Paulson Finally Doing the Right Thing

"America can always be counted on to do the right thing, after it has exhausted all other possibilities." - Winston Churchill

The recently passed $700 billion bailout bill does contain the authority for the Government to buy new preferred stock in troubled financial institutions. At yesterday's news conference, Secretary of the Treasury Henry Paulson indicated that he might just do that. This would be following the lead of the U.K., which yesterday indicated that they are buying major stakes in its most troubled banks.

This is exactly the approach that will do the most good. The core problem right now is that we have an overleveraged financial system which is trying desperately to de-leverage. When all try to deleverage at the same time, it drives down asset prices, which pushes down equity even further, which actually causes leverage to go up.

Simply buying troubled assets is likely to be very ineffective in such a situation. If a firm is leveraged at say 25:1, with $1 billion of equity supporting $25 billion of assets, then an incremental billion spent buying assets will only reduce leverage to 24:1. On the other hand, injecting that same $1 billion onto the equity side of the balance sheet will reduce the leverage to 12.5:1.

In addition, equity prices are very transparent, so there will not be a question of whether the Government is deliberately overpaying to favor some institutions with more political pull. The "toxic assets" prices are anything but transparent.

Buying big slugs of preferred stock also accomplishes two other critical objectives. First, it gives the taxpayers the best possible shot at actually making money out of this whole mess. Second, it punishes the existing shareholders by diluting their stake. If those that enjoyed the fruits of all this poor lending on the way up do not suffer -- and instead are simply bailed out -- then people will be encouraged to act recklessly in the future.

We knew that the authorization was in the package, but honestly I did not think that this administration would use it. After all, government ownership of major financial institutions, even if only temporary, is pretty much the dictionary definition of Socialism. I was hopeful that the next administration would, however, and am very happy that Paulson has come to his senses and seriously considering such a move.

The coordinated rate cut last week by most of the major central banks of the world was also the right thing to do. The question is: Is it enough? There was a little bit of evidence that the credit markets were becoming unstuck, but it was tentative at best. The longer the credit markets are frozen the worse the damage will be on Main Street. A nasty recession is pretty much already baked into the cake, but a depression is not.

The market is deeply oversold, and is already 35% off of its highs, which is worse than the average bear market. Then again, the system is in far worse shape than in your average bear market situation. Still, I would expect at least a short-term bounce in here soon. It may be a deceased feline, but it will be big enough to be tradable. Use the bounce to realign your portfolio.

I would continue to avoid the Financials. Dividends need to be cut or eliminated (preferably eliminated), and instead of buying back shares, companies will have to be selling new shares, either to the government or to other private investors. Current owners of those stocks will be seriously diluted, and we have still probably have several more failures of financial institutions to come.

Consumers are in the process of switching from being borrowers to being savers. That process means that they have to cut back on their spending. The more easily deferred the product or service a firm sells, and the less essential it is for basic living, the worse position a firm will be in. Can the car make it one more year? Yes, probably, so why go buy a new car today? Can you wear last year's fashions and not be cold or naked? You betcha. Spend $60 for dinner for a family of four at a casual dining restaurant twice a week? I don't thinks so.  People will eat at home or go to McDonalds (MCD)  instead.

Avoid the manufacturers and retailers of such products. Retailers in the middle of the price point distribution such as Gap (GPS) , J.C. Penney (JCP), Macy's (M), Abercrombie & Fitch (ANF) and Kohl's (KSS) are most at risk. Discounters like Wal-Mart (WMT)  and grocery stores like Kroger's (KR)  and Safeway (SWY) along with Drug stores like Walgreen's (WAG) should hold up better.

On the other hand, are things going to get so bad that you don't buy toilet paper, or let the baby go without diapers? No, I don't think so. Thus companies like Kimberly Clark (KMB) and Procter & Gamble (PG) are good places to hide out, and when they get hit with everything else it is a good time to accumulate them.

The same goes for some of the pharmaceutical companies like Abbott Labs (ABT) and Bristol Myers (BMY). While people are driving a little bit less and that has driven down oil prices sharply from the highs of July.

The price of oil is still well below a year ago, and the Energy sector is the only sector expected to show any significant growth in net income in the near future. Valuations in the group have gotten just plain silly cheap with the sector as a whole (total market cap/total expected net income) trading below 7x 2009 earnings. Most of the energy firms are sitting on fortress balance sheets and are rolling in cash. Stocks to consider are:  Conoco (COP), Exxon (XOM), Transocean (RIG), National Oilwell Varco (NOV) and Devon (DVN).

