How to Trade When Government Controls Investment

Includes: BAC, C, GS, JPM, MFGLQ, NMR
by: James Bibbings

Let me start by thanking each and every one of you for following me and analyzing what I have to say. Last week I wrote an article titled “The 11th Hour, Moments Before a US collapse.” That article summarized some thoughts that I had regarding government intervention. I followed up with a supporting article earlier this week titled “GDP Fallacy, Do Governments Willfully Mislead People” in which I supported the first two points of my original thesis. In the second article I also began to investigate potential investment opportunities that might make sense if we can gain an understanding of the government’s intentions within our increasingly unexplainable market. Today I want to discuss point three in my original theory, so if you aren’t up to speed, get reading. If you’ve been following me the whole time let’s get started; remember to remain mindful of the GDP equation and the fact that GDP measures economic well being:

GDP = (A) Private Consumption + (B) Gross Investment + ((NYSE:C)) Government Spending + ((D) Exports - Imports))

Point Number Three

As I explained previously, the government controls 25% of the GDP equation through its spending. Since day one of the recession they have also known that controlling 25% of GDP wasn’t enough to make a lasting impact. Thus, recognizing that 75% of the country’s well being was outside of their control, the government had to find a way to gain more influence. Let’s jump back quickly to my first article, and point number three:

To further influence GDP the government must control more of the equation. By controlling debt, or the means by which most gross investment comes, the government could influence roughly 50% of the GDP equation. Since private banks were [still are] failing, in order for the banking industry to survive, the government portrayed that US banks "must" be bailed out. [Although this was not true and they should’ve been allowed to fail]. Thus, through the first bailout a large portion of letter B, or gross investment, moved under government oversight.

Since the government’s only goal was to capture more control of the “well being” equation (also known as GDP) they saw an opportunity in our failing banks. By taking control of the banks they effectively took control of gross investment and they did so as quickly as they possibly could. Due to this effort, throughout the great recession a specific question has been repeatedly asked: “What is the criterion for bailing out some financial entities but not others?” Most recently this question was asked for the umpteenth time as CIT Group was on the verge of collapse a couple weekends ago. Inquiring minds have been pondering the situations involving CIT Group, Lehman Brothers, Bear Stearns, and several others that the government decided not to bail out. They are wondering; what was different about CitiGroup (C), Bank of America (NYSE:BAC)/Merrill Lynch, AIG or any of the other financial entities that were pulled from the brink of destruction through government assistance?

The official answer to this question has always been one that involved systemic risk coupled with a generic “these companies were too big to fail” statement. Certainly that explanation is plausible and might even seem reasonable if bailing anything or anyone out was the right choice. Yet, all of these companies were large enough to fit the systemic risk/too big to fail criterion right? Of course they were! If they weren’t, there would be no room for debate about who is saved and who is not. So if it can be argued that they were not entirely taken due to systemic risk, what then?

These entities have more similarities than they have differences and for the most part are materially similar. Thus, it is my opinion that the decision to save or not to save lies within a financial companies level of overall access to, and exposure within the markets. Although this seems the same as too big to fail-systemic risk, consider the situation for a moment from a different perspective. If companies aren’t allowed to fail is there actually any systemic risk? Under this guise if you’re the government and you need to influence GDP but can’t “officially” control gross investment what do you do?

Taking Control of Gross Investment

To gain 50% control of the GDP equation the government needed to control the largest amount of total market liquidity possible, regardless of which side of the trade they were on. Conversely to looking first at the size of counterparty exposure and overall risk to other companies; consider total liquidity and overall market positions. Consider the type of market influence and power that comes through owning and controlling the vast majority of outstanding positions regardless of their profitability. As an example assume for a moment that all of the bailed out companies were “stopped out” of the market, couldn’t make margin, and were forced into liquidation. The government being the generous big brother they are then is able to come and quietly take over these trading positions. In exchange for doing so they require a certain level of control in company operations. This control allows them alone to decide who gets paid out on trades and who does not. Think for amount about how powerful being in that position is.

As you can see, this type of influence over companies with huge market exposure could very quickly influence the lending side of any financial company’s business. As we have seen through Hank Paulson’s own admissions, throughout the bailouts the government moved in ways that were sometimes illegal. Therefore is it really that inconceivable to think that not cooperating meant no payouts on positions? As you can see by bailing these firms out, the government effectively gained control of the gross investment portion of the GDP formula without anyone seeing it. They all but owned the bailed out banks, and could pay out positions to any others as they saw fit; how’s that for being influential?

By changing the implied definition of systemic risk, the differences between CIT Group, Lehman, and Bear Stearns when compared to CitiGroup, Bank of America/Merrill Lynch, and AIG become clear. The bigger the exposure the more gross investment control can be influenced. How could systemic risk have anything to do with it if systemic risk was never actually possible? Thus it’s entirely plausible that forcing banks to do as the government suggested outweighed systemic risk at all times.

Tin Foil Hat Land or Something More

For this discussion it is important to remember that in the cases of Merrill Lynch and Bear Stearns the government all but forced them into shot gun weddings with Bank of America and JP Morgan Chase (NYSE:JPM). Furthermore, these “acquisitions” were largely subsidized, and in the case of Merrill Lynch a total government bailout came from the merger anyway. Here, through the consolidation of Bear Stearns and Merrill, along with the bailout of CitiGroup, AIG, and Bank of America, the government managed to quietly gain control of a vast amount of US financial market liquidity; and they did this without directly investing a single cent into the market.

Once in control of liquidity the government was then able to pick and choose who had capital and who didn’t. As we now know, the Treasury and the Federal Reserve assisted those who would cooperate and were willing to push aside those who wouldn’t. They even publically announced how some market positions would be unwound as they handpicked each of the counterparties that would receive monies out of AIG. Furthermore, they also opened up the door for nearly every company with some type of financial business to become a bank holding corporation and gain access to TARP. Under this ideology, since the government had the other side of almost every trade joining TARP became mandatory for anyone with large positions in the market place. Recall that the TARP plan was needed to provide “liquidity” to banks but remember that it was done by force in order to wield still more market control.

To further support this TARP allegation, remember that for a period of time banks could not exit the program regardless of their financial well being. Recall also that banks clamored that the government forced them into accepting TARP funds when they didn’t want or need them. Banks were doing everything they possibly could to get out of government mandated TARP loans but were not allowed to. It was only in late June that some of the banks were finally able to repay government funds. Here what was the reason the government wouldn’t let them pay back taxpayer money? Could it be that they needed to retain control of as much liquidity as possible for as long as possible. To find out how this plays into steps 4, 5, and 6 stay with me next week for more details and support.

What Does This Mean For Your Investments?

It means that the financial companies who received government assistance likely were used to funnel money out to counter parties to keep their names out of the bailout mud. It means that in exchange for this, companies such as Goldman Sachs, JP Morgan Chase, MF Global, Nomura Securities, RBC Capital Markets, and any other bank large enough to be a primary bond dealer is likely to continue working with the government to swallow as much debt as possible. This will likely keep bond yields lower than they should be which in turn will keep bond prices fairly stable. Banks that remain under government control will need to sell more assets, trade more, lend more, and will likely underwrite lower quality debt in the process to fuel GDP. The banking sector is not healthy and will get worse because of this. Don’t forget that there are still trillions of dollars in credit card debt, commercial loans, and residential write downs that will need to occur. Be conscious of what you’ve learned regarding GDP thus far. Remember what the government may do if it needs to influence gross investment once again. Most importantly stay tuned as the saga continues and read about points 4 through 6 next week.