Bailout 1.1 Passed. Will We Have to Go Back to the Well for v2.0?

So the bailout bill finally passed. No doubt all those amendments helped convince Congress to give the nod to the legislation. While others get all excited over such proposal like the one to suspend mark to market accounting, my favorite amendment is:

SEC. 503. EXEMPTION FROM EXCISE TAX FOR CERTAIN WOODEN ARROWS DESIGNED FOR USE BY CHILDREN.

For investors the key question is whether the authorities will have to come back to the well again later. To evaluate any solution, here are the issues to consider:

• Does it give the system solvency? or just liquidity?
• Who finances the rescue?
• How does it affect the US consumer?

Does it make the system solvent?
I have written before about the solvency and liquidity. The scale of the Fed’s liquidity injections into the financial systems has been off the charts. The latest report states:

Banks' discount window borrowings averaged $367.80 billion per day in the week ended October 1, nearly double the previous record daily average of $187.75 billion last week, Federal Reserve data released on Thursday showed.

Liquidity isn’t the problem. Solvency is. What price does the Treasury pay for these toxic assets and will it make the system solvent? I keep repeating Brad Setser’s comments but it’s worthwhile to keep them in mind:

If [the US Treasury] pays a high price for various dud assets, it won’t move nearly as much off the banks’ balance sheet — which may leave residual questions about the health of key institutions. On the other hand, if the Treasury pays a low price, it may leave a lot of banks in trouble and in desperate need of new equity.

If the bailout doesn’t create sufficient solvency in the system, then we may need another bailout. Jonathan Weil has suggested direct equity injections [read: nationalization] into the banks would be a lot more efficient way of spending $700 billion.

Who finances the bailout?
The question of who finances the bailout has profound investment implications. If it’s financed by the printing press it will be highly inflationary. On the other hand, if the majority of the burden is borne by foreigners (China, Japan, Middle East states, etc.) then the results are likely to be deflationary.

If foreigners have to finance the bailout, then what do they want? Over in his blog, Fabius Maximus proposed that a Brady bond-like solution for the US:

The Master Settlement of 2009

I. The US receives $1.5 trillion in new lending in 2009 and 2010, with smaller loans in the following five years. New lending under this agreement ends in 2015.

II. Existing US government and agency bonds held by foreign central banks are rescheduled. Principal or interest payments begin in 2016, amortized over the following 30 years at low fixed interest rates.

III. The bonds are denominated in an index of currencies, weighted by the debt held by each nation. We lose the ability to inflate the debt away by printing money.

IV. The US dollar is immediately devalued by some fixed amount (perhaps 20%). The lower dollar will reduce our imports, as they become more expensive. Our exports again become competitive on world markets, so we can earn the money to pay our debts.

V. Our creditors will demand (and receive) consensions [sic]. We can only guess what those might be. China will certainly ask for a sphere of influence that includes Taiwan.

How does this affect the US public?
Lastly, the reaction of the US public may be as relevant as Argentinians demonstrating in the streets in the last crisis in Argentina. Nevertheless, Macro Man was right when he noted that Americans are at serious risk of class warfare:

[The chart] shows a surge in corporate profits (at the apparent expense of wages) as a share of national income. It is the divergent fortunes of these two series that has fueled Main Street anger and turned "no" voting Congressmen into class warriors.

Stories of giant CEO severance packages also didn’t help matters.


Inflation or deflation?
For investors, we come back to the key question of inflation or deflation.

How does the solution, however it is implemented, affect the balance sheet and spending power of the US consumer? What happens ultimately affects earnings and growth, which is what the equity markets are all about.

Given all the turmoil, it may be wise to sit out October and wait for the dust to settle.

Comments

[Kath H.:]

First, the Bailout is Plan B, not Plan A. Plan A was the privatization of Social Security. It had nothing to do with increasing Social Security payents, it had everything to do with injecting billions into the stock market to keep it growing.

Second, the problem is that the U. S. has a credit fueled consumer economy. It is a Ponzi scheme based on cheap labor achieved by immigration, legal and illegal and by borrowing to fund today's expenses.

The U. S. needs to shift to a sound economy. The U. S.needs to produce something.

2008 Oct 03 05:57 PM

[AlexS:]

Not all wooden arrows. Just certain ones.

2008 Oct 03 06:07 PM

[appone:]

"Inflation or deflation?
For investors, we come back to the key question of inflation or deflation."
With all the G7 governments doing their best to inflate, the question is who is going to win, the governments (inflation) or the natural economic tendencies of the markets (deflation).
Temporary rallies not wthstanding, deflation is the natural solution and I believe it will prevail. It won't be a nice experience.

