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What’s An Investor To Do?

Bailing out the overextended remains the headline of the week. Will bondholders come to an agreement on restructuring Greek debt? Will Greece receive the proposed bailout that allows a rollover of the debt coming due March 20? Are Portugal and others lining up behind Greece to negotiate further bailouts?

The International Monetary Fund (NYSE:IMF) announced this week that it will seek an additional $500 billion from its members to fortify its bailout war chest. The United States, which provides 17% of IMF funding, quickly declined to contribute. Hooray! Finally, someone rejecting the concept that we must bail out bankers and other bad decision-makers at all cost. Perhaps this is the first in a succession of actions needed to eliminate moral hazard. Companies, governments and investors must be allowed to fail when they make fatally flawed decisions. If, instead, they are bailed out, others are encouraged to repeat the risk-taking, hoping for a big reward if successful, and comforted in the assurance that major losses will be covered if a bailout becomes necessary.

The inequity is obvious. At the investor level, the risk-taker can win big if the risk is rewarded. On the other hand, if the market penalizes the risk, but the loss is covered by a bailout, the taxpayer eats the loss.

Now we read headlines out of Europe claiming that austerity required to pay back some of the debt load should not be pursued to the extent that it jeopardizes growth. In other words, don’t let the difficult get in the way of the desired. If reducing debt becomes uncomfortable, add a little more debt to promote desired growth. Unfortunately, at current debt levels in many countries, there is no realistic way that they can grow their way out of the hole. The hole just keeps getting deeper because of the cost of servicing the existing debt.

Meanwhile in our country we hear that the Fed is seriously considering QE3, another attempt to promote growth by adding to the debt load. Some speculate that the Fed will again try to prop up the housing market by buying more mortgage-backed bonds, as they have done in earlier quantitative easing episodes. Besides again promoting moral hazard, that behavior would penalize investment managers such as ourselves, who correctly forecast the losses that would flow from the irrational overleveraging in real estate. Investors who blindly chased yield in low-quality real estate investments were rewarded with high returns when that sector was soaring. Without Federal Reserve support, many of those investors would have given up those gains and more in lost principal when real estate prices collapsed. Instead, they were bailed out and received their principal back in addition to the high yield. Managers like us, who avoided such securities because of the correctly perceived danger, settled for lower yields in securities that survived the downturn without government rescue.

Today investors face a similar quandary. Far more asset types–even whole countries–are threatened by excessive debt. Should investors settle for lower returns from investments that will survive inevitable debt implosions in the years ahead? Should they invest more aggressively, betting that the world’s governments and central banks will be willing and able to prevent destructive debt collapses? Or should they acknowledge the long-term debt danger but invest more aggressively anyway with confidence that they will successfully time their exit from risk before serious damage is done? A sobering consideration was voiced recently by former Federal Reserve Governor Bill Poole, who said that the United States is just a few years behind Greece when you look at the numbers. In choosing a path, investors need to assess their ability to withstand losses, should governments and central banks fail to solve the debt dilemma or if investors’ timing is less than precise.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.