Posted By: Dirk van Dijk, CFA

Comments

[User 265729:]

I don't think there's many people who would agree with that...

Paulson is still running behind the curve and offering solutions for month or two month ago problems. The snowball is getting larger and larger, Paulson and Bush are running behind it, huffing and puffing.

If Paulson and Bush ever do get in front of it, the snowball will be so large it will plow them both under. They offer yesterday's solutions.

2008 Oct 12 04:56 PM

[User 265729:]

Oh! Since you are offering quotes... Here are a couple...

-Prosperity is just around the corner... (Herbert Hoover, 1932)

-Faced by failure of credit, they have proposed only the lending of more money. (FDR, 1933)

2008 Oct 12 05:01 PM

[asteroids:]

Investing in those companies won't solve the real problem. The credit default swaps and all that other exotic garbage are the issue.

The SEC should declare them illegal products and the head of the
SEC should resign.

The Treasure should buy up all that junk at 5-7cents to the dollar.

Presto. Trust comes back. Banks start to function. Things will get better.

2008 Oct 12 05:52 PM

[romang:]

That quote can not be anymore true today then when Churchill said it. Paulson should have done this a year ago. It would have saved the sates or at least cushioned the fall.

2008 Oct 12 09:03 PM

[whidbey:]

Isn't final demand the determining issue of recovery, all else equal ? The banks are just utilities and we do need them to function reliably but they are not the final objective which consumption. We need money in the hands of consumers, you decide how you want it there. I hate stimulus hand-outs. I like tax holidays, and government backed loans to homeowners in trouble. I know, the dollar goes to Hell, but not if we can stabilize the economy and the consumer. Those the magic buttons that will cause the elevator to rise again. The first bounce gets tested, so no long term investing yet. But, one find day....

2008 Oct 12 09:24 PM

[Getridofthe...:]

Is anyone concerned about the state of municipal finance? I worry that this is the next significant show to drop. I am hearing more and more from my colleagues and friends that municipalities are in deep trouble. I would like more insight and information about the fiscal health of munis. Banks have a lot of money - liability and asset side - that depends on munis.

2008 Oct 13 01:07 AM

[Stone Fox C...:]

So punishing existing investors is a good thing? Thats anti-capitalism. All of the risk takers that caused this problem have already been punished. They all hold stocks down 50 to 90%. How will punishing somebody that bought MS last week at $15 help??? Nobody will want to invest if thats the thought process. Buying the toxic assets off the balance sheet is the best answer. Not really sure anybody has a goal of deleverging past existing levels and nobody still holds 25:1 ratios. Even MS will be much lower then that with the $9B deal.

The key is to get these assets off the BS so that counterparties won't fear further writedowns. Banks will be able to lend without risking the unknown. Giving a bank $5B that sill has exposure to $50B in loans that could be written down $25B doesn't really help. The issue is to make the downside known. Providing the investment holds to solidify banks that may wish to sell loans at the same time. Govt must buy at market values though. Screwing investors will just cause market instability.

2008 Oct 13 01:31 AM

[zalo:]

I agree with you that the best solution is just to cleanse the bad assets from the banks by giving put free money. But that is not politically viable by any standard. It has never been done in that way in any financial crisis. Pouring in capital is the second best solution, though it punishes investors that bought in the cheap as it dilutes them.
Now, if i where to invest in recapitalizing a bank in the cheap, i will certainly wait to see if the government goes in, and this behaviour will certainly end up in that the government will be the only capitalist pouring in money. True, but from the government point of view, there is no other solution as at this moment there are no private investors out there willing to put in money.

2008 Oct 13 02:10 AM

[john s. gordon:]

curbs - the reason hoobert heever said that was that the bankers told him to say that. remember, a bank is an institution that will lend you some money if you can prove you don't need any.

aster - if credit default slops were government-regulated as insurance (which they really are) problem would be minimal rather than maximal.
> jack

2008 Oct 13 12:07 PM

[nova:]

Stone Fox Capital, "Banks will be able to lend without risking the unknown."

Good. Let nationalize the entire financial system and have Soviet States of America. Shit did not worked there and it will not work here.

2008 Oct 13 07:46 PM