What A Fine Mess You Have Gotten Us Into
One week ago, I posted Oppose The Treasury’s Bailout Plan. Since then, most criticisms of Henry Paulson’s original proposal supposedly have been incorporated into the new compromise bill, including my criticisms.
But my concern at present is whether the bailout will work at all. I think the complexities of the reverse auctions on small illiquid distressed securitized assets will prove difficult. Further, the talk that the baioout won’t cost anything is highly unlikely. Of all of the US Government’s bailouts, only the Chrysler bailout made money. So long as you are in a fiat money system, in a bailout, the job of the government is to prevent contagion and minimize loss, in that order. Bailouts don’t make money, and that should not be expected.
But hey, if they are going to play for profit, let them play big. I was joking around when I wrote my article 2300 Smackers, and I am joking a little here as well. Why not use the $700 billion to capitalize 10 new banks with $70 billion of capital each? Let them lever up 10:1 — you have $7 trillion of buying power. Let the public participate along side the government and the power expands further. With a profit motive, they will buy and finance what makes sense, and five years from now, the government would sell its stakes, and pay down debt.
The rough part is that they have a non-profit-oriented main shareholder, looking to bail out dodgy institutions. Also, if the risk is smaller than $7 trillion, these institutions won’t do well. Also, what of the financials who don’t have government sponsorship? Couldn’t the government just take super-senior convertible bond stakes in institutions that are under duress? (Oh, that sounds like one-off bailouts? Could be a lot cheaper than the current plan…)
And what of the borrowing? Can this be funded at reasonable yields, and with the dollar at current purchasing power levels? I have my doubts, though the markets have been benign over the last few days.
Consider the actions of the Federal Reserve in concert with the Treasury. As I pointed out in Entering the Endgame for Monetary Policy,there is a panic quality to the Fed’s actions. This concept is endorsed by Brad Setser, Randall Forsyth, and Michael Panzner, among others. With the short term money markets in disarray, we have Asian Central Banks cutting rates, which aids the West, but increases inflationary risk.
Three notes to close:
- I don’t know what Monday will bring in entire, but a failure of Fortis seems likely. Note that the ECB is not on the hook here but the Belgian central bank (which probably feeds into their Treasury).
- What the FDIC did with WaMu affects other banks like Wachovia. Bidders will let the holding company fail, and bid for the operating bank subsidiary assets. Holders of holding company securities get hit, as their likelihood of getting reasonable recoveries disappears.
- We are putting a lot of faith in the health of Citigroup, Bank of America, and JP Morgan. If one of them fails, the game is over. Given their complexity, and the recent takeovers, the odds of there being a significant mistake are high. Consider further that they are counterparties for more than 50% of all derivative transactions, so the synthetic leverage is high as well.
All “solutions” to the crisis at this point in time are bad solutions. The time to act was 10-15 years ago, where we could have implemented contra-cyclical policies in bank regulation, as well as enforcing a strict separation between regulated and nonregulated financial intermediaries. (No ownership, no lending, no derivative agreements.)
I don’t know what next week will bring us. Last week was bad for me on a relative performance basis. My inclination is to look at companies that have good global demand, and not much debt. As for bonds, keep them short, unless you are buying long TIPS.
September 28th, 20086:15 pm at
I just don’t like the trickle down theory–that if you pump money into Wall Street, some of it will trickle down and everything will be all right. They think the solution to this whole mess is to get banks lending to people again. There are several problems with this belief:
1. This whole mess is the consequence of too much borrowing. The government’s solution is to get people borrowing again–interrupt the healthy deleveraging that is happening in the consumer sector.
2. Hopefully, if banks begin lending again, they won’t resume the lax lending standards that they had over the past 5 years. This implies that people will need to come up with down payments. According to the data, Americans generally don’t save and haven’t saved over the past several years.
