Winners and Losers in the Bailout Bonanza

With the exception of a few curmudgeonly old Republicans, there has been general rejoicing at U.S. Treasury Secretary Henry M. Paulson’s $700 billion banking system bailout. Indeed, to hear some commentators you would think it was cost free - they explain joyfully that assets will only be acquired at a discount, so of course there is a good chance the taxpayer will not be out of pocket on the deal.

Well, if you believe that I have a bridge to sell you. The deal has large costs to taxpayers, and considerable negative implications for our economic future. Investors didn’t buy into the upbeat spiel either: U.S. stocks were routed Monday on fears that the bailout’s cost could sink the U.S. economy.

The Lowdown on the "New" Banking Sector

Let’s begin with the implications for investment banking. There aren’t any, because there will no longer be any investment banks. The decision by Goldman Sachs Group Inc. (GS) and Morgan Stanley (MS) to apply for banking licenses means the 1985-2008 investment banking model - of institutions leveraging their balance sheets to the max to take on all kinds of assets (debt, equity, real estate … the lot) - is as dead as the proverbial dodo. [An analysis of Goldman and Morgan’s transition into commercial banks here].

It was always likely to meet that fate. Very high leverage - combined with illiquid and hard-to-value investment positions - is a recipe for disaster as soon as any kind of downturn occurs. One might think that such sophisticated operators would have figured this out. But the reality is that these "experts" use their sophistication only to maximize their own compensation, not that of their shareholders. I have said for many years that an individual investor buying shares in investment banks was playing a mug’s game; the events of the last few months have proved me right.

Going forward, Goldman Sachs and Morgan Stanley will have to reduce their leverage by about half in order to become acceptable to U.S. Federal Reserve regulators. This means that either their assets will have to be cut in half or their capital will have to double - or some combination of the two. But understand this point: No matter which way they go, it will be highly dilutive to each firm’s earnings per share number.

For commercial banks, the economics are more interesting. They will have more access to the investment banking business, because the traditional Wall Street houses will no longer have additional "cachet" in this business; the mergers-and-acquisition-advisory business, for example, should become a significant contributor to profits at many of the top-tier commercial banks.

Even more interesting: The sector may find its compensation costs declining. Traditionally, investment banks have paid outrageous amounts in compensation to their senior employees, and commercial banks have discovered that in order to keep top quality talent, they have to come close to investment bank packages - a difficult undertaking with their shares being much less exciting than investment banks’ as compensation. Now there are no more investment banks, outrageous compensation packages will be more difficult to come by (in any case, they might cause difficulty with the Fed regulators), so specialists in onetime investment-banking operations will find their pay packages considerably diminished.

While it’s unlikely that top earnings will drop until a senior vice president (the new term for "partner") at Goldman Sachs National Bank makes only $300,000 or so by 2018, money-center banks should find that their overall savings on compensation would be enormous. And those savings will flow straight to the bottom line.

Profits and Losses

Don’t assume this bailout will solve the housing finance problem completely. It won’t. Remember, a pretty high portion of the housing loans made in the 2005-2006 time frame were called "liar loans" for a reason - they involved out-and-out fraud, with no proper checking having been done on the borrower’s earnings, other debts, or on the actual value of the property itself. [Analysis of the bailout deal here].

Assuming the managers of the government’s new $700 billion slush fund are even halfway competent, they’ll avoid the real rubbish, and leave the biggest losses for banks’ shareholders to absorb. Since the total losses from this mess - including those from credit cards and others from leveraged loans - have yet to fully materialize, and could actually reach $2 trillion to $3 trillion, there will be plenty of losses to go around.

The bottom line is that the best banks - those that maintained some semblance of underwriting standards - are a better bet than the worst, even if the worst may receive (in cash terms) more of the $700 billion from the bailout fund.

The U.S. economy will be afflicted by inflation, however much the authorities may wish to deny this. Theoretically, since the new fund will resemble Herbert Hoover’s Reconstruction Finance Corp. of 1931-1932, and might bring about the same result - an intensified recession as the public sector borrows in the weak capital markets to finance politically connected rubbish. In practice, the Fed will do everything it can to avoid this: It will monetize the new debt, adding the $700 billion to the money supply, resulting in roughly a 7% increase in the M3 portion of the U.S. money supply.

