The Benefits of a Bailout Plan

In today's semi-political investment environment, it starts to become a little hazy whether we've turned the corner or whether we're still headed for an even worse market crash. Press reports have praised the work of Treasury Secretary Henry Paulson and Congress for diverting the economy from a new version of the Great Depression.

The only problem is that their plan has not been adopted. It still must run the gauntlet of the U.S. Congress. Anyone who knows something about politics understands that trying to get a bill passed is like playing a grown up version of telephone - you may not get out what you put in.

Here is what we know so far. While the plan has been dubbed the "son of RTC" - referencing the independent Resolution Trust Corporation that bought the assets of failed savings and loans in the 1980s - it will be very different from the RTC.

While the RTC took the assets of defunct savings and loans, wiping out shareholders, the Paulson process is looking to protect Wall Street. The U.S. Treasury Department will buy as much as $700 billion in toxic assets from institutions that are still solvent. Shareholders in the bailout firms will have their equity cut, but not destroyed.

Unfortunately, this will protect the same corporate dynasties that ran many of these firms into the ground with excess leverage. It also moves these depreciating assets onto the balance sheet of the U.S. government.

But there is something important that investors need to take away from this current meltdown…

The bailout, while important and publicized, is distracting many from the bigger long-term picture. And that's opened the doors for us to score some great bargains.

The Risks of a Bailout Plan… and the Benefits for You

By holding "reverse auctions," the Treasury plans to buy these loan portfolios from multiple banks. But the greatest danger is government officers buying assets that no one understands. How much they are really worth? Banks could offload non-performing assets with larger risks than currently disclosed.

When risks are divorced from investments, you naturally have an increased opportunity for fraud.

In my opinion, the wholesale nationalization of much of the mortgage market and many banks sets a bad precedent. And the plan's insuring of money-market funds guarantees managers taking more risks will climb and the due diligence of the buyers will fly out the window. Before long, all of Wall Street will be selling bad assets here.

America has over 200 years of bankruptcy law that should be governing these transactions. If managers who accumulated too much risk by not adequately qualifying lenders are allowed to continue in their jobs, we are doing a disfavor to the intelligent managers who accepted lower returns for more prudent lending practices.

I believe the shareholders and executives at these mismanaged firms should be wiped out. These investments have clearly failed, and management is to blame. It's the risk we all take, and the risk of investing. It allows new managers and companies to fill the void. This type of creative destruction - however painful - always strengthens the economy in the long run.

The silver lining is that many of these investments may come back to benefit the consumers. In the final review of the Savings & Loan bailout, U.S taxpayers saw a net gain from their "purchases." And the simple reason behind it was that assets were purchased for less than they were worth and sold at a profit when their value was realized.

It's the very principle behind deep-value investing.

Why the Imbalance in Stock Prices?

The current mess has created lots of imbalance in stock prices. As thousands of financial "professionals" worry about their job prospects, stock prices are getting hammered. But that doesn't mean that all of these companies deserve this mistreatment. There are solid businesses out there that have been completely undervalued by the market.

I've long been a proponent of contrarian investing and buying assets on the cheap. It delivers superior long-term returns and uncovers portfolio "superstars." And it seems that I'm not the only one beating the pavement for deep values…

Warren Buffett just took a $5 billion stake in Goldman Sachs (GS), with the ability to buy another $5 billion more. And MidAmerican Energy, one of his subsidiaries, just bought Constellation Energy (CEG) shares for half of what they were trading at earlier this month.

Clearly Buffett has been using the liquidity crisis to grab some phenomenal bargains. And we should be on the lookout for the same. The market's recent fluctuations have been offering investors some tantalizing buys.

So keep a level head and invest with caution in the current environment. The rules of the game are changing and short-term relief could be replaced with higher inflation and a longer bear market.

But that doesn't mean there aren't some great values out there.

Comments

[User 269770:]

Um, hello? What are you smoking?! The only reason banks want Uncle Sam involved is because they know he (you) will overpay. You think they can't sell assets on their own? Sure, but they want to hold out for the price a SUCKER is willing to pay. Any gains will be far outstripped by the massive losses from this junk paper!

And foreclosures keep coming! I say we wait till lending is straightened out -- they'll tell you it is but then why is fraud up 47% in 2008?! -- because as long as they're still making bad loans for overpriced houses, we're bailing out the banks without shutting off the tap. The losses will just keep coming.