3. If the government manages to stop the credit market dislocation, that still doesn’t address the broken consumer problem. This year, we have seen the consumer weaken considerably. We have also seen rising unemployment that has yet to hit consumer spending. Corporate earnings, in my opinion, decline dramatically from here and we will see a bankruptcy crisis outside of the financial sector as consumer cuts back on discretionary spending.
Now, you kind of joked above and I’ll joke here. Let’s have a trickly up bailout. The 600 stimulus checks we all got earlier this year cost 150 billion. At 700 billion, we could all get 2800 dollar checks. The way Americans manage their money, it would all end up in the bankers’ hands eventually. Why not have a trickle up bailout, which would be more palatable to Americans (who oppose this bailout more decisively than they elect a presidential candidate every 4 years).
September 28th, 20088:45 pm at
David wrote: “As for bonds, keep them short, unless you are buying long TIPS.”
But you just had two posts in the last week crowing about buying yieldy, long-duration financial bonds back in 2001-02. What’s changed?
And if you like TIPS, do you really think the real rate is attractive?
5 yr conventional Tsy = 3.06%
5 yr TIPS = 1.86%
5 yr TIPS coupon = 0.625%
So inflation expectations are 3.06-1.86=1.20%
1.20% - 0.625%= 0.575% real return
I’m just a bond newbie, so maybe I’m doing this wrong, but I’d sooner go with long conventional Tsy than TIPS here. Long Treasury yield are a classic lagged indicator, and inflation is clearly headed down in the short and intermediate term. I am confident of this because the bailout plan is not being financed with seignorage, but with further borrowing, which will retard future growth and therefore future inflation. Demand for Treasurys is extremely high, so supply concerns are overdone.
What I don’t get is why the arbitrage opportunity between FNM and FRE agency bonds and Treasurys is so wide….
September 29th, 20089:39 am at
I suggest that you seriously review your position. David Rosenberg chief economist at Merrill Lynch says all portfolios should be invested in LT treasuries NOT TIPS. I have been killed on my TIP positions. Rosenberg says we are in a deflationary environment which will last for some time.I wish I had taken his advice earlier.I concur with “bond newbie” above..
September 29th, 20084:31 pm at
Regarding TIPS I believe David is looking at the future, but I’m sure he’ll respond later and I shouldn’t try to speak for him. He’s several leagues above me, but even I knew one can’t lend to all who request a loan. I’m blessed to be in Treasurys. At some point, the massive U.S. spending will result in inflation.
September 29th, 20085:09 pm at
Regarding TIPS I believe David is looking at the future, but I’m sure he’ll respond later and I shouldn’t try to speak for him. He’s several leagues above me, but even I knew one can’t lend to all who request a loan. I’m blessed to be in Treasurys. At some point, the massive U.S. spending will result in inflation.
September 29th, 20086:16 pm at
The argument for buying TIPS is duration (which can also work against you). Disclosure: Long long TIPS.
PS: Beautiful day on the hill
September 29th, 20087:17 pm at
You say “we are putting a lot of faith in the health of Citigroup, Bank of America, and JP Morgan. If one of them fails, the game is over.”
What does this mean? That FDIC won’t insure these accounts? What are you talking about?
September 29th, 20088:44 pm at
Your example of recapitalizing the banks is the better way , similar to 1930’s RFC , much better than the Paulson - RTC version
October 8th, 20083:23 am at
Big Troubles for the Euro…
David Merkel submits: The Euro has been falling recently versus the Dollar. Why? There have been many theories proposed, but I want to offer my own theory this evening. Fiat currencies are political creatures, and are only as strong a…
October 22nd, 200811:24 am at
Belinda, what I mean is that BAC, JPM, C, and WFC are now so large that the government would have a hard time dealing with all of the knock-on effects if one went under.
Bond newbie, my apologies. Were I managing corporates now, I would not be aggressive yet. Too many things are breaking that don’t break in ordinary recessions. I do like the yield on TIPS now, and would be overweight, but not max overweight. I would be equal weight on credit now, there is enough spread to make things interesting.