That will cause inflation. The market thinks so, too: Otherwise, why would gold prices have zoomed $40 an ounce and oil $16 a barrel Monday, once the shape of the package had become clear? We’re basically talking about $700 billion of demand that’s being injected into the U.S. economy, but the Organization of Petroleum Exporting Countries [OPEC] and other oil producers are likely to capture a substantial percentage of that through oil-price increases.

The Winners and Losers in the Bailout Bonanza

Treasury bonds are a major loser, since inflation is rising and $700 billion of extra debt must be issued. Go for the Rydex Juno Inverse Government Long Bond Fund [RYJCX], a fund designed to move inversely to Treasury bonds. Up to now, it’s been a poor play as T-bond yields have trended steadily downward and prices steadily upward, but it’s about to become a good one.

Gold has to be a winner, so you should consider the StreetTracks Gold Shares Fund (GLD), which may be the most efficient way of getting a pure gold play.

Finally, for the first time in two years, I will venture to recommend a U.S. bank. With $700 billion being poured into the sector, one of the major banks has to be a big beneficiary. But the question is, which one?

Avoid Citigroup Inc. (C): With so many different ways of losing money worldwide, it’s bound to find another one in this downturn.

Avoid Bank of America Corp. (BAC): I would be very bullish on BAC after its Merrill Lynch & Co. Inc. (MER) buy - if the morons hadn’t previously bought Countrywide Financial Corp., a black hole of losses.

Wachovia Corp. (WB): The bank’s leaders were as dumb as bricks when they bought a huge California home mortgage operation right at the top of the market in August 2006 - and they probably made other mistakes also.

Wells Fargo & Co. (WFC): Possibly, but I don’t like the California emphasis or the fact that it was among the most active in the subprime market.

By a process of elimination, I am left with JPMorgan Chase & Co. (JPM), which was relatively less active in mortgages and picked up a heavily subsidized investment-banking bargain in Bear Stearns. It will doubtless get its share of the $700 billion, and not be left with so much rubbish that even the Feds won’t buy. With an earnings multiple of a fairly modest 13, an asset multiple (market capitalization/ stockholders’ equity) of a modest 1.1, a dividend yield of 3.2% and a dividend that appears at least moderately secure, there is comfort on the valuation side too.

Original post

Comments

[bbzz24:]

Bailout is good!
- Gordon Gekko

2008 Sep 23 06:33 AM

[Chuck:]

I've got a bridge in Alaska that I can sell you, cheap.

2008 Sep 23 08:19 AM

[cove3:]

I am confused as to leverage/capital regulation which has existed for both investment banks and bank holding companies.

I thought investment banks were exempt and that only the deposit bank and brokerage subsidiaries of bank holding companies were regulated as to leverage.

Yet I saw that a few years ago, Goldman, JP Morgan etc were allowed to increase their leverage, implying some regulation existed.

Also, the argument for Goldman becoming a bank holding company was that it would have access to depositor money. I thought that the deposit bank of a bank holding company could not play games with moving depositors money out to it's investment bank subsidiaries.

Anybody know the answer to this?

Ron

Also

2008 Sep 23 09:37 AM

[who:]

winners...DB, ABN, BarCap, foreign IB's picking up the business?

2008 Sep 23 11:30 AM

[Emerald:]

Citi and B of A will initially benefit from the bailout. Wait until their stocks rise 25%, then sell. JPM has the largest derivatives book in the world. (Care to explain their risks to me? Ask Buffett.) Wachovia, I think not. Short the long Treasury, buy gold.

2008 Sep 23 01:34 PM

[GMiki1:]

Absolutely gold is the winner here. But buy energy stocks, too because after a continuing emergency in general and hyperinflation, we're going into a serious energy way past-peak crisis. I LOVE CNX at this price. But, then too, I love silver.

2008 Sep 23 05:00 PM

[ozzy43:]

Much of this seems sensible, BUT - I have to call foul when I see statements like this:

"Assuming the managers of the government’s new $700 billion slush fund are even halfway competent, they’ll avoid the real rubbish, and leave the biggest losses for banks’ shareholders to absorb."

Government money managers competent? What planet are you from? The whole point of this deal, Paulsonanke's blatant lies notwithstandnig, is to stick the taxpayer with as many of the toxic assets as humanly possible. They'll go straight for the rubbish - and pay top dollar (hold-to-maturity prices rather than 'fire sale prices') for it, as recent quotes from the deadly duo PROVE. The only way this would NOT catastrophically impact taxpayers is if the real estate market goes rocketing upward while the default rates plummets immediately. Anyone see that happening any time soon? If so, I have some ocean front property here in Phoenix and I'm ready to make you a sweet deal.

