Investment Implications of the Treasury Plan

After one of the most turbulent and eventful weeks in U.S. financial history, I'll offer the following comments about the government's massive market interventions and the investment outlook.

Government Intervention

After financial markets descended into a state of chaos, panic, and dysfunction last week, the government announced the most aggressive intervention since the 1930s. In an effort to halt the panic on Wall Street and "solve" the problems besetting the financial system, the U.S. Government announced three momentous measures. First, it unveiled a plan (subject to Congressional approval) to spend up to $700 billion to buy bad loans (primarily mortgage-related investments) from financial institutions. Second, it decided to use the taxpayers' money to guarantee money-market funds for the next year. Third, it temporarily banned the short selling of 799 financial stocks.

By the end of the day on Wednesday, there was general agreement that the government had to act to restore investor confidence and avert a further collapse in the financial markets. Credit markets had stopped functioning, investors were fleeing all risk assets, (including money market funds!), and markets were in a state of fear over the potential failures of more financial institutions. Given the magnitude of the crisis, there was a sense of inevitability that the government would intervene to keep the system from melting down. The predominant mood was that it is unfortunate that it came to this, but a government bailout was necessary under the circumstances.

However, to acknowledge the unfortunate necessity of government intervention does not imply that the plan announced last week was the best one. There are serious issues with the government's temporary ban on the short selling of financial stocks (what happened to free markets?) and its yearlong guarantee of money market funds (where are the consequences for mismanaged money market funds and rewards for properly managed ones?), but those measures are small compared to the Treasury Department's $700 billion bailout proposal.

The central question of this proposal, it seems to me, is why should the U.S. taxpayer be bailing out the stock and bondholders of grossly mismanaged financial institutions? If the U.S. taxpayer is going to finance a bailout of primarily bad mortgages, surely there is a way to do it where the benefits flow more directly to those who are facing mortgage defaults and foreclosures, rather than to the investors, managers and employees of financial institutions who profited wildly during the bubble years. The transfer of bad investments from the books of recklessly overleveraged financial firms to the books of the U.S. taxpayer looks to me like a classic case of privatized profits on the way up and socialized losses on the way down. From Thursday's lows to Friday's closing prices (after the government's bailout proposal sent their stocks soaring), Morgan Stanley gained 140%, Goldman Sachs gained 50%, and Citigroup gained 40%. From the perspective of the U.S. taxpayer, or from the perspective of the shareholders of AIG and Lehman Brothers, which were wiped out days before the government came to the rescue, the present outcome seems less than equitable.

Just as there is indignation over the recklessness and greed of Wall Street, there is profound and growing frustration over the lack of appropriate oversight and regulation of our financial system, and the stupendously poor monetary policy of former Fed Chairman Alan Greenspan. Although booms and busts are a necessary feature of capitalism, the damage from this particular train-wreck could have been vastly minimized if our financial authorities had taken appropriate action when the credit/real estate/derivatives/leverage bubbles were developing five years ago. The government should have acted to regulate the derivatives (e.g. credit default swaps) that brought down AIG. Warren Buffet warned years ago that derivatives were "weapons of mass financial destruction." Greenspan praised them, as well as the securitization of mortgages, as wonderful financial innovations that dispersed risk; he also ignited the entire credit bubble by keeping short-term interest rates far too low for too long in 2002-2004. The government should have acted to control the reckless real estate loan underwriting that was obvious to any thinking observer and helped create the housing bubble, and should have limited the insane 30-to-1 leverage of Wall Street firms that was the principal cause of the bailout we are now facing.

There is also the question of how will this country, whose finances are already tenuous as a result of persistent deficits and unfunded entitlements, will pay for the estimated $1 trillion of bailouts that have been enacted and proposed in the past two weeks. Obviously the government does not have this money; it will have to be borrowed into existence and added to the massive debts that we are piling up for our children and grandchildren. I am not optimistic, but I hope that in the political debates to come there is appropriate attention given to this generational inequity.

Investment Implications

The stock market is a reflection of mass psychology, and almost by definition bear market lows the point of maximum pessimism. It is hard to imagine greater pessimism than existed the middle of last week. On Wednesday, the 3-month T-bill rate declined to zero, which hasn't happened since the Depression. On Thursday, investors pulled $105 billion out of money market funds. Given this extreme pessimism, combined with the government's market intervention and proposed bailout, it is highly likely that the stock market has made a short to intermediate term bottom. However, we believe it is premature to assume that a longer-term bottom is in place. The pain in the financial system may be dealt with by the government bailout, but it is unclear how much additional pain will be felt in the real economy.

If Congress approves the Treasury's bailout plan, it will lead to a dramatic expansion of government liabilities, which significantly increases inflation risks. This is clearly bearish for Treasury Bonds and bullish for gold and for commodities generally. Gold reacted in a dramatic way to last week's developments, gaining $150 in the space of two days before pulling back somewhat at the end of the week. The sharp drop in Treasury bonds on Thursday and Friday was partly a result of investors moving out of the bomb shelter and back into risky investments, but it was also recognition of the degradation of the country's credit as a result of the money printing that will take place to finance the proposed bailout.

Comments

[User 30121:]

Thank you for the article!

2008 Sep 23 06:50 PM