Tuesday, September 30, 2008 0 comments ++[ CLICK TO COMMENT ]++

Thoughts On The Bailout and Related Issues

The bailout will likely pass in one form or another, now that presidential candidates John McCain and Barack Obama are asking for it to be supported. Some, such as Paul Krugman and John Hussman have argued that the Paulson plan misses the most important need: a need to provide additional capital to financial institutions. The linked article from John Hussman explains in clear layperson language why this bailout does not help the institutions in question, unless the government purposely overpays them. If the government does purposely overpay, it will raise ethical issues regarding who actually gets to make the decisions, who profits (or minimizes losses,) and so forth. A lot of left-leaning individuals, including me (I'm in Canada though,) have little faith the Bush administration. It already took the country on a totally ficticious war, fired attorneys that it did not like, formulated environmental policy in secret meetings influenced by industry, awarded very expensive military contracts with no, or in some cases questionable, bidding, and undertook massive tax cuts that are highly questionable. John Hussman speculates in an older article that the tax cuts, which largely went to the wealthy (most investors are wealthy), were recycled into the housing bubble, it might end up being the worst economic blunder by any government in several decades. It's one to thing to simply let a bubble blow bigger, but it's another to do so while significantly weakening the balance sheet of the nation. It's not clear who the Bush administration will "reward" by overpaying for assets (if they actually decide to overpay.)

Having said that, there is a reason Paulson and Bernanke are pursuing this even if it doesn't capitalize banks (unless they purposely overpay--Bernanke alluded to this with his 'hold-to-maturity' prices but no one has admitted to any solid numbers.) They, contrary to Krugman and others, feel that the lack of transparency and the lack of a market (many securites are supposedly not trading at all) are the big problems. They are betting a huge chunk of America's wealth that liquidity will solve the mess. People like me are skeptical but it remains to be seen.

It also seems that many so called free market supporters have started spouting nonsense. Going against what I said in my post yesteday, 24/7 Wall St is calling for the FedFunds rate to be cut to zero. A lot of these guys & gals are desperate and very short-term-oriented. I don't think I even need to go into it but to point out why that is a dumb idea, consider the side-effects. Why would any private investor provide short-term funding in such a scenario? One oft-ignored point in Japan is that the low interest rate has caused Japanese savings to flow to the rest of the world. Instead of it being invested in Japan, it ended up flowing elsewhere searching for higher yield. The low interest rates also led to their businesses being inefficent. If short-term rates are 0.5% and long-term rates are 3%, a business that can produce a 5% return is good enough (ever wonder why P/Es in Japan stayed high?).

Although I don't follow Austrian Economics--it's not science--one of the key reasons they don't want a central bank is because they would prefer if the interest rate is set by the market. If it was up to the bank, it can easily succumb to short-term desires of those on the Street and do something that mis-prices everything. Let's not forget that Alan Greenspan was considered a 'maestro' and was heaped praise all throughout his tenure, even though holding rates low kept blowing a bigger bubble. It's doubtful that the market would have kept rates that low for so long. I'm not against central banks but just presenting this view so that we can avoid one of the potential problems cited by the Austrian Economists.

24/7 Wall St is having a bad day today with another suggestion of bailing out hedge funds because their collapse will hurt the banks. Again, it's a ridiculous argument so I'm not sure it's worth saying much. Everyone seems to have forgotten that losses when things sour should accrue to the risk-taker. The biggest problem out there is leverage. Not just in banks but also in hedge funds. If hedge funds are bailed out, they will keep doing what they have always done. In fact, I would argue that some funds out there won't survive without leverage. That is, the only reason some of these funds seem to post good returns--returns worth paying 2% MER + 10% of profits--is because of leverage. Even a dumb guy like me can take a below-market 8% return and turn it into way-above-market 16% return with 2x leverage.

All of this is quite surreal for me. I consider myself left-leaning so I'm ok with select government intervention, bailouts, subsidies, and so forth. But now we are seeing all these self-proclaimed free-market supporters, ranging from publications like 24/7 Wall St to WSJ to private ones, calling for huge bailouts. Ironically, these were precisely the ones that were bashing government and calling for de-regulation all this time. It seems that the self-proclaimed capitalists have become communists.

I'm not against government intervention but there needs to be a high probability of real benefit... I just hope the Canadian government doesn't start doing something stupid soon.

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