Let's please understanding something quite simple: this is a BAILOUT. It is not an economic rescue plan - obviously, since it does not address root causes of the actual economic problem. As Mish Shedlock astutely puts it:

"Before one can work out a solution, the first step is to identify the problem. The problem is not a lack of liquidity, it is not a lack of trust, it is not lack of consumer confidence, it is not subprime lending, and in fact the problem is not housing at all.

The problem is consumers and corporations are deep in debt with no way to service that debt.

Attempts to bail out banks and brokers at taxpayer expense will do nothing but add to consumer debt, weaken the US dollar, and literally waste $700+ billion dollars that can and should go to more productive uses."

It's a bailout - and who is getting bailed out? The crooks in the executive suites of Goldman Sachs and Morgan Stanley, et.al. And it's being rammed down the throats of the other set of crooks...err...of our inaptly titled 'representatives' who pitifully bleat about the need for 'oversight' (to anyone who believes that these clowns and stuffed suits are even *capable* of such a feat, I re-ask my question: what planet are you from?) before handing over a probable multi-trillion dollar check (consider: when was the last time a govt program cost what they said it would cost at the start of it? Seventeen eighty-something?).

To take a Goldman Sachs flunky like Paulson at his word - arguably a man more responsible than any other in the world for the toxic garbage now steadily and ineluctably poisoning our economy to death, thanks to his actions while CEO of GS (doesn't *anyone* do due diligence on these shady govt characters?) - is to exhibit the most astonishing level of naivete.

2008 Sep 23 06:24 PM

[CPST1:]

Where do you find that the bailout forgives the debt or the loan? Nor is it a write off. The tax ramifications or how this looks to the IRS is going to make this a tangible deal or not, and the meter is running. The plan is not a relief package for the parties involved so they each walk away freely from their obligations.

It's a bum loan that can't be covered for which; you and your bank are each paying interest on the obligation. I count two interest payments now instead of just one, plus the discount on equity.

2008 Sep 23 07:07 PM

[Old Coach:]

Buffet goes in for GS so GS wins. Bailout from former GS CEO so GS wins. Ex GS exec now WB CEO offloads toxic paper then probably does deal with GS so now GS and WB win. BAC just got ML for a steal so BAC wins. MS will find a way to win.

Congress is posturing. They've got a gun to their heads and they know it. Mark to market accounting will be adjusted so all financials will get a break and off we go til the next crisis.

Meanwhile the idiots that we elect on both sides of the aisle will keep trying to blame each other. Throw mud at everyone in the arena so decent intelligent people stay away. All the while, the Chinese are fixing to lend us our lunch money and then eat our lunch!

Where have all the grown-ups gone?

2008 Sep 24 12:02 AM

[puddytat:]

Big Losers THE AMERICAN PEOPLE Big Winners THE WEASELS WHO RUN WALL STREET.... If you had 700 billion, which you don't, why not spend it on infrastructure... build roads, bridges, hospitals, learning centers for poor families. That would create jobs , people pay taxes buy things and raise families.. All good stuff. Instead your plan creates a black hole for assets worth nothing.
Nice job... great leadership... so much for free market.

2008 Sep 25 04:00 PM

[puddytat:]

As a Canadian I am so incredibly encouraged by the comments here. I thought most Americans thought the Government you have actually know what they are doing. Sorry... they don't.. One week Paulson is saying no bailout... the next we get the mother of all bailouts... As if Americans have not been asked to go through enough... they lost houses, cars, jobs , no credit and after all that Paulson hands them a bill as well. Your politicians are indeed crooks. There should be a million people outside the Whitehouse today saying they should shove the bailout up you know whos you know what. Please don't take this lying down my American friends... you have been abused too much over the past 10 years to finally let your government do it to you too.
I have such a sickening feeling for my friends down in the States over this matter. As I pointed out in earlier posts. Spend the 700 billion on infrastructure... put people back to work... that would create prosperity for generations. This bailout will created debt for generations. This cannot be allowed to happen to the most amazing people on the earth.
I truly cannot see how this can be allowed to happen. A dark day in history.

2008 Sep 25 04:09 PM