikhail Saakashvili, is a Georgian nationalist who in 2003 was swept to power in part on a promise to bring South Ossetia and Abkhazia back under Georgian rule. Ever since then, tensions have remained high. Meanwhile, the Bush administration and many European states have offered strong rhetorical backing to Saakashvili, the Columbia University-educated democrat. The Bush administration has even mused about letting Georgia into NATO. That would give Georgia an explicit security guarantee from the alliance, whose member states would be obligated to intervene militarily on Georgia's behalf if any external state (i.e. Russia) attacked it. So admitting Georgia into NATO is obviously regarded as an intolerable prospect by Moscow.

The Kremlin, for its part, has repeatedly tried to provoke Saakashvili into sending Georgian troops to try and reoccupy the two regions. In August, these provocations finally succeeded. The Georgian military started shelling civilian targets in South Ossetia, prompting Russia to launch an excessive "peacekeeping" campaign to defend the region against Georgian "aggression." So, once again, the Russian military has driven Georgian troops out of South Ossetia.

But it didn't stop there. They've also occupied key cities, towns, and ports in the rest of Georgia, blown up transport links connecting one part of the country to another, and embarked on a mass campaign of looting. All the while the Russian government has been signing EU-brokered "cease-fire" agreements which they promptly proceed to violate before the ink has had a chance to dry.

The question is, why did Russia try to provoke Georgia into launching attacks in South Ossetia? For a number of reasons, but mostly because it would give Moscow an excuse to mobilize a brutal display of military force against the Georgian government. This would show the world just who the real boss is in this strategically sensitive part of the former USSR. For all its rhetorical support, the Bush administration was never prepared to intervene militarily on Georgia's behalf in a Russian-Georgian conflict. The Kremlin knew that, and called America's bluff.

Moreover, now that the West sees that Russia is really willing to launch a war against Georgia at the drop of a hat, do they really want to take on the formal obligation of defending Georgia by letting it into NATO? This fiasco the Georgian president let himself be drawn into will only serve to make American and European politicians think twice before admitting Georgia into the alliance. And that was the whole idea. Putin, meanwhile, is relishing his glorious little war against his renegade southern neighbor.