2008 Sep 25 12:47 PM

[websmith:]

Yeah, and they've got WMD too. Bush first helped the military industrial complex take the population's wealth and now he is trying to help the banking industry take the rest of it.

Perhaps this bailout, like rising gas prices that are causing us to move more aggressively towards renewable clean fuels, will also wake up the Citizens and the outcome of the election will be changed.

What the banking industry did was, literally, a crime and what they are trying to do now is, literally, a crime against the United States.

What the government by the people and for the people is missing is that the banks are not in a position to demand or dictate terms as they come begging. They are weakened and we are the United States Government. We get to specify the terms and if they don't like them, they can go somewhere else.

If the Fed continues to not play nice, we can point out that it exists illegally and start printing Treasury notes at any moment and begin distributing them to a massive number of banks that would sign up over night. We can finance the auto and construction industries that the banks are now squeezing. We can then begin to use the interest to pay down the national debt.

We are the United States of America and it is really infuriating to see our Senators grappling at the banking industry's feet. These guys need to stand up for their country.

ewebsmith.com/bus/taxp...

2008 Sep 25 01:07 PM

[phermes:]

The bailout is not the end, it is the beginning - the "toxic" debt that exists in the world in the form of CDOs and CDSs - which Warren Buffet called "weapons on financial mass destruction" - is in the hundreds of trillions of dollars, and everyone is beginning to notice that the emperor has no money. Banks are bankrupt, with up to 30X their "reserves" out in credit (they are essentially printing money, some say counterfeiting) and leveraged to the gills on air - otherwise known as toxic debt. Who is complicit in this? From the bottom up, mortgage companies (and of course the silly subprime people who believed them - but I watched these guys at work, and the average American was no match), then the banks and investment banks who packaged this garbage into CDOs, in essence creating more "wealth" based on sheer BS. Enter the investment banks and monoline lenders with another brilliant financial instrument based on sheer nothingness - the credit default swap, essentially an insurance on your toxic debt packages - except, oops, there were no regulations in place to insure that the insurers actually had the capital to pay off when the depts went bad. (We would want some rules to spoil the fun.) Wait, I'm not done. Moody's and other credit rating agencies are in there, with AA and AAA ratings of this junk - the ratings allowed the shill game to go on. Finally, the Fed, Greenspan (as scapegoat), who kept interest low, allowing real estate prices to skyrocket to unsupportable levels while at the same time sucking in more subprime buyers. And then, congress, who allowed the whole thing to go on.

Listen, this is only a surprise (or a pretend surprise - "Gosh, how did this happen?") to pundits and commentators. I sat down with a mortgage guy 4 years ago and previewed the whole scenario - and I'm no economist; I'm a marketing person. Obviously the ARMs and other clever mortgages would not fly, obviously people would default, and they were the bottom cards in the house of cards. (It's more complex than this - overleveraged corporations with no organic growth in decades play their role, but space forbids...)

Meanwhile, we have a country that doesn't need to bailout a failed banking industry (and reward the criminals - yes, criminals; they had motive, intent, and they destroyed lives - with the ability to recoup their losses and continue on) - it needs to find a way to reinstate its stripped-mined manufacturing base, where real wealth is created. $700 billion would have gone a long way in low interest loans to viable industries, particularly leading tech in renewable energy that would place us in the lead in the vital category. Instead that money (remember, money is only potentiality - it is no longer backed by anything but faith, promise and belief) is going to the very people who created the problem. It didn't, as our politicos have said, shore up the economy. It shored up a house of cards run by greed that cares not a whit for country or people. And therefore, it shored up a system that will fail again and again in exactly the same way - this "sudden crisis" is as old as the banking industry and we have just prolonged it, maybe bought a respite, and paved the way for a worse fall that will have everyone throwing up their hands again and going, how could this have happened?

Time to wake up. If you reward bad behavior it tends to persist. I'm sorry, but people dealing in trillion dollar transactions that decide the fate of nations - and the men, women and children who live therein - need some rules to live by. So banish the word regulation from your vocabulary if it makes it impossible for you to think. And tell me, what human endeavor do you know that operates without any rules?

2008 Oct 05 02:41 PM