Bailout or Savvy Investment?

I’ve been hesitant to offer my opinion about the proposed $700B bailout package since the news pertaining to that plan is ongoing and constantly changing. But now that rumors are flying and I’ve had clients call in to ‘blame this on Bush’ and to complain that it dumps a massive debt directly on the heads of taxpayers, I feel the need to spell out some truth as I understand it and perhaps some more realistic scenarios. Regardless of what portion of this proposed legislation passes, I don’t think we’re heading into the next Great Depression. The biggest problems with this market the way I understand it is a lack of liquidity, the perils of bank interdependency, and a need for some new regulations in an era of leverage and risk. These are problems we can cope with as a nation with a little cooperation. Here is some clarification about this historical event:

If the Fed does get approved to buy ‘bad debt’ off the balance sheets of various financial institutions it would mostly consist of them buying residential and commercial paper at a steep discount to its market value. Now, determining a market value for a pool of borrowed money which includes subprime issues and other alt-a paper is very difficult--often impossible in the midst of this ‘dead credit’ market which we’re currently in. In all likelihood, the government will buy these loans for 30 or 40 cents on the dollar, in some cases less. These purchases would be at ‘fire sale’ prices which, in a stable market, would be worth considerably more. While holding these loans, the government would be receiving the interest on these loan pools, in many cases ranging from 8-12% or more.

If the Fed were to hold these loans to maturity, they could very possibly earn a profit because of the low purchase prices. Remember, most of these loans will not default after all. On the other hand, they can go ahead and sell that paper for 60 or 70 cents on the dollar, or perhaps more, representing what could be a massive profit. So, an important understanding would be that the government plans to re-sell these loans through competitive market mechanisms. $700B in taxpayer dollars would not be spent and gone--rather one could go as far as to say it represents a possible good investment of tax dollars. In the meanwhile, it will stabilize the markets, helping ordinary people, myself included, who hold money in 401k, 403b, IRA, and individual investment accounts. I’m sure most of us wouldn’t mind seeing our investment accounts bounce back towards their highs at some point in the not-so-distant future.

As for the recession, depression, inflation, and dollar concerns, we must return to the fact that we aren’t simply buying these debts off corporate balance sheets and taking them as a taxpayer loss. This will be a managed program aimed at stabilizing the market--not to give rich CEOs more room to breathe easy. Ben Bernanke went as far today as to say it’s as likely the Fed would lower interest rates in the future as it is they raise them. They don’t anticipate inflationary results from this legislation. The market tends to learn from its mistakes, and we’ve seen what happened to inflation and the dollar after the savings and loan crisis of the 1980s. This is a different time and a different problem. And I think once the dust settles Congress will realize the necessity for these measures along with their possible positive outcomes and sign off on it.

Comments

[Tman:]

Makes sense to me.

2008 Sep 25 05:55 PM

[CLH:]

You are one of the few whoe understand that the gov will make billions from this so called bailout which I call a steal. Russell you have explained it well.

Guru above doesnt seem very intelligent.

2008 Sep 25 05:58 PM

[JParallel:]

I recall Paulson telling congress that the purchases would have to be above 'Fire Sale' prices to have a meaningful effect.

2008 Sep 25 06:08 PM

[MarvinMBA:]

Created emergency bailout for the big shots...business as usual.

2008 Sep 25 06:20 PM

[eddie6442:]

You state, "most of these loans won't default at all". What this confirms is that the massive writedowns of these assets are artificial. The result of faulty legislation or accounting principles. Americans are paying an unreal price for what is looking questionable. Exploit some laws to drive prices down to panic levels, then buy these same assets for pennies on the dollar and somebody makes $$$$$$$$ zillions!

2008 Sep 25 06:31 PM

[CPST1:]

At 30 cents on the dollar that would be quite an offer if the MBS were a rent with an option to buy. There is a considerable amount of grey area for the tenancy at will, or that these homes must remain vacant if foreclosed against. Why move out if it can be determined that the house is a red herring property, or that, the bank that holds the mortgage is now belly up. It’s a 60 Minutes segment just waiting to happen…

One option would be to have a new sort of ecommerce business that could facilitate the functional value of the mortgage so that payments were kept current and the house was not dormant. Ideally, you could buy the house and keep the former homeowner…

So far, we’ve rented with the option to buy that allows the rent to be applied as down payment, or that it is surrendered as rent if the option to buy is not exercised. Such tenants if Indian tribal members have alternative means to secure down payment from the local tribe….

The second problem is the no-show, sub prime owner at the condominium building in Fl, because the association fees are not maintained and the cost falls onto the occupants in more ways than one. In truth, no one has ever seen any of the sub prime paper owners… The foreclosures allow however, for the units to be rented in lieu of the association fees until a new owner has contracted to purchase the unit. Fl property taxes are hellacious as are its drug traffickers.

2008 Sep 25 07:15 PM

[hotpbwiki:]

While the bailout may provide solution that starts working next year, in the short term the damage has already been done. The economy will move lower over the next six to nine months.

2008 Sep 25 10:06 PM

[toxxum:]

"consist of them buying residential and commercial paper at a steep discount to its market value"?? How so? If banks sell at a steep discount, they will need to show the losses in their balance sheets and will have trouble meeting the capital requirements. So far, they could avoid doing so since there are currently no "market prices" that could be established, given that no one wants to buy the garbage. So, tell me, how could the Fed possibly buy at a discount, wihtout pushing the banks into bankruptcy?

2008 Sep 25 11:06 PM

[Steven Hansen:]

while i see the need to stop the bleeding of the retirement accounts, the same effect could be accomplished by guaranteeing these retirement accounts.

the more people talk about getting money to flow again, the more at a loss i am to see how this bailout actually stimulates money flow. the big boys want the credit market to function normally but we are going into a recession. we need a stimulus package aimed at consumers.

2008 Sep 26 02:12 AM