2008 Oct 03 06:42 PM

[Jackson Cash:]

AlexS I thought that too!

Therefore I'm going to simplify and am going to change my company logo to -- you guessed it -- A wooden arrow with a kid on it!

Whew! Now I can finally move my PO box back onshore.

2008 Oct 03 06:56 PM

[cristian:]

All this is empty talk.. You nailed one thing right, solvency. How can an outsourced economy be solvent ? It is time to pay the fiddler. For the majority I see two choices. They will riot, or they will learn to live to third world standards. The wise guys were claiming that this is not a consumer driven economy. Perhaps so, but then what can you expect from people that cannot exercise basic logic.

2008 Oct 03 07:02 PM

[closedbooks:]

I appreciated your point about the US public reaction being as relevant as the Argentinians demonstrating in the street. This bill passed today was like sand kicked in the face, "how dare you vote down this bill on Monday, we''ll add a bunch of junk to make you wish you had supported it the first time". More acceptable to Main St? What a laugh. Not too many Joe-Six-Packers with a quarter million in the bank..

2008 Oct 03 08:45 PM

[investor88:]

Cam Hui leaves the question of inflation vs deflation open and is looking for market direction to indicate which course prevails. Reader appone is more sure and says deflation would be the outcome.

The evidence so far is deflation of assets [stocks, property, risky bonds] and but moderate inflation in cpi, ppi and commodities. Governments tries to inflate but the markets are in deflation and develeraging mode. The basic market forces will ultimately win as it always has - I agree with appone!!

2008 Oct 03 09:04 PM

[Nikola:]

US makes lots of things. It's the third largest exporter in the world. China passed it to be #2 only a year or two ago.

Problem is that many of the US exports are in technology, and US hasn't been innovating lately. Solar? Mostly Chinese companies. Stem cell? You guessed it. While the US won't have a space vehicle in a few years, the Chinese are making their first space walks. Autos were a big American export. Well, autos are moving towards electric. Guess who's leading in that market. It's not Tesla Motors.

Unless the US starts innovating (and that means tax breaks, investment in education, and smart immigration) it really will just be a Ponzi scheme, and that won't last.

Interestingly, this problem has nothing to do with the current crises. Except that it has opened a window of opportunity to see the problem clearly and act. Of course, very likely the chance will be missed. Both presidential candidates are quite uninspiring in this respect, and they are supposed to set the tone.

2008 Oct 03 09:13 PM

[Steven Hansen:]

the class warfare issue was also during the great depression. it is repeating now because more than 1/2 of society did not benefit from the bubbles which are now bursting, but will suffer the consequences of the bubble collapse.

therefore this bailout plan only benefits half of the population. as a pragmatist, i was hoping there would be some benefit included for the 1/2 which will not benefit from TARP.

2008 Oct 03 11:02 PM

[GeminiAtlas:]

Yeah, this bailout seems too Rube Goldberg (i.e 400 pages). Lots of parts that would need to allign to make a difference. The buying of equity stakes by the government (or a trust set up by the govt) seems more elegant. Dilute the stockholders and recapitalize the banks in one fell swoop. Who owns lots of bank stocks? Of course the executives that have made a ton of money during the boom. When the recapitalized banks and other players figure out how to unbundle the toxic paper, then the markets will work again. After awhile when things get back to normal, the gov't can spin out its equity share. Of course that would be too simple. Oh, right, I'm sure Bernanke and Paulson have plenty of their friends who own bank shares (and I'm sure they have some bank shares themselves), and they wouldn't want their pals' stocks decimated by a massive dilution. D'oh! I knew there was a catch somewhere in there...

2008 Oct 03 11:08 PM

[bearfund:]

Deflation is not bad in and of itself if you have money. The bad thing about deflation is all the stuff governments do in an effort to prevent it.

2008 Oct 03 11:28 PM

[SeeTheLight:]

A major triumph for America. With the world watching intently, it voted down the sleeker bailout 1.0 (which I thought was a poor plan but better than nothing), instead to pork it up with a bunch of crap aimed at bribing votes (which I thought they should vote down). Nice display of American hypocrisy, you can't take the bitter pill without the "sweeteners".

This will only delay the inevitable. The balance of payments has been imbalanced towards imports for a long time in the US and American have been paying it with more and more debt. Now they have chosen to run the printing presses or take more loans (god forbid they raise taxes like Canada did to get rid of its debt and deficit when their government overspent in a similar mess).

Sometimes you just have to suck it up and take responsibility for the thievery of your fellow citizens. Put them in jail, throw them out of office, but the price tag is still there and can not be paid simply by printing cash or borrowing more.

