Criticism of the U.S. Bailout Plan, Part 1

“The Devil Is In The Details” – Proverb

Joe Nocera’s September 19th column Hoping a Hail Mary Pass Connects in The New York Times offers some cogent criticisms of the U.S. government’s bailout program.

… the financial system has seized up. But so far, the government’s actions haven’t helped. Letting Lehman go bust may have sounded good at the time, but it has had disastrous consequences.”

It has led to complete chaos in the multitrillion-dollar market for credit-default swaps and was a crucial reason Morgan Stanley was forced to scramble to stay alive this week. It is also why questions were raised about the viability of Goldman Sachs, a firm with a pristine balance sheet and almost none of the bad assets that are bringing down other firms.

The rescue of A.I.G. further undermined confidence because, within the space of several days, the government did a complete about-face. The bailout suggested the Treasury Department was as confused about what to do as the rest of us.

So rather than help solve the crisis, the Treasury Department has actually contributed to the biggest problem in the market right now: an utter lack of confidence.

Nocera thinks that Criticizing Short Sellers is misleading at best.

The idea that short sellers are the cause of the problem “is more myth than fact, and in any case, it’s not the dynamic here.”

Stocks are falling because companies made huge mistakes that have caused them a heap of trouble. Indeed, in July and August, short interest in financial stocks declined by 20 percent. Why did the stocks continue to go down? Because there were too many sellers and not enough buyers: it’s that confidence thing again. Blaming the shorts is classic blame-the-messenger behavior.

While agreeing that we should save the Money Market Funds, he raises the question of moral hazard.

It bails out poorly managed money funds — the ones most likely to break the buck — at the expense of funds that haven’t taken the extra risk that causes a sudden drop in value.

And then there’s this: If you have your money in a bank account, only $100,000 is insured. But if you have it in a money market fund — which usually has a slightly higher yield precisely because it has a small element of risk — you now have unlimited insurance. It’s the world turned upside down.

Finally, when it comes to the actual Buying of Distressed Assets by the government, Nocera asks

How is the government going to assess these securities — and what price will it pay for them? In many cases, these securities aren’t being sold because they are still overvalued on a firms’ books. That is, their mark-to-market price is unrealistically high. Will the government buy it at the too-high price? If it does, the firms won’t have to take additional write-downs — but it will constitute a huge, unjustified bailout of Wall Street. (More moral hazard.)

But what if the government drives a hard bargain, and gets the securities for what they are really worth — 20 cents on the dollar, say, instead of 50 cents? In that case, the firms would have to take yet more enormous write-offs, which would further damage their balance sheets, and they would have to raise billions more in capital. Maybe the removal of these bad assets would allow the firms to raise the capital. But maybe not — meaning one or more could conceivably have to file for bankruptcy, creating yet another spasm of financial turmoil. It’s a huge roll of the dice by the government.

In conclusion, he says, “As much as we all hope the worst is over, it’s probably not.
And as much as we might hope that the government finally has the answer, it probably doesn’t.”

Not pretty, but there it is.

U.S. Government Fights Credit Crisis

“Desperate times call for desperate measures.” – Proverb.

This week has been among the most volatile on record for Wall Street and financial markets around the world. We came as close to a financial meltdown as I ever hope to see.

In today’s New York Times, the headline story, Vast Bailout by U.S. Proposed in Bid to Stem Financial Crisis described a “financial crisis that Fed and Treasury officials say is the worst they have ever seen.”

The Wall Street Journal said

“The federal government is working on a sweeping series of programs that would represent perhaps the biggest intervention in financial markets since the 1930s, embracing the need for a comprehensive approach to the financial crisis after a series of ad hoc rescues.

At the center of the potential plan is a mechanism that would take bad assets off the balance sheets of financial companies, said people familiar with the matter, a device that echoes similar moves taken in past financial crises. The size of the entity could reach hundreds of billions of dollars, one person said.”

How did we get here?

A previous post discussed one factor, the lack of risk management at various investment banks. In addition, we had lurched from one ad hoc case-by-case “solution” to another – from Bear Stearn’s forced buyout a few months ago, to the U.S. government’s take over of Fannie Mae and Freddie Mac to Lehman’s bankruptcy.

One of the world’s largest insurance company, AIG, was the next corporate giant to run out of money or the time to raise it. The cumulative effect of all of these unfavorable events was just too much for people to handle rationally.

According to the New York Times, by Thursday September 18th there was so much panic that “the Federal Reserve poured almost $300 billion into global credit markets and barely put a dent in the level of alarm.”

Buried deep within the Times article is this very upsetting quote:

“None of those actions, however, brought much catharsis or relief, with banks around the world remaining too frightened to lend to each other, much less to their customers.”

Banks afraid of lending to each other! Now, that’s a panic to remember.

Money Market Funds

And there’s more. Investors were worried about the safety of the $3.4 trillion invested in Money Market Funds. So much so, that the Feds have stepped in to reassure investors that these instruments remain ultra safe. Who ever thought that such reassurance would be necessary? (This totally unexpected concern resulted from one Money Market Fund suffering losses due to holding Lehman Brothers commercial paper.)

Short Selling Ban

And, finally, according to CNN.com:

“The U.S. Securities and Exchange Commission took what it called ‘emergency action’ Friday and temporarily banned investors from short-selling 799 financial companies.

The temporary ban, aimed at helping restore falling stock prices that have shattered confidence in the financial markets, takes effect immediately.

“This will absolutely make a difference,” said Peter Cardillo, chief market economists at Avalon Partners. “Short sellers are going to have to cover their positions very heavily.”

Granted, banning short selling is a controversial policy. Whether it will have a long term effect remains to be seen.

Finally, a Comprehensive Plan

This certainly seems like a comprehensive approach to all of the fear that has been present. The Feds to the rescue! Confidence has been restored. Democrats and Republicans actually working together! Without a doubt, “desperate times call for desperate measures.”

Orthodox free-market conservatives might argue that the markets would have (eventually) sorted all this out without government intervention. I, however, don’t think so.

Conclusion

How this will all play out remains to be seen. We are certainly seeing one of the strongest stock market rallies ever. Will this continue? Have we seen the bottom? No one knows, but it is a strong possibility.

In any event, we continue to recommend well-diversified, properly structured portfolios and a long-term buy-and-hold philosophy. No one we know was smart enough to have bought at precisely 1 PM on Thursday, September 18, 2008, the exact bottom of the decline.