As I said, a triumph for American hypocrisy. You are committing economic suicide. Comeuppance served with a side of pork.

Do you really believe any country watching this will want to invest at anything other than loan shark terms? So it means likely short term inflationary as more dollars are printed and dumped into the economy.

Long term, deflation, the balance of payments needs to inverted. Welcome to a long recession. As for the wealth divide, it will continue. The fear of socialism is driving it. Freedom in America, what a joke. The masses have been indoctrinated to think that this slavery is a freedom of choice and that the free market will give wealth for all. God forbid we have social programs to help support the poor and middle class. That's socialism. Evil evil! Better than any dictatorship or communism could do, make the masses believe that the divide of wealth is not just acceptable its preferable.

Up until now, the free market worked for America because they were so far ahead of the world in manufacturing after WWII. That advantage is slipping each year. The more you resist reality, the bigger the hangover. USA, a country run by the socialism of money (aka lobbying), only they indoctrinate that that is the free market, and since occasionally a Bill Gates rises from the masses to join the elite, the masses think its freedom. Pipe dream for all but a select few, keeps the "dream" alive. Better than a dictatorship or communism. America is bliss.

2008 Oct 04 04:07 AM

[Chris Marshall:]

I was wondering whether the Government has taken into account how private equity/sovereign wealth funds can now invest in financials?

1) mark to market eased ( hide more crap under the carpet)
2) undetermined warrants for the Treasury, to dilute the financials equity values
3) Deal to make good all losses, in the event that the bailout loses money.

So if you are inclined to invest in preferred equity of a large bank, for a long term investment, how would you now value it?

This package has made the financials more opaque than ever, it looks likely that the only people that can recapitalize the banks, in these circumstances, is the Treasury. Therefore you can expect a further massive bailout plan in the new year.

2008 Oct 04 04:26 AM

[hoover:]

It seems to me that the bailout is to keep the markets calm long enough to get past the elections, and to encourage banks and other beneficiaries to give generously to political campaigns before the elections. Later this year, or early next, more money surely will be needed -- lots more. The bailout after all is a world bailout because all of the major econmies are linked. Before long government will have to increase borrowing just to pay the interest on national debt. Consumers are not far behind either. Common sense tells you that if Joe or Jane Sixpack that makes $40,000 a year with little hope of increasing their pay, they need to be frugile in order to survive. But, with a home worth $180,000 and a $190,000 mortgage, a car with $12,000 still owed, $38,000 in credit card debt (at 24% interest), $11,000 still owed at Macy's for furniture, a $20,000 401k that is down $6,000 this year, normal health and household expenses, and three dollars in the bank, this person isn't going to make it. What do they do? They get a car title loan at 30% interest, re-finance part of the rest of their debt (getting further screwed by predator lenders), get a payday loan in th middle of the week, buy a few lotto tickets and go to the local casino to try to "win" some money. Dumb and reckless? Yes, but governments do the same thing. We are in big trouble.

2008 Oct 04 09:09 AM

[John Pseudonym:]

Inflation came first this year. That whacked at the wealth of this nation and sent more of money oversees.

Now deflation is working it's magic to further decrease the wealth of this nation.

Finally, inflation will return and will be the final blow to the America sending it's once wealthy people into abject poverty.

2008 Oct 04 10:09 AM

[Duude:]

This plan is designed to add enough liquidity to make the MBS market attractive enough for hedge funds to take a bigger plunge and to allow financially ailing banks to convert some of their portfolio to cash which should help them in their quest for solvency. Many problems still exist, as we still have the problem of transparency of the MBS market and of financial firms steeped in default credit swaps. Banks are still not lending to one another. This must be addressed immediately.

2008 Oct 04 11:21 AM

[bearfund:]

WAKEUP, give me a break. Any politician who gets voted out will take up a cushy prearranged lobbying gig, and will be replaced by an identical drone from his party's freezer full of hacks. In the unlikely event that his seat is one of a couple dozen or so that the two largest parties (and no others) actually fight over, there's a slim chance he'll be replaced by an identical hack with a different logo on his party membership card.

Wow. I bet they're quivering in their boots over your "retaliation". Way to shake things up.

If you want real change, demand that your state legislature ratify the Permanent Strength Amendment - foobazco.org/~psa/psa.html - and put a stop to the never-ending series of financial crises that paper money, fractional reserve banking, and excessive leverage have brought us. No one can stop the business cycle, but the Permanent Strength Amendment would limit the amplitude of its oscillations and provide the basis for a healthy economy and slow, steady growth.

2008 Oct 05 12:36 PM